Financial literacy is the key to raising our game

November 18, 2005

The link between accountability and accounting is crucial to institutions' good governance, says Nigel Savage

Much has been written in recent years about the accountability burden in the private and public sector. In the private sector, regulation and disclosure have traditionally been seen as the price of limited liability and access to markets. In the public sector, it is the price of receiving public funds and ensuring that institutions contribute to the strategic development of the sector.

The Higher Education Funding Council for England is carrying out a consultation called "Accountability for Higher Education Institutions", or the so-called "single conversation". It is a good example of a regulator entering into a dialogue with the regulated. The aim of the conversation is to reduce the cost and burden of regulation while preserving accountability.

The single conversation is not a wholly self-regulating framework. But to the extent that higher education institutions are in effect self-regulating, then the accountability burden from Hefce can be correspondingly reduced.

Self-regulation must be strong enough to enable organisations to identify and address not just serious immediate financial weakness but also risks that could threaten the viability of institutions that, on the face of it, appear to be in robust health.

My own research 25 years ago into corporate accountability left me with a somewhat cynical view of the value of self-regulation. In the private corporate sector, it largely failed because assumptions were made that the pillars of self-regulation - non-executive independence and audit - were functioning effectively, when in reality they were not.

The system is now much improved, partly thanks to the right mix of direct legal regulation and heightened awareness of the role of non-executive directors as well as improved professional standards in the audit profession.

At the heart of self-regulation, it is necessary to have strong, independently minded, financially aware members on the main board and the audit committee. Independent members should be strong enough not just to challenge the management and the auditors on the annual accounts, but on the institution's risk management, internal control and overall governance arrangements.

The success of the audit committee depends in turn on the nominations committee being able to deliver individuals with the right skills and, in the case of higher education institutions, who are prepared to provide their services pro bono .

Financial awareness is an absolute requirement for membership of an audit committee. In my own sector of law, sadly, too few law-firm partners are aware of the financial and business context in which their firms and clients operate.

Such awareness is not about being an accountant. It is about the ability to understand the importance of the accounting judgments made by management, why management makes them and the impact of those judgments on the financial statements.

Roman Weil from the Chicago Graduate School has recently carried out research into this area. He asserts that it is not sufficient to ask tough questions "unless members have the awareness to evaluate the answers and ask proper follow-up questions".

Professor Weil has gone further and carried out research grading members of audit committees for financial literacy and then tracking the stock market returns of the companies.

His findings show a clear correlation between the performance of a company and the financial literacy of members of the audit committee. In other words, raising the level of financial awareness significantly "raises the game of those companies that make the effort".

There are clearly lessons here for the higher education sector. We still have work to do in terms of the balance of the relationship between the executive and non-executive roles in the sector.

The Committee of University Chairmen has performed valiantly given the limited resources to which they have access. Their Guide for Governing Bodies is an exemplary manual on governance and accountability, but it is only a start.

We need to do much more to underpin the role and independence of governing bodies and assist in raising the financial awareness of members of audit committees in a sector that has complex financial arrangements and considerable emerging challenges to financial stability.

Nigel Savage is chief executive of the College of Law of England and Wales, a board member of the Higher Education Funding Council for England and chairman of the Hefce audit committee.

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