Governance, Accountability and Audit - Essay Example

?Governance, Accountability and Audit Table of Contents Question 3 Question 2 7 Question 3 12 Question 4 16 References 20 Question Corporate governance is considered as the set of mechanisms which assists in protecting the interests of shareholders. Corporate governance also facilitates in enhancing the economic perspective with regard to an organisation. It is a broad term which delineates procedures, duties, strategies, regulations and institutions that direct organisations in the way they act, manage and control the operational activities. Corporate governance works to accomplish the objectives of an organisation to enhance the organisational value and to manage relationships amid stakeholders (Khan, 2011). The characteristic of corporate governance in the United Kingdom is based on ‘comply or explain’ approach i.e. either organisations’ need to comply with the existing code or need to explain new code to government authorities. The compliance with the board related recommendations of the UK Code of Corporate Governance is expected to minimise the agency problems and to enhance the performance of organisations. Agency relationship is an agreement under which the principal appoints the agent in order to perform certain services. As a part of agency relationship, principal renders certain decision-making power to the agent. In agency relationship, problem arises regarding how to encourage the agent to perform in the best benefits of the principal (Biswas & Bhuiyan, 2008). Since industrial revolution, large organisations have continued to bring considerable changes in financing, ownership and administration forms. New technologies are continuously modernised, demanding huge investment in the industry. In order to supply money for this huge investment, people from diverse segments of society are looming in different industries with their savings. As a consequence, many sole proprietorship businesses are turning into joint stock businesses. In such type of businesses, the risk bearing activities of proprietorship and managerial activities are performed by diverse parties. These parties often have conflicting nature of interests. For instance, the interest of shareholders is to enhance the equity of organisation, without considering the value of debt. On the other hand, interest of creditors is to enhance the probability of organisations to repay debt, which often hinders organisations to undertake risky projects. On the other hand, interest of managers is to increase their individual return rather than the return of external investors. This return of managers can differ owing to the incorporation and influence of strategies which justify paying them higher salaries to ascertain diversion of resources for individual advantages. Even the different shareholders of an organisation have diverse interests. The large shareholders have interest to control the organisation and they desire to maximise their returns at the cost of smaller shareholders. These differences in interest at times can cause principal-agent problem between owners and managers. In agency relationship, managers bear the whole cost of failing to pursue their individual objectives, but capture only a fraction of the advantages (Biswas & Bhuiyan, 2008). Control mechanisms are vital to minimise the divergence of agents’ interests from principals’ interests. Corporate governance is possibly the broadest control instrument used for effective deployment of business resources. Corporate governance acts as a network between different parties of agent relationship for enhancing their value in the organisation. The UK Code of Corporate Governance offers certain recommendations for the board with respect to leadership, efficiency, responsibility, compensation and relationship with shareholders in order to minimise the agency problems (Financial Reporting Council, 2012). Although the recommendations for board are intended to minimise agency problem in an organisation, these recommendations are not perfect for numerous reasons. For example, with reference to the UK Corporate Governance Code, board needs to establish independent non-executive directors. However, in reality, independence of non-executive directors is a challenging task to accomplish because of the influence of other board members on their activities. The other example can be rendered with respect to remuneration for executive board. In the UK Corporate Governance Code, it is recommended that incentives are subject to challenging performance standards which can reflect the organisational objectives. However, the effectiveness of incentives is not without any limitation. There are several deficiencies of incentive mechanism recommended by UK Code of Corporate Governance. The first deficiency is that managers can manipulate the returns by adopting favourable accounting strategies and thus can ensure that their interests are being served while the incentives are associated with the returns. The second deficiency is that the motivational possibility of incentive possibly diminishes whenever it is associated with strict market measures which are dependent on several aspects that are beyond managers’ control. Furthermore, it can be stated that incentive plans concentrate only on preferred consequences without paying much attention to the way of accomplishing those. Empirical evidences demonstrate mixed outcome about the recommendations of corporate governance code. There prevail a number of subjective evidences of an association between corporate governance practices and organisational performance, however, these evidences mainly concentrate on particular dimensions or elements of corporate governance such as board structure and arrangement, tasks of non-executive directors and different control instruments. For example, the study of McKnight & Weir (2009) on a number of UK organisations revealed that alterations in board composition during post-Cadbury period had not impacted