Corporate Governance and its Importance
Governance is the way by which an entity is guided and controlled and is held responsible for accounting for its actions and results. It is a framework formulated through which accountability, transparency, legal compliances and true and fair view is ensured. Thus, comes into picture “Corporate Governance”.
Corporate Governance is the system which is comprised of practices, rules and processes for directing the organization to work within rules based frame. Corporate governance revolves around the concept of interest to stakeholders whether external or internal such as investors, customers, government, lenders, banks and the general public at large. It not only provides a framework for achievement of the objectives of a company but also includes every aspect of management, that is, from plan of actions and internal controls to performance analysis and appropriate disclosures (Cochran, 2017).
The direct stakeholder that influences the corporate governance are the board of directors as they are directly elected by the shareholders or other members of the board. The BOD is responsible for making decisions such as dividend policies, compensation policies and corporate officer appointments (Fridson & Alvarez, 2012). This responsibility extends to the environmental and social concerns. The actions of board of members or directors are important for an entity as the responsibility of moving within the framework of corporate governance as well aligning the interests of internal shareholders with that of external stakeholders (Dash, 2016).
A bad corporate governance can lead to questions on the integrity, reliability and objectivity of the company which would have impact on the financial status of the company as well its reputation would come at stake. For example, Volkswagen AG in 2015 was a scandal where it got revealed that the firm had furnished emission tests in Europe and America. Due to this, its stock price fell down to nearly half and it’s sales globally was down by 4.5% (Girard, 2014). Other cases such as Enron and Worldcom shook the public confidence and trust in the companies, market and the accounting and auditing industry. Bad governance can be a result of not having efficient auditors, companies not complying with the instructions of their auditors, low compensation packages for officers, no beneficial incentives, etc. Corporate governance have been considered as a needed pressure over the companies after the introduction of Sarbanes-Oxley Act, 2002 in United States, which was introduced to gain back the public confidence & trust in the companies after the occurrence of such accounting scandals of high valued companies.
Theoretical Concepts of Corporate Governance
Good governance is a vital need for a business to survive in the long run. It stretches from the company’s profit objective to companies social obligations of enjoying a good corporate citizenship that includes awareness regarding environment, ethical behavior and sound practices of corporate governance (Johnstone, 2014).
We can also analyze major theoretical concepts such as agency theories, resource-dependence theories, stakeholder’s theories and stewardship stories around which the corporate governance revolves. Let us discuss such theories in brief:
- Agency theories: this theory came into being due to a difference between the owners of the company who are considered as ‘Principals’ and the executives who are responsible for managing the entity and are referred to as ‘Agents’. This theory works on an assumption that the Principals suffered from an agency loss which is considered to be less than the returns they deserve on their investments because of not managing the company directly. A part of their return goes to the agent which could have been shareholder’s share. Thus, suggestions say to provide rewards in terms of finance to executives so that they manage to maximize the owner’s profits. Further, the board has to develop a strict control, supervision and performance monitoring of the agents in order to protect their Principals interests.(Chriss, 2009)
- Stewardship theories: this theory follows a different path than the agency theory. It states that the executives are the stewards of the shareholders or owners and both of these groups have a common goal. Therefore, the board should not be too strict instead it should empower the executives so that they can maximize the productivity level and in turn, maximize profits. It focuses on the relationship that involves mentoring, leading, training and mutually formed decisions(Loughran, 2010).
- Resource Dependence theories: this theory says that it is the board who is responsible for providing resources to executives so that organizational goals can be achieved. This theory invites interference from the board while supporting the executives with a strong force of labor and intangibles. It focuses on mutual decision making with major approval of executives and some of the board. For example, board members if they are professionals can use their in depth knowledge to train and instruct their executives in a different way that contributes towards achieving the maximum organizational performance. (McLaney & Adril, 2016)
- Stakeholder theories: this theory stresses on the assumption that the shareholders are not the only persons having a stake in a company or a corporation. This theory gives importance to other stakeholders such as customers, clients, third parties, suppliers and other stakeholders that they took hold a stake in the company. Thus, management should rather focus on providing the maximum returns to all the stakeholders and not just the shareholders(Dayananda, Irons, Harrison, Herbohn, & Rowland, 2008). Thus, this theory approaches towards the corporate social responsibility which stresses on ethical terms and standards even though that leads to some reduction in long term profits of the company. Thus, the board is bestowed upon with the responsibility of ensuring the returns to all their stakeholders in terms of whether dividend or satisfaction etc by taking into practices the principles of sustainability and corporate governance (Noreen, 2015).
Coming across to the case of medium sized company where an employee addresses about the conversation he overheard. The following conversation took place between the chief executive officer called Paul with one of the non executive director called Alan who is also Paul’s cousin. Paul explains Alan the stress on the company before disclosing the financial reports in the general meeting that the profits of the respective period are showing a fall and this can be considered as a threat to the company’s operations as this might result in some severe circumstances such as losing of some potential shareholders, fall in the market price and decrease in their credibility status (Picker, 2016). The listener, that is, Alan suggested him to include the sale proceeds of their toothbrush division which hasn’t actually accrued but is expected to occur till October. This would raise the profits slightly higher than previous year’s profits. On being asked by Paul that whether an fraudulent action won’t take place if the accounts are signed off, Paul replied that fraud wouldn’t be happening as “.. Its just a manipulation of timing rather than numbers”. The last statement was agreed by Paul.
