Theoretical Perspective Of Corporate Governance Accounting Essay

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Corporate governance is not easy to define as a result of the perpetually expanding boundaries of the subject. Definitions vary according to the context and the cultural situations (Armstrong & Sweeney 2002) and the perspectives of different researchers.

The OECD, Organisation for Economic Co-operation and Development, defined corporate governance as a mechanism which monitors and controls firms. Corporate governance also defines the role as well as the relationship of the management, board, shareholders and the stakeholders of an organisation . Corporate governance also establishes a framework through which the main aims of the firm are defined, and the method these aims will be achieved as well as monitoring firm performance are determined, (OECD 2009). While the conventional definition of corporate governance does acknowledge the fact that 'other stakeholders' are important for the adequate functioning of a corporate entity, most of the debates are focused of the relationship between shareholders and the corporate managers.

In 2001, a broader definition offered by OECD was:

"Corporate governance refers to the private and public institutions, including laws, regulations and accepted business practices, which together govern the relationship, in a market economy, between corporate managers and entrepreneurs (corporate insiders) on one hand, and those who invest resources in corporations, on the other (OECD 2001, p. 13)."

However, the importance of sound corporate governance does not limit itself to shareholders interest being satisfied, consequently a proper definition of corporate governance should not just describe directors' commitments to shareholders since ideas constituting proper corporate governance vary across several nations . Adrian Cadbury defined corporate governance as:

"Corporate governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The governance framework is there to encourage efficient use of resources and equally to require accountability for the stewardship of the resources. The aim is to align nearly as possible the interest of individuals, corporations and society. The incentive to corporations is to achieve their corporate aims and to attract investment. The incentive for the state is to strengthen their economies and to discourage fraud and mismanagement (Cadbury 2000)."

There are various explanations for the expanding significance of corporate governance. One major reason for this growing interest is due to the several financial scandals associated with governance failure and misconduct. Empirical evidence shows that poor corporate governance structure is related with financial reporting fraud (e.g. Dechow et al. 1996, DSS; Beasley 1996). Corporate governance was set up with a scope to minimize financial frauds such as BCCI, Polly Beck and pensions funds of Maxwell Communications Group in the late 1980s and early 1990s in the UK, controversial executives' pay (like Byrne, Grover and Vogel), and the use of anti takeover strategies and tools by managers. Moreover, corporate firms that promote and implement proper governance are backed by deep and transparent financial markets and efficient resource allocation. This in turn enhance financial and economic stability and boosts growth rates, while firms with weak governance do the opposite.

2.2 Theoretical Perspective of Corporate Governance

2.2.1 Agency Theory:

Corporate and "principal-agent" or "agency" problem have been associated is numerous debates and studies. This theory was initially mentioned by Berle and Means (1932) in a paper associating separation of ownership in large corporate entities. The principle agent, or also referred as agency problems, is commonly the starting point of most debates on the concept of corporate governance. The interests of stakeholders are not always aligned. Depending on the parties involved in conflicts, agency problems can be categorized as: managerial agency (between stockholders and management); debt agency (between stockholders and bondholders); social agency (between private and public sectors); and political agency (between agents of the public sector and the rest of society or taxpayers).

The basic concept of agency theory is that the managers are motivated is satisfying their own interest, thereby, showing less commitment to safeguard shareholder interests. For example, the managers can be more keen to build luxurious offices, buy company cars and the owners will bear these costs. Moreover, the managers usually possess more technical knowledge, experience and know-how the firm's operations and the market will be in a favorable position to pursue their own goals and desires rather than shareholders (owners) interests (Fama, 1980; Fama & Jensen, 1983).

Jensen and Meckling (1976) show how shareholders/investors had to incur additional costs in order to ensure that managers of the firm are satisfying the formers' interest. They define agency costs as:

"-being the sum of the cost of monitoring management, such as budgeting, auditing, control and compensation systems (the agent); bonding the agent to the principal; and residual losses and it includes . As with any other costs, agency costs will be captured by financial markets and reflected in a company's share prices. Therefore, different internal and external mechanisms have been considered via corporate governance to prevent agency conflicts as well as reducing costs associated with such agency."