agency costs. They have also found that increasing board proprietorship can minimise agency costs. On the basis of the study of Gul & et. al., (2012), it can be observed that institutional ownership which is a mechanism of corporate governance minimises the degree of agency cost. Besides, smaller sized boards also lead to reducing agency cost. On the other hand, the study of Biswas & Bhuiyan (2008) had found mixed outcomes with respect to corporate governance and agency relationship as well as organisational performance. Their study rendered evidences that corporate governance has significant relationship with organisational performance, but whether better corporate governance results in increased organisational performance is still unclear. The study of Joint DTI/King’s College London Seminar in 2005 proved that “one size fit all” corporate governance codes are highly problematic for organisations at different thresholds in organisational life cycle (Department for Business Innovation & Skills, 2005). In any joint stock business, agency problem is quite natural which results in a considerable number of costs. Corporate governance codes prevail to reduce these problems, but it is not always possible to completely eradicate such problems because the mechanisms of corporate governance are not much effective and mostly subjected to existing legal structure of a nation. Due to this reason, blind implementation of corporate governance tools may not result in deciphering anticipated consequences. Good corporate governance along with widespread adoption makes it more challenging for organisations to ascertain the impact of corporate governance on agency costs and organisational performance. Thus, finally it can be concluded that whether the corporate governance code has been effective in accomplishing these two objectives is still uncertain. Question 2 The effect of corporate governance on organisational performance has gained significant attention in academic disciplines in past few years. This attention has largely been inspired by the accounting scandals that have disturbed the UK economy. In corporate governance, board of directors is the most vital element. Irrespective of increase in researches, there is yet much argument about the relationship between organisational performance and board of directors. For example, researchers have found conflicting relationship about the impact of board of directors on the organisational performance, because it is dependent on other factors such as trust and size of organisations among others. The UK Code of Corporate Governance recommends that as a minimum half of the members of boards in large listed organisations must be independent non-executive directors (NEDs). Independent director are also referred as outside directors or NED. The concept of independence is an important subject in the context of NEDs. According to Iwu-Egwuonwu (2010), independence in the context of NEDs refers to the notion that a director is independent in personality and judgement without having any impartial or interpersonal relationship with the organisation beyond the autocracy. On the other hand, non-independent directors are those executives who are related with board of the organisation such as Chief Executive Officer, Chief Operating Officer or any other nominated member of board. However, the key question is that how both directors may help to enhance the board and firm performance. Board performance in this context denotes the effectiveness of board to run the organisation effectively. Conversely, firm performance relates to the financial effectiveness of an organisation. Directors play various roles for controlling and monitoring organisational resources. Agency theory suggests that independent non-executive directors may theoretically lead to better organisational performance. It proposes that non-executive directors because of their presumed independence can be capable of better management of strategy, risks and organisational resources, which might in turn assist in improving the organisational performance. The resource dependence theory observes non-executive independent directors as ‘boundary spanners’ who extract experiences from several business situations. It expects that more resource rich non-executive independent directors would facilitate to bring in valuable experiences for better organisational performance. This claim has obtained certain empirical evidences. Carpenter & Westphal (2001) stated that independent non-executive directors contribute to strategic decision making procedure of an organisation. Furthermore, independent non-executive directors can facilitate organisational borrowing ability, information attainment and alliance establishment. However, several cases also depicted that the experience function of independent non-executive directors is more noticeable for Chinese boards rather than Western boards. The Chinese cultural tendency to depend on relationship and the institutional authoritative aspect are claimed to be behind the intensified role of non-executive directors. Therefore, the resource dependence theory is being argued in relation to the effectiveness of NEDs in the Chinese organisations. Institutional theory argues that appointing independent non-executive directors to the board may simply signify an organisation’s attempt to comply with formal stress and thus might not essentially result in better organisational performance. This theory suggests that organisations may assign independent non-executive directors for several reasons. The first is regulative reasons. The enactment of new regulations necessitates listed organisations to appoint independent non-executive directors to the boards. The second reason is normative reason. Institutional theory recommends that organisations try to act in such a manner so that they are not observed as different with respect to financial performance and consequently they do not want to be pulled out for criticism. The third reason is conformity. The