This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.
The Cadbury committee of 1992 in its paragraph 2.5 defined corporate governance as, "the system by which companies are directed and controlled. Board of directors is responsible for the governance of their company. The shareholders' role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place." (Financial Reporting Council, June 2010). The Board of directors and auditors appointed by the shareholders thereby carry out the responsibilities on behalf of the shareholders. These mainly include setting up targets for the company, appointing professionals in order to achieve them, supervising the management and reporting to the shareholders. Corporate governance is therefore related to how the board of a company add value to the company through its operations.
Corporate governance has become prominent owing to number of reasons. Privatization wave in 1990s forms one of the major reasons. In 1991, with 2.7 % to about 27 % GDP of countries around the world, coming from privatization revenues, it soon became necessary to determine how the newly formed companies would be owned and controlled. (Becht, Bolton and Röell, Oct 2002) An increased household savings through mutual funds and pension funds, created a new group of investors that could influence corporate governance. The East Asia crisis highlighted the corporate governance problems of the emerging markets wherein management and large investors affected the interests of small investors. The hostile takeover wave in Europe and the US in 1990 and 1980s respectively, also influenced corporate governance rules since majority of these involved privatized companies. Along with all the reasons there were major scandals like Enron, WorldCom which not only shattered the confidence of investors but also forced many of them to file for bankruptcy. (Becht, Bolton and Röell, Oct 2002) Due to all these reasons, there have been significant changes in the scenario of corporate governance. Auditing has now become more stringent. It made the American president sign the Sarbanes-Oxley Act that imposes a number of corporate governance rules on all public companies with stock traded in the US.
Scandals like Enron made countries all over the world become more aware about their corporate governance policies and auditing standards. With growing international trade, it is not uncommon to find many foreign companies to be listed in London or New York Stock Exchange. It therefore became essential to establish common standards for financial reporting and gain the trust of foreign investors. It triggered a revolution where some countries accepted the principle-based standards; while others turned towards rules-based standards. With 120 countries having adopted IFRS to file their financial statements by January 2011(Mintz, 2011) and many more US companies switching from US GAAP to IFRS, the debate between principle-based and rules-based standards for accounting has now become prominent in accounting.
Although both the methods are based on the conceptual framework of accounting principles, the difference lies in the extent to which they assist in implementing those principles. In rules-based accounting, the accountant as well as the auditor has to adhere strictly to a set of rules. Rules-based standards provide statements that are consistent and therefore comparable to other similar situations. With definite rules, accuracy is ensured and ambiguity of aggressive reporting by management is reduced. However, they are not flexible to accommodate the rapidly changing markets. Even though they are easier to audit, many-a-times accountants find loopholes; thereby companies misreporting information to their investors while still following the rules. The plethora of rules that are to be followed make reports complex in nature and it also provides a leeway to companies to find harbour behind them from ethical reporting. For e.g. Enron omitted many of its liabilities from balance sheets through its special-purpose entities. As Harvey Pitt rightly said to the SEC in March 2002, "The development of rule-based accounting standards has resulted in the employment of financial engineering techniques designed solely to achieve accounting objectives rather than to achieve economic objectives."(Berkowitz & Rampell, 2002).With accounting scandals like Enron, WorldCom, Tyco etc. the focus has now shifted towards principle based standards.
Principle-based approach uses Generally Accepted Accounting Principles (GAAP). In principle based standards, general guidelines are provided which are then subjected to interpretation and better judgement of the accountants while preparing financial reports. Although set of general principles are given; these are then applied by accountants according to the situational demands and preference is given to 'substance over form' in financial reporting. This method being more flexible and broad in nature; can accommodate for the rapidly changing markets and be applicable to a variety of circumstances. However reports prepared may lack consistency and thereby it becomes difficult to compare them. Also it is difficult to audit such reports as they rely on the judgement of the reporting authorities. As argued by Berkowitz & Rampell (2002), issues regarding income measurement and recognition would remain controversial and the professional judgement of the auditors and accountants cannot be left unquestioned.
Corporate Governance in UK has been principle-based as opposed to the rules-based standards of the US. The Cadbury committee report of 1992 was the first such step to prevent financial frauds after Poly Peck, one of its major companies went bankrupt in 1991. The Greenbury Report of 1995 recommended further changes to the basic principles of 'best practice' putdown by the Cadbury committee. The Hampel Report of 1998 suggested that both the reports be combined and thus the Combined Code for UK was developed. It set out standards of good practice for listed companies on board composition, development, remuneration, shareholder relations, accountability and audit. It stated the disclosures to be made by the companies listed on London Stock Exchange. Although the basic principles were stated, there was no specific content and the companies were given freedom to explain their governance policies. The companies had to confirm that their financial statements complied with the principles of the Code or explain the special circumstances for the non-compliance if any. Again it was up to the share holders to evaluate this explanation. (Financial Reporting Council, May 2000). The Code is currently published by Financial Reporting Council and has been revised time to time in order to account for the changes in the market. The latest revision was the UK Stewardship Code, published in July 2010.