Many authors highlight the importance of agency problem when analyzing the role of the boards and other corporate governance features with firm performance (Cadbury, 1992; Vienot, 1995; Hampel, 1998; OECD, 1999; King, 2002)

2.2.2 Stakeholder Theory:

A stakeholder is any group of individuals who are directly or indirectly concern with a firm's operation and can have an impact upon its activities, in achieving the firm's target (Freeman 1984). According to Ansoff (1965), an adequate balance is required when satisfying the stakeholders' interest, conflicting in nature, is vital for a firm to achieve its objectives. Therefore, an important approach of stakeholder theory is to identify the stakeholders an organisation is responsible for. Any stakeholder is relevant if their investment is, in some form, subject to risk from the activities of the organisation (Clarkson 1995).

Main criticism of stakeholder theory is to identify the genuine stakeholders of an organisation. One argument is that meeting stakeholders interests also opens up a path for corruption, as it offers agents the opportunity to divert the wealth away from the shareholders to others (Smallman 2004). But the moral perspective of stakeholder theory is that all stakeholders should benefit from equally rights in a firm, and managers should operate the firm for the welfare of all stakeholders, regardless of whether the stakeholder management enhance financial performance (Deegan 2004).

2.2.3 Stewardship Theory

Although due to effective separation of ownership and control, the agent may be opportunistic, stewardship theory argues that the agents are not necessarily motivated by individual goals, rather they are motivated to work in the interest of their principal (Barney, 1990; Donaldson, 1990; Davis et al, 1997; Donaldson and Davis, 1991). Unlike agency theory, stewardship theory favors CEO duality. This theory imply that the power of the executives and best stewardship role can only be performance when the role of the CEO and Chairperson of the board is combined (Donaldson and Davis, 1991; Ong and Lee, 2000). Another important aspect of stewardship theory suggests that including independent directors on the board is beneficial for improving decision making as well as ensure proper functioning of the firm's operations.

Stewardship theory sees a strong association between managers and the prosperity of the firm, and therefore the stewards protect and maximise shareholder wealth through better firm performance. A steward who improves performance successfully, satisfies most stakeholder groups in an organisation, when these groups have interests that are well served by increasing organisational wealth (Davis, Schoorman & Donaldson 1997).

2.3 Empirical Literature

2.3.1 Board Composition and Firm performance

The board of directors regarded as the most outstanding governance mechanism of the internal control system along with ownership concentration provide a vital monitoring function in dealing with agency problems in the firm between investors and management and between controlling and minority shareholders.

2.3.1.1 Board Composition

Hermalin and Weisbach (1991) provide evidence on board mechanism. In their research in the United States, they used the performance measure Tobin's Q and concluded that low proportion of internal directors compared to outside directors is not related in increasing firm economic performance but are rather effective monitors and a critical disciplining device who aid managers in sound decision making regarding acquisitions, executive compensation and CEO turnover. Further backed by Bhagat and Black (2002) who used the same performance measure and suggested there is too little to assume a cross-sectional relationship between board composition and firm economic performance.

Other Studies in different countries have provided empirical evidence on whether board composition is related to performance on firms. Dahya et al (2002) examined the effectiveness of board following the implementation of the UK Code of best practice by Cadbury Committee. The code required board in UK firms to include at least 3 outside directors and that seat of Chairperson and CEO should be occupied by different individuals. However the code is not mandatory but an explanation should be put forth by firms as to why they are not complying. Dahya et al, 1998 notice that CEO turnover substantially rose and that sensitivity of turnover to performance is stronger after its implementation. They concluded that is the higher proportion of outside directors on the board that explains the turnover.

