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Importance of Corporate Governance for Fraud Prevention

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Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Published: Tue, 06 Feb 2018

In the era of globalisation, corporate scandals are no longer shocking news in corporate world. A recent corporate fraud has happened in Paris in Societe Generale Bank, where an employee committed a fraud of GBP 3.7 billions. It is not a new story for the corporate world as it has seen cases of BCCI (Bank of credit and commerce internationals), Polly Peck, Maxwell, Allied Irish Bank, Enron, Pamalat, Barings Bank, WorldCom, Xerox and many more. Frauds in Financial statements have become a common area of frauds now days. These frauds have increased the responsibility of auditors and also of government to pass effective laws so that scope of committing frauds can be reduced. Corporate Governance in any company is for that only. Companies are bounded by corporate governance guidelines and procedures, so that chances of fraudulent activities can be reduced.

  • Meaning of Corporate Governance

According Cadbury Report 1992, Companies are controlled and directed by the system of corporate governance. In companies, Corporate Governance is the responsibility of Boards of Directors. Auditors and directors are elected and appointed by the consent of shareholders, which give them the feeling of satisfaction that a suitable corporate governance system is working to reserve their rights and benefits.

Corporate governance set the relationship between management, board, shareholders and other stakeholders. Corporate governance enables directors and auditors to manage their responsibilities towards shareholders and wide stakeholders of the company. In contrast , corporate governance increased the confidence of shareholders that they will get an reasonable return on their investments, whereas for the stakeholders it provide the assurance that company manages its impact on society and environment in a responsible manner. Corporate governance include the combination of various laws, regulations, listing rules and voluntary private sector practices that facilitate the company to draw more capital, execute efficiently, generate profit and meet other legal obligations and general societal expectations. Corporate governance is about commitment to values, about ethical business conduct and about making a distinction between personal and corporate funds in the management of a company.

Corporations pool capital from a large investor base both in the domestic and in the international capital markets. In this context, investment is ultimately an act of faith in the ability of a corporation’s management. When an investor invests money in a corporation, he expects the board and the management to act as trustees and ensure the safety of the capital and also earn a rate of return that is higher than the cost of capital. In this regard, investors expect management to act in their best interests at all times and adopt good corporate governance practices.

  • Need for Corporate Governance

A corporation is a body of various stakeholders include customers, employees, investors, vendors, government and society. It is necessary for any corporation to present transparent and true pictures to its shareholders. Today, this has become essential for the business world because every company wants to enter into the global capital and also want to draw the attention and also keep hold on the top human capital from different areas of the world. Company want the partnership with different vendors on the big collaborations and want to be in harmony and peace with the rest of the community. A corporation will never succeed until and unless it demonstrate and also it embrace the ethical conduct.

Corporate governance in business is in relation to the ethical conduct. Here, the ethic is very much concerned about the different codes of principles and the values which help the person to differentiate and choose between the right and the wrong and as a result, help to choose from the other alternatives. Additionally, the parties which are involved in the conflicting interest give rise to the ethical dilemmas. Therefore, keeping in mind the principles which are totally based on culture, context and the value of the company, the manager make their decisions. For a business which is running good, it is very much important that it always go in the good direction by keeping the stakeholders expectations in mind.

Well, corporate governance is not just the law,it is much more than the law and it can’t be imposed and run by the legislation alone because its different parts comes from the management’s mindset and their culture. The affairs of the organisation are conducted by the corporate governance in order to provide the fairness for all of the shareholders which comes from these three- accountability, integrity and the openness. To certify standards, the legislation can and should put down a general framework which is the “form”. The integrity and the credibility for process will finally determined by the “substance”. The substance is inevitably connected to the management’s ethical standards and mindset.

The corporations should always need to identify that the prosperous development and the growth of the company require the full support and the cooperation from their stakeholders and this is possible only when the corporation is following the best practices of the corporate governance. Here for shareholders, management of the corporation needs to perform as the trustees and avoid the difference of benefits among various sections of stakeholders, particularly between the owner and the other stakeholders.

