Michaela Rankin, Patricia Stanton, Susan Mcgowan, Kimberly Ferlauto & Matt Tilling

Chapter 7: Corporate governance

Solution Manual

to accompany

Contemporary Issues in Accounting

Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling

PREPARED BY:

Sue McGowan

John Wiley & Sons Australia, Ltd 2012

CHAPTER 7

CORPORATE GOVERNANCE

Contemporary issues7.1 Audit committees put risk management at the topof their agendas

1. Traditionally, audit committees have primarily focused on managing financial reportingrisk (i.e. risk of misstatements in financial statements) and reviewing aspects such asinternal control systems. Do you believe the expansion of this committee’s role toconsider business risk appropriate? (J, K)

There is no correct answer here and students may have different views. Points to make could include:

An essential part of any audit committee, even if focussing primarily on financial reporting issues, would include an assessment of risk as this would impact on issues such as going concern, impairment, values in financial statements etc, so the committee does need to understand the company’s risk profile.
Given significance and importance of risk management (and failures associated with this in the global financial crisis) there is a need to manage and control risk. It could be argued that given its other functions, that necessarily require an understanding of this risk, that the audit committee is well placed to provide such control and oversight.
Alternative views are:
This could overburden audit committees and impede its effectiveness.
It could be preferable to have a separate risk committee who can therefore concentrate on business risk

The Institute of Chartered Accountants in Australia together with the UK Financial Reporting Council and the Institute of Chartered Accountants of Scotland, have recently published a paper “Walk the line: Discussions and insights with leading audit committee members” which provides insights from a series of interviews with audit committee chairmen of publicly listed companies about the role and challenges facing audit committees. This can be accessed from

2. The extract notes a link between compensation structures within companies and riskmanagement. Explain how these are related? (K, AS)

It should be understood, that compensation structures provide powerful signals about what an organisation values and rewards. As such they provide a way to direct employee behaviour. Hence compensation structures should consider how they will be interpreted by employees and what actions they will encourage (and discourage). If compensation structures for example reward risk (for example, focusing on short term targets and not considering long term impacts) then these would be expected to increase the companies risk profile.

Students may think of some specific examples:

If a bank pays bonuses on the basis of loans granted but does take into account the risk associated with the loan (i.e. whether there is likely to be a default by the customer) this would seem to explicitly encourage granting of loans even where risk of default is high. (A compensation package to deter this could either have a ‘claw back’ provision – so ifloan goes ‘bad’ bonus needs to be repaid, or have a large part of bonus paid at a later time when the likelihood of default can be more accurately assessed).

Contemporary issues 7.2 The individual must take responsibility for doing the right thing

1. This article discusses the issue of a code of conduct in corporate governance. Discusswhether a code of conduct is important for corporate governance. (J, AS)

Every organisation has its own unique culture or value set. Most organisations don’t consciously try to create a certain culture. The culture of the organisation is typically created unconsciously, based on the values of the top management or the founders of an organisation.

The culture of an organisation is vital in corporate governance. A code of conduct is important in supporting this culture as it outlines explicitly expectations and responsibilities. It ‘sets the scene’ as to what is acceptable and what not is acceptable, actively can encourage and support either unethical or ethical behaviours. It also provides evidence of the value the company places on such behaviour.

However, as noted in the article, it is also important that the code is supported and that senior company members are committed and also adhere to the code.

For example, in the case of Enron (as noted in the text) the company was perceived to have ‘best practice’ in terms of codes of conduct and corporate governance yet in reality the culture and actual company practices were less than ethical.

Students may find it useful to look at some examples of codes of conduct. It is likely that their own university will have one. My own university has a code for staff (and also one for students) that outlines specific issues (such as respect for others, conflicts of interest, confidentially) but has a final guideline that staff should consider:

If you would be ashamed if your conduct was reported in a University newsletter or a local newspaper read by friends and colleagues, you should question whether your behaviour is ethical.

2. The article states that it is impossible to legislate for ethics. Do you agree with this? Ifthis is the case, does this mean regulation is ineffective? (J, K, AS)

Ethics relates to people and how they behave. If people are to act ethically they need to first, appreciate their actions and decisions involve ethical choices and second, be willing and able to then make the ‘right’ decision.

The fact that crimes are committed, and we have gaols full of prisoners, is clear evidence that legislation (law) itself does not prevent people from acting inappropriately.

