Corporate governance: Fact or fiction?
Andrew Higson
School of Business and Economics
Loughborough University
Loughborough
LE11 3TU, UK
Email:
Web: accounting-research.org.uk
Corporate governance: Fact or fiction?
Abstract
In view of the near collapse of the banking sector, one has to question the success of “corporate governance”. Sarbanes-Oxley was meant to rectify the deficiencies in corporate governance following the collapses of Enron and WorldCom, yet, these changes did not save the banking sector. The reviews that have been conducted since have not really suggested significant changes to the system of corporate governance. So, are only minor adjustmentsrequired, or are there more fundamental problems? In order for directors to be held accountable it is important to understand what they have done. A prime means of communication between the directors and stakeholders is through the corporate financial report. However, unless the contents of the complex financial statements are understood by stakeholders, then this way of holding the directors accountable may be problematic. Yet, the assessment of corporate performance is often based on the figures in the financial statements – as are management bonuses. This paper suggests that a financial reporting expectations gap, comprising the audit expectations gap and a financial statements expectations gap, may be preventing users from effectively holding directors accountable for their actions – until it is too late.
Key words: Corporate governance; performance; expectations gap.
Corporate governance: Fact or fiction?
Introduction
The past two decades have seen the rise of “corporate governance”. However, time and time again, faith in its mechanisms appears to have been misplaced. Following the failures of Enron and WorldCom, Sarbanes-Oxley was enacted in the USAin order to cure the perceived corporate ills, and thus give back credibility to corporate America. Organizations all around the world have spent thousands of hours in order to become Sarbanes-Oxley compliant – to enable them to conduct businesswith companies based in the USA. The central focus of Sarbanes-Oxley was to strengthen corporate governance procedures in order to help prevent fraud and mismanagement (e.g. the accountability of the directors, strengthening of internal controls, greater prominence to the audit committee, and enhancing the independence of the external auditors). However, the financial crisis in 2008, which nearly resulted in the collapse of the financial sector of the Western world, must raise questions over the success of Sarbanes-Oxley, and more significantly, over the whole idea of corporate governance (Higson, 2010). Whilst reviews have been conducted following this crisis (e.g. the Walker Review [2009]of banks and other financial institutions), suggestions for specific changes have been very limited (e.g. FCR, 2010). Therefore, the question must be asked as to whether the root of the problem has really been identified.
This paper examines possible weaknesses in the current system of corporate governance and focuses on the communication between the directors and stakeholders through the corporate financial report. Unless the contents of the complex financial statements are understood by stakeholders then the prime means of holding the directors accountable may be problematic. Yet, the assessment of corporate performance is often based on the figures in the financial statements – as are management bonuses. Therefore, it is critical that stakeholders fully appreciate the scope, assumptions and limitations of the financial statements.
The Responsibilities and Accountability of the Directors
The classic definition of corporate governance was set out in the Cadbury Report (1992, para.2.5) as “the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the board include setting the company’s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The board’s actions are subject to laws, regulations and the shareholders in general meeting.” The UK Corporate Governance Code (2010, p.1) adds: “The purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company.” But how can this be achieved?
One of the main pillars of corporate governance has been the growth in the use of non-executive directors. Their roles being to challenge and contribute to the development of companies’ strategies. In the collapse of the banking sector it would seem that the non-executives were unable to limit the actions of management. The greater emphasis being placed on audit committees was aimed at increasing the independence of the external auditors. However, Collier (1997, p.79) considered ‘[a] review of the literature suggests that the claimed advantages of audit committees are not always realized in practice and that the support for audit committees is based upon anecdotal information on their effectiveness rather than objective evidence’. And he (1997, p.81) suggested why audit committees may not be effective:
- their establishment may be to merely provide the appearance of monitoring;
- non-executive directors may not, in fact, be independent;
- there may be deficiencies in their operation; and
- the whole idea may be flawed.
These comments seem to have been prophetic as the existence of audit committees did not save Enron, WorldCom or the banking sector, and so the usefulness of the audit committee in assisting with auditor independence may be questionable.