Corporate governance becomes the key element in order to improve the firm’s economic efficiency. With the help of the corporate governance, the corporations keep in mind the interest of the ample series of constituencies, and also of community where they are operating. Additionally it ensure that the board is accountable for shareholders. As a result, it guarantees that the corporations as a whole are operating for the benefit and profit of society. Though by taking the advantage of asymmetry between the shareholders, huge amount of profit can be made in short run, and by balancing the interest of all shareholders itself guarantee the growth and the survival of the corporation in long run.

Heavy cost can be incurred if there is failure to execute the good governance which can be the regulatory problems. Many proofs suggest that those corporations or companies which do not implement and follow the significant corporate governance measures can give the considerable risk premium in the public market at the time when it is competing for the limited capital. In recent times, the analysts of the stock market received a high appreciation from the market for showing the relationship between the returns and the governance. For this context, different reports do not only talk about the governance in common but they also recommend the explicit alter investment which is totally based on weakness or strength of the infrastructure of the corporate governance of the company. The best thing about the credibility which is given by the procedures of a good corporate governance is that it help to provide the confidence of clients (national & international) in order to draw more ‘patient’, the capital for the long term, and also help to cut down the capital cost. All this increased attention is because of arises of the financial crises in different parts of the world. Like, the financial crises in Asia brought the attention of the corporate governance subject in Asia. Recently, the scandals in the US also disturb the unsatisfied corporate landscape and peace which are unexpected in a sense. These scandals lead to a new set of initiatives in corporate governance in US and trigger a new discussion in the United Kingdom with European union and in the rest of the world.

  • Meaning of Financial Statement Fraud

Financial statements are the picture of financial position of a company which includes balance sheet, profit and loss accounts, and trading accounts. Frauds here, means deliberately and intentionally done activities for self interest and cheating the second party. Under the Statement of Auditing Standards (SAS) 1101, it is stated that “Auditors should plan and perform their audit procedures and evaluate and report the results thereof, recognizing that fraud or error may materially affect the financial statement”.

Accounting to Benny K.B. Kwok 2005, Misstatements in financial statements can arise from either by error or by fraud. Error refers to an involuntary misstatement in financial data of a company which include omission of an amount or disclosure, such as

  • A mistake in gathering or processing data from which financial statements are prepared;
  • An incorrect accounting estimate arising from oversight or misinterpretation of facts; and
  • A mistake in the application of accounting principles relating to measurement, recognition, classification, presentation or disclosure.

The usage of both – the dishonesty to get the financial advantage illegally and intentionally falsification also disturbing the statements, leads to fraud which can be done by any person from the management, or the employees or any third party.

In fraud following things involves “Falsification or alteration of accounting records or other documents; Misappropriation of assets or thefts; Suppression or omission of the effects of transaction from records or documents; Recording of transaction without substance; Intentional misapplication of accounting policies; Wilful misrepresentations of transactions or of the organization’s state of affairs”.

Financial reporting in the UK is based on three principles:-

  • Companies Act 2006
  • Accounting standards or specifically Statements of Standard Accounting Practices(SSAP) and Financial Reporting Standards
  • And the requirements of the Stock Exchange.
  • Companies Act 2006

According to the Companies Act 2006, accounting records maintained by every company must:

  • Be sufficient to show and explain the company’s transactions;
  • Disclose with reasonable accuracy at any time the financial position of the company at that time and
  • Enable the directors to ensure that any Profit and Loss account or Balance Sheet gives a true and fair view of the company’s financial position.

Accounting records should contain day to day entries of all transactions, full record of company’s assets and liabilities and full information regarding company’s stock. According to Companies Act 2006 under section 145(B), if the financial statements of a company do not meet the requirements of the Act, the court may ask for revised financial statements and the cost of re- preparing financial statements would be bear by the party in abuse of preparing defective or false financial statements.