However legislation can still have some impact by:

Although legislation tends to target clearer and more explicit examples of unethical behaviour it could be argued that this at least provides insight into societies expectations (and limits to acceptable behaviour).
It could be argued to deter some of the worse abuses. Company directors can be subject to criminal actions and we saw with Enron imprisonment of directors.
Legislation can also provide protection to whistle blowers

An alternative view is that legislation can lead to a ‘rules based’ approach to ethical behaviour – where the perception is that as long as acts within bounds of legislation (i.e. to letter of the law) then that behaviour is acceptable.

Review questions

1.Explain what is meant by corporate governance and why it is needed.

Corporate governance in very simple terms is ‘the system by which business corporations are directed and controlled’ (Cadbury, cited in Cowan, 2004, p. 15.).

The OECD’s definition expands on this:

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.

To have a good corporate governance system ensures that the corporation sets appropriate objectives, and then puts systems and structures in place to ensure those objectives which are set are met. It also provides a means for persons both within and outside the corporation to be able to control and monitor the activities of the corporation and its management.

With the increasing globalisation of business and competition for capital, companies that can provide assurances of good corporate governance will have a competitive edge in the market place and facilitate economic growth.

2.‘Corporate governance is primarily focused on protecting the interests of shareholders.’ Discuss.

This would depend on what point-of-view you take:

(a)Traditional — the role of the corporation from a traditional view by Milton Friedman is that ‘corporate governance is to conduct the business in accordance with the owner or shareholders’ desire, 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’.

(b)Pluralist model — the responsibility of corporations goes beyond the narrow interests of shareholders and should be extended to a wider group of stakeholders.

(c)Anglo-Saxon model — tends to focus on the problems caused by the relationship between managers and owners and often takes a control-orientated approach, concentrating on mechanisms to curb self-serving managerial decisions and actions.

In practice, shareholders are a key focus on most corporate government systems in large corporations. Whether the focus should be primarily on shareholders interest is of course debatable and this would make a good discussion question for the class. Of course, other entities (such as not-for-profit and public sector entities) should also practice good corporate governance and these entities would not have ‘traditional’ shareholders. Students may wish to consider whose interests would be of primary focus with such entities.

3.What are risks of poor corporate governance and the advantages of good corporate governance?

Risks of poor corporate governance can be from:

a company making use of resources to benefit themselves. In some cases, it may go as far to involve fraud. It is often more subtle in regard to false reporting because of the desire to maintain the value of benefits provided to corporate managers.
corporations taking actions that shareholders may not consider desirable
corporations ‘hiding’ or providing‘false’ information to shareholders to avoid consequences
disparity between payments received by managers or corporations to their performance.

Ultimately students should realise that such actions can risk the wealth of shareholders and other stakeholder groups (such as employees and customers), can increase costs to the corporation and even put at risk the continuation of the corporation itself.

Advantages of good corporate governance:

provides assurance that companies are properly managed
required for an efficient market
facilitates economic growth.

4.Explain what is meant by the positive accounting theory and its relationship to corporate governance.

Positive accounting theory, using as its basis contracting theory, views the firm as a network of contracts or agreements. These contracts determine the relationships with and among the various parties involved. A key relationship is the agency contract.

An agency relationship by definition has two key parties:

a principal who delegates the authority to make decisions to the other party
an agent who is the person given the authority to make decisions on behalf of the principal.

In this context the agent is the manager and the principals are the shareholders. Whilst the agent has a duty to act in the interests of the principals there is a common assumption in economic theory which is, if individuals are rational, they will act in their own best interests and this can lead to the agent making decisions to 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 principles to measure, observe and controlthe agent’s behaviour.

• bonding costs. These are restrictions placed on an agent’s actions deriving from linkingthe agent’s interest to that of the principal

•residual loss. This is the reduction in wealth of principals caused by their agent’s non-optimalbehaviour.

This theory also identifies ways in which managers can act against shareholders’ interestsknown as ‘agency problems’, and that these problems can be reduced bylinking management’s rewards to certain conditions. Students should refer to Figure 7.1, page 191, which provides an overview of the shareholder–manager relationship in agency theory. Chapter 5 also explains in more detail this theory.

Corporate governance is concerned with controlling and directing businesses and in the company context there is a often a clear separation of owners (shareholders) and managers. Hence an agency relationship exists. A number of the principles in corporate governance (and these are further reflected in more specificprescriptions/rules) are espoused to address the problems associated with the agency relationship as outlined in positive accounting theory.

For example the OECD principles ofcorporate governance specify that:

• managers’ remuneration should be linked to shareholder interest and that a key responsibilityof the Board is ‘aligning key executive and board remuneration with thelonger term interests of the company and its shareholders’.

• the remuneration policy for executives and board members needs to be disclosed toshareholders.

