The Marshmallow Experiment

Instant gratification takes too long

Who would ever guess that a brief observation of a four-year old alone with a marshmallow would be an excellent predictor of college entrance exam scores — twice as good a predictor as IQ test scores?

And an excellent guide to where an organisation's internal controls may be in decline.

In one of the most amazing developmental studies ever conducted, Walter Michel of Stanford created a simple test of the ability of four year old children to control impulses and delay gratification.

Children were taken one at a time into a room with a one-way mirror.

They were shown a marshmallow.

The experimenter told them he had to leave and that they could have the marshmallow right then, but if they waited for the experimenter to return from an errand, they could have two marshmallows.

One marshmallow was left on a table in front of them.

Some children grabbed the available marshmallow within seconds of the experimenter leaving. Others waited up to twenty minutes for the experimenter to return.

In a follow-up study, children were tested at 18 years of age and comparisons were made between the third of the children who grabbed the marshmallow (the "impulsive") and the third who delayed gratification in order to receive the enhanced reward ("impulse controlled").

The third of the children who were most impulsive at four years of age scored an average of 524 verbal and 528 math on their SAT scores.

The impulse controlled students who scored 610 verbal and 652 math.

This astounding 210 point total score difference on the SAT was predicted on the basis of a single observation at four years of age!

The 210 point difference is as large as the average differences between that of economically advantaged versus disadvantaged children and is larger than the difference between children from families with graduate degrees versus children whose parents did not finish high school.

At four years of age gobbling a marshmallow now v. waiting for two later is twice as good a predictor of later SAT scores than is IQ. Poor impulse control is also a better predictor of later delinquency than is IQ.

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So what does this tell us about internal control environments.

You will be not surprised when Honestly Lay Bare says that it tells us an enormous amount.

The separation of a population between impulsive and impulse controlled and the correlation between those two populations as to future success suggests that the short term rewarding of employees may indeed have a negative impact on the success of the company.

As such, where you see an incentive program that is heavily weighed towards the short term (relatively real time gratification) against a program that has medium to long term incentives (deferred gratification) be warned.

The internal control environments based on real time gratification are likely to be ones where there is inbuilt underperformance and inefficient process (as there is no long term reward for sustaintable practices).

The internal control environments based on deferred gratification are likely to be ones where there is an incentive to ensure that the processes introduced are as at least sustainable to the point whereby the employee receives their reward.

**

All that from a marshmallow!

The Thieving Nun

A thief believes everybody steals

Two of England's most famous people come from West Wickham.

Enid Blyton, the writer and W.G. Grace, the cricketer.

Perhaps less well known is Colleen McCabe but remembered she will be in West Wickham for as long as records of misdeeds are kept.

From 1974 to 1989 she was a nun with the Sisters of Charity of St Vincent de Paul.

After 15 years she decided to become a teacher, and joined St John Rigby Roman Catholic School where she was made headteacher in 1991.

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If you walk up Layhams Road in West Wickham you will see All Saints Catholic School.

All Saints Catholic School was previously St John Rigby Roman Catholic School.

Opened in 1979, St John Rigby Roman Catholic college was a voluntary aided school, maintained in partnership with the Roman Catholic Archdiocese of Southwark. Staff at the school were employed by the governing body.

Between 1994 and 1999, St John Rigby college lost at least £500,000 as McCabe forged signatures and lived a high life financed by the school's corporate credit card.

McCabe, bought Gucci jewellery, meals at fine restaurants, West End theatre "extravaganza" trips, a journey on the Orient Express and sunshine holidays.

Meanwhile her school went from one financial crisis to another, with a library full of empty shelves and teachers having to clean their own classrooms.

On top of her use of the school's credit card, she made "substantial withdrawals" from school accounts to clear personal credit card excesses.

Between January 1993 and September 1999, the school was grant maintained, and it was the freedom of this status that allowed McCabe to steal without fear of discovery. Grant maintained schools were free to buy services where they wished, and St John Rigby's governors chose not to use Bromley council's auditors.

The two firms of auditors employed by the school missed the thefts.

Baxter & Co of Orpington and MacIntyre of Holborn were criticised by the trial judge. Gaping holes in the accounts that both firms apparently missed were spotted by Bromley's auditors "within a day of looking at the books", said the presiding judge at McCabe's trial..

In the same period, the school was given a clean bill of health by Ofsted (Office for Standards in Education, Children's Services and Skills as part of Her Majesty's Chief Inspectors of Schools).

