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The impact of cultural paradigms on internal control frameworks

Introduction

Having previously worked extensively globally, in different cultures and with different languages, I recently started an assignment in South East Asia for a government organization to improve their internal controls, internal audit capabilities and their ethics and integrity framework.

One of the requirements of the current project is to develop and deliver relevant training to members of the Internal Audit Department that exists within the organization, as well as to senior management and other management members from provincial and regional offices.

South East Asia, as is well known, is improving rapidly economically, and the governments are generally aware of the need to increase transparency, reliability of reporting and levels of corporate governance to ensure a continuous in flow of foreign capital and know how into the country.

Internal audit has a unique position within an organization, on a micro level, and by implication on a macro level, country wide, to assist in achieving these objectives.  However, the effectiveness of Internal Audit is very much predicated on the way it is structured, its level of independence and the competence of resources available.

The on going challenge has been to present best practice drawn from my experience and based on international standards and benchmarks, in a location where there are many barriers to reaching these benchmarks.  The local management team has been somewhat worried that the model provided is ahead too far from current capabilities to implement effectively, and hence I included a section on cultural effects on internal control frameworks in their initial training course on the practice of Internal Audit.

Ever since I left Europe in 1981 I have moved about every 3 years to different locations on different contracts, obtaining and completing contracts with major multinationals.  I have as a result become profoundly aware of the differences and similarities between different cultures and within myself.  The point was rather bluntly made by a fellow Dutch person who remarked some years ago that I had learnt Dutch extremely well, as she no longer recognized me as a Dutch person.  I do not believe that her comment was necessarily based on my language or accent, rather I believe she had commented because of my behaviour and reactions to certain situations.

In essence, the past 15 years have been a revelation to me how an individual adapts to and absorbs different cultural aspects to allow him to survive in a succession of different environments without losing his identity, while retaining a core set of values and standards. This period has been marked by oftentimes great frustrations and also great breakthroughs to the point where I believe any person with the same level of experience internationally could truly be labelled a Homo Chameleonensis.

I believe a similar process is required in the adaptation of internal control frameworks and standards, including COSO, to different cultural entities, both countries or organizations.  We are aware of differences in cultural environments between, for example, private and public sectors, or private and public companies, and an understanding of these differences is crucial for an Internal Auditor to be effective.  In this article I will focus on cultural differences between countries and their impact on adaptation and implementation of effective internal control frameworks, with a final conclusion which may not appeal to everyone.

Cultural Paradigms

In the late 1990’s, in my search to answers on cultural issues that I was facing, I came across a book written by Geert Hofstede, a well respected researcher and social scientist from the Netherlands, who has written extensively on cultural paradigms and classifications.  Mr Hofstede and his colleagues undertook extensive studies through work groups and surveys to identify whether cultures could be categorized.  Instinctively, this is a sensitive issue, as it can lead to negative comparisons between cultures and stigmatization, but I believe the books written by Mr Hofstede have circumvented this problem very well, by basing their observations on statistical evidence.  In addition, my 26 years of wandering the earth have confirmed the acuity of observations, conclusions and definition of paradigms.  I would call the moment of reading and absorbing his book a great turning point in my search.

I will focus here on summarizing the key organizational issues deriving from their studies which they presented in different types of structures with labels.  Mr Hofstede proposed that culturally there are four different types of organizations.  Naturally some organizations in reality may be a hybrid, leaning more towards one or the other.  Two relevant types of organization are described below:

Family Organization

The family organization structure is, as would be expected, driven by powerful leaders who expect and receive respect through patronage.  Every employee is related to the whole organization through organic bonding and rules of engagement are similar to those applying to a family.  Age and length of experience are for example a major factor in determining progress in the organization.  Problems and issues are dealth with within the family acording to status and relationships.  There is no one right answer to any specific question or problem.

Eiffel Tower Organization

Eiffel Tower organizations, as you would expect them to be, are very mechanistic organizations where hierarchies and expectations are well defined.  To construct the Eiffel Tower one needs the right tools and materials to ensure following layers are supported, and there is little latitude in making decisions.  They are either wrong or they are right, or, as in the Tower, the steel used is either correctly gauged or not.  The culture of this organization is objective, rationale and leaves little room for emotionality.

History of Internal Audit

I will not spend a large amount of effort on describing each detailed step of the history of audit, which has been well covered in other articles and studies.  In my opinion there are a number of relevant key milestones which have created Internal Audit as we now know it, and which at the same time impact greatly on the type of organization that is required to support modern concepts of Internal Control and effective Internal Audit.  These milestones are:

The Dutch East India Company (Vereenigde Oost Indische Compagnie or VOC) was established in 1602, when the Government of the Netherlands granted it a monopoly to carry out trading activities in Asia. It was the first multinational corporation in the world and the first company to issue shares.

