Audit, Governance and Scandals

Audit, Governance and Scandals

(1) Lessons learned from corporate scandals

Ethical dilemma in most scandals has been coupled with ineffective boards, ineffective corporate governance and control mechanisms, and distorted incentive schemes, accounting irregularities, failure of audits, dominant CEOs, Dis-functional management behavior and lack of sound ethical tone at the top.

Some corporate failures are related to the corporate ownership structures, and governance framework.

* Leadership; top management of top companies involved in scandals have used aggressive accounting estimates, income smoothing policies, loss avoidance and all sorts of cooking books. Some of the reasons being:

- Tone set at the top

- Dominant CEO position

- Desire of power or greed

- Ineffective internal controls

- etc.

* Accountability, control, audit & Governance: failure of corporate governance to safeguard the interests of shareholders and reducing agency costs deriving from the separation of ownership from control.

- Investors rely on independent auditors for reliable financial information

- Linked directly with power, achievement & relationships in corporate governance structure

* Fraud/ fraudulent financial statements: deliberately misstating or omission of amounts or disclosures in financial statements to mislead financial statement users. Reasons could be linked to fraud triangle factors:

- Incentive/ Pressure

- opportunity

- rationalization

* Personal interest/ compensation package: Board members or managers attribute corporate funds to themselves as salaries, bonuses and stock options.

- Likelihood of fraudulent financial reporting

* Bubble economy or market pressure : the pressure tied to the management desire to satisfy unrealistic expectations of investors and analysts

* Ethical climate: Dis-functional management behavior and lack of sound ethical tone at the top.

(2) Reform proposals mandated

In U.S., the Sarbanes-Oxley Act of 2002 has been labelled the most significant legislative development in corporate governance, financial reporting, and auditing since the 1933 and 1934 Securities Acts.

In UK the scandals led to the Cadbury report on 1992 which dealt with the relationship between chairman & Chief Executive, non-executive directors; reporting on internal controls; etc.

- Post-SOX changes in corporate governance

1- Fixing audit process- aimed at eliminating or reducing relationships that may pressure, seduce, or tempt external auditors not act as diligent judgmental monitors of their corporate clients. It is based on the laws regulating internal control process, certification of financial reports, financial literacy and expertise on audit committee and new auditing process regulator (PACOB)

2- Increase board independence - designed to reduce conflict of interest or interpersonal pressures in order to make it more likely that the directors will act as judgmental monitors of management rather than as reciprocating colleagues.

3- Improve disclosure and transparency - aimed at provision of better information to investors to enable them to use their powers more effectively, and to reduce frauds and scandals.

(3) Agency problem & Agency cost

The separation of ownership from control leads to agency problem, which results in significant cost to shareholders and managers.

- Information asymmetry leads to agency problem. It is more crucial for corporate governance to have more disclosure in the corporate report so as to avoid shaking the faith of the investor/ shareholders.

- This can be achieved through the provision of sustainability reporting

- In comparison with outside dominated corporate governance, inside dominated corporate governance system reduce agency cost.

Reforms:

- There have been a lot of reforms within the inside-based systems, for example, the SOX Act demand for corporate governance restructuring and the provision of the environmental reporting.

- Executives' compensation disclosure is one of the issues addressed by SOX Act 2002 as a means of eliminating the agency cost.

- It also advocates for linking the executive pay to performance in order to eliminate the agency problem

- 1995 Greenbury Report in UK made recommendations about directors remuneration

NB: Excessive executive remuneration point back to bad governance by Boards.

(4) Corporate social Responsibility

Social responsibility of business encompasses the economic, legal, ethical, and discretionary expectations that society has of organizations at a given point in time.

- It focuses on corporate environmental accounting, management and disclosure

- CSR could be linked to stakeholder theory and legitimacy theory

(1) Stakeholder theory shows the direct impact that stakeholders have on the management decisions regarding company activities and disclosures.

ST can also be a valid tool for providing insight into managerial behavior when the business environment requires managers at macro level to interact with the identified stakeholders.

(2) Legitimacy theory provides insight into managerial behavior when the environment is, at conceptual level, dealing with heterogeneous, competing groups of stakeholders.

Legitimacy theory highlights how organizations are continually seeking to make sure that they operate within the limits and norms of their particular societies.

Reforms & evaluations

In response to the legal and stakeholders requirements, companies tend to positively disclose social and environmental information through their annual reports.