Influences on corporate governance
Influences on corporate governance

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Influences on corporate governance

2.2 Recent governance failures

As we have discussed before, the creation of corporate regulation is often linked to perceived failures of corporations and their management to behave in the way society expect them to. Corporate governance is not an exception to this trend, and, as with accounting, different countries may well experience difficulties at different times. For example, the development of British codes of best practice, which began with the Cadbury Committee, can be related to governance scandals such as Polly Peck and Coloroll in the late 1980s and early 1990s. However, the wave of corporate scandals, mostly in the USA, at the turn of the century has been marked not only by the number of cases but also by the effect they have had on investor confidence and market values worldwide. To stop the rapid erosion of investor confidence, the United States took drastic action in record time with the Sarbanes-Oxley Act in 2002. But first we review the problems behind these corporate failures in order to better understand the regulatory responses.

The combined impact of various US corporate scandals caused the Dow Jones Index to drop from a high for 2002 of 10,632 on 19 March to 7,286 on 9 October, wiping out trillions of dollars in market value. Investor confidence in the fairness of the system and the ability of corporations to act with integrity was ebbing. According to a poll in July 2002, 73 per cent of respondents said that Chief Executive Officers (CEOs) of large corporations could not be trusted (Conference Board, 2003). Amongst the many negative effects of this was a worsening of the pension funding crisis caused by the dramatic drop in the value of pension fund assets. It also increased the cost of capital and caused a virtual cessation in new securities offerings. The International Federation of Accountants (IFAC) claims that while there has been a lot of strategic guidance for business, there has been too little said about the need for good corporate governance. However, even the strategic guidance on well-run corporations given by authors such as Collins and Porras (1994) or Collins (2001) would, if followed, have prevented the worst abuses. These authors emphasise the fact that successful companies were visionary companies, with a long track record of making a positive impact on the world. They did more than focus on profits; they focused on continuous improvement. They took a long-term view and realised that they were members of society with rights and responsibilities.

However, the long-term view is something of a rarity in many companies. A critical factor in many corporate failures was a poorly designed rewards package, including excessive use of share options that distorted executive behaviour towards the short term. The use of stock options, or rewards linked to short-term share price performance, led to aggressive earnings management to achieve target share prices. When trading did not deliver the earnings targets, aggressive or even fraudulent accounting tended to occur. This was very apparent in the cases of Ahold, Enron, WorldCom and Xerox (IFAC, 2003).

One accounting chief on trial told the jury that Adelphia manipulated its earnings figures for every quarter between 1996 and 2002 to make it appear to meet analysts' expectations. ‘We reported numbers we basically made up’ he said (Los Angeles Times, 2004a). IFAC (2004) examined a number of cases of corporate governance failures. Some of the better known cases of financial irregularities are summarised in Table 1.

Table 1: Recent financial irregularities

Company Country What went wrong
Ahold NL earnings overstated
Enron USA inflated earnings, hid debt in SPEs
Parmalat Italy false transactions recorded
Tyco USA looting by CEO, improper share deals, evidence of tampering and falsifying business records
WorldCom USA expenses booked as capital expenditure
Xerox USA accelerated revenue recognition

In terms of corporate governance issues, Ahold, Enron and WorldCom all suffered from questionable ethics and behaviour at the top, aggressive earnings management, weak internal controls and risk management and, of course, shortcomings in accounting and reporting.

Enron is an excellent example where those at the top allowed a culture to flourish in which secrecy, rule-breaking and fraudulent behaviour were acceptable. It appears that performance incentives created a climate where employees sought to generate profit at the expense of the company's stated standards of ethics and strategic goals (IFAC, 2003). Enron had all the structures and mechanisms for good corporate governance. In addition, it had a corporate social responsibility task force and a code of conduct on security, human rights, social investment and public engagement. Yet no one followed the code. The board of directors allowed the management openly to violate the code, particularly when it allowed the CFO to serve in the special purpose entities (SPEs); the audit committee allowed suspect accounting practices and made no attempt to examine the SPE transactions; the auditors failed to prevent questionable accounting.

The use of questionable accounting and disclosure practices, their approval by the board and their verification by the auditors arose from a variety of forces, including:

  • pressure to meet quarterly earnings projections and maintain stock prices after the expansion of the 1990s;

  • executive compensation practices;

  • outdated and rules-based accounting standards;

  • complex corporate financial arrangements designed to minimise taxes and hide the true state of the companies, and the compromised independence of public accounting firms (UNCTAD, 2003).

Most governments have an imperative to try to foster a healthy economy, since this should lead to a better quality of life for all. Inevitably, when the economy suffers as a result of the actions of a relatively small number of people, the government is bound to react. Many initiatives in this area can be seen as a desire to make explicit the obligations that society expects the different actors to fulfil, and provide a framework for penalising their failure to do so. Such initiatives may also serve as an indication of change in social expectations (sometimes referred to as ‘social inflation’), where the generally accepted view of what is acceptable behaviour changes. The regulatory changes crystallise a change in the ethical and moral environment.

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