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Why do companies fail?

Author: ICAEW Insights

Published: 21 Sep 2023

Corporate governance and internal control weaknesses are often the root cause of corporate failure. However, without fully understanding the subtleties at play, revisions to the Corporate Governance Code will only go so far in addressing the problems.

Understanding human behaviours, analysing international and cross-cultural examples and applying insights from diverse fields including economics, sociology and law could shed light on the reasons why companies fail – and highlight how academic research can help provide businesses with insights to help understand and reduce the risks of corporate failure.

The government White Paper, Restoring Trust in Audit and Corporate Governance, highlighted that where companies fail without obvious signs of weakness in their annual reports, internal control weaknesses are often the root cause. 

And yet, in recent years internal control, assurance and resilience “have not attracted the attention they deserve”, in the words of David Styles, Director of Corporate Governance and Stewardship at the FRC, in his foreword to the consultation document. 

Improving director accountability for effective internal control, assurance over controls and reporting on resilience provide potential solutions to the issue of surprise failure and the FRC’s commitment to improving these areas is to be applauded.

However, while an update to the Corporate Governance Code is certainly a stepping stone on this journey, it should not be seen as the end destination. Currently, there is insufficient investigation into the causes of surprise corporate failure to be able to suggest potential remedies or ways to mitigate the risk of failure. 

For this reason, ICAEW, funded by its charitable trusts, has initiated a research project to investigate the causes of corporate failure, specifically focusing on internal control and corporate governance, with the goal of uncovering evidence and providing practical risk mitigation solutions. Initial analysis highlights three key areas to strengthen corporate governance against the risk of unexpected failure, leading to three essential questions that boards and advisers could ask to start to unpack failure risk.

1) Behaviour

 What incentivises people to behave in a certain way? How do their behaviours contribute to particular outcomes? The way that “pathological” personality characteristics can play a part in governance malpractices and misconduct is a critical dimension of corporate governance research that our analysis shows has often been overlooked.

To better understand this, factors to explore include ethical decision making, organisational culture, risk appetite, leadership quality, stakeholder relations and behavioural biases. These areas are known to influence organisational outcomes, and potentially contribute to corporate failure. Organisations could start by asking what mapping and analysis of these factors has been done, and how matters arising have been addressed.

2) Best practice

What works well elsewhere and why? Research has shown, for example, that countries with strong shareholder rights tend to have lower rates of corporate failure. International and cross-cultural research on corporate governance is enabling us to carry out comparative analyses of different corporate governance models and practices around the world. This can help to identify universally applicable practices as well as those that are culturally specific, and can help us enrich our understanding of effective governance. It will take some time before these learnings can be drawn on in the regulatory framework.

More immediately, organisations could ask what governance practices are seen to work well within their own networks. Where a particular approach is viewed as specific to a cultural or national context, why is this and are there lessons that could be learnt?

3) Outside insights

What could I apply from a different context? Integrating insights from diverse fields such as economics, psychology, sociology and law is providing innovative insights into the causes, prediction and prevention of corporate failure. A multidisciplinary approach is giving academics a more comprehensive and robust understanding of the complex factors contributing to corporate failures, fostering innovation and continuous improvement in addressing this critical issue. We could learn from this to, for example, find inspiration from medical research or in industries with robust root cause analysis systems, such as the airline industry.

Organisations could ask what insights are available from other contexts – internally or within their networks – that could help strengthen governance. For example, a business might have strong controls over a business critical operation that might provide inspiration, or a replicable model, for control enhancement elsewhere.

Building research insights

Overall, we believe that academic research can not only identify the causes of corporate failure but also guide the development of evidence-based solutions that can inform policy development, enhance our understanding of effective governance, and contribute to a more resilient and proactive business environment.

The response to the call for literature reviews underscores the significance of academic research in comprehending the factors, both internal (boards and audit committees) and external (regulators, market dynamics, and social influences), that prevent corporate failures and charting the path toward effective solutions.

Identifying patterns and trends: By systematically analysing likely contributing factors such as financial mismanagement, market volatility, leadership deficiencies, and external economic influence, academic research can identify patterns and trends in business failures. This evidence-based approach can help to pinpoint common issues and guide future solutions.

Delving into root causes:  Beyond surface-level explanations, academic research can delve into the root causes of failure, crucial for sustainable solutions addressing core issues instead of symptoms.

Correlation and interplay of factors: Data-driven insights can establish causality and uncover intricate relationships between factors, enabling tailored solutions and preventative measures.

Preventive models: Academic research on corporate governance could facilitate the development of predictive models and early warning systems. By predicting potential issues, businesses and policymakers can take proactive measures to mitigate risks.

We plan to publish initial findings of the research in Q1 2024, with confidence that these insights will benefit regulatory and policy development and find direct applications in businesses. This research complements ongoing efforts to educate members on corporate risk mitigation.

We have collaborated with Professor Sir Andrew Likierman of London Business School to provide resources on professional judgement, and are working with the FRC to apply this thinking to help skills development. 

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