Principles of Corporate Governance - Essay Example

Corporate Governance Corporate Governance Introduction Corporate governance s and legislation are usually developed to mirrorthe lessons derived from corporate failure. Responding to the 1929 crash of the stock market and also as part of the New Deal, the 1933 Securities Act and 1934 Securities Act were passed by Congress (Bratton 2007, p. 64). Since then, both state legislatures and Congress have carried on passing comprehensive laws aimed at regulating the securities industry. More recently, one of the most notable corporate scandals and economic disasters witnessed in the 21st century was that of Enron. A staff of executives used of the American energy company. This prompted the adoption of the Corporate and Auditing Accountability, Responsibility and Transparency Act (commonly known as the SOX). Essentially, the Act was to mandate reforms that would fight corporate accounting fraud by enhancing corporate responsibility and financial disclosures. Further, for the sake of overseeing auditors, the Public Companies Accounting Oversight Board was also created by the Act. This paper will discuss the Enron case and research academic literature to evaluate the amendments to the code/legislation and determine whether they will resolve the issues of corporate governance as well as assessing the effectiveness of the changes. For the purpose of discussion, an overview of the Enron Scandal and the Sarbanes-Oxley Act will be given, followed by the evaluation of amendments to the code/legislation. Overview of the Enron Scandal The most notable causes of Enron’s downfall were associated with corporate governance, revenue recognition, special purpose entities and mark-to-market accounting. When the sale of natural gas was deregulated via legislation passed by Congress, Enron increased its prices and soon became the North America’s largest seller by 1992, earning $122 million before taxes and interest. However, poor financial reporting and accounting loopholes were used by the chief executive officer and the chief financial officer to conceal billions of dollars that had accrued as debt from projects and deals that had failed. Eventually, this led to the bankruptcy as the company executives continuously misled the audit committee and board of directors on matters concerning high-risk practices of accounting. Further, they also pressured their auditors, Arthur Andersen, to ignore such matters. Enron reported the entire value of all trades it conducted as revenue as opposed to reporting the cost of the products as the cost of goods sold and selling price as revenue (Salter 2008, p. 104). This aggressive approach to accounting interpretation effectively inflated trading revenue. Then, the new chief executive officer adopted the mark-to-market accounting, requiring income to be estimated the moment a contract is signed as the current worth of net prospective cash flow. This, he claimed, was a representation of the true economic value. However, the considerable inconsistencies while attempting to match cash and profits always resulted in false and deceptive reports. Although the company was able to record income from deals and projects, in reality they had not received any money. Essentially, this increased financial earnings only in the accounting books. Then, since the company had accelerated its income but could not include the profits in future years, they had to indicate that they were still doing more deals and signing more long-term contracts. This was to show that they maintained the same rising income, aided by special purpose entities that were created to meet specific and temporary purposes. That was done by managing and funding risks associated with particular assets while disclosing minimal details on the use of such special purpose entities, effectively overstating equity and understating liabilities by evading conventional accounting practice. Public accounting statements were falsified and manipulated in an effort to cover up Enron’s true financial situation while its success was largely being driven by accounting fraud. Overview of the Sarbanes-Oxley Act The Sarbanes-Oxley Act (SOX) was enacted in reaction to accounting and corporate scandals and offer protection to investors through the improvement of reliability and accuracy of corporate disclosures pursuant to securities laws (Kimmel, P, Weygandt, J & Donald, E 2011, p. 217). Summarily, its key elements include the PCAOB (Public Company Accounting Oversight Board); auditor independence; corporate responsibility; enhanced financial disclosures; analyst conflicts of interest; commission resources authority; studies and reports; corporate and criminal fraud accountability; white collar crime penalty enhancement; corporate tax returns; and corporate fraud accountability. It was formulated on the premise that it is the management’s responsibility to evaluate and report on their company’s controls. Then, it is the external auditors’ responsibility to audit the assertions of the management and draw their own independent conclusions about the effectiveness of the company’s internal controls (Rolf 2005, p. 14). Through