US company law reform in the wake of Enron
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For answers to some of these questions, in late October Bulletin spoke to Dr Bin Srinidhi, Associate Professor in CityU's Department of Accountancy and a key member of its Accounting and Corporate Governance Centre. Dr Srinidhi's interest in corporate governance research reflects his diverse background that combines studies of accounting, management and technology. He focuses on, for example, how different facts, such as the increase in knowledge-based assets rather than tangible assets, are creating a greater need for corporate governance to generate credible relationships between investors and managers. Part of Dr Srinidhi's work looks at how generally accepted accounting principles and their implementation interact with corporate governance. He has also written on the effect of changes in legislation on information asymmetry in the
Q: Could we start off with your research interests? And how are they related to the current reforms in the wake of Enron and the Sarbanes-Oxley Act?
A: I'm involved in one project with Professor Ferdinand Gul and Professor Judy Tsui* on the effect of information asymmetry on earnings management. Information asymmetry occurs when managers of a corporation know things that are not known to investors and that's why managers need to report to investors. The higher the degree of information asymmetry the greater is the mistrust of what managers say, and the greater need for vigorous forms of contracting for managers to disclose what they know. The whole idea is to build the confidence level of investors so that they will feel comfortable to invest. As laid down in the Sarbanes-Oxley Act, US regulators in the wake of Enron would require better corporate disclosures but such disclosures are not only on disclosing more things but also on disclosing with greater confidence. That is, corporations should not only disclose more but should also be able to provide more evidence to back it up, so that investors will have more confidence in what has been disclosed. There are certain areas with a greater priority in disclosing, for example, the
Q: Where do the demands for corporate governance come from and how do scandals like Enron and WorldCom affect such demands?
A: The demand for corporate governance, according to the economists, comes from two sources: incompleteness of contracts and the legal environment. Incompleteness of contracts means that they cannot deal with all potential eventualities that may happen. For example, I have an employment contract with my employer but it will not be possible to contract with me on every eventuality. What happens if I fall sick for two days? The contract cannot specify explicitly or implicitly what is to be done in every possible situation like this. What my employer or any organization can do is to set up procedures on what to do if such eventualities take place and through such procedures to resolve the eventualities amicably between the two parties-or if not amicably, in a transparent way that is seen by everyone as decently fair. So corporate governance procedures are designed to settle incompleteness of contracts. Secondly, even if the contracts are complete, what is the extent to which the legal system in the country will help to implement these contracts? If it takes every lawsuit five or 10 years to clear, there is not much point in coming into the contract because there is so much delay that one can break the contract with apparent impunity. So confidence in the legal system on implementing the existing contracts is weakened or lost. In that case, corporate governance has to expand to cover some of the areas where the law is weak. Two possible situations can result: the law may be strong but the situation may be leading to incompleteness of contracts; or the law may be weak and one needs additional procedures put in place to take care of the weakness in the legal implementation system. These are the two main demanding forces. On the other hand, the supply of corporate governance comes from the legal, accounting, auditing and managerial systems. The basic issue in corporate governance is to match the demand with the supply.
Q: What are the corporate governance procedures? How did Enron fail?A: Basically there are a couple of procedures. The first is the accounting procedure, that is,
Enron represents a failure on many fronts, but mainly it is a failure of the management system, that is, the lack of a vigorous internal control system within the company. It also signifies a failure of the auditing system, on the part of Arthur Andersen, the auditing firm. Even though Andersen had the competence, they probably did not have enough independence. Enron is one of the many cases audited by Arthur Andersen that have had problems, such as Global Crossing.
Q: So, is the latest round of
A: In terms of the reforms, naturally, the answer shifts back to the auditing and regulations systems and the system of how and what the stock exchange should demand from the firms for their listing. There are two ways to look at this: to treat them as individual failures with lessons not necessarily requiring wholescale change; or as a complete failure in the overall system, representing some malaise in the core.
Coming to the management system, the act is very harsh, too. It requires the CEO and CFO to certify the financial statement on a quarterly basis. It also requires the CEO and CFO to certify the existence of an internal control system; it demands that they certify that they have personally reviewed such a system within the previous 90 days. Any false certification is a criminal act, and clearly this sounds over-prescriptive to me because a CEO should balance the emphasis he gives to internal control with strategy, marketing and a whole lot of other important issues as well.