Inspectors visited the school in 1996, 18 months after McCabe began using the school funds as a personal bank. Ofsted reported that "the principal and the senior management team provide strong leadership and a clear ethos".

Moreover, inspectors thought McCabe provided "strong, sensitive and skilful leadership". Financial planning and administration were "good". The school provided "good value for money" and the auditors' report was "excellent".

An Ofsted spokesperson said inspectors were not auditors and had relied upon the accounts and the auditors' report. But that doesn't explain their failure to spot a headteacher who staff described as a "bully and a despot"

McCabe's thieving came to light in 1999, with the end of grant maintained status.

Bromley Council took over control of the school and their auditors made a routine visit. What they found led first to the suspension of delegated powers - in effect the school was no longer allowed control of its day-to-day budget - and McCabe's arrest followed swiftly afterwards.

Three years later she was beginning a jail sentence.

On Board

Nearly all men can stand adversity, but if you want to test a man's character, give him power.

Honestly Lay Bare has as its mission statement - well at least what it wrote on Day One of setting up its website and it needed something to fill the front page! - that it would mostly focus on internal auditing, risk management and corporate governance but that there would be times when interest takes us down paths less busy yet not less interesting.

Well today we combined one of the key themes of Honestly Lay Bare - corporate governance - with one of the less travelled paths that we like to amble down.

Our journey today takes us through the smokey corridors of the history of the concept of a Board of Directors.

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Let's start at the top - the role of the Chairman.

It is often said Chairman has its origins in 10th century Kingdom of England when the king or his spokesman sat alone in a chair before the group, who sat on benches.

Anyone that has ever been to a Board meeting will realise that not much has changed in 1,100 years!

The history of Boards is somewhat less clear - other than to say that it was an incremental development.

Until the end of the nineteenth century, it seems to have been generally assumed that the general meeting (of all shareholders) was the supreme organ of the company, and the board of directors was merely an agent of the company subject to the control of the shareholders in general meeting.

A 1906 English Court of Appeal (the second most senior court of the English court system) changed all that.

In the case of Automatic Self-Cleansing Filter Syndicate Co v Cunningham [1906] 2 Ch 34 (HLB: why do the great precedent cases always involve companies with such wonderful names) it was held that the division of powers between the board and the shareholders in general meeting depended upon the construction of the Articles of Association and that, where the powers of management were vested in the board, the general meeting could not interfere with their lawful exercise.

The Articles were held to constitute a contract by which the members had agreed that "the directors and the directors alone shall manage."

The new approach did not secure immediate approval, but it was endorsed by the House of Lords in Quin & Artens v Salmon [1909] AC 442 and has since received general acceptance.

Under English law - and by extension most Western world corporate systems - unless the directors are acting contrary to the law or the provisions of the Articles, the powers of conducting the management and affairs of the company are vested in them.

The modern doctrine was expressed in Shaw & Sons (Salford) Ltd v Shaw [1935] 2 KB 113 by Greer LJ as follows:

"A company is an entity distinct alike from its shareholders and its directors. Some of its powers may, according to its articles, be exercised by directors, certain other powers may be reserved for the shareholders in general meeting.

If powers of management are vested in the directors, they and they alone can exercise these powers.

The only way in which the general body of shareholders can control the exercise of powers by the articles in the directors is by altering the articles, or, if opportunity arises under the articles, by refusing to re-elect the directors of whose actions they disapprove.

They cannot themselves usurp the powers which by the articles are vested in the directors any more than the directors can usurp the powers vested by the articles in the general body of shareholders."

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This takes Honestly Lay Bare to the point where we start wondering about the future.

Can we envisage a time when the near century old precedents that are the foundation of the Board's authority be dismanted and if so how?

For the perpetual record of those that will be reading Honestly Lay Bare in 100 years time - we are a confident bunch here at HLB that we will be still around and / or our writings are immortal - we predict that the role of the Board of Directors will change fundamentally ... and within our lifetime.

There is a tide of e-democracy that is slowly sweeping over forward thinking Governments.

Once that wave hits the shores of our Parliaments it will be only a matter of time before it washes over our corporate structures as well.

How will it manifest itself - we don't know.

But we can see the swell rising in the distance.

Hold on for an amazing ride.

Yum!

One a penny, two a penny ...

Honestly Lay Bare and Mrs Honestly Lay Bare have a beautiful, loved, loving and very, very, very, very special 20 month old daughter.

