Week 5

1. Week 5 Corporate Governance

2. Learning Objectives • Upon completing this topic you should be able to: • Explain the interest in corporate governance; • Explain what corporate governance is and why good corporate governance systems are needed; • Discuss the relationship between positive accounting theory and corporate governance; • Discuss the key areas involved in corporate governance; • Explain and evaluate the alternative approaches to corporate governance; • Discuss recent developments and issues in corporate governance; • Explain the role and impact of accounting in and on corporate governance; • Discuss and analyse the role of ethics in corporate governance; • Discuss international perspectives and developments in corporate governance.

3. Where does this fit into unit learning goals? • apply a range of theories of accounting to explain financial accounting and reporting practices and appreciate the judgements, estimations and assumptions influencing accounting numbers; • critically assess and appreciate changing influences in standard setting; the compliance regime in capital markets and impacts of regulatory requirements on financial reporting practices; • assess the role of financial accounting in sustainable development and corporate social and environmental performance reporting; • analyse a range of financial reporting issues, including intangible assets, financial instruments and foreign currency transactions, from both a practical and theoretical perspective; and • demonstrate effective individual research skills to produce professional quality business documents to solve financial accounting problems; and demonstrate in individual summative assessment tasks the acquisition of a comprehensive understanding of the topics covered by this unit.

4. The Growing Interest in Corporate Governance • Interest in corporate governance appears to be driven by • Highly publicised corporate misconduct • Agency problems • Realisation of other benefits

5. Problems with the Management of Corporations • Management self interest • Fraud • Perquisites • Anti-social corporate behaviour • Hiding or falsifying information • Perceived gap between performance and remuneration

6. Problems with the Management of Corporations • These problems, real or perceived, can have wider ramifications. • Poor governance is linked to • Poorer firm performance • Increased regulation for all companies • Decreased consumer confidence • Reduced economic growth • It has even been implicated in a number of national and global financial crises

7. Advantages of Good Corporate Governance • In a globalised and competitive environment good governance can be a significant advantage. • Good governance can • Reduce the cost of capital • Increase shareholder base • Manage increased scrutiny • Increase consumer confidence • Facilitate economic growth

8. What is Corporate Governance? • The procedures and processes according to which an organisation is directed and controlled. • 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

9. Corporate Governance Stakeholders • Whose interests are to be protected and what are ‘appropriate’ objectives of the corporation? • Traditional or ‘Anglo-Saxon’ Model • The key role for corporate governance is enabling the efficient use of resources by helping financial markets to work properly and gives priority to shareholder value

10. Corporate Governance Stakeholders • Summarised by Milton Friedman: Corporate governance is to conduct the business in accordance with the owner or shareholders’ desires, 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’.

11. Corporate Governance Stakeholders • Alternatives to the traditional view suggest that corporate governance must go beyond the narrow interests of shareholders and should be extended to a wider group of stakeholders. • European Models • Multiple stakeholders

12. The Need for Corporate Governance Systems • The corporate structure requires governance • Separation between capital contributors and management • Under the best circumstances managers should act as though they had contributed the capital • It would appear this does not happen and managers may ‘bias’ or distort the financial statements

13. Positive Accounting Theory and its Relationship with Corporate Governance • Refer Week 2 for discussion of PAT • Positive accounting theory explains that for efficiency reasons companies are formed and can be viewed as a network of contracts or agreements that determine the relationships with and among the various parties involved. • One important agency relationship that arises from this nexus is that between the managers and the capital contributors who authorise the managers to make the key business decisions.

14. Overview of the Shareholder–Manager Relationship in Agency Theory

15. Corporate Governance Guidelines and Practices • 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. • The environment in which the corporation operates.

16. Elements of Corporate Governance • Review Table 7.1 in the text. • Key elements • Controlling and directing the directors (and senior management) • ensure that the key managers make appropriate decisions • Role of shareholders (and other stakeholders) • ensure that shareholders have the ability to protect their interests in the corporation • Transparency and accountability • ensure that the stakeholders (including shareholders) are sufficiently informed about the activities of the company and its management

17. Elements of Corporate Governance • Summary of ASX 8 Principles of Corporate Governance • Lay solid foundations for management and oversight • Structure the board to add value • Promote ethical and responsible decision making • Safeguard integrity in financial reporting • Make timely and balanced disclosure • Respect the rights of shareholders • Recognise and manage risk • Remunerate fairly and responsibly

18. Approaches to Corporate Governance • The Rules-Based Approach to Corporate Governance • Prescribe precise practices that are required or recommended to ensure good corporate governance. • Associated with enforcement by legislation or listing rules, with imposition of penalties if the rules are not followed.

19. The Rules-Based Approach to Corporate Governance • Advantages • Provides a set of minimum corporate governance practices that must be followed by all corporations. • Aids enforcement and clarifies potential liability. • Disadvantages • Lowest common denominator approach • Encourages form over substance • Focus on legal liability not stakeholder interests

20. The Principles-Based Approach to Corporate Governance • Identifies general principles or objectives for the corporate governance system to aim to achieve. • Responsibility is placed on the managers to consider which practices are appropriate, given their circumstances.

