CH7 Textbook Corporate Governance - Rankin PDF

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LEARNING OBJECTIVESAfter studying this chapter, you should be able to: 7 reflect on why there is such a high level of interest in corporate governance 7 communicate what corporate governance is and justify why good corporate governance systems are needed 7 critically analyse the relationship between...

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CHAPTER 7

Corporate governance LEA RNING OBJECT IVES After studying this chapter, you should be able to: 7.1 reflect on why there is such a high level of interest in corporate governance 7.2 communicate what corporate governance is and justify why good corporate governance systems are needed 7.3 critically analyse the relationship between positive accounting theory and corporate governance 7.4 reflect on the key areas involved in corporate governance 7.5 justify the alternative approaches to corporate governance 7.6 reflect on recent developments and issues in corporate governance 7.7 critically analyse the role and impact of accounting in and on corporate governance 7.8 justify the connection between corporate governance and corporate failure

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7.9 critically analyse the role of ethics in corporate governance 7.10 reflect on international perspectives and developments in corporate governance.

Rankin, Michaela. Contemporary Issues in Accounting, 2nd Edition, Wiley, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/murdoch/detail.action?docID=5049576. Created from murdoch on 2020-11-04 06:26:09.

Agency relationship and problems

Corporation Other stakeholders

Shareholders

Employees

Managers /directors Affected by: Business environment

Social environment Corporate governance practices and procedures Regulatory environment

Legal environment Rules

Principles Culture

Ethics

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Focus on

Controlling the directors and managers

Role and rights of shareholders and other stakeholders

Transparency and accountability

CHAPT ER 7 Corporate governance 201

Rankin, Michaela. Contemporary Issues in Accounting, 2nd Edition, Wiley, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/murdoch/detail.action?docID=5049576. Created from murdoch on 2020-11-04 06:26:09.

How corporations are managed affects all our lives. They control a large part of the resources of this planet and are increasingly the dominant form of economic organisation. Clearly, decisions made by the people who run corporations affect the prosperity of individuals directly involved with the particular corporations (such as their shareholders and employees) but their decisions also have a much wider impact. In some instances those running companies have abused their positions or been accused of mismanagement and corporations have been found wanting. The global financial crisis, the collapses of Enron and WorldCom in the United States, the collapse of ABC Learning in Australia and companies polluting the environment, including the BP Gulf of Mexico oil spill, are examples. Ideally, we want those in positions of responsibility in companies to run them properly and to make the right decisions. How can we try to make sure that companies act appropriately? ‘Corporate governance’ is the term used to cover the series of principles, mechanisms or procedures developed to this end, and this chapter focuses on some of the underlying causes of corporate governance problems and the role of accounting in effective corporate governance. The role of corporate governance practices in relation to corporate failure is also explored in some depth. It must be remembered, however, that decisions are made by people, and so there is a need to consider the behaviour of individuals in companies; this involves us looking at the role of ethics in corporate decision making.

7.1 The interest in corporate governance LEARNING OBJECTIVE 7.1 Reflect on why there is such a high level of interest in corporate governance.

Over the past decades, interest in corporate governance practices has increased as a direct result of highly publicised cases of corporate misconduct and concerns over the management of corporations. There is also a growing realisation that good corporate governance can not only help in avoiding problems but can also provide other advantages. Although the corporate structure has many advantages (such as facilitating capital investment and limiting some risk, through the limited liability afforded to shareholders), the separation of the management of the corporation from those who contribute resources (such as shareholders) can lead to problems.

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Problems with the management of corporations Various examples show what type of problems may occur. • Those managing a company may use the resources to benefit themselves (rather than shareholders). Often this can involve fraud for example, in the case of Bernard Madoff where a Ponzi scheme was used to defraud investors1 and in the case of Parmalat where documents were forged to hide debt and flows of cash to family members.2 However, it is often more subtle and in many corporate scandals it has been argued that false reporting has sometimes been motivated by the desire to maintain the value of benefits provided to corporate managers (such as the value of share options). • Corporations may take actions that shareholders (or society) may not consider desirable. For example, Mitsubishi in Japan failed to inform customers of potential safety problems with vehicles or recall the vehicles for repair, which allegedly led to accidents including one resulting in the death of the driver.3 • Corporations may hide or provide false information to shareholders to avoid consequences. For example, Enron failed to inform shareholders of the true level of debt, WorldCom incorrectly recorded expenses as assets to increase reported profits, and during the global financial crisis Lehman Brothers was accused of using creative accounting to hide debts.4 • In recent times a disparity (‘mismatch’) has been perceived between the payments received by the managers of corporations and their performance, with directors and executives of corporations receiving massive payments and benefits even when corporate performance is poor or declining. Although these examples may be the focus of media attention, high‐profile corporate scandals and misconduct are not recent occurrences. Of course, it could be argued that the problems mentioned areinevitably part of the risks of doing business and the history of corporations for more than the past100 years is associated with regulations to protect the public, usually in response to corporate scandals or failures. Thesehave 202 Contemporary issues in accounting