Another survey conducted by Wymeersch (1998) provided a deep insight on the composition on European board of directors. According to Wymeersch's findings the role of the board of directors in not defined in the law enforced in most European nations. Consequently, shareholders' aim of wealth maximisation was not the principal target of European boards. British, Belgium and Swiss adhered closely to American model while for the other European countries composition of board would vary. European board are most often unitary as in the US. However, some European countries the two-tiered system is the rule. In a two-tiered system, the board consists of a managing board, all executive directors, and supervisory board composed of non-executive directors. The two tiered rule can be mandatory is some nations such Germany and Austria while being optional in countries like France and Finland. In the case of Germany, employees are represented in the supervisory board, a system called co-determination, and it is mandatory for firm with more than 500 employees.

Evidence of the effectiveness of board of directors differs widely across the world. Kaplan and Minton (1994) conducted a study upon the effectiveness of board in the Japanese system, They studied mainly the relationship of the appointment of outside directors to Japanese firms' board and their performance. They noticed an increase of appointment of outside directors in the events of poor stock performance and earnings losses by firms. Kaplan and Minton measured using stock returns, operating performance and sales growth, that firms experienced more stability and marginal increase in their corporate performance.

Rodriguez and Anson (2001) examine how the market reacted to the implementation of the Spanish code of the best practice, Olivencia Code. The code requires 23 recommendations to Spanish firms that aim at improving and strengthening supervisory role of board of directors in Spain. Rodriguez and Anson reported improvement in stock prices to the announcement of compliance however which stipulates a significant restructuring of the board. Firms that operated poorly showed strong reactions to the announcement of the Olivencia Code compliance.

2.3.1.2 Executive Directors

While the board of directors consists of a ratio of non-executive (outside/independent) directors and executive directors (inside), most studies on board of directors are mainly focused on the benefits and drawbacks of outside directors. Consequently, evidence on the importance and beneficial role of executive directors is scarce.

However, both inside directors and independent directors share, more or less, common goals and interests. Like independent directors, whose role will not be discussed in this paper, executive directors do play their role as governance agent safeguarding between the firm and its owner interests and at the same time maintaining the contractual relationship between the firm and the board of directors (Willianmson 1988). Executive directors, often called internal manager, are vital source of information concerning the constraints and opportunities of their respective firm. With regards to their monitoring role, it is expected that executive provide first-hand information to other board members (Boumosleh and Reeb, 2005). Executive are active participants in the firm's business decision making process , unlike outside directors they obviously have access to all vital information that is beneficial for the firm's decision making. The do not only ease decision making process but also are expected to educate independent directors in firm's operations during board meetings. (Fama and Jensen, 1983). Some studies have provided evidence on the beneficial role of executive directors. Vance (1978) carried a research on firm's performance, measured in terms of return of investment and stock appreciation, are significantly influenced by inside directors' technical know-how and managerial experience more than any other participants in the boardroom. A common goal shared by both executive and independent director is to monitor the CEO. Despite being under the supervision of the CEO, inside directors can have indirect control over the latter by channeling sufficient information to independent directors if there is CEO entrenchment. Thus, effective monitoring role from inside directors and reduction of information asymmetries, may promote a sound corporate governance structure which will obviously lead to a better economic performance of the firm.

However, in reality executives are usually considered as less independent parties from the CEO, which may render their role of monitoring less effective in contrast of outside directors. As they are subordinates of the CEO nor they are in a position to monitor or discipline the CEO (Daily & Dalton 1993b). Consequently, a majority of executive director representation on the board does not necessarily mean improvements in firm performance.

Empirical research on the relationship between board composition and firms' performance have is mixed. Having outside directors in the board is believe to be an advantage for the firm. Petra (2005) stated that outside directors plays a vital and beneficial role in decision making with their vast know-how, expertise and contracts. Independent directors who possess wide breath of industrial experience will contribute effectively to board committee as well as provide key strategic vision which will influence positively decision making process. (Ingley and Van der Walt, 2005). Moreover, board consisting of a higher ratio of independent directors compared to inside directors are more likely to replace their CEO if the firm has produced poor performance (Weisbach 1988) and can freely evaluate management's performance and act to remedy in case expectations and targets are not met (Kesner et al, 1986).

