BoardMatters Quarterly, April 2012

International political risk: considerations for audit committees

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If you aren’t going overseas, your competition will eat you alive, but there are many traps. You’ve got to be prepared.

Forward View by Tapestry Networks

Slow domestic growth continues to influence many US companies to invest in emerging markets.

The International Monetary Fund noted in January 2012 that, “Emerging markets account for around half of global economic output but, given the continued process of deleveraging across the rich world, [we] expect them to contribute over 80% of world GDP growth in 2012.”4

However, doing business in emerging markets introduces a host of complex political risks.

Audit chairs are increasingly concerned about political instability, economic uncertainty and risks related to their companies’ overseas investments. As one audit chair remarked recently, “If you aren’t going overseas, your competition will eat you alive, but there are many traps. You’ve got to be prepared.”

In a recent meeting of audit committee chairs, one noted, “Boards are terribly naïve about the real political risk our companies are exposed to in emerging markets.” In this and other discussions, audit committee chairs highlighted three political risks:

  • Security risks: “We had to close a plant in [one emerging market] because of the exploding violence there. It’s almost a lawless area, and we couldn’t even get employees to come to work.”
  • Changing local laws and regulations: “[In one emerging market], the government came in, enacted new tax laws and retroactively assessed [our company] for violations against those laws. You’ve got to be aware and be prepared for unexpected intervention.”
  • Political uncertainty: “Our business can grow [in one country] unabated except for the fact that the political leadership there is unpredictable. We have a tremendous amount of cash on our balance sheet, and we can’t emancipate it because of the currency controls. What are the implications for our financial statements?”

Leading practices for mitigating political risk

Most audit chairs noted that despite the significant risks in emerging markets, avoiding them is not an option. That’s where all the growth is.

Audit chairs shared the following practices as ways to mitigate political risk:

  • Look for unexpected risks. The board and audit committee should explicitly discuss the political risks that a company is accepting by investing overseas.

    One chair explained that some risks are calculated and unavoidable. “For example, if you are in the oil and gas industry, you know you are going to be in some areas where there is some political instability, but that’s a calculated risk that you have to take.”

    He went on to say that, “The risks that you don’t know about are the ones that can really hurt you. So it’s important for the board to get everything on the table before expanding into a country, especially an emerging market country.”

  • Nurture local relationships. Government relations are extremely important in emerging markets. One board travels to countries that are particularly important and meets with government officials. That board’s audit chair said that, “In some cases, the government is biased toward their own, homegrown companies. We found a way around that. We invested … with a partner that has strong credibility with the government, so we reduced our exposure.”
  • Establish strong oversight of country managers. Some companies prefer to use expatriates as country managers because they trust them to uphold the policies and ethical standards of the company.

    However, more companies are hiring locals as country managers because those individuals have the key relationships and the cultural sensitivity needed for the job. Regardless of whether the company hires a local or an expatriate, managing political risk is mainly the responsibility of the country managers. A leading practice is to have country managers present to the audit committee about the trends and emerging risks in their country.

  • Establish relationships with providers of emergency assistance services. Some audit committees use organizations to provide emergency backup. If there’s a coup, for example, a plan is in place to make sure local people can get immediate help.
  • Leverage internal audit and the external auditors. Internal audit can assess how well country risks are being mitigated. If things are not organized or well-documented, that’s a red flag.

    The external audit firm also can be a significant source of value. As one audit chair explained, “The auditors have a much broader perspective and can identify issues based on their experiences with other companies.”

Audit chairs acknowledge the considerable political risks inherent in expanding and operating in emerging markets and agree that avoiding these risks could mean a significant decline of market share. As a result, boards and audit committees continue to search for effective practices to identify and mitigate these risks.

Forward View is prepared by Tapestry Networks. Tapestry Networks organizes and leads nine audit committee networks with the active support and engagement of EY that collectively consist of 150 individuals, who chair more than 200 audit committees and sit on over 380 boards at some of the world’s leading companies. EY refers to the global organization of member firms of EY Global Ltd., each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm in the US.

Used by permission of Tapestry Networks. This article may not be reproduced, distributed, displayed or published without the express written consent of Ernst & Young LLP and Tapestry Networks.

4 World economic growth is originating almost exclusively from the developing world, The Economist, 24 January 2012.