Rankin, Michaela. Contemporary Issues in Accounting, 2nd Edition, Wiley, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/murdoch/detail.action?docID=5049576. Created from murdoch on 2020-11-04 06:26:09.

included the need for financial statements and audits. However, good corporate governance practices go beyond reporting and regulations. Furthermore, the risks in not having good corporate governance practices are high, not only to individuals who may be directly involved with specific corporations, but to business and the economy in general. Failures in corporate governance practices have been linked to the recent global financial crisis. For an individual company, the failure to assure others that it has good governance practices can reduce its value; for the economy, a lack of public confidence in corporations can result in reduced economic growth. Given the key role that financial reporting and auditing play in corporate governance, failures or poor corporate governance also risks a loss of confidence in the accounting profession itself.

Advantages of good corporate governance Companies that can demonstrate good corporate governance practices have advantages. With the increasing globalisation of business and competition for capital, companies that can provide assurances that the company is being appropriately managed can gain a competitive edge. Reducing perceived risks to investors can reduce the cost of capital. Furthermore, the expansion of company shareholdings to a broader base (in many countries, small shareholders are becoming increasingly common, either by direct investment or indirectly through their superannuation/pension plans), combined with more organised and active shareholders lobby groups, is placing more scrutiny on company management. A key reason for the interest in corporate governance and many of the current prescriptions for best practice is that they are needed for an efficient market and to facilitate economic growth: The presence of an effective corporate governance system, within an individual company and across the economy as a whole, helps to provide a degree of confidence that is necessary for the proper functioning of a market economy. As a result, the cost of capital is lower and firms are encouraged to use resources more efficiently, thereby underpinning growth.5

7.2 What is corporate governance? LEARNING OBJECTIVE 7.2 Communicate what corporate governance is and justify why good corporate governance systems are needed.

Corporate governance in very simple terms is ‘the system by which business corporations are directedand controlled’.6 The definition of corporate governance used by the Organisation for Economic Co‐operation and Development (OECD) explains this as:

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the procedures and processes according to which an organisation is directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organisation — such as the board, managers, shareholders and other stakeholders — and lays down the rules and procedures for decision‐making. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.7

A good corporate governance system ensures that the corporation sets appropriate objectives and then puts systems and structures in place to ensure that these objectives are met, and also provides the means for others, both within and outside of the corporation, to control and monitor the activities of the corporation and its managers.

Corporate governance stakeholders The determination of whose interests are to be protected and what are appropriate objectives of the corporation are central questions and will influence the related corporate governance systems. The traditional view of the role of the corporation is best stated by Milton Friedman who argued that: Corporate governance is to conduct the business in accordance with the owner or shareholders’ desires, which generally will be to make as much money as possible while conforming to the basic rules of the society embodied in law and local customs.8 CHAPT ER 7 Corporate governance 203

Rankin, Michaela. Contemporary Issues in Accounting, 2nd Edition, Wiley, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/murdoch/detail.action?docID=5049576. Created from murdoch on 2020-11-04 06:26:09.

This view that corporate governance relates to ensuring that the interests of the key providers of capital to the corporation (the shareholders) are met underlies many of the current requirements and practices in corporate governance. This view is referred to as the ‘Anglo‐Saxon’ model and is the basis for many current corporate governance models including in Asia where there is convergence to this model.9 This approach views a key role for corporate governance as enabling the efficient use of resources by helping financial markets to work properly and gives priority to shareholder value.10 The Anglo‐Saxon model tends to focus on the problems caused by the relationship between managers and owners (because of the agency relationship discussed in the next section) and often takes a control‐ oriented approach, concentrating on mechanisms to curb self‐serving managerial decisions and actions. A wider view and more pluralist model that is increasingly being supported is that the responsibility of corporations goes beyond the narrow interests of shareholders and should be extended to a wider group of stakeholders. For example, German models of corporate governance emphasise multiple stakeholders, while other European countries have more focus on employees. Corporate governance systems are increasingly considering stakeholders beyond the traditional shareholder groups, and a range of models exists with varying emphases on stakeholders and views of corporate responsibility. This extension of corporate responsibility is also discussed in the chapter on sustainability and environmental accounting. Before considering what is involved in practising good corporate governance and briefly examining current guidelines, the next sections consider why there may be a problem with corporate governance and one dominant positive theory in accounting linked to this.

7.3 The need for corporate governance systems LEARNING OBJECTIVE 7.3 Critically analyse the relationship between positive accounting theory and corporate governance.