The Amsterdam Stock Exchange is said to have been the first stock exchange to introduce continuous trade in the early 17th century. The Dutch pioneered trading in financial instruments including short selling, option trading, debt-equity swaps, merchant banking, unit trusts and other speculative instruments.  This created the acceptance of the concept of separation between managers/ caretakers of a company and owners/ shareholders.

From the 1840’s we see the establishment of the first independent auditing firms in the United Kingdom.  This proces accelerated as a result of growth in number of Stock Exchanges, volume of trades and increasing demands from shareholders for assurance.  Many now famous auditing firms were established in the United Kingdom, including Deloitte, Coopers & Lybrand and Price Waterhouse.  These auditing firms independently reviewed and confirmed the reliability of company financial reports for the shareholders.  A “Nation of Shopkeepers” was coming of age.

Lifting the corporate veil with Salomon v. Salomon & Co. (1896), [1897] A.C. 22 (H.L.).  The ruling was a major decision of the House of Lords in the area of company law. The effect of the courts ruling was to firmly uphold the concept of a company as an independent legal entity.  The effect of Salomon v Salomon was to legally confirm the separation between the owners/shareholders of a company and the managers/ caretakers of companies, establishing the principles of duty of care and responsibilities.  This decision increased the exposure of caretaker managers to claims from shareholders.

From this moment onwards, with the technical revolution accelerating, the information age subsequently commencing, and the increasing regulatory requirements to protect investors, economies and capital markets from major disasters, during the 20th century we have seen a fine tuning of the concept of separation between owners and stewards of corporations, and an acceptance (now becoming global) that organizations serve their stakeholders rather than themselves.  This finds its expression in the concept of corporate governance, which is increasingly seen as a major contributor of both a company’s and a country’s wealth. 

The unremitting pressure to perform, create wealth and operate efficiently thereby created a uniquely mechanistic way of doing business, where rationality and logic allowed the best to survive amongst fierce competition.  From the foregoing one could conclude that anglo saxon commercialism, including concepts and definitions of Internal Control and Corporate Governance, has been and has become an increasingly dominant force during this period.

Application of Theory

In 2004 I was asked to conduct a workshop in a very large country in South East Asia for a major corporate, on the impact of culture on the effectiveness of implementing good corporate governance and improving the internal control environment.  For this company it was no option as they were listed on the New York Stock Exchange and needed to comply with the Sarbanes Oxley Act 2002 provisions.

Using the concepts previously discussed as a basis I asked a group of employees numbering 30, from all levels of the organization, to determine their current organizational structure.  Not surprisingly, they concluded themselves that theirs was a Family Organization.  When I asked them what they thought the desired organization would be to comply with Sarbanes Oxley Act and accepted concepts of corporate governance, they were quite clear that the Eiffel Tower organization would be the most appropriate.  In terms of their desired organization, they indicated a hybrid of organizations would be preferable.

For example, when asked how they would like to be viewed within the organization, about 30% of them answered they would prefer to be seen as family members, whereas 40% would like to be seen as human resources and 30% as specialists and experts in their field of work.

Impact on Corporate Governance structures

The results of this workshop, which from experience working in Asia can be replicated through the region to various degrees, will have a profound impact on the likely effectiveness of implementing any corporate governance and internal control frameworks within organizations outside the anglo saxon business world.

When presenting the results of the workshop to senior management and the Board of Directors of the organization it was clear that they created a major impact, not altogether positive.  Shortly thereafter there were discussions in which some directors voiced their opinion that it might be better to de-list from any western stock exchange due to the likely strain of superimposing a western cultural concept in Asian organizations.

An example was a discussion which I had with a senior operations manager while discussing the introduction of a Code of Conduct at the organization.  As far as he was concerned, no regional expansion of the distribution networks would be possible without some kind of gifts in the form of substantial sums of money to local decision makers.  In the absence of such gifts he indicated that local competitors without any formal requirements to adhere to any foreign regulations would certainly be able to fill the gap and gain market share through stronger distribution networks.

In the end the organization went in a direction of complying with form rather than substance. There is no doubt that outside stakeholders, without a full understanding of underlying substance, will be pleased with progress on corporate governance developments and improvement. The reality will unfortunately turn out to be rather different.

Conclusion

Cultural paradigms and their impact need to be carefully considered by organizations in cultures that are much different from the original cultures from which concepts of internal control and corporate governance originate.  The reality is that sooner or later, all globally aspiring organizations will need to move towards the Eiffel Tower organization structure, for reasons not just related to corporate governance but simply to ensure that they remain competitive. 

The real question that arises is whether, considering that culture is the result of thousands of years of evolution and change, it will ever be possible to meet the exacting expectations of anglo saxon inspired concepts, and what effect this will have on societies at large going forward.