Chapter 7: Corporate governance Contemporary issue 7.1 Audit committees put risk management at the top of their agendas Questions 1. Traditionally, audit committees have primarily focused on managing financial reporting risk (i.e. risk of misstatements in financial statements) and reviewing aspects such as internal control systems. Do you believe the expansion of this committee’s role to consider business risk appropriate? 2. The extract notes a link between compensation structures within companies and risk management. Explain how these are related? 1. 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: http://www.charteredaccountants.com.au/Industry-Topics/Audit-and-assurance/Current-issues/Recent-audit-headlines/News-and-updates/Thought-leadership-paper-reviews-the-role-of-the-audit-committee 2. 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 if loan 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 issue 7.2 The individual must take responsibility for doing the right thing Questions This article discusses the issue of a code of conduct in corporate governance. Discuss whether a code of conduct is necessary for good corporate governance. The article states that it is impossible to legislate for ethics. Do you agree with this? If this is the case, does this mean regulation is ineffective? 1. A code of conduct is necessary for good corporate governance. A well designed and implemented code of conduct should reduce risk of inappropriate or damaging behaviour on the part of employees. Such behaviour can have a great impact on companies both financially and in terms of reputation. The existence of a robust code of conduct portrays integrity in the eyes of stakeholders. It sets the tone and contributes to the positive image of the organisation. 2. Student responses may vary here. Some may agree with this statement while others may not. Points for consideration include: Can we predict what ethical dilemmas may arise and are we therefore able to cater for every possible situation in the potential legislation? Is it always black and white? Right or wrong? Or does it depend on context? There could be more than one way of dealing with an ethical dilemma. How would we monitor compliance and enforce if ethics were regulated? Is legislative backing necessary for employees to take a code of conduct seriously? It does not mean that regulation is ineffective. It does however highlight the difficulties associated with implementing and enforcing legislation. We are also talking about predicting and managing human behaviour and each individual is unique. This makes a blanket approach such as implementation of legislation that applies to all people and all situations impossible. Regulation is not ineffective, but rather, difficult to apply and enforce when it comes to ethical behaviour. Review questions 7.1 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. 7.2 ‘Corporate governance is primarily focused on protecting the interests of shareholders.’ Discuss. This would depend on what point-of-view you take: 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’. Pluralist model — the responsibility of corporations goes beyond the narrow interests of shareholders and should be extended to a wider group of stakeholders. 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. 7.3 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. 7-4 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 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’, and that these problems can be reduced by linking management’s rewards to certain conditions. Students should refer to the chapter, which provides an overview of the shareholder–manager relationship in agency theory. Corporate governance is concerned with controlling and directing businesses and in the company context there is 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 specific prescriptions/rules) are espoused to address the problems associated with the agency relationship as outlined in positive accounting theory. 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 ‘aligning 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. 7.5 Identify the key areas addressed in corporate governance and provide examples of practices related to each of these areas. Explain how any individual practices identified 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 appropriate decisions Specific examples of corporate governance requirements here are minimum standards of experience for directors; requirements that at least some of 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 information is 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 governance in table 7.1). 7.6 What is the rules-based approach to corporate governance and what are the advantages 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 of shareholders 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). 7.7 Explain the difference between a rules-based and a principles-based approach to corporate governance. What are the advantages and disadvantages of each approach? A rules-based approach identifies specific practices that are required to achieve good corporate governance. A principles-based approach provides broad principles or objectives for the corporate governance system that reflect good corporate governance practice and it is up to management to determine how this objective can best be achieved. For example, the broad principle may be that the corporation should ensure that there is accurate and adequate disclosure of information. Rather than identifying the specific practices that may assist in helping meet this objective, a principles-based approach places the responsibility on managers to consider which specific practices are most appropriate, given the individual circumstances of the entity. The advantages of a rules-based approach are: It provides a minimum set of corporate governance practices that must be followed by all corporations No uncertainty around which practices are required Easy to enforce (they have either implemented the required practice or they have not) No blurred lines with regard to potential liability in terms of litigation The disadvantages of a rules-based approach are: It encourages a minimalist checklist type approach. Good corporate governance should be something to aspire to. It requires much more than meeting a minimum set of standard practices. Legislative backing changes the focus from promoting the interests of shareholders and stakeholders to about what we need to do to avoid legal liability. Promotes a one size fits all approach which may not be appropriate when each entity faces its own unique circumstances The advantages of a principles-based approach are: It 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 of the entity and the environment in which it operates. The disadvantages of a principles-based approach are: 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. Directors may not be competent or act in good faith. Many of the corporate abuses that have renewed the interest in corporate governance practices have stemmed from people not acting appropriately. It can lead to uncertainty about what constitutes appropriate practices. 