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/