Corporate governance rules and prescriptions are needed because of the nature of the company structure. This, at least for all but small family companies, means that the people who have provided the resources to the company (the shareholders and lenders) do not actually run the company directly. These capital contributors need to rely on managers. This separation between capital contributors and management is the source of many issues and problems relating to corporate governance. It could be argued that if managers behaved properly (i.e. acted as though they had contributed the capital), there would be no difficulties. Alternatively, people could opt not to contribute capital to companies; rather, they could only invest in businesses that they themselves manage. A dominant positive theory, positive accounting theory, provides an explanation why these things do not happen and why managers may bias or distort the financial statements. This stream of accounting theory and associated research is referred to as accounting policy choice research and is based on agency theory. It is often referred to simply as ‘positive accounting research’ because it has been the prevalent positive paradigm in accounting research for more than 30 years.

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Positive accounting theory and its relationship with corporate governance As noted previously, many problems with corporate governance are caused by the separation of management and the owners of capital. So why have this separation? With contracting theory as its starting point, positive accounting theory explains that for efficiency reasons companies or firms are formed and can be viewed as a network of contracts or agreements that determine the relationships with and among the various parties involved in the firm: suppliers, employees, distributors, shareholders, lenders and so on. One important agency relationship that arises from this nexus is that between the managers and the capital contributors (such as shareholders), as shareholders authorise the managers to make the key business decisions. An agent is considered ethically and often legally to have a fiduciary duty. This means that the agent (i.e. the manager) is placed in a position of trust and assumes a duty to act in good faith and should act in the best interests of the principal (i.e. the shareholder). As outlined in the chapter on theories in accounting, there is a common assumption in economic theory which is, if individuals are rational, they will act in their own best 204 Contemporary issues in accounting

Rankin, Michaela. Contemporary Issues in Accounting, 2nd Edition, Wiley, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/murdoch/detail.action?docID=5049576. Created from murdoch on 2020-11-04 06:26:09.

interests. Therefore, although managers should supposedly make decisions that are best for the principals, in some instances they will make decisions that maximise their own wealth rather than the principals’. Principals are also rational and will expect that the managers will not always act in the shareholders’ interests. This leads to three costs associated with this agency relationship. • Monitoring costs. These are costs incurred by principals to measure, observe and control the agent’s behaviour. • Bonding costs. These are restrictions placed on an agent’s actions deriving from linking the agent’s interest to that of the principal. • Residual loss. This is the reduction in wealth of principals caused by their agent’s non‐optimal behaviour. This theory also identifies ways in which managers can act against shareholders’ interests known as ‘agency problems’. These problems involve managers making business decisions that result in less than optimal results from the perspective of the principal. The three ‘agency problems’ (risk aversion, dividend retention and horizon problem) are outlined in the chapter on theories in accounting. Agency theory explains that these problems can be reduced by linking management’s rewards to certain conditions. This in effect bonds the interests of the managers to those of the shareholders. The mechanism to do this is by contracting with the managers, through a bonus plan that specifically deals with each of these problems by linking managers’ remuneration to certain performance outcomes (including accounting measures such as profit or share price). Further, given the assumption that individuals act in their own interests, the theory argues that managers will be expected to attempt to maximise any bonuses. A key implication of agency theory is that it provides a reason and explanation for the need for accounting reports: to help monitor and control the activities of managers. In the context of corporate governance the tenets of agency theory are evident in specific prescriptions. For example, the OECD principles of corporate governance specify that: • managers’ remuneration should be linked to shareholder interest and that a key responsibility of the board is ‘[a]ligning key executive and board remuneration with the longer term interests of the company and its shareholders’. • the remuneration policy for executives and board members needs to be disclosed to shareholders.11 Figure 7.1 summarises the key principles of the shareholder–manager relationship in agency theory. FIGURE7.1

Overview of the shareholder–manager relationship in agency theory

Firm as a nexus of contracts (linked to efficiency and economic theory) Agency costs: Agency contracts: between agents and principals Two types: • manager−shareholders • manager−debtholders.

• monitoring • bonding • residual loss. Arise from conflict because both parties are assumed to act inself-interest.

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Price protection: principals pass these costs to agents.

Manager−shareholder agency relationship Agency problems: • risk aversion • divided retention • horizon problem. Note: These problems are ways in which managers can act to transfer wealth.

Bonus plan Tie management remuneration to bonus contract to reduce problems. Bonus can be linked to: • profit • share price • dividend payout role.

Bonus plan hypothesis • opportunistic choice of accounting policies by managers to optimise bonus • where bonus plan tied to reported earnings, managers will adopt accounting policies to shift reported profit from future periods to currrent periods • theory tested by observation.

CHAPT ER 7 Corporate governance 205

Rankin, Michaela. Contemporary Issues in Accounting, 2nd Edition, Wiley, 2017. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/murdoch/detail.action?docID=5049576. Created from murdoch on 2020-11-04 06:26:09.

7.4 Corporate governance guidelines and practices LEARNING OBJECTIVE 7.4 Reflect...