One review following the banking crisis, Walker Review (2009) considered that problems were behavioral and not organizational and so no new legislation was required:
“It is very doubtful whether any form of stronger statutory provision in relation togovernance could have prevented that part of failure that was attributable to the generalfailure (on the part of regulators, central banks and rating agencies as well as boards) toforesee fat-tail eventsxii[“xii Essentially a “fat tail” event is an extreme or catastrophic event, that occurs with a higher likelihood than expectedunder “normal” conditions (normally expected probabilities), even though the average outcome is the same.”]such as the relatively sudden effective closure of wholesalemarkets. There is an important asymmetry here in that errors of commission, oftenassociated with specific events or decisions, are generally more readily identifiable forpurposes of legislation, regulation and enforcement than errors of omission which tendto stem from some behavioural process or deficiency which is more difficult to pindown. Moreover, in respect of greater engagement with the boards of their companiesby institutional investors, although there is scope and need to encourage incorporationin fund management mandates of a greater degree of obligation to engage and theleverage exerted by voting outcomes might be increased, it seems unlikely that muchmore could be done through new statute or regulation to promote this in practice.” (para.1.18)
“More generally, the dependence of the overall quality of corporate governance on behavioural issues and style suggest that further regulation beyond the specific tightening in capital and other requirements may have little or no comparative advantage or relevance when set against the powerful influence exerted by the FSA Handbook and the Combined Code process. No doubt because directors and boards know that there is continuing opportunity to promote adaptation in the Combined Code, together with its inherent built-in flexibility, a sense of ownership has been generated among those that the Code is designed to influence. The consequence is a degree of readiness to conform that would be unlikely to be matched by box-ticking conformity with new statutory provision. In any event, any further statutory provision in this area – for example in respect of a director’s necessary qualification – would almost inevitably call for interpretation and guidance which, in the end, might not be very different from that in the Combined Code, but with the serious disadvantage that it would be materially less capable of adapting to changing circumstances.” (para.1.19)
Certainly, behavioural factors are important because management’s motivations provide the driving force behind the way the financial statements (which are often viewed as the public face of an organizationand indicate its performance) are prepared and presented (Higson, 2003). These motivations may range from the meeting of profit targets (so as to satisfy City expectations or the achievements of personal bonuses) to ensuring the survival of the business (Graham et al., 2005). Motivational aspects can permeate the whole way an organization is run and the way its results are presented to the outside world. Management has a keen interest in the picture that is presented to the outside world. The Blue Ribbon Committee (1999:1076) considered that ‘some companies do respond to analysts and short-term market pressures by “managing” their earnings’, it continued, ‘[w]hilst earnings management is not necessarily inappropriate, it can become abusive when it obscures the true financial performance of the company’.
“In recent years there have been numerous instances of the price of a company’s stock dropping precipitously when the company failed to meet analysts’ earnings forecasts by only a penny or two a share, or failed to meet their revenue forecasts. The Chairman and the Chief Accountant of the SEC, among others, have expressed concerns that some entities may have been ‘managing’ their earnings inappropriately (often referred to as ‘earnings management’) in order to meet analysts’ forecasts and thereby avoid a precipitous drop in the share price of their stock. They also have expressed concern that auditors have not challenged these actions, but instead have ‘waived’ known potential misstatements of earnings or revenue because the amounts involved were quantitatively immaterial.” (Panel on Audit Effectiveness, 2000:56)
An important part of corporate governance requires the assessment of corporate performance. The problem is how to judge corporate performance – and its associated risks. Therefore, a clear understanding of the scope, assumptions and limitations of the financial statements would appear to be necessary prior to their use in assessing the success of management.
Corporate Financial Reporting
The financial statements are usually taken as an indicator of corporate performance –but is this a valid assumption? Given the scale and complexity of some modern business as well as the complexity of the International Financial Reporting Standards,do raise questions about what the financial statements show and whether their users really understand them.
The past fifty years have seen increasing emphasis by the accounting standard-setters on the decision-usefulness of the financial statements. In the 1990s there was theStatement of Principles debate in the UK – where the accounting standard-setters set out the basis of their conceptual framework as being focused on decision-usefulness. This stance was heavily criticized but this criticism seemed to be ignored and the standard-setters stuck with decision-usefulness. Subsequently, the Company Law Review Steering Committee (2001, paras. 8.127/8) also seemed to criticize the focus on decision-usefulness.
Laughlin & Puxty (1981, p.74), who were critical of the decision-making emphasis, reported that: “We know of no literature concerned with the provision of external information which takes as fundamentally relevant the wellbeing of the reporting enterprise.” Anthony (1983, p.15) advocated that “financial accounting should focus on the entity as such, rather than on the interest of equity investors in the entity, as is the present focus”. Therefore, instead of assessing the performance of the reporting entity, the emphasis on the provision of information so that users could do with it what they wanted. One would have thought that such an approach was questionable.