Some research has produced evidence of a positive relationship between board composition and firm performance. Eillingson (1996) finds that the association between CEO compensation and firm performance is stronger when a firm's board constitutes of a high proportion of outsiders. Moreover, the appointment of additional directors in the board has been associated to positive abnormal returns (Rosenstein and Waytt, 1990). Lee et al (1992) finds that board constituting of higher ratio of independent directors than insiders is associated to higher returns in contrast to board composed mostly of executive directors. Other studies have suggested a positive link between having more outside directors and higher firm performance (Marr & Rosenstein 1994: Daily and Dalton 1992: McKnight and Mira (2003): Cotter, Shivdasani and Zenner (1997).

However, lack of time and appropriate expertise of outside directors (sahra & pearce 1989) and their fear to challenge difficult decisions made by management (Lorsch & Maclver 1989) does not contribute to corporate performance. In a study of random sample of 200 Fortune 500 firms in 1991, Johnson (1996) finds boards composed of more inside directors are less likely to adopt anti-takeover provisions and golden parachutes than board dominated by independent directos, and this may affect firm performance overall. In addition, in research conducted by Kosnik (1990) is had been observed that greater diversity in outside directors' principal occupations increases the tendency of corporations to use greenmail. Due to information asymmetry, lack or limited access to knowledge about the firm, could negatively affect board performance Abdullah (2004).

2.3.1.3 Board Size:

Board size refers to the number of member constituting the board. Some studies have been in favor of boards composed of fewer members ( Lipton and Lorsch 1992: Jensen 1993: Yermack, 1996). Lipston and Lorsch (1992) suggest that smaller board size firms are less unlikely to face problems of social loafing and free riding than board huge in size which inevitably increases better and effective communication among members, hence avoiding distortion of information, and greater co-ordination. In the same vein, Yermack (1996) and Eisenberg, Sundgren and Wells (1998) provided evidence that of an inverse relationship between board size and firm performance, hence supporting that smaller boards perform better.

However large boards enhance monitoring ability as well as provide better advice (Klein 1998: Coles, Daniel & Naveen, 2008; Brown and Caylor 2004) found a positive relationship between board size and corporate performance and stated that independence of the board is essential for it efficiency. Chaganti et al. (1985) also find that firms with larger boards also maintain better stability in the long run compared to firms with smaller boards which go bankrupt more often than larger ones. Hence, larger board also assist survival of corporations in the long run. Singh and Harianto (1989) found that large boards restrict CEO domination within board, as such avoiding use of golden parachute contracts not of shareholders' interest, therefore leading to a better board performance.

2.3.2 Leadership Structure and Firm Performance.

2.3.2.1 CEO -Chairman Duality

CEO-Duality is considered as a vital board structure mechanism. It simply refer to a situation where the title for both CEO and Chairman of the board of directors is occupied by one individual. However, many commentators have called for prohibition of CEO serving dual titles (Fama & Jensen 1983 and Rechner & Dalton, 1991). Coles & Hesterly (2000) stated that this mechanism widens the power of the CEO at the expense of board members, which gives rise to agency costs and may affect firm perform. Micheal C Jensen (1983) argue that:

"the function of the chairman is to run board meetings and oversee the process of hiring, firing, evaluating and compensating the CEO. Clearly the CEO cannot perform this function apart from his/her personal interest....for the board to be effective, it is important to separate the CEO and Chairman position"

Boards, in which 2 separate individuals serve the title for CEO and Chairman, are regarded as independent since CEO power is significantly diluted, in contrast to duality structure, and increases board ability to perform effectively in its decision making role and strategic planning (Fama and Jensen 1983). Westpal and Khanna (2003) argue that market reaction to poison pill strategies implemented by corporations is significantly more negative for firms consisting for duality system. Poison pill is a defensive tactic used by management with approval from the board of directors to hinder hostile takeover from other corporations.