7.8 Discuss the impact of the global financial crisis and recent corporate collapses on corporate governance practices. There has been an increased focus on risk management. Company failure to manage and control risk has been found to be a big contributor to the global financial crisis. It is also a common cause of corporate collapses or failures. Risk management is often ineffective because the process of risk identification and analysis is not carried out in enough depth. We first need to fully understand the risks before we can put controls and safeguards in place to manage and control them. This has also led to an increasing role for audit committees. There has also been an increased focus on executive remuneration. The issues associated with exorbitant executive remuneration have been contentious for a while and were highlighted even more so during the global financial crisis. Issues of concern that arose were that directors and executives were paid huge bonuses which appeared to be unrelated to performance of the company. These are paid even when company performance was deficient. Another issue was that remuneration packages and bonuses were found to reward short term goals and this encouraged excessive risk taking. 7.9 Explain the term risk management. Why is risk management such an important part of good corporate governance practice? Oversight and responsibility for risk management lies with the board. Risks can be wide ranging and as the ASX code states may include “operational, environmental, sustainability, compliance, strategic, ethical conduct, reputation or brand, technological, product or service quality, human capital, financial reporting and market-related risks”. It is important that the board identifies, analyses and considers an overall strategy for managing and controlling these risks. 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 not being able to understand or appreciate the risks involved culture (pursuing growth in profits) of the corporation encouraged risk taking a ‘disconnect’ or ‘mismatch’ between a 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 to protect the 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. 7.10 Explain the problems identified over the years in relation to risk management and remuneration and discuss how these relate to corporate governance. Problems identified in relation to risk management include: 1. Ultimate oversight and responsibility for risk management lies with the board. Risks can be wide ranging and as the ASX code states may include “operational, environmental, sustainability, compliance, strategic, ethical conduct, reputation or brand, technological, product or service quality, human capital, financial reporting and market-related risks”. Hence it is important that the board considers the overall strategy. Managing these risks in isolation (at activity level) is not sufficient. 2. Cleary the board needs information about risks the company faces and how these are managed. Without sufficient information, and understanding of these, the board cannot perform its duties. It is claimed this was problematic given the complexity of the financial instruments associated with in the global financial crisis. The ASX code now recommends that management provide a report to the Board about the risk management systems implemented and their effectiveness. 3. 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 and influenced by reward systems, management actions and attitudes. A culture of growth needs to be balanced with consideration given to any risks. 4. There needs to be a consistent approach to risk management and it needs to be reflected in the company’s procedures and practices. For example, any formal policies to reduce or control risk are likely to be s disregarded if compensation packages actually reward risk. Problems identified in relation to remuneration include: A disconnect/mismatch between bonuses paid to executives and company performance. This was seen as particularly problematic given lack on information about these packages and any ability to curb/stop these bonuses. There can be really 2 concerns here. First, often there is a perception that remuneration to some executives is excessive- how can these people warrant such huge payments. In good corporate governance directors/executives are supposed to act in the best interests of shareholders. Yet paying what seems unjustifiable amounts to themselves could be seen as a conflict of interest. Second, remuneration packages are supposed to be tied to company performance; this is what the Board and other executives are responsible for and hence what they are rewarded for. Yet despite poor or deteriorating company performance (even in some cases failure) many executives still received large (and increased) bonuses. How can this be justified? Compensation packages focused on short terms goals and encouraged excessive risk. 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 not 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 if loan 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. 