independent non-executive directors facilitate organisations to depict conformity which in turn can provide advantages through increased sincerity, resources and survival competencies (Peng, 2004). On the other hand, non-independent directors may also help to enhance the board and firm performance. Non-independent directors engage in several regular activities such as meeting, management decision making and information reporting which aid independent directors to fulfil their roles. In summary, it can be stated that the tasks of independent non-executive directors are dependent on the information of non-independent directors. Furthermore, non-independent directors also communicate in aid of the organisation about the development and the execution of organisation’s strategies, hence it can enhance the board performance. Non-independent directors administer the operations of organisational plans and strategies, evaluate the major risks and ensure that the organisation is properly controlled and supervised, thereby assisting in enhancing the firm performance (Sterling Resources Ltd., 2013). Independent non-executive directors are considered as much effective with respect to coordination within an organisation. Independent non-executive directors are used for monitoring the performance of other executive managerial employees. As a result, it serves to minimise the divergent interests between shareholders and management, consequently reducing the agency costs. It seems that organisations advocating independent non-executive directors engage in good corporate governance structures along with practices. Such strong corporate governance structures act as a basis to access the international capital market (Lawrence & Stapledon, 1999). However, empirical researches have found mixed association between independent non-executive directors and organisational performance. On the basis of a research of Hutchinson (2002) on Australian organisations, it has been found that investment opportunities of organisations are strongly related with the proportion of executive directors. The study also suggests that a high proportion of non-executive directors ensure that the activities of organisations are value adding. According to the research of Rebeiz (2008), a board including more independent non-executive directors bestows a positive influence on the financial performance of the organisation. He proclaimed that the relationship between independent non-executive directors and financial performance of organisations is nonlinear in nature but curved with negative concavity. The study of Kumar & Sivaramakrishnan (2007) described that the interests of board are essentially associated with interests of non-independent directors. A more dependent board displays greater association with the non-independent directors. Their study reveals that when independent directors are greater in number, the board performs worse. The reason is that high level of independence at times creates tension between monitoring and contracting administration role. The supposition of these authors was that organisational performance can actually improve when the board is more reliant on non-independent directors, but can decrease when more independent directors are included in the board (Iwu-Egwuonwu, 2010). Therefore, by drawing upon the relevant theoretical and empirical literatures, it can be stated that both independent and non-independent directors have their individual tasks which can facilitate in improving the board and firm performance. Non-independent directors through their leading and developmental activities aid to enhance the performances of board and organisation. On the other hand, independent directors with their expertise and support to the non-independent directors can add value to the firm. For example, in Barclays, non-independent directors exercise authority in order to act in accordance with the organisation’s structure. On the other hand, independent directors make contributions to ensure that board fulfils the objectives. They use fair influence on the organisation and direct the executives to serve the organisation beside them (Barclays Corporate Secretariat, 2011). Question 3 (a) In the year 2001, Enron Corporation, a Houston based organisation had registered insolvency under Chapter 11 of US Bankruptcy Code (Benston & Hartgraves, 2002). The collective blame for the business failure has fallen on the gatekeepers. The conventional opinion was that gatekeepers such as the external auditors, security analysts and the credit rating agencies had avoided their duties and allowed dishonest conducts in the organisation. This collapse of Enron had prompted global reformation of corporate governance and was also considered as the failure of the organisation as well as the financial system. There is still much debate about the issue regarding the understanding of the reason for failure at Enron of the gatekeeping functions (Laby, 2006). Gatekeepers are reputational arbitrators who deliver confirmation and authorisation services to the investors. After the collapse of Enron, an interrogation was raised about the responsibilities of gatekeepers. The US Accounting System permitted Enron to establish corporate vehicle in order to change the amount of asset in off-balance sheet. In order to enhance the financial performance, Enron indulged in deceitful trades with fake partners. As a result, the amount of liability was also moved to the false partner’s balance sheet. Enron’s collapse was probably unavoidable once the dishonest trades started to unravel. The external auditors were apparently involved in these dishonest conducts. Instead of inspecting the fake trades and consulting with the directors of Enron regarding the risks associated with these activities, the external auditors had neglected them in order to demonstrate a wrong impression about the organisation in the market. The revelation of these fake entities and their influence on Enron’s balance sheet had created