However some studies have favored the dual structured system. Stoeberl and Sherony (1985) and Anderson and Anthony (1988) argue that CEO duality establishes strong and explicit leadership in formulating and implementing effective strategies. It has also been argued that 2 separate individuals serving CEO and Chairman title may give rise to information sharing costs (Brickley, Coles and Jarrell, 1997), conflicts between both parties and decision making process and execution may become less efficient. Faleye (2007) using Tobin's q also provided evidence that duality system was beneficial for firms operating in a highly competitive market. Donaldson and Davis (1991) report a higher shareholder returns measured by return on equity for firms adopting the duality system. Dahaene De Vuyst and Ooghe (2001) found that a duality structure has substantial impact on the return on asset. This is explained as the chairman acting as CEO will be active in daily operations of the firm and will do his/her best to maintain consistent growth of the firm as well as their personal reputation.

However a number of empirical research were conducted to provide estimates on the performance of the combined title system and little evidence were found on whether separating titles had an impact on firms' performance (James A Brickley, Coles and Gregg A Jarrell, 1997). While Rechner and Dalton (1991) found a positive relationship between separated leadership structure and firm performance, Boyd (1995) found that duality structure actually helps firm performance. Petra (2005) and Yarmack (1996) also provided evidence that firms with non-duality system is highly valued in the market, since it is believe that internal control is strengthened when CEO is monitored by the Chairman.

2.3.3 Board Committees

Committees is an essential mechanism available for board of directors for decision making process (Bacon and Devis, 1973) as well as providing monitoring or oversight function of the boards consisting of the setting up of audit, remuneration and nomination committees. These committees provide better insight of the board operations and hence enhance the accountability of the board (Harison, 1987) as well as encouraging financial accounting disclosure promoting more reporting practice which reduces managerial discretion and increases quality. (Carson, 2002). Due to the various corporate failures that occurred in the late 1980s and 1990s, the Cadbury Committee was set up in May 1991, publishing a report (Cadbury Report 1992), mentioning that 3 committees should form part of the board structure:

audit Committees, Review of financial reporting and internal controls;

nomination Committee, Board appointments and succession planning; and

remuneration Committee, to decide executive directors' pay and policy.

However, it is possible that firms set up committees just to give impression of doing something. For committees to operate effectively it is suggested that it should be constituted of mostly, if not wholly, independent directors, who obviously should possess required expertise and knowledge about the firm's activity and market (Keong 2002) and also information along with professional advice should be readily made available to these committees.

Studies by Lorsch and MacIver (1989), Daily (1994, 1996) and Kesner (1988) explain that most major processes and decisions are originated from a board subcommittee such as audit, remuneration and nomination committees, rather than boards-at-large. These committees enable the boards to cope with the limited time factor and the complexity of information that they need to deal with (Dalton et al. 1998).

Board accountability and better quality financial reporting were seen important as a result of the financial scandals of the 1980s. Nowadays, audit is regarded as a major aspect of corporate governance structure. Consequently, effective audit leads to proper good governance mechanism which enhances firm performance. Indeed, auditors and audit committees play an essential role in controlling financial management of the company so as to improve performance.

Previous studies carried out to determine the association between reliability of information and audit committees suggest mixed results. Organisations having an audit committee are more likely to provide trustworthy information than those which do not. However, Beasley (1996) suggest that despite having an audit committee, information published by firms is not necessarily reliable. However, Petra (2007) show that independent audit committee has a beneficial impact on the quality of financial statements.

Hus am Aldamen, Keith Duncon, Fimone Kelly, Ray MeNamara, Stephen Nagel (2001) analyse the relationship between audit committee operations and firm performance. They firm performance is enhance when firms set up smaller audit committee which adequate experience and financial expertise..