7.11 Corporate governance has been highlighted as an important factor in alleviating the risk of corporate failure. Evaluate which aspects of corporate governance are likely to guard against corporate failure. Strong corporate governance that is likely to guard against failure will have the following characteristics: Boards are active in setting and approving the strategic direction of the company Boards are effective in overseeing risk and setting an appropriate risk level for the entity Boards consist of independent directors, with audit, compensation and nomination committees made up completely from independent directors Directors own an equity stake in the company Director quality - At least one of the independent directors should have expertise in the entity’s core business, attend the majority of meetings and limit the number of boards they sit on Boards should meet regularly without management present 7.12 ‘Any corporate governance system is only as good as the people involved in it’. Discuss. As the text notes decisions in, and about, corporations are made by people. The quality of any corporate governance is ultimately affected by the people involved in it. The following points could be discussed: Competence — clearly, if individuals do not have the requisite expertise or experience then this will adversely impact on decisions they make and reduce the quality of corporate governance. Integrity (ethics) of individuals. Whether or not individuals will act ethically is affected by a number of factors. These include: the individual’s own moral code the culture of the corporation and of peers. This is particularly important in relation to top management. In a number of corporations it is argued that either ethical or unethical behaviour permeates due to the stance taken by the ‘leaders’. the consequences of the decision. For example, if asked to do something that is not ‘right’ by a manager and refusing could impact on employment/future promotion; how ‘wrong’ is the decision and will it have a significant impact on others; what is the likelihood of being caught and what are the consequences if found to be acting unethically). Does the quality of individuals become more or less important if you have rules-based or principles-based corporate governance codes? There is no correct answer here. Rules-based allows companies to restrict practices to the specific rules and, hence, can argue that a form over substance approach can justify or defend unethical behaviour so long as rules are followed. Principles-based requires interpretations — presumably, if individuals do not act ethically there will be flexible interpretations of these. This is also obviously affected by enforcement and also legal issues (such as courts and what standards they consider when determining guilt and penalties for unethical behaviour). Does the quality of individuals become more or less important if you have voluntary or legislated corporate governance codes? This relates to the points made above. Again, if voluntary then relies more on individuals. However, legislated codes again can lead to the same problems as rules-based approach. The text notes the example in Hong Kong where codes are high but often not implemented. Application questions 7.13 Obtain the annual reports of a range of companies in the same industry and country and search for any disclosures in relation to corporate governance principles and practices. In relation to these disclosures: (a) identify the key areas considered by these companies (b) are there any differences or similarities in corporate governance practices? (c) do you believe you could judge or rank the relative standard of corporate governance of these companies based on the information provided? If not, what other information would you need to do so? (d) which company would you rank has having the best (or worst) corporate governance from these disclosures? Explain how you have arrived at this decision. (e) compare your rankings with those of other students. Identify and discuss the reason for any discrepancies between rankings. No specific answers can be provided as this will depend on the companies considered. Go online and download a couple of annual reports in the same industry, from 2013 to 2018 and see the differences. Discuss the following in class: What have you found out about the key areas? Explain the differences and similarities in class, on your Blackboard or WebCT. Discuss the judgement you have made. Did you identify the best and worst cases or corporate governance? 7.14 Obtain the annual reports of a range of companies in the same industry in different countries and search for any disclosures in relation to corporate governance principles and practices. In relation to these disclosures: (a) Identify any differences or similarities in corporate governance practices. (b) Can you provide any reasons from the business and regulatory environments in the countries that would explain these differences? No specific answers can be provided as this will depend on the companies considered. Again go online and download annual reports from various countries to discuss in class. It may also be useful to consider, identify and compare: country economic and business environmental factors any specific corporate governance guidelines or requirements issued for companies in the specific countries considered, for example by local stock exchanges, as well as considering enforcement mechanisms. In class, explain the differences or similarities in corporate governance practices. 7. 15 Many small companies argue that corporate governance requirements are too costly and onerous and should be restricted to the large ‘top’ companies. (a) Do you think that corporate governance principles should apply to smaller companies? (b) Provide examples of particular corporate governance practices or principles that you do not think should apply to smaller companies? Explain why you think these practices or principles are also important for smaller companies. (c) What would be the advantages of smaller companies complying with corporate governance principles? (d) What might be the consequences for smaller companies of not complying with corporate governance principles? (a) The basic principles of corporate governance would appear to apply to all companies, even smaller and medium-size companies. As discussed in question 1, corporate governance in very simple terms is ‘the system by which business corporations are directed and controlled’ (Cadbury, cited in Cowan, 2004, p. 15.). 