More disclosure seems to be fine, but this act requires the Securities and Exchange Commission (SEC ) to review the disclosures made by public companies at least once every three years. Considering the number of companies listed with the SEC, it would require a huge number of people and organizational resources to do this. It certainly looks like a little bit over-regulation in this respect.
Q: What about the proposal to set up a new regulatory board to oversee the accounting industry?
A: Setting up the Public Company Accounting Oversight Board seems to be a reasonable idea, given the failure of Arthur Andersen. The tragedy here is that the concept of the industry's self-regulation is giving way to public oversight which could eventually become bureaucratic, inefficient and even corrupt. Still, for the time being, it looks like the lesser of two evils. The SEC is to set up the board to oversee the accounting profession and to have two members with accounting background and others with a non-accounting background. The board will oversee all public accounting firms, and review and establish quality control procedures. However, the act makes no distinction between domestic and foreign companies. Any company listed in the US is subject to this act, whether it is a US or foreign company, which means that a US company operating in Hong Kong, for example, is clearly subject to this act too, and subject to SEC triennial review as well. So whatever happens to the
There are both good things and bad things in the act. More disclosure requirements, greater auditor's independence-these are reasonable and good things. On the other hand, restrictions placed on management-what has happened is that Enron and WorldCom have created the impression that most management is dishonest and have to controlled like criminals-I think that is the last thing to do.
Q: Do you see, on the heels of such company law reform, that the American corporate governance model is moving towards a European model?
A: The culture is different. The objective of the Anglo-American accounting system in the
Q: Under the effect of the Sarbanes-Oxley Act, do you see the US GAAP (Generally Accepted Accounting Practices) moving towards IAS (International Accounting Standards) for the a greater harmonization of accounting standards?
A: Independent of Enron, there is a greater movement in the world towards the
The European model has focused a lot on creditors and banks. Globalization has increased so much over the last decade that there is greater movement of equity capital around the world, so it means that they have to come up with a system more in line with the interests of equity investors, so international accounting standards have evolved with the US GAAP in mind. There is, in fact, very little difference between the US GAAP and the IAS but the difference between the IAS and old European models like the German system is huge. It takes a bigger leap for the European model to move away from the German model towards the IAS than for the IAS to move towards the US GAAP. But it doesn't end there; even if accounting standards are harmonized, it doesn't mean that corporate governance systems are going to be harmonized. We need to look at the auditing system, the quality control of auditors, the competence of auditors and their independence, management systems and the cultural aspects. I don't see how these things are going to be harmonized in the near future, but with increasing globalization, a movement towards bringing systems together is inevitable. The way these come together is to facilitate greater flow of capital and the creation of greater confidence among investors. Basically, it looks as if the
Q: Many critics take issue at stock options being used as an incentive to motivate directors and managers in the
A: In the
Q: So, what is your main criticism of the latest round of company law reform in the
A: I think we should let the market do the job, and there should be a proper balance between market force and regulatory mechanism. Lately, the pendulum has swung a bit. Regulations are basically of two types: one on information, the other on those on the actual operations of the corporation. Regulating the flow of information usually means an increase in the amount of information flow, forcing corporations to disclose more information to the shareholders and the public. This actually results in higher efficiency in the market, so regulation of information is not that bad. Regulation of information is very different from regulation of actions. There is a tendency to simplify things or overdo it, to sweep everything with the same brush. If you try to regulate what firms do, it may not be very good for the economy. The Sarbanes-Oxley Act both regulates the information as well as how directors manage. I am happy with the information side, such as, additional disclosure, providing more information, auditors' independence, which will likely increase investor confidence, but at the same time, I'm concerned that putting too many restrictions on managers and on how they manage their firms is going to stifle growth potential.
Q: What is the impact of the
A: I think whatever is done in the
* Professor Gul is currently Head of CityU's Department of Accountancy and Director of Accounting and Corporate Governance Centre while Professor Judy Tsui, a former head of the department is, is now Dean of the faculty of Business and Information Systems at the Hong Kong Polytechnic University.