Due to the existence of agency problem, directors would favor estimation of their management compensation on firm performance, for example on net income or market valuation. Previous research how that CEO compensation is reduced when the board monitors the firm decision-making (Boyd 1994). Consequently, remuneration committee allows the boards, which control management decisions, keep CEO compensation under control.

Nomination committees help the board of directors to appoint members for vacant positions available on the board, which will reduce the involvement of board members, as well as nominating the CEO during the nomination process (Petra 2007). Benefits of nomination committees are that they will appoint individuals who will act as advocates of shareholders (Byrd & Hickman 1992)

Studies on board sub-committees and firm performance are mixed. Klein (1998) provided evidence that firm remuneration committee and firm performance was positively linked, however the relationship was not strong. On the other hand, Petra's (2007) in his study on board structures consisted of audit, remuneration and nomination committees has no relationship with earnings informativeness to the stock market performance. Moreover, Weir and Laing et al. (2002) found audit committee structure has no impact on firm performance.

2.3.4 CSR Reporting:

Corporate social responsibility (CSR) is now seen as an integral part of corporate strategy. Nowadays firms face an increasing obligation to publish CSR reports (Day & Woodward 2009). KPMG (2008) accoutns that about three-quarters of Global Fortune 250 companies examined, between the period of 2007 and 2008, have an officially conveyed CSR strategy that constitute of defined aims. Results from the Economic Intelligence Unit's 2007 survey show that almost 30 percent of analyzed direcotrs consider CSR practice as a main priority issue for the firm with further 40 percent fixing it as high priority.

CSR is defined as:

"achieving commercial success in ways that honour ethical values and respect for people, communities and the natural environment (Liyanage 2007, p. 28)."

Thus, the role of CSR reporting to is convey the implications of the firms activities to the society, in achieving their aims (Deegan 2004). It can also be referred to as the process of communicating the environmental and social effects of the economic actions of firms to specific interest parties within society and to society at large (Gray, Owen & Adams 1996).

According to Buhr and Graftstrom (2007), several companies about their CSR activities as a crucial success factor and refer to CSR as a business policy that creates new market opportunities, product differentiation (McWilliams & Siegel, 2001; Waddock & Graves, 1997), competitive advantage, customer satisfaction and avoid government fines (Freedman & Stagliano, 1991; Shane & Spicer, 1983). It also build creates goodwill, ameliorate firms' reputation, reinforce their brand names and also aid firms to motivate employees. They also favor the concept that CSR reporting enhance firms' value and improves performance.

There various methods used for corporate social responsibility. Measurement of corporate social responsibility depends on addressing the stakeholders (Wood & Jones 1995). According to McGuire (1988), corporate social responsibility is measured using three criteria: expert evaluation, content analysis of annual reports and other documents, and performance in monitoring pollution. A study conducted by Rettab et al. (2008) uses financial performance measures, employee commitment and corporate reputation as measures for corporate social responsibility.

Effects of corporate scandal to the society and the importance of stakeholder orientation has raise awareness for firms to act responsibly, to include issues associated with CSR to the decision-making of corporate boards for responsible corporate conduct (Spitzeck 2009). However, Arora and Dharwadkar (2011) argue that, current level of demand for socially responsible investment is lower than the supply of socially responsible investment. As a result effective governance structures will ensure that managers will act in the best interest of the principal, which suggest that effective governance will reduce positive CSR. According to Turnbull (1994), corporate decision-making can increase efficiency through participation of stakeholders. Therefore de Wit et al. (2006) consider that establishment of the necessary governance structures is important to integrate stakeholder concerns.

Empirical evidence on the association between Corporate social responsibility and firm performance shows indecisive outcomes, which are positive, negative or neutral (McWilliams & Siegel 2000). Margolis and Walsh (2001) report 55% these studies identified a positive association between CSR and financial performance, 22% reported no relationship, 18% found mixed relationships and 4% reported a negative relationship. Similar results were reported by Orlitzky et al. (2003). McGuire (1988) and Nelling and Web (2009) did not find any relationship between CSR reporting and stock market performance.

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