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. The basic principles would apply to all corporations, large or small. Although it could be argued that the mechanisms to achieve these would vary as these issues become more critical in larger companies with greater separation, and also in smaller companies cost efficiencies would need to be more carefully considered. (b) Student answers may vary here. It is suggested that the same principles should apply but specific practices may vary. For example, PCW have produced a toolkit for corporate governance in small and medium enterprises. This is the link to the tool kit http://www.himaa.org.au/Governance/toolkit_print.pdf Smaller companies should still strive to fulfil the same principles and objectives as larger companies when it comes to corporate governance. In smaller companies there may be less emphasis on protection of shareholders and other stakeholder interests because there are less of them, but in principle, this is still important. Good corporate governance practices will also enhance reputation and increase confidence in the entity. The principles and objectives are the same and are just as important for smaller entities. It is just that they go about achieving them in different ways. Specific practices Implemented might be different to those implemented by larger corporations. Please see toolkit above for examples. (c) Advantages of good corporate governance would also apply to smaller companies. In particular, for small companies these would include: provides processes and assurance that companies are properly managed managing risk and facilitating economic growth (including entering emerging markets as investors need assurance that appropriate controls/systems are in place). (d) These were noted in question 3 above, that 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 as to involve fraud. It is often more subtle, 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. Students may wish to consider the following: List the particular websites that address corporate governance for small companies. Did you find any advantages to small companies having corporate governance requirements? What were the consequences? 7.16 A friend cannot understand why executives and directors of companies are often paid bonuses and not simply paid a set salary. (a) Using principles from positive accounting theory, explain the reasons for, and nature of, bonus plans offered to directors and executives. (b) Why are shares or share options often incorporated as part of a manager’s remuneration package? (a) Need to first explain agency theory which is a key principle in positive accounting theory. 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. The separation of ownership and control means that managers can act in their own interests which may be contrary to the interests of shareholders. Managers have variety of ways of reducing wealth to shareholders for the benefit of themselves. These problems include risk aversion, dividend retention and horizon. Given these specific difficulties (the problems discussed below) to alleviate these problems managers remuneration is not simply paid as salary but by a bonus linked to variables that try to reduce these problems. The problems are: the risk aversion problem — managers prefer less risk than shareholders because their human capital is tied to the firm. Shareholders are more diversified because their human capital is not tied to the firm. Managers can reduce their own risk by investing in low risk investments rather than maximising the value of the firm through higher risk projects. A bonus plan that relates managers’ salaries to profit may encourage less risk aversion. the dividend retention problem — managers prefer to pay out less of the company’s earnings in dividends in order to pay for their own salaries and perquisites (big offices, expensive business trips). Relating a part of mangers’ remuneration to profit and requiring that a minimum dividend payout ratio be maintained can help. the horizon problem—managers are only interested in cash flows for the period they remain with the firm whilst shareholders have a long term interest in the firm’s cash flows. Principals may relate part of managerial compensation to share prices, particularly for managers whose tenure is nearing completion. Bonus schemes can reduce these problems by tying manager’s remuneration to some index of the firm’s performance, which has a high correlation with the value of the firm (share prices, earnings). This ties managerial compensation to performance. Remuneration can also be tied to dividend payout ratios or to options or share bonus schemes Hence, this explains why is it preferable to pay managers a bonus (linked to appropriate variables/targets) rather than a set salary. It may be interesting to examine details of remuneration packages of directors etc. (often these are disclosed in annual reports or available on the company’s web page as a separate remuneration report) and see how these principles are reflected in the packages. (b) The rationale for incorporating shares or share options as part of a manager’s remuneration is to reduce the potential problems that arise due to the agency relationship between mangers and shareholders. In other words, it addresses the issue of conflicting interests. It aligns the interests of managers and shareholders so that managers are more likely to act in the best interests of shareholders, rather than acting in their own self-interest in a way that is detrimental to shareholders. 7.17 Obtain the annual report for a listed company and examine the remuneration packages provided for executives. (a) Identify the key components of the remuneration packages for directors and executives. Do the principles of agency theory provide a rationale for each of these components? (b) Would these packages provide incentives for these executives to manipulate accounting figures? (c) How much information is provided about any bonuses paid? Is this information sufficient to allow shareholders to determine if these packages are reasonable? Note: these are disclosed in annual reports (or available on the company’s web page as a separate remuneration report) and see how these principles are reflected in the packages. A suggested example is the 2010 annual report for AMP — this includes details of the remuneration package and related benchmarks. You can access this from links from http://www.amp.com.au/ or the 2011 annual report for Crown Ltd which includes details of the amounts of potential cash bonuses. You can access this from links from http://www.crownlimited.com. (a) Relate the key components of the remuneration packages identified to the three problems of agency theory identified. These problems include risk aversion, dividend retention and horizon and are discussed in the answer to 7.4. You may wish to consider the following: Are the benchmarks/targets for obtaining these bonuses clear? Are these reasonable for rewarding performance? For example, if linked to the share price of the company do they take into account general share price movements