  • Accounting Standards

In UK, all accounting standards till 31 July 1990 used to be called Statements of Standards Accounting Practice (SSAP) which was formulated by the Accounting Standard Committee (ASC). SSAP was then gradually replaced by Financial Reporting Standards (FSA) produced by the successor to the ASC, the Accounting Standards Board (ASB). UK Accounting Standards laid down the guidelines regarding how particular types of transaction should be reflected in the financial statements of a company to present true and fair picture of company’s financial position.

  • The stock exchange listing requirements-Yellow Book

Rules which governed the listing of securities of the stock exchange in the UK are known as the Yellow Book. According to Yellow Book, listed companies are required to publish their financial statements within six months of their financial year end. Most of the listed companies however, publish their financial statements quarterly. It is necessary from the point of view of shareholders because shares of companies are in the hands of general public and they need continuous information regarding firm financial position so that they can take right investment decision.

According to SSAP December 1999, “the objective of financial statements is to provide information about an organizations financial performance and financial position that is useful to a wide range of readers for assessing the stewardship of the organization’s management and for making economic decisions”.

For the purposes of this discussion, we are talking about financial statement fraud in a major public company context; a context that can affect confidence in the financial system. We are not talking about what might be called ‘internal fraud’ or a great many other types of dishonest conduct in corporate life. This is about projecting a false state of affairs on a large scale and in a very public context.

  • DEFINITIONS

Corporate governance is about promoting corporate fairness, transparency and accountability

Wolfensohn, president of the Word bank, June 21, 1999.

“Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. 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”, OECD April 1999. OECD’s definition is consistent with the one presented by Cadbury [1992].

According to Elliot and Willingham, “financial statements fraud is management fraud, the deliberate fraud committed by management that injures investors and creditors through materially misleading financial statements”.

Key words used in the research:

Currency option: In this option the possessor has the right to sell or buy the currency at a particular phase of the time at a particular price. In this the possessor doesn’t have the obligation.

Currency forward: The prices are locked in this contract so that the counterparties can sell or buy the currency on the upcoming or future date. Here the possessor who holds the contract are obliged to sell or buy the currency at a particular future date, at the particular quantity and on a particular price. These transactions are also called as outright forward currency transactions.

Option: when the option is exercised to earn profit then it is known as in- the-money option.

Call option: In this type of option, the buyer who wants to buy any assets, commodities etc. has the right to buy at a particular period of time but he is not obliged, whereas the seller is highly obliged to sell the assets etc. at a particular time to the buyer. A premium has to be paid by the buyer to hold this right. This option is carried out when the strike price is below the price of the market of the agreed commodities.

Put option: In this option, the seller has obligations to buy the commodities, assets etc. from the buyer whereas the buyer has the right, but there is no obligation, to sell the agreed commodities, assets etc. at a particular period of time for a particular price. This option is carried out when the strike price is more than the price of the market of the agreed commodities.

Prime broker: The person who settle down the cash and security for their clients in the financial market by charging them fees is known as the prime broker. They manage the money of their clients by using different strategy in the market.

Research Questions and Objectives

Research Questions

  • Financial statements frauds -ethical or technical issue?
  • How firms manipulate their financial statements?
  • What are the motives of financial frauds other than monetary?
  • What is the role of corporate governance in controlling these frauds?

Research Objectives:

  • To analyse the major areas of frauds.
  • To examine role of top management in fraudulent practices.
  • To analyse the efficacy of various acts and rules passed for enhanced corporate governance.
  • To analyse the importance of financial statements in investment decision making.
  • To explore the causes and consequences of financial statements frauds.

Scope of study:

Research study will be restricted to European countries financial statement frauds as US market is more explored than European market. Research will examine and critically analyse the case study of Ireland based bank named Allied Irish Bank.