The approach of company towards their problem is an unethical approach as the fear of losing shareholders is letting them adopt an unethical way. As per accounting standards, the anticipated expenses are recognized beforehand but the anticipated income could not be recognized until and unless the same has been accrued. This relates with the accounting standard AASB 15 relating to Revenue Recognition that states a five model. According to AASB 15, the five model could be explained as follow:
- Identifying the customer with contract: the contract is being identified and the parties to the contract are identified. It is not necessarily in written but can be verbal or implied. The thing to be ensured with it is that the respective parties to the contract are willing to perform their obligations.
- Identification of performance obligations: for the sake of contract, the respective performance obligations are identified and the same is being accounted separately.
- Determination of transaction price: An entity is required to identify the price associated with the goods or service which is supposed to be delivered to the customers. Usually, the transaction price is fixed and agreed between both the parties, that is, buyer and seller. However, it may vary due to discounts and rebates.
- Allocation of transaction price to the performance obligations: if the performance obligations are distinct in a sense that if the contract contains more than one performance obligations, the transaction price are allocated to each of such obligations separately.
- Recognizing revenue when the performance obligation is satisfied: Revenue is recognized by the entity when the performance obligations are satisfied by one party, that is, goods and services are transferred as promised and this is when the customer obtains the control over the goods.
Where IFRS 15 requires an entity to recognize revenue when the control is being transferred to the customers whereas IAS 18/AASB 18 focuses on transfer of risks and rewards associated with the goods. This at times causes changes in the timing of some revenue items.
By having a clear understanding about the respective standard and relating it with the company’s case, where Alan said that it is the manipulation of timing and not amounts, the approach is regarded as incorrect in a sense that the sales haven’t taken place in actuality. Only estimation has been made that the amount already recognized will take place in future. However, it is a matter of uncertainty that such sales might not take place due to a number of reasons such as change in preference of customers, change in price level, financial troubles, etc. This is why, revenues are not recognized until and unless the performance obligation in the contract is recognized. Thus, the company goes wrong in the accounting terms (Siciliano, 2015).
Impact of Bad Governance
Coming to ethical terms, it is true that a company to enjoy high quality status and reputation has to keep its investors and shareholders happy who are the sources of finance. Losing potential investors could bring financial issues in a company. However, this doesn’t allow a company to adopt an unethical way. If the shareholders come to know about the action, it might lead to worst situations for the company as it would directly have an impact on the trust and confidence of the shareholders in the company (Strathern, 2010). However, ethical behavior demands a true and fair presentation of financial reports whether it has a profit or loss or whatever the consequences the company might suffer due to losses.
Let’s now talk about how the auditing norms would be affected. If such sales are recorded and duly approved by the auditors, the auditor’s independence would be at stake. Where an auditor is expected to conclude an opinion on the financial reports, which is free of biasness and independent in nature, his integrity would be questioned and thus, the auditor would be equally responsible for such an action. Once the company is dragged into such consequences, their genuine reasons of keeping their shareholders happy would be irrelevant. Every such action would be considered fraudulent in nature and that’s how the information would be scrutinized. The authentication by the auditor and the directors of the company would br a proof of the fraudulent action taking place and that the auditor is biased and didn’t act in his professional competence.
A fraudulent action by a company would raise a question on the accounting and auditing norms and would even question the corporate social responsibilities of the company. This somewhere reflects the weaknesses of the company that can be explained as follow:
- The company hasn’t built its good relations with the shareholders and that is why, is afraid of explaining their reasons of having losses which might lead to losing of shareholders.
- The company should focus on having better future plans than manipulating books and impressing their shareholders. It could explain the future plans and can still have the trust of its shareholders despite having losses.
- The company’s thoughts of presenting the fake values in the reports are incorrect as this reflects that the company has a weak financial strength and it is highly dependent on its shareholders. Also, losing shareholders would decrease their credibility in the market reflecting a weak status of the company(Taillard, 2013).
As an accountant, the correct solution for the above situation is the true and fair presentation of financial reports because that would go with the accounting, auditing and ethical norms. The company shall choose to explain the reasons of its loses and come up with better future plans through which it can sustain the confidence level of its shareholders.
References
Chriss, N. A. (2009). Black-Scholes and beyond. New York: McGraw-Hill.
Cochran, C. (2017). Internal auditing in plain English. Chico, California: Paton Professional.
Dash, S. S. (2016). INSTITUTIONAL THEORY AND CSR. Retrieved from www.anzam.org: https://www.anzam.org/wp-content/uploads/pdf-manager/2844_ANZAM-2016-407-FILE001.PDF
Dayananda, D., Irons, R., Harrison, S., Herbohn, J., & Rowland, P. (2008). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press.
Fridson, M., & Alvarez, F. (2012). Financial Statement Analysis: A Practitioner’s Guide. New York: John Wiley & Sons.
Girard, S. L. (2014). Business finance basics. Pompton Plains, NJ: Career Press.
Johnstone, K. (2014). Auditing. Mason, OH: Cengage.
Loughran, M. (2010). Auditing For Dummies? Hoboken, NJ: John Wiley & Sons.
McLaney, E., & Adril, D. P. (2016). Accounting and Finance: An Introduction. United Kingdom: Pearson.
Noreen, E. (2015). The theory of constraints and its implications for management accounting. Great Barrington, MA: North River Press.
Picker, R. (2016). Australian accounting standards. Milton, Qld.: John Wiley & Sons.
Siciliano, G. (2015). Finance for Nonfinancial Managers. New York: McGraw-Hill.
Strathern, M. (2010). Audit cultures: anthropological studies in accountability, ethics and the academy. London: Routledge.
Taillard, M. (2013). Corporate finance for dummies. Hoboken, N.J.: Wiley.
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