for similar companies? If they do not, then they may be penalising or rewarding managers for market factors rather than their own performance. Are there any components that do not ‘fit’ with the principles of the shareholder/manager agency relationship? If so, why do you think these components are included? (b) You will need to consider the following: If any of the bonuses are linked directly to accounting numbers (such as profit) then there may be incentives to manipulate to increase bonuses If linked to non-accounting numbers (such as dividends or share price) then you would need to consider market efficiency? For example, if the market would increase share price if profit increases via changes in accounting profit (i.e. the market is not efficient) then this would also create incentives to manipulate accounting figures. This will depend on the reports that you have found. You will probably find that in many cases there is limited information (in particular about benchmarks — often generic information about benchmarks is included rather than specifics). This makes it difficult for shareholders to consider however there could be legitimate coemptive reasons for not disclosing this information. 7.18 In many countries in Asia it is claimed that concentration of ownership/control by families of companies causes particular difficulties with corporate governance. For example, Hong Kong billionaire Richard Li owns 75 per cent of Singapore-listed Pacific Century Regional Developments. (a) Examine corporate governance guidelines and identify specific recommendations for practice aimed at protecting minority investors. (b) Would these suggested practices be effective where there is a higher concentration of family control in a company? (a) This will vary depending on the guidelines examined. For example: The ASX principles of best practice do not seem to specifically refer to minority shareholders. However general principles regarding shareholders and requirements of independent board members may assist. Link to ASX if this needed is http://www.asx.com.au/governance/corporate-governance.htm The OECD principles do refer to minority shareholder interests in a number of specific instances. http://www.oecd.org/dataoecd/32/18/31557724.pdf The Chinese code has many references to minority shareholders http://www.ecgi.org/codes/documents/code_en.pdf The Pakistan Corporate Governance guide for family- owned campiness also specifically identifies the need to respect and protect minority shareholders http://www.cipe.org/regional/southasia/pdf/CG_Guide_Pakistan_08.pdf (b) There is no correct answer here. However, should consider issues such as: Even where codes specifically address issue of minority shareholders how can it be ensured that rights considered given influence that any dominant shareholders will have. Given that investment is choice and minority shareholders would know of limitations to their power/influence when investing does this justify should corporate governance be focused on majority concerns. Students may also wish to go online and download information on Pacific Century Regional Developments and consider the specific circumstances of the company. 7.19 Each year various bodies give corporate governance awards. Examples are, in Malaysia, an annual award is made by Malaysian Business, sponsored by the Chartered Institute of Management Accountants (CIMA), and with The Australasian Reporting Awards (Inc.) – an independent not-for-profit organisation – makes annual awards. (a) Locate the criteria on which these awards are based and compare these for different awards. (b) Are there any significant differences between the criteria? (c) In what areas of corporate governance reporting did winning companies outperform other companies? (d) Does the wining of an award for reporting necessarily mean that these companies have best corporate governance practices? (a) For example, the Australasian Reporting Awards and criteria for corporate governance awards states that “These Awards seek to recognise the quality and completeness of disclosure and reporting of corporate governance practices in the annual reports of business entities in the public and private sectors.” for private sector entities states. Review the criteria section at http://www.arawards.com.au/ (b) This will depend on awards criteria reviewed. (c) This will depend on information available. For example, the Australasian Reporting Awards identifies companies that have been ranked as gold, silver or bronze and specifies what the differences are in being awarded this rating. So it may be useful to look at reports for companies in these different rankings to identify any differences. For example, one difference between gold and silver is that gold requires ‘full’ disclosure whereas silver requires ‘adequate’ disclosure. (d) Students should consider: How would you tell if a company did not follow these practices that they have claimed? How likely it is that companies who do not have good corporate governance practices would disclose this fact? It may be what is not disclosed that is important. (Remember: Enron was perceived as one of the best but fell short in practice) 7.20 Australian companies listed on the ASX must report on their corporate governance practices on the basis of ‘comply or explain’. That is, they are not required to comply with all of the specific corporate governance practices detailed by the ASX but if they choose not to comply, they must identify which guidelines have not been ignored and provide a reason for their lack of compliance. (a) Examine the corporate governance disclosures of some Australian listed companies and identify any instances where best practice recommendations of the ASX have not been met. (b) Do you believe that the noncompliance in these instances is justified? (c) What are the advantages of having a ‘comply or explain’ requirement rather than requiring all companies to comply with all best practice recommendations? (a) Examples are in questions 7.9 and 7.10. Students should be able to find own examples. (b) See responses to questions 7.9 and 7.10. Responses will depend on the nature of non-compliance and also circumstances and reasons given by particular company for non-compliance. (c) The advantages is that this allows specific circumstances of a company to be considered when determining appropriate corporate governance practices (so for example, does not impose a ‘one size fits all’ approach regardless of the size of the company). This is consistent with the principles-based approach to corporate governance. While this allows flexibility, the fact that the need to disclose and justify non-compliance also allows shareholders and other stakeholders to clearly identify any instances of non-compliance and also requires management to consider this (it could be argued as need to disclose if do not comply then management need to explicitly consider whether or not non-compliance is justified as will be open to scrutiny). 