The Implications of US Corporate Scandals during 2000-2002

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Author and Contributor

Tinting HUANG

The new millennium started with a series of high-profile financial scandals in US,

making corporate malfeasance as the main risk facing equity markets (Stice et al.,

2004). Given the occurrence of US Corporate Scandals during 2000-2002, this essay

will critically provide implications and suggestions regarding corporate governance,

information disclosure and Sarbanes Oxley Act (SOX).

1.1 Corporate Governance

The ineffective corporate governance provides opportunity to the scandal. Therefore,

some implications for the improvements can be drawn.

1.1.1 BOD Structure

Firstly, the independence issue of BOD should be addressed. As Weisbach (1988)

maintained, a more independent board is important in monitoring managers’ behavior.

SOX Section 301 requires that Audit Committee in all listed firms entirely consists of

independent directors. To achieve this, more non-executive directors should join the

board. However, Fama and Jensen (1983) argue that the inside directors have better

knowledge of the company, so they are significant in decision making. Therefore, it

can be indicated that a company should set a balanced board consisting of both

independent non-executive directors and executive directors (John and Senbet, 1998).

1.1.2 CEO Duality

Another issue that should be addressed is the CEO duality since the influence of CEO

on the board can reduce the likelihood of detecting the fraud and the effectiveness of

monitoring. The separation of two positions can guarantee that BOD can find and

report the potential problems quickly. On the other hand, a CEO duality can also mean

strong leadership, which improves efficiency of decision-making (Finkelstein and

D’aveni, 1994). The CEO and chairman is still the same person in many US

Corporations now, but whether this may influence the independence of the BOD and

problem detection is still unknown. This might be a possible threat in the future and

needs further improvement.

1.1.3 Compensation System

Most US companies adopt an equity-based compensation system. The goal of

adopting this is maximizing shareholders’ wealth by creating incentives for executives

to increase stock price of the company. However, the occurrence of most corporate

scandals was due to highly incentivized executives manipulated the financial

reporting of the company to report high earnings. Therefore, the issue of the

relationship between the compensation system and the likelihood of fraud arises.

Jensen (2004: 3) points out that “the equity-based compensation is like throwing

gasoline on a fire”. However, many companies which adopted the same compensation

system did not commit a fraud. This observation suggests that the equity-based

compensation system itself will not lead to a fraud, while the extent of incentives (e.g.

the number of stock options grants) provided to executives under equity compensation

may do so (Johnson et al., 2003). Apart from that, large-sized stock option grants may

also generate high incentives for executives to manipulate financial reporting in order

to increase share prices, resulting in accounting fraud. Thus, compensation committee

should make the trade-off between the positive effects and the negative impacts, such

as balancing the size and strength of the equity incentives.

1.2 Information Disclosure

According to Spence (2002), signalling theory can be applied to reduce the

information asymmetry between two parties. One party promulgates and

communicates information while another party receives and interprets information).

Based on this, issues of non-financial information disclosure and the role of media in

Corporate Social Reporting (CSR) are addressed here, contributing to the fraud

detection and better corporate governance.

1.2.1 Non-financial Information Disclosure

The problem of transparency is identified in many business scandal cases. Here, non-financial

information could be applied as a remedy to address the disclosure problem. Non-financial

report should contain a complete outline of the corporate behavior, in order to provide

stakeholders with a clear description of the company’s situation. For example, companies

need to disclose information on employee-related aspects, human rights, anti-corruption and

bribery issues, and diversity on the BOD (ibid).

Perrini (2006) also argues that it is meaningful to set standards to disclose

non-financial information. Standards can be applied to increase comparability and

reduce the probability of misleading information. However, Ho and Wong (2001)

maintain that the simple adoption of more International Accounting Standards (IAS)

does not guarantee a higher level of transparency. Aggressive standards may exert

pressure on companies and increase the likelihood of earnings management. Thus, it

can be suggested that standard setters should be aware of the outcomes of different

extent of disclosure and avoid over-regulation. Moreover, an atmosphere of voluntary

disclosure is encouraged.

1.3 SOX Limitations

As a result of a series of corporate scandals such as Enron and WorldCom, SOX was

promulgated to reduce the possibility of the fraud. It deals with some problems

identified above to some extent. However, SOX has several limitations. According to

Eugene et al. (2002), SOX is the reaction to the past scandals, and thus cannot be

developed to take precautions against unanticipated crises in the future. Another

negative effect of SOX is the high costs to companies. To meet the requirements of

SOX, companies have to reallocate resources, thus causing investments postponement

and reconsideration. This led to the restraint of the potential growth and innovation of

firms, especially small firms. Furthermore, increased legislation is also a problem

concerned by companies and investors. From their perspectives, heavier legislation

means more government interaction in financial market. As a result, negative effects,

such as capital outflow and further business functions outsourcing, will damage the

financial market.

References:

Eugene, B. and Robert, A. K. (2002) “The Problem of Regulatory Unreasonableness 100”.

Fama, E.F. and Jensen, M. C. (1983) Separation of ownership and control, Journal of Law and

Economics, 27, pp. 301-325.

Finkelstein, S. and D’aveni, R. A. (1994) CEO duality as a double-edged sword: How boards of

directors balance entrenchment avoidance and unity of command, Academy of Management

Journal, 37(5), pp. 1079-1108.

Ho, S. M. and Wong, K. S. (2001) A Study of The Relationship Between Corporate Governance

Structures And the Extent of Voluntary Disclosure, Journal of International Accounting Auditing

& Taxation, 10, pp. 139-156.

John, K. and Senbet, L. W. (1998) Corporate governance and board effectiveness, Journal of

Banking & Finance, 22(4), pp. 371-403.

Perrini, F. (2006) The Practitioner’s Perspective on Non-Financial Reporting, California

Management Review, 48(2), pp. 73-103.

Spence, M. (2002) Signalling In Retrospect And The Informational Structure Of Markets,

American Economic Review, 92, pp. 434-459.

Stice, J., Stice, E. K. and Skousen, F., (2004) Intermediate Accounting, 15th edition, New York:

Cengage Learning.

Weisbach, M. S. (1988) Outside directors and CEO turnover, Journal of Financial Economics, 20,

pp. 431-460.

Picture Source: http://think-left.org/2013/07/25/the-citys-great-financial-scandals-and-their-ghosts-past-and-future/

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