the PCAOB, SOX establishes and provides auditing and accounting standards, which also require public auditing firms to register with PCAOB and be subjected to annual quality reviews. This was intended to restore the confidence of the public in financial markets by strengthening corporate governance, enhancing the disclosure of financial information as well as an increase in corporate accountability. The ultimate mission of the PCAOB is the regulation of auditors of companies that are traded publicly. This is meant to ensure that the relationship between auditors and clients are free from commercially conflicting interests and the corporate financial statements go through tough external scrutiny. Analysis of the Effectiveness of the Amendments to the Code/Legislation The amendments of the code/legislation are in large part effective especially with regards to public companies. The development of corporate governance codes especially after the Enron scandal were intended to re-empower and reform corporate boards of directors; encourage companies to adopt corporate codes of ethics; clarify the role of internal counsel; lay the cultural foundation of shareholder activism; and also change the way private companies are run. Supporters of the amendments opine that at the time the Enron scandal took place, the existing laws were not strict enough. However, it must be mentioned that laws existed only that they did not have the same focus borne by the new ones and/or the amendments. According to Li, Pincus and Rego (2004, p. 69), the amendments have resulted in better internal control of financial reporting as well as independence and expertise among better-focused directors, committees and boards. This opinion can be supported because the amendments and new legislation imposed new ethics, disclosure, audit and reporting requirements and also created whistleblower structures. On the other hand, the late 1990s technology boom led to cozy relationships between corporations, auditors and investment analyst. For example, Enron tolerated such relationships and viewed conventional practices of accounting as not being compliant to the new economy that was founded on telecommunications and computers. Then, the standards at that time were designed to offer protection to accounting firms in the event that they get into legal trouble in their audits. Most importantly, they were not written to reflect the interest of the general public (Deakin & Konzelmann 2005, p. 5). From this point of view, it can be shown that the new laws and amendments are designed to ensure that rather than protecting the accounting firms, the audits are conducted to protect the general public. Agreeably, there were legally prescribed punishments earlier for violators of the set accounting standards. However, it is also apparent that while punishment will serve as a deterrent, corporate codes of ethics and more clear-cut missions will be more crucial to guide the accounting practice in a manner that also reflects the public interest. Before SOX was enacted, the need for the timely reporting of selling of securities by an entity or a person consisting of 10% and above of the equity securities in a company that was publicly traded was not enforced (Oesterle 2008, p. 449). This was the key factor that enabled Enron executives who held interests in excess of 10% in the company to sell their equity securities before making employees and the general public with individual accounts aware. Since the employees were not made aware of the sales on time, they had no way of detecting extraordinary transfers that had the potential to affect the value of the company. However, the new code/legislation stipulates that sales of 10% and above be reported by the close of the second day of business after making the sale. This can only be viewed as having positive effects since the transfer of securities will be monitored by all employees and public with individual accounts, increasing the chances of detecting fraudulent activities. Essentially, the net effects of the amendments and new code/legislation go beyond its elements. According to Kimmel, Weygandt and Donald (2011, p. 198), the new legislations may not be exactly revolutionary when viewed in terms of the substantive changes it introduced. This is because the existing laws that guided the elementary duties, principles and corporate governance standards remained largely the same. However, the corporate world and accounting firms were indifferent to the existence laws. Therefore, it can be argued that the changes and new legislation were revolutionary in sense in which it brought about cultural and attitudinal changes. Corporate boards of directors were re-empowered and reformed, with the most effective change being the shift from the notion that the board is meant to serve the management to one that the management works for the board. Initial corporate structures were designed for such a perspective but less of it was witnessed in the day-to-day operations of corporations and more in the official procedures of documentation. The present code/legislation is largely effective because of the recognition that the independence