7.21 In the 2009 annual report of Boral Ltd (an Australia-listed company), the corporate governance disclosures include the following note: The Board has considered establishing a nomination committee and decided in view of the relatively small number of Directors that such a Committee would not be a more efficient mechanism that the full Board for detailed selection and appointment practices. The full Board performs the functions that would otherwise be carried out by a Nomination Committee. (a) Examine the ASX corporate governance principles and identify the best practice recommendations in relation to nomination committees. (b) What potential governance problems are these recommendations designed to meet? (c) Is Boral’s deviation from these best practice recommendations justified? (d) In March 2010 (see 2010 annual report), Boral did introduce a Nomination Committee (as part of the Remuneration Committee) although it is noted that the number of directors remained the same. What reason can you think of for this change, given Boral’s previously stated reason for not complying with this best practice recommendation previously? (a) ASX Corporate Governance Principles can be found at http://www.asx.com.au/governance/corporate-governance.htm The ASX recommendations for a nomination committee are related to Principle 2; Structure the Board to add value. The specific recommendation for the nomination committee is 2.4. This indicates that for smaller companies a separate, formal committee may not realise desired efficiencies. The recommendation includes: A charter establishing roles and responsibilities Composition of at least 3 with majority independent and chaired by independent director Responsibilities include making recommendations about required competencies of directors, succession plans, appointments and process for evaluation of performance Selection and appointment process and re-election of directors (b) Students should see that given the role of the Board of Directors is it essential that those on the board are the ‘best’ people for this role. Also the responsibility to ensure that the composition of the Board is of the right level of expertise, experience and independence to ensure that it can meet its obligations, lies with the Board itself, a nomination committee assists in this by specialising in the recruitment (so ensuring that the company is able to recruit the ‘best’ people for these positions) and also should assist in ensuring a balance of executive and non-executive directors (o to avoid potential dominance. bias and protect shareholders interests). If the nomination of Board members is undertaken without a nominations committee this means that the Board itself is deciding on members without input or review from any others. Firstly, the Board itself may not have the time or expertise to search and recruit the best people (especially given their other duties). Also it is difficult for the Board to consider itself and its members objectively. Historically, in particular the recruitment of non-executive directors by the chairman of the Board, has been seen as often compromised at least in terms of independence — clearly, if appointed by the Board itself, new directors may feel under an obligation to support the people who have appointed them. Students should recognise that a key risk in the Board making appointments without a nomination committee is that the existing Board may choose members who will agree with their own views and not be willing to challenge or provide objective advice/criticism. (c) Boral website is boral.com.au. Information about these best practice recommendations can be found on the website: Boral 2009 annual report relating to Board appointments and nomination committee and the annual directors review. Boral site is http://www.boral.com/ Boral have justified their non-establishment of a nomination committee on the basis of efficiency in light of the small number of Board members (this was 6 but was increased in 2007 to 8). The ASX guidelines do state that for smaller boards a nomination committee may not be efficient. Also, Boral notes that they do use an external consultant in the process of identifying and assessing potential candidates. This could alleviate some of issues of not having a nomination committee. Students may arrive at different views as to whether deviations from best practice guidelines are acceptable. (d) The 2010 Boral annual report states: In March 2010, the Board decided that it would be desirable to have a committee to assist the board with its nomination responsibilities. Accordingly, the responsibilities of the Remuneration Committee were expanded to encompass nomination responsibilities, and the Remuneration Committee was reconstituted as the Remuneration and Nomination Committee. In addition to responsibilities relating to remuneration, the Committee now has responsibility for making recommendations to the Board on matters such as succession plans for the Board, suitable candidates for appointment to the Board, Board induction and Board evaluation procedures. P34 It should be noted that in 2010 although the number of directors remained the same (at 8) there was a change in 2 directors. Also a comparison of the 2009 and 2012 annual reports reveals that more information is provided about this corporate governance area in the 2010 annual report and it is also apparent that a review of company policy in this area was undertaken. For example: The 2009 Annual report stated: The Directors believe that limits on tenure may cause loss of experience and expertise that are important contributors to the efficient working of the Board. As a consequence, the Board does not support arbitrary limits on tenure and regards nominations for re-election as not being automatic but based on the individual performance of Directors and the needs of the Company. (p 33). The 2010 Annual report stated: The Directors have adopted a policy that the tenure of Non-Executive Directors should generally be no longer than nine years. A Non-Executive Director may continue to hold office after a nine year term only if the Director is re-elected by shareholders at each subsequent Annual General Meeting. It is expected that this would be recommended by the Board in exceptional circumstances only.