a concern amid credit rating agencies and as a result, they demoted the long-term liabilities of Enron. The external auditors were also involved in ‘mark-to-market’ accounting activities which played a critical role in the collapse of Enron (Khan, 2011). The contribution of security analysts was also quite contentious in the collapse of Enron. The security analysts had failed to predict the upcoming disaster of Enron. Even though the security analysts observed indications about Enron’s deteriorating financial performance, they passed the decision about Enron’s financial aptness. The support of security analysts allowed continuous infusions of funding for Enron in the financial market. In the year 2001, after the collapse of Enron’s stock, only two of eleven security analysts rated the stock as ‘sale’. Their ignorance on the aspects of financial performance allowed the collapse of Enron (Jickling, 2002). Similar to security analysts, credit rating agencies also failed to fulfil their obligation in the case of Enron. The credit rating agencies were negligent in their coverage of Enron. They did not investigate properly about the financial reports provided by Enron’s officials. Security analysts not only ignored the analysis of proxy statement of Enron, but also were unaware about the information contained in it. The credit rating agencies also seemed to have been least interested about the evaluation of financial performance of Enron. It is the duty of credit rating agencies to demonstrate a clear picture about the progress of an organisation, thereby rather than relying on the information provided by the organisation itself, credit rating agencies must depend on more reliable sources. Due to this reason, credit rating agencies also were unable to perform their responsibilities to provide a clear picture about the organisation’s financial condition (CIPE-Egypt, 2009). (b) The collapse of Enron in 2001 has had remarkable influence on the procedure of corporate law reform. The motivation of the reform was not only limited to the United States, rather it had expanded in the European communities notably in the UK. In the US, after the collapse of Enron, Sarbanes Oxley Act 2002 was imposed by the government. On the basis of this new Act, the stock listed organisations in the US are required to obey comprehensively the provisions of the Act. In the UK, corporate governance code had been reformed in order to strengthen the gatekeeping role of external auditors (Davies, 2005). In the post Enron period, the US had made the existence of Audit Committee a compulsory for every stock listed organisation in order to deal directly with the external auditors’ activities. The Audit Committee was also required to resolute any kind of discrepancies between management and external auditors on financial reporting. In the UK, the Turnbull recommendations provided the Audit Committee to play an extensive role in the internal control of organisational activities and risk management functions. However, unlike in the US, the corporate governance system of the UK had not explicitly stated about the role of Audit Committee. Furthermore, there are several areas on which policy makers need to concentrate more and require significant attention. For instance, in post Enron period, the UK had enhanced the number of board members in the Audit Committee which is deemed unnecessary because the addition of additional personnel can lead to gauche stewardship. Furthermore, there is no strict Act which completely forbids external auditors to perform non-audit activities (Gillan & Martin, 2007). There are continuous alterations and new developments in the US and the UK with respect to corporate governance rules and these alterations are planned to refine the behaviour of organisations through business. The reforms in the US and the UK are not similar; their coverage and features are diverse in nature. In the US, the new Act stimulated a structure of compulsory rules in order to certify that organisations are monitored closely and operated effectively on the basis of compliances. However, these activities have proved to be quite exclusive for organisations. On the other hand, in the UK, the reforms in corporate governance have a significant impact on the board structure and accordingly in the business. In the UK, the obedience of corporate governance is vogue in nature. It denotes that the reforms of corporate governance codes have not gone far enough to eradicate the problem of accountability and audit in organisations. The facet of corporate governance must be provided with a governing position in the company law and there should be no exception for any organisation. Question 4 (a) Executive compensation has drawn a considerable amount of curiosity for several financial economists due to several economic incidents. On the basis of a study of Bebchuk & Fried (2006), the main pattern for economists’ research of executive compensation has expected that pay provisions are the outcome of “arm’s length contracting” principle which represents the agreement between executives to acquire best agreements for themselves and the board which pursue to acquire best agreements for shareholders. In this approach, board of directors is observed to be operating at arm’s length from executives and to enhance the value of shareholders. The arm’s length contracting understanding identifies that executives do not inevitably serve the interests of shareholders. It acknowledges that executives might act in such a manner which fits their own interests. This model indirectly assumes that unlike executives, directors can be trusted on to serve the interests of shareholders. On the basis of executive compensation, pay composition is directed mostly by shareholders’ interests and functioned at arm’s length from the executives. The arm’s length approach bestows a significant influence on the structure and composition of executive pay in the US and the UK. In large organisations, directors have both monetary