of directors is crucial if the board must serve efficiently as a means of checking the management (Black 2007, p. 197). In the event that the board does not exercise appropriate oversight, the code/legislation gives room for director liability. Since corporations have been strengthened and subjected to greater oversight from proactive board members amidst increasing need for independence, greater diversity has been realised among board members. This has enabled corporations to develop, document and test internal controls periodically with the objective of preventing fraudulent financial reporting. Unlike previous situations, audit committees serving on the boards have more responsibilities and greater powers which include working alongside external auditors of in-house controls (Deakin & Konzelmann 2005, p. 4). For example, when the management or the board’s audit committee does not respond to reported misconduct presented by independent auditors, the independent auditors will be able to inform higher institutions of the dispute and to resign. This has greatly encouraged companies to adopt corporate codes of ethics by requiring them to disclose whether their financial officials and top executives followed or failed to follow stipulated codes of ethics. Further, if there was no such code of ethics in place, the company would have to explain the reason. While it is acknowledged that necessary audit improvements are ongoing concerns, Toffler and Reingold (2004, p. 94) point out that critics often overlook the generation of greater focus on improving stronger ethics and corporate governance as contributed by the amendments. Hence, they must be reminded that the amendments were enacted to remedy a series of corporate failures and were designed to address functions that protect the investing public’s interests. Effectively, the new code/legislation addresses at least two key areas of protecting investors. First, it addresses the chief executive officers’ and chief financial officers’ accountability and responsibility for all financial disclosures that relate to controls. Second, it increases engagement and professionalism of corporate audit committees. The creation of the PCAOB to oversee public company auditors replaced the self-regulatory scheme and mandated true independence. According to Healy and Krishna (2008, p. 3), this meant that the inspection powers of the PCAOB subjected the audit of a corporation’s internal controls to scrutiny. The significance of this development cannot be denied because the PCAOB was enabled to summon any partner at an accounting company and demand to see the documentation of their last five engagements (Ayala & Ibárgüen 2006, p. 416). It can be seen that the absence of such a body with such powers was among the factors that contributed to the scandals and falsified statements at Enron. Generally, it can be argued that apart from the 2008 economic crisis and the Olympus case, financial auditing and reporting has significantly improved since the code/legislation was introduced after the Enron scandal. This is largely attributable to the improved standards and discipline that has been realised by the new inspection processes (Healy & Krishna 2008, p. 5). A significant lesson learned from the Enron scandal is that of the role of in-house counsel (Shakespeare 2008, p. 421). On one hand, their jobs have agreeably been made more demanding in terms of the necessary expertise and the fact that keeping the job depends on how the chief executive officer and his team of executives view them. On the other hand, their roles have been clarified which means they can work more effectively and efficiently because they are now able to focus on the needs of the corporation. For example, before the new code/legislation the in-house counsel at Enron was not able to focus on who his client was (Kohn, Kohn & Colapinto 2007, p. 129). According to Kimmel, Weygandt and Donald (2011, p. 202), this role was clarified after Enron and in-house counsel now know that rather than the management, their client is the corporation. One of their roles is to report material violation to either the chief executive officer or chief legal officer who must then investigate the report and respond to it. This is a positive development because if the in-house counsel is not satisfied with the chief executive officer’s or chief legal officer’s response, they are obligated to report the misconduct to the audit committee. Given that the executives face additional punishment for not responding appropriately of giving false statements, misconduct has highly been deterred. On the other hand, before the new code/legislation, it was common for external auditors of public companies to develop longstanding and close relationships with chief executives to an extent that most accounting and audit discrepancies were overlooked (Kuschnik 2008, p. 69). Such was the case with Enron, but the lessons learned are becoming more apparent as the new code/legislation requires corporations that trade their securities publicly to establish independent audit committees in charge or appointment and compensation. The independent committee also oversees the