(p 35). There is no correct answer to why Boral has changed this practice. Possible reasons/motivations could include: The changes in 2 new directors may have motivated the board to review this policy. They may have decided that the task was more appropriately and efficiently handled by a committee. Increased scrutiny (or expected) on corporate governance practices following the global financial crisis. In particular in Australia the changes relating to shareholders voting and rights in relation to directors remuneration could have prompted company to undertaken these changes. It is also likely that the company overall would be under increased scrutiny due to its performance. As company operating in the building industry, the company has been adversely affected by the global financial crisis (particularly the impact on US property market) and also by a downturn in the Australian building industry. Given the impacts on profits/earnings etc. this would be expected to bring more scrutiny on directors’ performance/abilities etc. 7.22 In the 2010 Annual report of Biota Ltd (an Australia-listed company), the corporate governance note disclosed an audit committee composed of two directors (chaired by an independent nonexecutive director and supported by one other nonexecutive director). (a) Examine the ASX corporate governance principles and identify the best practice recommendations in relation to audit committees. (b) What potential governance problems are these recommendations designed to meet? (c) Does Biota’s audit committee meet these guidelines and if not, is any deviation from these best practice recommendations justified? (a) The ASX practices are outlined below in principle 4. Recommendations include: Establishing an audit committee Structure of this committee A formal charter Disclosures (b) Students should recognise that the audit committee recommendations relate to Principle 4. So the establishment of an audit committee is seen as essential to safeguard the integrity of the financial reporting. The outline of the audit report above indicates the problems that this is trying to alleviate. The audit committee is trying to ensure that the financial information is not compromised (i.e. for example, it aims to ensure that the selection and appointment of the auditor who checks the reports is independent, that the financial information provided to shareholders is adequate, and that the internal control systems and management processes underlying financial reports are adequate). This committee also assists in trying to ensure that reporting is not unduly influenced by management. (c) Information about the company’s ASX Corporate Governance Council Guidelines can be found in the 2010 Biota annual report (www.biota.com.au) Obtain the annual report for Biota and answer the questions. Clearly Boral has not met the minimum three membership requirements as recommended by the ASX, although both members are non-executive independent directors. It states (p. 12) that “The Board is of the view that the composition of the Audit and Risk Committee and the skills and experience of its members are sufficient to enable the Committee to discharge its responsibilities with the charter. All other non-executive directors are able to attend meetings at the discretion of the Committee Chair as observers.” Biota could argue that have reduced membership on basis that it is a smaller company with only 7 directors. Also 6 of the 7 board members are independent, including the Board Chairman, and it is noted that “The Board Chairman attends most meetings as an ex officio member of the committee.” The fact that is chaired and supported by non-executive directors could be argued to alleviate any concerns, as well. Also the fact that auditor has policy of rotation also may alleviate concerns. Students may arrive at different views as to whether deviations from best practice guidelines are acceptable. 7.23 At times there are problems (and subsequent investigations) with corporate governance, which include deficiencies in financial reporting. (a) Search the website of the Australian Securities and Investment Commission and identify a case that has been investigated that involves issues of corporate governance. (b) Briefly discuss the corporate governance issues and the role financial reporting played in these. Provide specific examples of deficiencies in financial reporting that led to the issues. (c) Suggest what specific procedures or practices could have prevented these abuses from occurring. (a) The ASIC annual report provides a summary of major cases and the media centre often provides summaries of cases considered or investigated (access from http://www.asic.gov.au). The ‘key matters’ section at http://www.asic.gov.au/asic/ASIC.NSF/byHeadline/Media%20centre has information on major investigations/cases. For example the 2010/11 annual report has details re breaches of duties by directors: http://www.asic.gov.au/asic/asic.nsf/byheadline/Westpoint+bulletin?openDocument Students will find other cases. For example, on the SEC (US) http://www.sec.gov/ site: http://www.sec.gov/news/press/2012/2012-21.htm - discusses a case of accounting fraud. (b) This will depend on the cases found by students. It may be useful to look at the annual reports of companies involved in investigations and consider their corporate governance disclosures (and practices). (c) Gain, this will depend on the cases found by students. It may be useful to consider the nature of cases and problems: e.g. did these require collusion (i.e. involvement of more than one person); how were problems detected (this may give hint of how could be prevented and whether corporate governance processes could have assisted); what corporate governance disclosures did these entities make (do these indicate systems acceptable). Case study questions Case study 7.1 Reining in executive pay Questions 1. This article discusses the recent changes to address alleged excessive executive remuneration. Identify the main features of the reforms and how these could be effective. 2. The article argues that the effectiveness of the reforms is based on the assumptions that shareholders will act. Is this assumption reasonable? What are the barriers to effective share holder control? 