Accountability and governance

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Companies globally need the ability to attract and draw inwards, funding from investors to expand and grow[1]. Prior to the decision for investors to provide their funds in a particular business, they will want to be certain that the company is financially stable and will continue to be so in the expected future. Investors therefore need to have assurance that the company is being well managed and will maintain its profitability.

In order to have reassurance, investors look towards the published annual report and accounts of the company and to any other information disclosures that the company might make. They presume that the annual report and financial records will present a true representation of the company's current position. These annual report and financial records are subject to an annual audit where an independent auditor observes the company records and transaction entries, and certifies that the annual report and financial records have been prepared in accordance with Generally Accepted Accounting Standards (GAAP) and give a 'true and fair view' of the company's activities[2]. Nevertheless, although the annual report can give a reasonably accurate representation of the company's activities and financial position at the present time, there are many sides of the company that are not effectively and successfully portrayed in the annual report and financial records.

There have been numerous high profile corporate collapses in the past that have arisen regardless of the fact that the annual report and financial records seemed fine. For example H.I.H., Enron, One. Tel etc. These corporate collapses have had an unfavourable effect on many stakeholders: shareholders who have seen their financial investments reduced to nothing; employees who have lost their jobs and, in many cases, the safety of their company retirement fund, which has also dissipated overnight; suppliers of goods and services to the unsuccessful companies; and the economic effect on the local and international communities in which the company operates in. In essence corporate collapses affect us all. Why have such collapses occurred? What might be done to prevent such collapses happening again? How can investor confidence be restored?

The answers links to corporate governance: a lack of effective and efficient corporate governance meant that such collapses could occur; however, good corporate governance can assist in preventing such collapses happening again and restore investor confidence. Corporate governance includes "the structures, process, cultures and systems that engender the successfull operation of organisations and mechanisms to cope with these elements"[3]. Corporate governance also includes the relations between the various stakeholders involved and the goals and objectives for which the corporation is administered[4]. The principal stakeholders are the shareholders, management, and the board of directors. Other stakeholders include employees, customers, creditors, suppliers, regulators, and the community at large.

An important subject matter of corporate governance is to ensure the accountability of certain individuals in a corporation through means that try to lessen or eliminate the principal-agent problem. The agency theory explains the relationship between the principal(s) and the agent(s). As applied to corporate governance the shareholder is depicted as the 'principal' and the problem, following the separation of ownership and control[5] is how the principal can guarantee that his/ her 'agents' (which are company directors or managers) will serve the shareholders interests rather than their own. Either by lack of attention to maximise shareholder wealth, or in terms of 'self-interested opportunism' - accruing wealth to themselves rather than shareholders - the principal is vulnerable to the self-interest of their agents[6]. The remedies to this conception of the agency problem within corporate governance involves the acceptance of certain 'agency costs' involved either in creating incentives/sanctions that will align executive self interest with the interests of shareholders, or incurred in monitoring executive conduct in order to constrain their opportunism.

Corporate governance aims to resolve problems which arise from the principal-agent relationship, whereby owners have an interest in maximising the value of their shares - whereas managers tend to be more interested in "the private consumption of firm resources and the growth of the firm".23 It addresses such problems through the contract drafting process and others measures which are developed.24 One measure which could contribute to corporate governance efforts in addressing the agency problem is the independent director's involvement.

An independent director is a non-executive director of the company who; apart from receiving director's remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its senior management or its holding company, its subsidiaries and associated companies; is not related to promoters or management at the board level or at one level below the board; has not been an executive of the company in the immediately preceding three financial years; is not a partner or an executive of the statutory audit firm or the internal audit firm that is associated with the company, and has not been a partner or an executive of any such firm for the last three years. This will also apply to legal firm(s) and consulting firm(s) that have a material association with the entity; is not a supplier, service provider or customer of the company. This should include lessor-lessee type relationships also; and is not a substantial shareholder of the company.