Remaining chapter shall follow the following planned strategy:

Chapter Two: Literature review: – It will cover 3000 words and include journals and articles citation.

Chapter Three: Research Methodology: – It will cover 1500 words. This section will give idea of data collection and also briefly explain limitation attached to it.

Chapter Four: Data Analysis: – This section will evaluate and analyse the data and follow the discussion.

Chapter Five: Conclusion and Recommendations: – This section finally concludes the research and provides recommendations.

CHAPTER TWO

  • Literature Review

2.1.1. Agency problem and Corporate Governance

2.1.1.1 Separation of ownership -origin of agency problem

Agency problem resulted from separation of ownership from control (Berge & Means 1932; Jensen & Meckling 1976) is still prevailing around the world. Findings have proved that firms having weaker corporate governance policies and structure face greater agency problems; which allow senior managers to cook their recipe of extracting more private benefits and finally firm perform worse at all levels (Core at al. 1999). Evidence for such a weak corporate governance structure and higher agency problems can be found from Asian Financial Crisis in 1997. At the time Asian Crisis 1997, firms which had good corporate governance structure provided better protection to shareholders especially to minor shareholders and performed better during the crisis (Joh 2003 and Mitton 2002). In countries like USA and European countries especially UK, agency problems are higher as evidenced from corporate scandals in USA and UK for example Maxwell Corporation (1991), Polly Peck (1991), BCCI (1991), Enron (2001), Barings Bank (1995), Parmalat (2003) and many more. The recent scandal happened in Societe Generale Bank of Paris 2008, in this also agency problem was the main reason for the frauds committed by the employer of the Societe Generale Bank of Paris.

An Agency problem is very crucial problem which had taken birth during 19th century. Agency theory is defined as a “contract under which one party (the principal) engages another party (the agent) to perform some service on their behalf” (Jensen and Meckling 1976). The problems arises when the agent do not work in the welfare of principal. More cases of frauds, where involvements of company’s top management were high, coming into light and the simple reason is principal agency problem. In the case of HealthSouth, CEO Richard Scrushy had instructed senior managers to show fraudulent income of $2.5 billion in order to meet Wall Street expectation.

2.1.1.1.1 Agency Cost

Agency costs are another issue which is bear by the principal for the frauds committed by the agent. The result of agency problem is reflected in company’s share price which can be seen as the loss to shareholders in terms of declined in the price of shares in stock exchange.Jensen and Meckling (1976) explained agency costs as the sum of monitoring

costs, bonding costs, and residual loss.

  • Monitoring cost:-

In UK companies are required to follow Cadbury (1992) and Greenbury (1995) reports for corporate governance. Monitoring cost are paid by the principal to monitor the behaviour of agents. Monitoring cost generally include costs of conducting auditing, writing executive compensation contracts and sometimes cost of firing the fraud employees and other top managers or executives. All these costs are paid by the principal, but Fama and Jensen (1983) argued that these agency costs which are initially born by the principal, ultimately borne by the agents as the compensation of agents are adjusted to cover these costs. Some researcher further argued that monitoring will restrict the managerial initiative (Burkart, Gromb and Panunzi 1997). Criticisers of Cadbury Report (1992) have argued that high level of monitoring may restrict the managerial entrepreneurship.

  • Bonding Costs

As argued by Fama and Jensen( 1983), monitoring cost ultimately bear by agents which need to set up structure that will act in interest of shareholders or principal , the cost of establishing these set up or system is known as bonding costs. These costs are not always financial in nature; it may include additional information provided to shareholders. Denis (2001) further argued that “the optimal bonding contract should aim to entice managers into making all decisions that are in the shareholder’s best interests”.

In UK, bonding structure which is imposed on closely held companies’ management, require companies to distribute all income after meeting all business expenses. Earning retention is big problem in UK; the mechanism of bonding may reduce the scope of this problem.

