The Role of Accounting and Auditing in Corporate Governance - Essay Example

A Critical Appraisal of the Role of Accounting and Auditing in Corporate Governance A Critical Appraisal of the Role of Accounting and Auditing in Corporate Governance Introduction Sound corporate governance demands that the board of directors of a business organization exercise adequate oversight over the CEO and other senior managers to ensure that they deliver on the expectations of the shareholders of the organization. On their part, the shareholders elect the directors during their yearly general meetings. The aftermath of the economic downturn the world experienced starting 2008 has risen the bar of effective corporate governance even higher (Christopher 2012). Managers and director are under greater pressure to deliver returns on shareholder investments in a challenging environment. This paper appraises the role of accounting and auditing in corporate governance. Discussion The Conflicting Interests of Principals and Agents The agency theory has influenced much of the contemporary thinking about strategic business policy and management in todays corporation that is commonly characterized by the ownership of shares (Li & Rwegasira 2008). In terms of the agency theory, the shareholders or owners of a corporation are the principals while managers are the agents, acting on the behalf of and charged with maximizing returns to the principals. In practice, however, the actions of many managers have been found to be opposed to the interests of the shareholders – the maximization of returns on their investments. As a result, there exists an agency loss in that the owners of the corporation get fewer returns on their investments than they would have had they been in direct control of the corporation (Li & Rwegasira 2008). In view of this problem, the agency theory proposes a number of mechanisms that are designed to reduce agency loss. First, the theory proposes the separation of powers between the management of the corporation and their board of directors (Mueller 2006). In theory, the latter are perceived to represent the interests of the shareholders. In essence, the separation of powers entails having a non-executive Chairperson. In other words, different people hold the positions of the Chairperson and the CEO. This way, the board of directors, which represents the interests of the principals, exercises control over the executive management of the corporation. Secondly, the theory of agency proposes incentive schemes that reward managers in monetary terms for maximizing returns to the owners of the corporation (Donaldson & Davis 1991). Typically, such schemes involve plans where senior executives are allowed to acquire shares in the corporation, usually at a reduced price. This way, the financial interests of the executives are aligned with those of the shareholders. Similar schemes reward executives, in terms of compensation and benefits, according to the shareholder returns; the higher the returns, the more the managers are paid in compensation and benefits. Also, the compensation of the executives may be deferred to the future in order to reward them for long-term shareholder value maximization and prevent short-term executive action that may harm the value of the corporation (Donaldson & Davis 1991). In the same breadth, the organizational economics kindred theory is also concerned with curtailing the opportunistic behaviour of business executives (Donaldson & Davis 1991). These include neglecting duty and engaging in excesses that harm the corporation. The main tool for curbing such opportunism on the part of the executives is the board of directors. This body is elected by the shareholders to monitor the actions of the executives. Such oversight can only be exercised fully where the board is independent of the executive and is chaired by a person who is not the CEO of the corporation. In an instance where the CEO and the Chairman is the same person, as is the case in many American corporations, the oversight role of the board is highly compromised. Such an order is likely to lead to agency loss and managerial opportunism (Donaldson & Davis 1991). The above discussion summarizes the theory of agency. However, research, even if to a limited extent, has cast doubt over the cherished assumption of the theory that the separation of power between the executive and the board maximizes shareholder returns. A 1991 survey of 321 American firms, where CEO duality is prevalent, revealed that shareholder returns were highest under conditions of CEO duality – the positions of the CEO and Chairperson are held by one person (Donaldson & Davis 1991). The limitations of the study notwithstanding, its findings do cast doubt over the popularity of the theory of agency as the solution to the conflicting interests of corporate owners and managers. The implications are is that non-American organizations must not readily accept the theory. After all, the theory of stewardship in which the same person holds the positions of the CEO and the Chairperson, might be the solution to the conflict of interest. The Role of the CEO, Chairperson and the Board of Directors Owing to the high numbers of failures in corporate financial reporting, many governments around the globe have enacted laws to enhance corporate governance in general and financial reporting processes in particular (Cohen et al. 2011). These efforts have mainly sought to strengthen audit committees so they can carry out their functions of internal controls, audit and the reporting of financial results. As such, regulators have underscored the importance of the independence of audit committees. For that independence to be realised, the commit must not have direct economic ties with