Early work by Fama and Jensen [7] argued that independent directors offer a means to supervise management operations and activities through an improved focus on company's financial performance. Pearce and Zahra [8] supports this view, that there is a positive correlation between the proportion of independent directors and company financial performance. Similarly, Lee, Rosenstein and Rangan [9] support this view, providing evidence indicating that boards majorly subjected by outside/ independent directors are associated with improved returns than those subjugated by internal/ executive directors. Baysinger and Butler [10] also describes that adjustments in board structure over a ten year period from 1970-80's suggests that there is a causal link with accounting performance. Furthermore, Millstein and MacAvoy [11] found that there is a significant relationship amongst active, independent boards and higher company performance.

To enhance the effectiveness of the corporate governance, it must comprise of an independent board of directors as stated under the Corporate Law Economic Reform Program Act 2004 (CLERP 9). Conversely, independent directors will not function efficiently and effectively if several essential principles are not met. There are five important factors that need to be considered in the independent directors' performance model.

First and most important, is the independence of directors. The initiative to introducing an independent director is to present objective and independent judgement on management's performance, whilst not being influenced by the company's management or major shareholders. In some companies, where there are serious insider control problems, for independent directors to examine a firm's major associated transactions exclusive of minority shareholders' interests being infringed, the fundamental characteristic of independence must be satisfied. In essence, directors must be independent from management, as well as from the controlling shareholder. They are not truly and fairly independent if the independent director(s) have any close relationships with either party, both agent or principal. As a result, independent judgement and fair view is not likely to be conveyed, and the interests of minority shareholders are unlikely to be rightly protected. In contrast, the actions of an independent director will adhere closely to GAAP provided that he or she is acting impartially. Therefore, independence is the requirement to ensure an unbiased and impartial position which in turn creates effective corporate governance practice.

Secondly, through motivation theory, money is essential and it has an express impact on satisfaction [12]. In many companies, directors' remuneration is often paid in two parts, one is a fixed fee and the other is often linked with firm performance, such as shares or stock options, so that to better align directors' interests with that of shareholders. The more income an independent director receives from his job, the more efforts he is likely to put in. In China, with no other payments such as shares or stock option available in the market, a sufficient incentive is necessary in order to attract good candidates and better align independent directors' interests with those of shareholders.

Thirdly, sufficient knowledge is required in order for independent directors to make sensible judgement. With independent directors' responsibility of handling company's related party transactions, their understanding of business know-how, product and financial knowledge is essential. Otherwise, they can be easily manipulated by the company or making irresponsible decisions. However, the current pool of independent directors is mainly drawn from academics or government departments, whom may lack of experience in dealing with business decisions of public listed firms. It is suggested that in order for independent directors to perform effectively, relevant training must be given and experienced foreign talents should be encouraged.

Fourthly, it is argued that in the absence of D&O liability insurance, it is very difficult to expect independent directors to play an active role. In fact, with increased job responsibilities, insurance becomes more important to indemnify directors from negligence, error, breach of duty and so on. To encourage independent directors to provide objective opinion, it is possible that they may need to stand up and against management's decisions, so sufficient assurance must be given. Under the current situation, it is important to see how soon the D&O insurance system can be implemented to Chinese listed firms.

Finally, for independent directors to function properly, great autonomy and resources are necessary. And the autonomy can only be useful provided the outside directors are truly independent. Without independence, higher the autonomy may lead to worse the performance. To assure independent directors' autonomy, job description need to be clearly defined, job-overlapping need to be avoided and company's interference need to be minimised. Overall, through the accomplishment and satisfaction of the five factors, independent directors will be better motivated, high sense of responsibilities will be resulted, and better performance will be achieved.

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  5. Lehman, C.R., The influence of agency theory within corporate governance, in Corporate governance: does any size fit? 2005. p. 251.
  6. Jensen, M. and W. Meckling, Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 1976. Vol. 39: p. 1021-1039.
  7. Fama, E.F. and M.C. Jensen, Separation of Ownership and Control. Journal of Law and Economics, 1983. 26: p. 327-349.
  8. Pearce, J.A. and S.A. Zahra, Board Composition from A Strategic Contingency Perspective. Journal of Management Studies, 1992. 29: p. 411-438.
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  11. Millstein, I.M. and P.W. MacAvoy, The Active Board of Directors and Improved Performance of the Large Publicly Traded Corporation. Columbia Law Review, 1998. 98(1283): p. 1291-1299.
  12. Vroom, V.H., Work and Motivation. 1964, New York: Wiley.