  • Residual Loss

Residual loss arises because the cost of fully enforcing principal-agent contracts would far outweigh the benefits derived from doing so. Since managerial actions are unobservable ex ante, to fully contract for every state of nature is impractical. The result of this is an optimal level or residual loss, which may represent a trade-off between overly constraining management and enforcing contractual mechanisms designed to reduce

agency problems.” (Patrick McColgan 2001:8).

2.1.1.2 Stewardship theory

Agency theory is more dominant in the perspective of corporate governance mechanism, but this view has been criticized by many writers (Hoskisson et al. 2000; Blair 1995; Perrow 1986). Agency theory had limitation in explaining sociological and psychological involved in principal agent conflicts (Davis & Thompson 1994; Davis et al.1997). Stewardship theory assume mangers as good stewards of the firms. Managers act diligently in order to attain high corporate profits and shareholders returns (Donaldson & Davis 1994). In an empirical study performed by Tian and Lau 2001 in Chinese shareholding firms, they find stewardship theory has received strong support in comparison to agency theory. Further Phan 2001 explained that “whether the assumptions of Agency Theory can be generalised to emerging markets, with their different sociological, economic, and developmental fundamentals, remains an important research question”.

In summary, agency theory has its roots in industrial and organisational economics. Agency theory assumes that behaviour of human being is opportunistic and selfish. Therefore, the theory recommends strong director and shareholder control. It suggests the fundamental function of the board of directors is to control managerial behaviour and try to ensure that managers act in the best interests of shareholders.

2.1.2 Review of Corporate Governance reports

In this section, international reports on corporate governance will be critically reviewed which were published in last decades. The international reports considered in this section are as follows:

  • “Report of the Committee on the Financial Aspects of Corporate Governance” (Cadbury Report, 1992)
  • “Where were the Directors? Guidelines for Improved Corporate Governance in Canada” (Dey Report, 1994)
  • The General Motors Corporation Guidelines (GMC, 2001)
  • “Committee on Corporate Governance” (Hampel Report, 1998)
  • “OECD Principles of Corporate Governance” (OECD Report, 1999)
  • Sarbanes- Oxley Act 2002

After the unexpected corporate scandals of renowned companies like Maxwell (1991), Polly Peck (1991), and BCCI (1991) among others in the UK, the committee for corporate governance under the guidance of Sir Adrian Cadbury along with Financial Reporting Council (FRC), the London Stock Exchange (LSE), and the other accountancy profession has been formed to address corporate governance issues. This report was known as Cadbury report which was first report in UK focused on the aspect of corporate governance such as financial reporting and reviewed the role of boards and auditors. This report was published in 1992. The Cadbury committee report finally draw two major recommendation for the structure of UK corporate board. Cadbury report suggests at least three non executive directors in the board and two of them should be independent from management. The positions of chairman and CEO should not hold by the same person. The purpose behind this set up was to reduce the individual dominance and ensuring higher level of monitoring for corporate board by introducing more independence. Beasley (1996) and Dechow et al. (1996) found that “firms with more independent boards are significantly characterised by a lower likelihood of financial statement fraud and earnings management”.

In Canada, during 1994 Dey report was published. This report was the first fully fledged report on corporate governance which a company should follow in order to list on stock exchange. Toronto stock exchange (TSE) adopted these guidelines in 1995 which were laid down by the Dey report. All TSE listed companies required to provide the difference in their corporate governance guidelines and guideline laid down by the Dey report.

After Dey Report 1994, other similar reports in other jurisdiction have been published. General Motors Corporation (GMC) in USA published its own corporate guidelines in 1994 after criticising by the shareholders regarding poor company performance and doubtful board practices. These guidelines were developed with consent of GMC board, its shareholders and other activists for corporate governance. These guidelines were welcomed by the institute California Public Employees’ Retirement System (CalPERS) and by the industry. GMC guidelines become the benchmark in USA for corporate governance.

