The Role of Accounting in the Collapse of Allco - Essay Example

?Critically evaluate the role of accounting in the collapse or failure of Allco. Introduction The last decade of the 20th century and the beginning of 21st century has seen a number of corporate accounting scandals in Europe and the U.S., including Enron, HealthSouth, Parmalat, Tyco, WorldCom and Xerox. The concept of earning management generally has been at the centre of these scandals. The accounting literature abounds in the various means of earnings management, which is an accounting procedure of hiding actual financial performance of corporations from those stakeholders who have a right to know the actual business position (Habbash, 2010). Causes of the Collapse of Allco Corporate collapse of Allco occurred like many other collapses but reasons of other collapses had been different than with Allco, which collapsed due to duality of the positions of the chairman and the CEO, the two topmost positions in the company, i.e., one of the chairman and the other of the chief executive were managed by the same person, by late David Coe. Media identified Coe as the executive chairman although later Bob Mansfield was the chairman and David Clarke, the chief executive (Walters, 2013). Financial environment worldwide was particularly not conducive otherwise but Allco suffered from the deficiency in corporate mechanism as board of corporate governance behaved like a private company. Criticality of Board Independence Board independence is very critical factor in the scheme of corporate things. The Australian Securities Exchange (ASX) has very clearly advised not to lead the two roles of chairman and chief executive officer by the ditto person. There has never been any ambiguity over this recommendation. Freedom of the board has been from the very beginning the leading principle of good corporate governance, as defined in the preamble of ASX. This issue is linked to the sound health of the capital markets, which has been central to the Australian economy. Take for example the case of Enron where the positions of the CEO and the chairman were managed by Kenneth Lay. Enron collapsed because of cheating and corruption of 18 years in securities (Walters, 2013). The same cannot be said about Allco that it cheated and practised corrupt practices but members of the board were found to be in compromising positions when it came to the issue of loan to one of its associate companies, the Allco Principles Trust (APT). Corporate Mechanism at Allco Former chief executive of Allco, David Clarke revealed the complicated corporate mechanism of the Company, which at one time had a market value of $5 billion and in 2008 it came rolling down to owing above $1 billion, affecting 50 related companies, facing settlement. The fall back in structured finance reduced the share price to almost half in late 2007. An associate company APT was given a loan of $50 million to ensure that margin calls do not bring down Allco share price. The leading shareholders of APT were holding senior executive level positions in Allco with Allco shares as capital (Lannin, 2010). Connection between Stock Prices and Earnings The relation between stock prices and earnings inspire managers to practice earning management. Generally, it is observed that public firms show increased discretionary accruals. Managers are additionally inspired to fulfil the stock market expectations of shareholders. They are motivated to leverage income before listing in stock market, for securing investors’ interests and outcomes of earning management can reflect on the capital market (Soffer et al., 2000). Functions of Allco Board A company’s board caters to the stakes of its shareholders, as executives are too busy in day-to-day management of the company. It is the responsibility of the chairperson to ensure that shareholders’ funds are invested to earn nice dividends. In the present condition, shareholders felt very unrelated and ignorant where their funds were invested and what role their super funds were playing in corporate governance (Walters, 2013). The Australian Financial Review has quoted Coe for being fully aware of the risks he was taking, as cited in Walter (2013): “You have got to start questioning some of the fundamental assumptions around the leverage going into the deals on a long-term sustainable basis … You need to be pretty confident of the sustainability of that cash flow” (Walter, 2013). Allco’s business expansion planning forced it to borrow huge funds, because of lacking cash-flow operating functions for investment in various industries as trains, planes and property. It wanted to control the impact of economic slowdown on earning management. As chairman of Allco, Coe used his power to control the agenda and board meetings to influence the market view over the financial reporting process. As both roles were played by Coe, monitoring of the role of CEO could not be made by a different person equal to the rank of chairman; the information was controlled from passing to the other members of the board to obstruct monitoring by them. As Coe was not an independent chairman, he lacked the initiative to check his own actions and tread cautiously. Had there been an independent chairman appointed, the deficiencies of the board could have been better ascertained through the job monitoring of the CEO. Coe could have cleared his doubts by appointing an independent chair-person to advice him not going too far in risk-taking with the public funds and secure the Allco from the collapse besides Allco shareholders and creditors (Walters, 2013). Acquisition of Rubicon Regardless of the concerns of investors and independent directors of Allco, acquisition of Rubicon was made, for which $63 million and shares of more than $130 million were transferred. Further, sale of assets was made in 2007 to present a rosy view of the company accounts in the financial market; yet another fall in the share price was effected to secure the Company from the collapse. Another asset sale of $68 million to the Singapore Investment Fund was made, a fund created by Allco, to further its business. Allco entered into borrowing contracts for investing in such assets as trains, planes and property (Lannin, 2010). Role of Independent Directors Independent directors can play a constructive role through their memberships of the sub-committees. If the number of non-independent members in the