and non-monetary inducements to favour executives. Furthermore, social and psychological aspects also tend to strengthen these inducements. In general, executives use their power in order to obtain greater pay than they would gain in arm’s length contracting. Due to these reasons, executives have authority to influence their own compensation. The use of managerial power to gain compensation more favourable in comparison to arm’s length approach enables them to extract more rents. The term ‘rent’ is used by economists in order to define additional income (Bebchuk & Fried, 2006). In general, there is no agreement that can perfectly align with the interests of both executives and shareholders. In optimal contracting perspective, compensation arguments are set by directors who intend to enhance the shareholder value by planning an ideal principal-agent agreement. In the alternative rent extraction perspective, board does not function at arm’s length rather executives have the authority to persuade their own compensation. Thus, executives are paid more than the ideal amount (Bebchuk & et. al., 2001). (b) The paradigm of Bebchuk & Fried rests on extensively acknowledged agency cost theory that leaves considerable options for professional managers’ with regard to how to operate an organisation. As a part to reduce the agency cost, executive compensation is planned to provide inducements that reward managers to perform in such a manner that can benefit the shareholders. The theory forecasts that board would employ schemes that pay every executive their reservation compensation along with premium for bearing the risks which arrive with incentives. These incentives induce executives to employ their will in order to create shareholder wealth. When the success of an organisation rests on the decisions and effort level of executives then compensation agreements must be extremely incentivised (Conyon & et. al., 2005). Shareholders usually have no direct influence on setting compensations for executives, but they have indirect ways of influencing the pay level by law suits or voting among others. In the voting ground, NYSE and NASDAQ guidelines had been implemented by the US in the year 2003 which necessitates the vote of shareholders on every standard option. However, this implementation is believed to have low impact on the compensation level of executives. It is appealed that irrespective of option plan, boards can still substitute other ways of compensation plan. The voting of shareholders hence can be considered as a weak restriction on compensation arrangements of executives (Conyon & et. al., 2005). Bebchuk and Fried’s paradigm shows that top executive compensation system in the US and the UK is inefficient because of the managerial influence. Recent researches recommended that in the US the executive pay is quite high and the executives are capable of exploiting the current corporate governance system. On the other hand, the UK is generally considered to be less afflicted by the issues of extreme executive compensation. The compensation board in the US has traditionally under appreciated the complete price of stock options. Through this description, the US organisations believed to overpay their executives by implying stock options as these are less observable to the investors. The executive compensation in both the UK and the US comprises similar components i.e. both countries’ executives are eligible for base pays and annual bonuses according to the performance. Besides, they also receive stock options. However, due to paradigm depicted by Bebchuk & Fried, it can be observed that compensation system is highly influenced by managerial power. According to the research of Conyon & et. al., (2005) on few organisations in the year 1997, it can be observed that the median pay of US CEOs was almost US$2.0 million annually and the median pay of UK CEOs was US$1.0 million annually. In the year 2003, the median pays of US and UK CEOs were increased to US$2.5 million and US$1.9 million respectively. This figure represents about 92% and 29% increase in compensation of executives in the UK and the US respectively. Further empirical evidences of executive compensation can be observed from the report of Washington Post which declared that in the year 2006, the compensation of the US CEOs was about 364 times higher than the compensation of average employees (The Washington Post, 2013). A separate research of Institute for Public Policy Research depicted that in the year 2010 the compensation of top UK CEOs was increased by 33% where market value of an organisation was increased by 24% (Werdigier, 2012). To conclude, it can be stated that arm’s length contracting is suboptimal in nature. In several circumstances, this arm’s length contracting influences the structure and composition of executive pay where executives attempt to acquire the best agreements. However, the arm’s length contracting is not the complete explanation of executive pay. Although it is a fact that the contract structure reflects the power of executive and that an executive having more power is paid more however it does not mean that the compensation of executives is not adjusted for shareholders. Thus, the validity of the assumption of Bebchuk & Fried cannot be established. With regard to excessive compensation, it is likely that corporate governance practices must be improved which can facilitate to enhance the compensation decision system for executives on the basis of organisational value. References Benston, G. J. & Hartgraves, A. L., 2002. Enron: What Happened and What We Can Learn From It? Journal of Accounting and Public Policy, Vol. 21, pp. 105-127. Biswas, P. K. & Bhuiyan, H. U., 2008. Corporate Governance and Firm Performance: Theory and Evidence from Literature. The University of Western Australia. [Online] Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1257617 [Accessed April 09, 2013]. Biswas, P. K. & Bhuiyan, H. 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