3. The article argues that other ‘incentives’ — such as taxation laws and denying contracts — should be implemented. Do you think such measures would improve corporate governance practices? 1. The article discusses changes in the US under the Financial Reform Act. These are aimed at improving accountability and transparency. The main features as described in the article are: Increased rights of shareholders: e.g. providing shareholders with rights to vote (although non-binding) on executive compensation and also to ability (under certain conditions) to nominate potential board members. Increased disclosure: e.g. of executive pay and how relates to actual financial performance of the company; ratio of CEO compensation to median workers’ pay Increased control i.e. board compensation committee must be independent Effectiveness of these reforms is interrelated. For example, adequate disclosure is required if shareholders are to be able to make an informed vote on whether or not to approve the compensation package. The type of information disclosed (such as how relates to actual performance and relationship to ‘median’ pay) would presumably ‘highlight’ more clearly any disparities or incongruities. It could be argued that as the shareholders vote is non-binding, this could be simply ignored; however companies (and directors) would presumably wish to avoid the situation where shareholders vote against their packages, particularly if there are provisions to allow these same shareholders to nominate their own board candidates. (Further details of reforms can be found in actual legislation but students are not expected to consider beyond article). Although not asked in the question it may be useful to consider the Australian situation where there is now a ‘two- strike’ rule, where if more than 25% of shareholders vote no to the company’s remuneration report at 2 consecutive annual general meetings then there is a possible ‘spill’ of the Board. 2. Students may note the following as barriers to effective shareholder control: Willingness to act. It could be argued that shareholders with diverse portfolios are less ‘concerned’ about specific companies, than their overall portfolios. They can manage risk by diversification and holding a range of shares/investments. In such cases they may be reluctant to intervene/take action. This has also been claimed to apply to some institutional shareholders who take a passive approach. Any ‘action’ here is likely to be restricted to changing their portfolio of shares (e.g. selling shares) rather than actively acting to challenge or question company management. Diversity and fragmentation of shareholders. In many companies there are numerous minority shareholders. To take effective action such shareholders would need to ‘combine’. This is difficult. In many cases few minority shareholders even attend annual meetings etc. Further, many of these shareholders may lack sophisticated business expertise. Cost of action. This also relates to discussion above. Taking action involves costs- be these time, money. For minority shareholders (or investors with diversified portfolios) the costs are likely to outweigh any potential benefits. Lack of information. Most shareholders rely on the information provided to them by the company. If this is deficient then the effectiveness of any action can be impeded. 3. The ‘incentives’ raised in the article are essentially economic incentives. Such incentives are used to promote or deter certain actions. The incentives mentioned in the article are: Setting a limit to tax deductions for executive pay Applying conditions on executive pay to be awarded government contacts If such incentives were introduced this effectively places a potential ‘real’ economic cost on companies (for example, if tax deductions limited for executive pay then any amounts over the limited cost the company ‘more’ as no deductions would be allowed). Students could argue regarding possible effectiveness: In practice it is likely that such ‘incentives’ agree to and implemented, would only be applied to extreme cases. Therefore their effectiveness is only limited to a few companies. Also incentives such as those related to government contracts would also only impact those companies involved in such contracts. Would these costs be material to a particular company- and therefore be an effective control/deterrent? For large companies, even though executive pay may appear disproportionate, these costs are usually minimal in the overall company’s costs. People and companies are very inventive. It is possible (if not likely) that if such incentives were introduced companies may ‘structure’ arrangements to avoid any such limitations. We see examples in relation to the law or even accounting standards where there can be the claim that the companies are following the ‘letter’ of the law but not the spirit’. If companies can avoid any limitations by such arrangements then this would impede effectiveness. Case study 7.2 ABC Learning ‘reliant’ on debt to cover cash shortfalls Questions Outline the importance of cash flow to ensuring the ongoing operation of a company. Discuss the corporate governance and board mechanisms that could have served to limit the chances of corporate failure in the case of ABC Learning. 1. The ongoing operation of a company requires adequate cash flow to pay debts when they fall due. It does not matter how bigger profit they report on the Income statement or how many assets are on their balance sheet. If they are unable to pay for goods and services to maintain the current level of operations, or if they are unable to repay their debts, the business will not be sustainable. 2. Student responses will vary here but some key points for discussion include: Design and implementation of more stringent policies and procedures with a strong commitment to Internal control from the top down Closer monitoring of financial reporting and results More long term planning and a solid strategy with regard to growth and expansion of the business. This case is an example of too much too fast with little integration. A more structured approach to risk assessment including closer monitoring of liquidity and long term solvency. Solution Manual for Contemporary Issues in Accounting Michaela Rankin, Kimberly Ferlauto, Susan McGowan, Patricia McGowan 9780730343530
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