procedures of the external auditors, which effectively reduces the chances of fraud. Within the current audit and accounting environment, the management staff of public companies is no longer able to develop strong, longstanding working relationships with external auditors. At the same time, the external auditors cannot provide the company with consultation on how financial statements should be produced. The essence of this is that the management’s ability to control external audit and financial statements is greatly reduced while the external auditors’ independence is strengthened (Jickling 2003, p. 1164). This is a clear indication that lessons were learned from previous scandals that were characterised by the close relationship of the external auditors and management. Consequently, that is why conflicts of interest are currently being prevented by prohibiting firms that audit public companies from providing them with non-audit services unless they have the approval of the independent audit committee. Further, more professionalism is realised by the provision that public auditing firms are not permitted to provide services to companies whose chief executive officers or chief finance officer was an employee of auditing firm within the previous year (Chhaochharia & Grinstein 2007, p. 7). By requiring that the lead audit review partner and the lead audit partner be rotated after five years, the code/legislation ensures that the longstanding relationships that result in careless or intentionally falsified audits are not developed. Conclusion It can be concluded that the overall impact of the new code/legislations that were informed by the Enron scandal and, in particular, the SOX Act, on auditing and accounting firms and their internal practices and operations are largely positive. This is especially so when one considers the reduction and prevention of fraud, maintenance of auditor independence and the enhancement of quality and accuracy of independent audits as well as the reputation of the auditing and accounting firms. This assertion was also supported by a Gallup poll conducted in 2004 which indicated a 45% positive rating having grown from 31% in 2002 (Oesterle 2008, p. 443). Putting caps on multiple engagements has created new and clear functions for small and medium-sized auditing and accounting firms. It has been shown that the Enron management pointed an accusing finger at the auditors and accountants and claimed little responsibility in the company’s downfall, protected by the then securities law. However, the new environment has significantly increased transparency by improving governance practice and expressly making the management responsible for their companies’ financial reporting’s accuracy and reliability. Therefore, the development of corporate governance codes after the Enron scandal can be said to have been informed by an analysis of what went wrong and is a reflection of the lessons learned. References Ayala, A & Ibárgüen, G 2006, ‘A market proposal for auditing the financial statements of public companies’, Journal of Management of Value, vol. 51, no. 4, pp. 411-420. Black, W 2007, ‘Why doesn’t the SEC have a chief criminologist’? The Criminologist, vol. 26, no. 6, pp. 193-208. Bratton, W 2007, ‘Does corporate law protect the interests of shareholders and other stakeholders? Enron and the dark side of shareholder value’, Tulane Law Review, vol. 1275, no. 9, pp. 61-75. Chhaochharia, V & Grinstein, Y 2007, ‘Corporate governance and firm value: the impact of the 2002 governance rules’, Johnson School Research Paper, vol. 23, no. 6, pp. 7-9. Deakin, S & Konzelmann, S 2005, ‘Learning from Enron’, University of Cambridge ESRC Centre for Business Research, vol. 274, no. 8, pp. 1-5. Healy, P & Krishna, G 2008, ‘The fall of Enron’, Journal of Economic Perspectives, vol. 27, no. 3, pp. 3-8. Jickling, S 2003, CRS report for Congress, Senate Committee on Banking, Housing and Urban Affairs, Washington. Kimmel, P, Weygandt, J & Donald, E 2011, Financial accounting, Wiley, London. Kohn, S Kohn, M & Colapinto, D 2007, Whistleblower law: a guide to legal protections for corporate employees, Praeger, New York. Kuschnik, B 2008, ‘The Sarbanes Oxley Act: "big brother is watching" you or adequate measures of corporate governance regulation’? Rutgers Business Law Journal, vol. 5, no. 6, pp. 64-95. Li, H, Pincus, M & Rego, S 2004, Market reaction to events surrounding the Sarbanes- Oxley Act of 2002, University of Iowa Press, Iowa. Oesterle, D 2008, ‘Early observations on the prosecutions of the business scandals of 2002-03’, Ohio State Journal of Criminal Law, vol. 19, no. 4, pp. 443-468. Rolf, C, 2005, ‘Efficacy of the Sarbanes-Oxley Act in curbing corporate fraud’, Rivier College Academic Journal, vol. 1, no. 1, pp. 1-16. Salter, M 2008, Innovation corrupted: the origins and legacy of Enrons collapse. Havard University Press, New York. Shakespeare, C 2008, ‘Sarbanes–Oxley Act of 2002 five years on: what have we learned’? Journal of Business & Technology Law, vol. 333, no. 5, pp. 416-421. Toffler, B & Reingold, J 2004, Final accounting: ambition, greed and the fall of Arthur Andersen, Wiley, New York. Read More