In UK, during 1998, Hampel Committee was formed to review the recommendations of Cadbury report (1992) and the Greenbury report (1995) relating to executive remuneration. The Hampel committee was also formed to cover some gaps by these two reports i.e. Cadbury report and Greenbury report. Hampel report suggests that good corporate governance goes beyond prescribed corporate structures. According to Hample Report (1998:15) on Corporate Governance Sir Hample “recommend that companies should include in their annual report and accounts a narrative statement of how they apply the relevant principles to their particular circumstances. Given that the responsibility for good corporate governance rests with the board of directors, the written description of the way in which the board has applied the principles of corporate governance represents a key part of the process”. Hampel report drew attention for the approach of box ticking which is a serious issue for corporate governance. It also examined the implementation of Cadbury and Greenbury report and suggested more clear recommendations on policies of remuneration, accountability and auditing.

During 1999, Organisation for Economic and Co-operation Development (OECD) laid down principles of corporate governance for the listed companies of member countries of OECD. It cover main subjects areas like rights and equitable treatment of shareholders, role of stakeholders in corporation structure, disclosure and transparency of financial facts and figures and majorly role and responsibilities of board. OECD guidelines become starting point for local policy makers of corporate governance.

After the ,shocking scandals of Enron and WorldCom, US congress along with NYSE (New York Stock Exchange) passed the reforms to address conflicts of interest and redefined relationship between companies and auditors. This reform was known as the Accounting Industry reform Act 2002 which is widely known as Sarbanes Oxley Act 2002. The main purpose of this act was to enforce the independence of external auditors. The act also reinforced duties and responsibilities for CEO’s and CFO’s by imposing strict penalties for misrepresenting company’s quarterly and annual reports. The penalty for misrepresentation was personal fines of US$ 1 million or imprisonment up to 10 years or both. Sarbanes Oxley Act has intense effect on the corporate governance policies on US and rest of the world. NYSE also imposed additional requirement for listed companies, under which listed companies must have independent directors in majority and must disclose business code of conduct and ethics for directors, officers including managers at all level, and employees. Whittington(1993) and Melis, (2004a) argued that “corporate financial reporting and corporate governance systems are highly correlated, with any improvement in either system having a positive influence on the other, and vice versa”

Combined code issued in 2006 replaces the combined issued in 2003. Financial service authority of UK, require listing companies to be obliged by the combined code 2006 and carry out consultation before listing. This new code contains main principles and provisions. Combined code 2006 asks listed companies to make a disclosure statement for code and that should be in two parts. Some of the provisions are not or less relevant for small or new listed companies. Also some provisions do not apply to companies below FTSE 350.

2.1.3 Global findings for adoption of corporate governance guidelines

According Stephanie Maier (EIRIS 2005:1) findings, “Only 25% of US companies separate the roles of chairman and CEO compared with at least 50% forcompanies in other developed economies. Swiss boards have the highestpercentage of independent directors(81%) – Germany, Austria and Japanall have less than 10%. Only 4% of companies in Japan haveaudit committees comprising amajority of independent directorscompared to over 95% in the USA,Canada, the Netherlands,Luxembourg, the UK and IrelandOnly 22% of companies in Singaporeand 25% of companies in Hong Konghave meaningful codes of ethics”.

Board size:

According to EIRIS 2005, average board size is minimum in New Zealand (7.2) and maximum in Germany (22.8). USA and UK comes at rank 7th and 8th with average board size of 10.7 and 11.4 respectively ( see appendices for details). Higgs Review (2003) suggested “An effective board should not be so large as to become unwieldy. It should be of sufficient size that the balance of skills and experience is appropriate for the requirement of the business and that changes in the board’s composition can be managed without undue disruption”.

Separation of ownership and CEO

According to findings by EIRIS 2005, in UK nearly 97% separate the ownership under unitary board structure whereas in US only 25% companies separate the ownership under the unitary board structure. In Ireland and Luxemb


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