the organization or its executives. Following the intensity of the regulations, audit committees might appear to be independent of the senior executives of the corporation. In practice, however, the independence of the committee may be significantly compromised or nonexistent in situations where the CEO has significant say on who sits on the audit committee (Cohen et al. 2011). Under such circumstances, the CEO is likely to nominate to the committee people with whom they have had prior working or social interaction. Research has reported that more often than not, people are invited to serve on the audit committee because of the links they have with senior management or some members of the board. Research has further demonstrated that where the CEO is involved in appointing members of the audit committee, the independence and efficiency of the committee are significantly diminished. In many jurisdictions, in discharging their functions, internal auditors report to one of four entities in the corporation: the management of the company, the board of directors, a board set up primarily to supervise internal audit, the audit committee or the general meeting of the shareholders (Ljubisavljević & Jovanović 2011). In a Serbian survey involving 159 companies, 65% of the firms reported that internal auditors report and are answerable to the company management, 43% percent to the board, 23% to the supervisory board, 18% to a meeting of shareholders and 3% to the audit committee (Ljubisavljević & Jovanović 2011). This finding highlights that the important role the board plays in the accounting and auditing functions of the corporation. According to the theory of agency, boards of directors are created and exist to check the management of the corporation against engaging in excesses and other actions that may jeopardize the interests of the owners of the corporation. However, the theory of managerial hegemony posits that many boards are puppets to be manipulated by senior executives. They exist only for the corporation to comply with legal requirements and appear to be a separate entity independent of the management. If this theory, which is more persuasive than that of agency, is anything to go by, then boards have very little influence on the independence and functioning of the audit committee (Öhman et al. 2006). The input and direction of the board of directors are crucial if the audit committee are to discharge their functions effectively (Öhman et al. 2006). Thus, a good working relationship is necessary between the two entities. At a personal level, the Chairperson’s of the committee and the board must have a good working relationship between them. Such a relationship would foster the timely sharing of information between the two entities. In addition, many audit practitioners believe that the audit committee should a subcommittee of the board, with the members enjoying all the benefits due to the directors. The proposal that the audit committee ought to be a subcommittee of the board is a positive. It could shield the members of the audit committee from manipulation by managers. However, this is possible only where the board is independent of the management in the first place. Otherwise, the managers could easily manipulate both entities and possibly fuel tension between them if doing so would be helpful to the furtherance of the interests of management. Where the audit committee is a subcommittee of the board, the challenge lies in ensuring that the two Chairpersons do not collude to further their interests and neglect those of the owners of the company (Christopher 2012). Conclusion In a bid to safeguard the interests of the owners of the company against the opportunistic tendencies of some managers, the agency theory was developed. One of the major proposals of the theory is a board of directors that is independent of the management. While the theory proposes other solutions to the problem, the board is the main solution. The theory assumes that the board will be independent enough to exercise effective oversight over the management. However, the theory of managerial hegemony posits that many boards are weak and prone to the manipulation of the executives. In addition, a study of American corporations with CEO duality revealed that those firms performed as well as, if not better than, those firms where the CEO and the Chairperson are separate. These shortcomings notwithstanding, both the management and the board have important parts to play in the financial reporting processes of the organization (Christopher 2012). References Christopher, J., 2012. The adoption of internal audit as a governance control mechanism in Australian public universities – views from the CEOs. Journal of Higher Education Policy and Management, 34(5), pp. 529-541. Cohen, J., Gaynor, L. & Wright, A., 2011. The Impact on Auditor Judgments of CEO Influence on Audit Committee Independence,Columbia: University of South Carolina. Donaldson, L. & Davis, J., 1991. Stewardship Theory or Agency Theory: CEO Governance and Shareholder Returns.Australian Journal of Management, 16(1), pp. 49-65. Li, X. & Rwegasira, K., 2008. Diversification and Corporate Performance in China: An Agency Theory Perspective. Journal of Transnational Management, 13(2), pp. 132-147. Ljubisavljević, S. & Jovanović, D., 2011. Empirical Research on the Internal Audit Position of Companies in Serbia. Ecnomic Annals, 56(191), pp. 123-141. Mueller, D., 2006. Corporate Governance and Economic Performance. International Review of Applied Economics, 20(5), pp. 623-643. Öhman, P., Häckner, E., Jansonn, A.-M. & Tschudi, F., 2006. Swedish auditors view of auditing: Doing things right versus doing the right things. European Accounting Review, 15(1), pp. 89-114. Read More