Little Honestly Lay Bare has just discovered the joys of hot cross buns.

In this Easter edition we will look at what Little's love of hot cross buns teaches us all about risk analysis.

A hot cross bun, or cross-bun, is a type of sweet spiced bun made with currants or raisins and leavened with yeast. It has a cross marked on the top which might be effected in one of a variety of ways including: pastry, flour and water mixture, rice paper, icing, or intersecting cuts.

In many historically Christian countries, buns are traditionally eaten on Good Friday, with the cross standing as a symbol of the crucifixion. They are believed by some to pre-date Christianity, although the first recorded use of the term "hot cross bun" is not until 1733.

It is believed that buns marked with a cross were eaten by Saxons in honour of the goddess Eostre (the cross is thought to have symbolised the four quarters of the moon).

English monarchs saw the buns as a dangerous hold-over of Catholic belief in England, being baked from the dough used in making the communion wafer. Protestant England attempted to ban the sale of the buns by bakers but they were too popular, and instead Elizabeth I passed a law permitting bakeries to sell them, but only at Easter and Christmas.

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And it turns out that hot cross buns are a great analogy for the deficiencies of modern risk management.

How?

Well - a sweet spiced bun made with currants or raisins and leavened with yeast WITHOUT the cross is by a large margin a LESS popular item in a bakery than if the sweet spiced bun made with currants or raisins and leavened with yeast that HAS a cross on it. (Authority: Honestly Lay Bare's mother in law's local baker!).

Yet - aren't they the same product and isn't the cross merely superficial dressing?

A rationale eye would suggest that they are in the sense that the product - with or without the cross - fulfils the same basic need, being that of nurishment.

And therein lies the link with risk analysis.

Often risk management frameworks look at similar events, issues, products, controls etc and assume that they perform the same function in the same way that a rationale eye assumes that a bun - with or without a cross - performs the same function.

What is missing, however, in such frameworks is that nearly identical events, issues, products, controls etc can have fundamentally different outcomes and yet our bias draws us to another conclusion.

It is difficult to propose what mechanism we could put in place to correct this bias.

Perhaps no formal mechanism is needed as such and all we need is to self acknowledge that such bias exists.

In doing so not only do we take our risk analysis to another level but - sadly for the discipline of risk management - we call out its inherent weaknesses.

Gut Feel

Instinct is untaught ability

Honestly Lay Bare lives near a Mercedes dealership (and for the astute reader ... yes also near a McDonald's with a police only parking sign!).

At this Mercedes dealership they have been maintaining for the last couple of weeks a countdown clock for how many cars they can sell within a specified period of time.

To the best of Honestly Lay Bare's albeit limited abilities, it appears that the countdown clock is part of a marketing campaign to show that Mercedes are somehow (don't ask us how - for that is definitely way beyond our cognitive abilities!!) immune from the global financial crisis.

Perhaps we have, all this time, misunderstood the Mercedes value proposition, but Honestly Lay Bare always viewed this brand as a luxury good where there was flexible demand dependant upon the prevailing economic circumstances.

Lo and behold it turns out that Mercedes are actually a necessity and demand for them actually increases in times of once every 80 years economic uncertainty. (The sign at the dealership would suggest that they are offloading more than a car a day!).

**

This brings us to the concept of outliers.

In statistics, an outlier is an observation that is numerically distant from the rest of the data.

They can occur by chance in any distribution, but they are often indicative either of measurement error or that the population has a heavy-tailed distribution.

Honestly Lay Bare is probably not inventing a new economic concept when it observes that the Mercedes sales data is an outlier to nearly every other piece of economic data currently being published.

Which brings us to what it is that we - as people interested in outliers (well you were up to this point!!!) - should indeed do when confronted with one.

In the first instance an outlier demands examination.

Why is it an outlier and what is causing the variation from the norm.

This is the reasonable, sound and sensible approach.

The second approach - and the one that many people often miss in their analysis of risk distributions - is, is the outlier the warning sign of an underlying trend?

It is this latter use of outliers that is often overlooked.

What if the sale of Mercedes was actually disproportionately related to the current health of the economy?

What would you do with that information.

This brings us to today's Honestly Lay Bare sermon - we see outliers in our work environments every day and, whilst we acknowledge them, we very rarely do anything with the information that the outliers contain.

For each circumstance there will be a different outlier so the challenge - and the profit - lies in identifying which ones are false positives and which ones are prophets.

The difference between the two will define the risk environment that you operate it.