audit, remuneration and nomination committees is higher than independent directors, the chances of manipulating the financial reporting procedure by the board of directors increases. It is significant in the interest of all stakeholders that corporate governance practices are adhered by separating the role of the chairman of the board from the CEO and other executive managers (Habbash, 2010). In the case of Allco, it was not so. Commitments of the CEO were not catering to shareholders’ overall interests. Although in the case of Allco, there were no issues of non-committed NEDs but not appointing a CEO and keeping this designation to self by the Company chairman cost heavily to the interests of shareholders. Too much freedom was taken in taking important decisions. Role of Independent Chairperson An independent chairperson of the board adds to the transparency in the connection between earnings management and corporate governance. It has been observed that companies with increased ratio of outside directors have reduced income-increasing accruals when income recedes below the point of risk. On the contrary when income is on the increase, evidence of income decreasing accruals gets highlighted. It is true not only in the context of outside directors in increased proportion to the total strength of the board but also holds good when the CEO duality is practised (Habbash, 2010). Duality of Roles Research on CEO duality where both roles of the CEO and the chairman are held by singular entity on the board, independence of the chairman in such a situation adds to the gathering of power of the board compromising the purpose and standard of board’s supervision. It results in centralisation of power in the CEO in excess impacting board agendas, holding meetings and managing the information flow to the board members. Study by Persons (2006) does not analyse, however, the duality factor, as most of the firms of the gathered sample data show increased agreement to the corporate governance practice of differing of two roles of the chairman and the CEO. Almost 98% of the companies of the gathered sample have segregated the roles of the two topmost ranks, requiring empirical calculation useless. In the case of Allco, at least this can be derived that the company was not adhering to corporate governance ethics and regulations and was going against the commonly practised traditions of running a public limited company. No doubt Allco has been a local target of global financial crisis but Coe can not be relieved from the blame of taking loans for materialising the acquisition of property group Rubicon when wind was moving in the opposite direction. Definitely, the privilege of the chairman’s independence was not kept under control by Coe. Analysis of Chairman’s Role Habbash (2010) has researched on the UK Corporate Governance Combined Code (2003)) criteria for chairman independence and applied them to decide chairman’s independence. Although it does not reach an outcome on the impact of duality on income management yet analysis of past studies has been made to prove that chairman impresses upon the value of reported income but in his research Hasbbash (2010) has cited Dechow et al. (1996)) to evaluate 96 U.S. companies for manipulating income by the Securities and Exchange Commission (SEC). Analysis has revealed that companies whose CEO is also holding the seat of the board of directors have increased possibility of accounting non-adherence action by SEC for alleged violations of GAAP. Errors were committed by Mr. Coe along with Mr. Fell and another senior level executive for going ahead with the acquisition of Rubicon. That’s why action has been initiated against Allco in the federal court in Sydney, Australia for such other similar accounting anomalies against the company founders, David Coe and Gordon Fell. If the CEO of a company also holds a position in the board’s nominating and compensation committees, possibilities are high of a connection between earning management and rank of chairman. If both the positions are held by different persons, as stated by Anderson et al., (2003)), positive impact over information material of accounting income increases. Review of all past research on the issue of CEO duality is not the same, as that of Anderson et al. and others. Whether Allco was deeply into earning management or not could be a different issue but statistics of the UK’s biggest 1000 listed companies reveal no connection between the both. Another related aspect that cannot be ignored is that no past analysis has been conducted on the independence of the chairman, as per the stipulated independence criteria enforced in the UK Corporate Governance Combined Code (2003)) (Habbash, 2009). Managerial Ownership Another issue that corrupted Allco’s name has been a positive connection between insiders’ ownership and earning management. As confirmed by Clarke, the past CEO of Allco, the $50 million loan to an associate, Allco Principals Trust, was made with the disguised aim of blocking margin calls from affecting the reducing share price of Allco and to let APT fulfil its margin loans but the surprising revelation was that the leading shareholders in APT were holding senior level positions in Allco, holding Allco shares as major assets (Lannin, 2010). The Australian data analysed by Koh (2003)) also reinforces a positive link relevant with the view that increased managerial ownership propels their accruals choice (Habbash, 2010). Lesson from the Allco failure is that public limited corporations should not be managed on the lines of private ones (Lannin, 2010). References Habbash, M., 2010. The effectiveness of corporate governance and external audit on constraining earnings management practice in the UK, Thesis. Durham University. Available at Durham E-Theses Online: http://etheses.dur.ac.uk/448/ [accessed 9 March 2013]. Lannin, S., 5 April 2010. The Allco show comes to town. Available from: http://www.abc.net.au/news/2010-03-24/the-allco-show-comes-to-town/378146 . [accessed 9 March 2013]. Soffer, L.C., Thiagarajan, S.R., & Walther, B.R., 2000. Earnings pre-announcement strategies. Review of Accounting Studies, 5 (1), pp. 5-26. Database: Springer Walters, K., 25 February 2013. What David Coe taught us: CEO and chairmen can’t be one. Available from: http://www.crikey.com.au/2013/01/25/what-david-coe-taught-us-chiefs-and-chairmen-cant-be-one/?wpmp_switcher=mobile Read More