Another consequence of the focus on decision-usefulness was emphasis on the relevance and reliability of the data in the financial statements to enable users to take economic decisions and the downplaying of what were the fundamental accounting concepts (a key one being prudence). Also, the focus of the financial statementsmoved from the income statement (emphasizing income and expenditure) to the balance sheet (with the emphasis on the assets and liability approach) and the resulting rise of comprehensive income with its focus on fair values and mark-to-market accounting. This would seem to follow the idea that “accounting repeatedly has been regarded as the theory and practice of measurement of income and wealth” (AAA, 1971, p.47). “The undisputed definition of income is that it is the difference between wealth at two points in time after adjusting for consumption for individuals or investment for firms” (Sterling, 1979, p.191). As a consequence Sterling considered that: “Since income and wealth are inextricably entwined, an incorrect measure of one yields an incorrect measure of the other and vice versa” (p.196). In economics “wealth” is an extremely difficult concept to define and thus measure. Moonitz (1961) considered that accountants had “translated the ‘wealth’ of economics into the ‘assets’ of accounting” (p.12). On this basis it might be claimed that the balance sheet showed the “wealth” of the business. However, “Canning [1929] asserted that scarcely any two amounts representing asset classes in a balance sheet can be added, legitimately, to obtain a measure of the wealth of an entity in respect of those classes; and a fortiori a balance sheet total for assets cannot be taken as a measure of aggregate wealth” (Chambers, 1998, p.42). Therefore, it is problematic whether a balance sheet (even adjusted for current values) could ever represent a company’s “wealth”. It is also important to appreciate: “All valuation levels are subject to the myriad of market forces… and as such can turn very nasty, very quickly and often at the worst time” (Ashley, 2003, p.143). Perhaps one should remember the words of Boulding (1962, p.55):
“If accounts are bound to be untruths anyhow… there is much to be said for the simple untruth as against a complicated untruth, for if the untruth is simple, it seems to me that we have a fair chance of knowing what kind of untruth it is. A known untruth is much better than a lie, and provided that the accounting rituals are well known and understood accounting may be untrue but it is not lies; it does not deceive because we know that it does not tell the truth, and we are able to make our own adjustment in each individual case, using the results of the accountant as evidence rather than as definitive information.”
In the 1936 version of the American Accounting Association's statement of accounting principles it was considered that “[a]ccounting is… not essentially a process of valuation, but the allocation of historical costs and revenues to current and succeeding fiscal periods” (pp.188-189). It could be argued that many of the problems associated with financial reporting stem from the vagueness of accounting “theory”, and the problems of specifying the objective of the financial statements (Higson, 2003).
So, a profession that had been noted for prudence and conservatism was suddenly at the forefront of innovative financial disclosure. Whilst it could be argued the “prudent” approach may have understated corporate “performance”, it probably limited the risks associated with the financial figures. The comprehensive income approach attempted to “capture” financial performance in a wider sense, but has probably increased the risks associated with the financial data – a factor which does not seem to have received much attention.
The External Auditors
So, what are the implications for the external auditors? One presumes that the external auditor’s report would imply that the financial statements were “fit for purpose”. However, the focus on decision-usefulness has not been endorsed by them – the audit report says nothing about this. Indeed, following the Bannerman case in 2002, some auditors in the UK added a paragraph to their audit reports specifically to exclude liability from users taking decisions based on financial statements audited by them (Arnull, 2008). Therefore, we have a situation where the standard-setters are saying that the objective of the financial statements is decision-usefulness, yet, other than from some vocal users of the financial statements, this stance seems to have limited support from those who have given this issue serious consideration.
Both accounting and auditing are often considered to be technical subjects. However, this perception of technical precision tends to undermine the complexities of external reporting and the real nature of the management-auditor relationship. As has already been noted, management is keenly interested in the picture that is portrayed in the financial statements. The very nature of financial reporting means that a whole multitude of judgements and estimates have to be made during the compilation of the financial statements – hence the potential for bias. In order for accounting data to be “useful” to users it has been seen that it needs to be reliable: “To be reliable, the information contained in financial statements must be neutral, that is, free from bias” (IASC, 1989, para.36), but are the financial statements free from bias? Is it the role of the auditors to eliminate bias, or minimise bias? If auditors view their role as being to examine the reasonableness of management's justifications for their representations, can it really be claimed that the financial statements are free from bias? If it is thought that the financial statements should be free from bias, what action must be taken to ensure this is the case? To simply say that the financial statements comply with accounting standards will in itself not ensure that they are free from bias. It is the subjective nature of accounting estimates and ulterior management motivations, hidden by the complexity of modern business structures, that make bias so difficult to detect. If management intend to smooth profits, even auditors admit that this is very difficult for them to detect (Higson, 2003). The treatment of an item in the financial statements may be acceptable, questionable or unacceptable, depending on the motivations behind it. Therefore, maybe the external audit should be viewed in the context of the audit of management’s motivations - and there should be questions over whether the financial statements are really free from bias. When it comes to fraud, the classification of an action often depends on the motivations behind it (e.g. was it deliberate or accidental?). So, at what point does bias become fraud? The dividing line between bias and fraud, in certain circumstances, may at the very least be very fine. Often it is the passage of time that makes things clear – a luxury the external auditors frequently do not have.