21. The Principles-Based Approach to Corporate Governance • Advantages • Places a higher level of duty on directors to determine which corporate governance practices are required. • Its flexibility means that practices can be adapted for the particular circumstances and environment of the entity. • Disadvantages • Directors must interpret these principles and decide which corporate governance practices are needed. • It relies on their honesty, integrity and commitment to good governance.

22. Practical Considerations • In most countries, corporate governance involves various combinations of both the rules and principles-based approaches. • Specific legislation that requires certain corporate governance practices to be followed by law. • Codes of corporate governance practice issued by government or industry groups and also by stock exchanges.

23. Activity 1 • Review the corporate governance statement of David Jones Ltd

24. Developments and Issues in Corporate Governance • The global financial crisis has provided an impetus for regulators, corporations themselves and other organisations to reconsider aspects of corporate governance. • An OECD review concluded that while the espoused principles of corporate governance were sound, there was a ‘gap’ between the principles and their implementation.

25. Increased Focus on Risk Management • The failure of many corporations to manage and control risk has been identified as a cause of the financial crisis. • Risk management deficiencies noted include: • Risk was not managed or monitored at the entity level, but rather at individual activity level. • Information about risks were not reaching the board. • Organisational culture encouraged risk taking • Disconnect between the corporation’s overall risk strategy and related procedures

26. Increased Focus on Risk Management • Risk management in many codes of corporate governance is not given prominence. • Many corporations are now endeavouring to introduce more formal and comprehensive risk management policies and procedures and integrate these into their existing corporate governance frameworks. • The task of ‘business’ risk management is now often delegated to the audit committee.

27. Elements of the Effective Governance Model

28. Executive Remuneration • This is a contentious issue regularly scrutinised by public and the media. • Concerns have been raised about • The size of executive remuneration. • The apparent disconnect between performance and pay. • The use of public (bail-out) money to pay bonuses. • The connection between remuneration packages and rewarding short-term focus

29. Executive Remuneration • In response to the financial crises and concern about remuneration there have been a variety of legislative responses. • In the US, the Dodd-Frank legislation includes: • ‘Claw back’ provisions if it is found that compensation paid was based on inaccurate financial statements • In Australia, recent legislation includes • Increased disclosure • A ‘two-strikes’ rule where if more than 25% of shareholders vote against the remuneration report for two consecutive years, the board itself can be put up for re-election.

30. Activity 2 • Explore the disclosures relating to executive remuneration • Documents long term and short term pay • Performance hurdles • Pay policy and philosophy • Alignment with owners needs (agency theory)

31. Role Of Accounting And Financial Reporting In Corporate Governance • Accounting clearly has a central role in directing and controlling a corporation. • Management accounting provides a significant part of the information on which company operations will be decided. • Financial accounting provides the means for outsiders to monitor the corporation and to assess how well those responsible for managing the corporation have performed.

32. Deterring, Preventing and Encouraging Certain Actions and Decisions • There are two key ways in which accounting is used to direct and control the managers of a corporation. • Encourage appropriate decisions • Linking managers performance to rewards • Transparency and disclosure • Requiring specific disclosure about areas relevant to corporate governance. E.g. • AASB 124 Related Party Disclosures • AASB 2 Share-based Payment

33. Informing Shareholders and Stakeholders • The key role for financial reporting in corporate governance is to provide the information needed to assess the performance of the corporation and its managers. • To be useful the financial statements provided must be transparent, unbiased and complete. • Financial statements are a crucial link enabling shareholders to monitor directors’ actions and to assist in identifying any deficiencies in the effectiveness of corporate governance

34. Financial reporting ‘problems’ • Historically and recently there are many examples of financial reporting failures. • The choices of accounting policy may not be neutral or unbiased. • Two key drivers are • Maximising remuneration bonuses • Meeting market expectations • Also instances of outright fraud

35. The Role of Ethics “At the core of good governance is ‘doing the right thing’ by acting with honesty, impartiality, integrity, trustworthiness, respect for the law and due process. A commitment to ethical values is fundamental” Peter Achterstraat, Auditor-General in New South Wales

36. The Role Of Ethics • Good corporate governance cannot exist without ethics. • The Sarbanes–Oxley Act in the United States requires disclosure of whether or not there is a code of ethics for senior financial officers. • CPA Australia argues that implementation of a corporate governance structure is not sufficient and will only work if the culture of the corporation supports good governance. • The Hong Kong Institute of Certified Public Accountants guidelines for public bodies places emphasis on the personal qualities of individuals as the foundation for good corporate governance.

37. Activity 3 • Examine ethics as a corporate governance issue

38. International Perspectives And Developments • The Anglo-Saxon model placing emphasis on shareholders interest dominates in the United States, Australia, Canada and the United Kingdom. • Asia is increasingly adopting the Anglo-Saxon shareholder model. • In Europe, there is more direct recognition of alternative stakeholders (such as employees in France and creditors in Germany).

39. International Perspectives And Developments • It is likely that corporate governance will increasingly consider broader stakeholders. • The principles-based approach prevails at the moment, backed by legislation for particular practices. • Future crises, collapses and financial reporting failures will influence future directions and approaches.

40. Next Week • Review problems with this topic • Question provided in class • Capital markets research in accounting • From a users perspective • How does accounting information relate to changes in share prices?