5.Identify the key areas addressed in corporate governance and provide examplesof practices related to each of these areas. Explain how any individual practicesidentified help ensure good corporate governance.

Corporate governance involves ensuring that the decisions made by those managing the corporation are appropriate, and providing a means to monitor corporate activities and the decision making itself.It is primarily concerned with managing the relationship between the shareholders, the key managers of the corporation (this is usually the Board of Directors), other senior managers within the corporation, and other stakeholders. Many countries have developed suggested (and sometimes required) lists of rules or descriptions of the types of practices that should be included in corporate governance systems. However it is generally acknowledged that there is no ‘one’ system of corporate governance. The practices and procedures required or desired will be affected by:

The nature of the particular corporation and its activities. For example, in some companies there are dominant shareholders whereas in others shareholding may be more widely spread, and
The environment in which the corporation operates

The text identifies three key areas to be addressed by any corporate governance system:

processes and methods to control and direct the actions of managers of the corporation to ensure make appropriatedecisions

–Specificexamples of corporategovernance requirements here are minimum standards of experience for directors; requirements thatat least someof members of board of directors be independent.

processes and procedures to ensure that stakeholders (such as shareholders) have the ability to protect their interests

–Specific examples here would be voting rights and rights of shareholders to call meetings.

to ensure that adequate informationis provided to ensure transparency and meet accountability obligations of management.

–Specific examples here include requirements in relation to annual reports.

Students may also wish to consider how these areas are addressed in the summary of 3 codes of corporate governancein table 7.1).

6.What is the rules-based approach to corporate governance and what are theadvantages and disadvantages of this approach?

Rules-based approach identifies precise practices that are required or recommended to ensure good corporate governance.For example, there may be a rule that an audit or remuneration committee be established. The text provides some examples of specific rules.

The advantages of this approach are:

It provides at least a set of minimum corporate governance practices that must be followed by all corporations, and
There is no uncertainties as to which practices are required. This also assists with enforcement and with potential liability in terms of litigation.

The disadvantages of this approach are:

While this provides a minimum set of practices, it is likely that good corporate governance requires practices beyond the minimum prescribed.
It also can encourage a ‘check list’ (form over substance) approach to corporate governance.
The legislative backing of rules can result in the view that corporate governance is about dealing with legal liability rather than about promoting the interests ofshareholders and stakeholders (Bruce, 2004).
It is generally accepted that there is no ‘one’ model of corporate governance.A rules-based approach is essentially a ‘one size fits all’ approach and does not take into account the specific circumstances of the particular entity (e.g. such as distribution of shareholders, nature of environment).

7.What is the principles-based approach to corporate governance and what arethe advantages and disadvantages of this approach?

Principles-based approach isgeneral principles or objectives of the corporate governance system which it should aim to achieve. For example, the general principle may be that the corporation should ensure that there is accurate and adequate disclosure of information. Rather than identifying the exact practices that may assist in helping meet this aim (such as directing specific times for rotation of auditors, certification of financial reports) this then places the responsibility on the managers to consider which practices are appropriate, given their circumstances.

The advantages of this approach are:

It arguably places a higher level of duty on directors to determine which corporate governance practices are required, rather than simply accepting a minimum set of practices as being adequate.
Its flexibility means that the corporate governance practices can be adapted for the particular circumstances and environment of the entity

The key disadvantages

It essentially leaves it to the directors to interpret these principles and decide which corporate governance practices are needed and so relies on their honesty, integrity and commitment to good governance. If directors are competent and act in good faith then this is not a problem, however given that many of the corporate abuses that have renewed the interest in corporategovernance practices usually stem from people not acting appropriately, this is problematic.
It can lead to uncertainty about appropriate practices.

8.Explain the problems identified from the global financial crisis in relation to risk management and how these relate to corporate governance.

The text outlines 4 problems with risk management.

a disjointed approach to risk management where risk was not managed or monitored at the entity level but at individual activity level so no effective understanding or oversight of risk for the corporation overall
information about risks not reaching the board or board members being able to understand or appreciate the risks involved
that the culture (pursuing growth in profits) encouraged risk taking
a ‘disconnect’ or ‘mismatch’ between company’s overall risk strategy and related procedures. For example, many remuneration packages provided incentives for high risk activities and short term outlooks.

A good corporate governance system ensures that the corporation sets appropriate objectives, and then puts systems and structures in place to ensure those objectives which are set are met. It also provides a means for persons both within and outside the corporation to be able to control and monitor the activities of the corporation and its management. A key role is toprotectthe interests of stakeholders (including shareholders). To do this it is essential that risk is understood, monitored and managed. However, historically most corporate governance models have not highlighted the importance of risk management.