This principle-based approach through the 'comply or explain' terminology of the UK Combined Code has been successful in ensuring the transparency of the financial reports. Contradictor to this, is the rules-based approach used in US. The Sarbanes-Oxley Act holds the CFOs and management responsible for the financial statements published by the companies. Also SEC very recently adopted certain changes recommended by NASDAQ and NYSE for companies listed in them. The companies who fail to follow them would be de-listed. (Macnamara, Feb 2004). As Macnamara (2004) further argues the principle-based approach extends a belief in the company's policies and thereby ensures excellent standards of practice as the company stands to lose its face if it fails to do so. Whereas in rules-based approach; following rules can sometimes lead to less than excellent standards which can be detrimental to the society. Principle based standards thus ensure better reporting than a minimum compliance to the rules. With the responsibility of the evaluation given to investors; public reporting and vigilance on the part of investors and media is also ensured leading to more transparency in statements. ( Macnamara, Feb 2004). Therefore there is no doubt that more and more countries are changing towards the principles-based standards for accounting and the Combined Code might serve as a good foundation to be based on.
Recent accounting scandals like Enron, WorldCom and Tyco have put accounting practices and the morality of accounting professionals under scrutiny. The accountant plays an important role by giving a true and fair representation of the financial condition of the organization to various users of the financial reports. However, with the collapse of giants like Enron, accountants have been held responsible for the receding standards of ethics. Constant evaluation of the business ethics and accounting standards has been rendered necessary in order to keep accountants from acting unethically.
Accountants provide information that is utilized by various users for their decision making. Managers use it to plan the organization's operations. Investors rely on it for making investment decisions, employees use it to determine pension funds or appraisals, trade suppliers use it to define credit limits and government bodies use it to determine tax payments. It is therefore necessary for an accountant to act ethically and prepare financial statements that represent a clear and true value of the company. (Duska and Duska, 2003). However, more than often accountants serve the interests of the organisation hiring them, thus violating the purpose of financial statements. As rightly questioned by Duska and Duska (2003) about the Enron scandal "if the public has yet to see the true picture (of economic affairs of Enron) what good were the two years' worth of audited financial statements that the company issued?"
In order to prevent fraudulent practices in accounting and to guide the accountants in case of any ethical dilemmas they might face during decision-making, different countries have set up different ethical codes for accounting. The ICAEW Code of Ethics used in UK is one such code. It is applicable to all members and students of ICAEW, member organizations, employees of such firms and affiliates. The revised code has been in effect since January 1, 2011. This Code recognises five basic principles of integrity, objectivity, professional competence and due care, confidentiality and professional behaviour. The members are expected to comply with these principles and safeguard their implementation in case of ethical threats.
The principle of integrity states that members should be honest in client's financial information. They should not use the confidential information in order to make any personal gains. Objectivity states that professional judgements are to be carried out without getting affected by any external sources or personal interests. The principle of professional competence states that the client should receive services that are adept according to the current practices, techniques, developments and professional standards. The confidentiality principle ensures that none of the confidential information of the client that is acquired through business or professional relations; be made available to third parties except in case of legal rights of disclosure. Such information is also not to be used for personal gains. The last principle of professional behaviour ascertains that the members will never act in ways that would be dishonour the profession. (ICAEW, January 2011)
The code also recognises certain situations that may pose as threats for the compliance of these principles. These include self interest, where in the personal interests, financial or other, may influence the judgement of the accountant. Self-review threat wherein an accountant would not review earlier decisions made by self before relying on them to make decisions in the current scenario. Next is Familiarity threat wherein the accountant being familiar with the client, becomes too sympathetic to his interests. Advocacy threat includes that the accountant may endorse the position of client in ways that would compromise his objectivity. Finally intimidation threat is the one where accountant may be forced to deter from making ethical judgements owing to professional threats. Along with these threats the Code has also discussed the safeguards that maybe applied in the event of the above threats. They may eliminate threats altogether or reduce them to acceptable levels. The safeguards mainly fall in two categories namely the ones created by legislation or regulation and the other created by the work environment. Although the applications of safeguards would be different in each case, the accountant should make judgement considering all the relative facts. (ICAEW, June 2005).
While following the principles put down by the Code, accountants may come across situations wherein they face dilemmas in making ethical judgements. As such it is required that accountants consider the certain factors, namely, relevant facts, parties, ethical issues involved, principles that can be assigned to the situation and all possible courses of action and then make judgments to solve the issue. In case of failure to reach a conclusion, the accountant may refer to other professionals for help. (ICAEW, June 2005). Thus the ICAEW Code of Ethics helps accountants in making useful and informed judgments. It thus ensures the professional ethics are followed by the accountants that cater to the public interests than mere selfish motives of company owners.