Corporate governance in the wake of Enron: From failure to reform

 

More than 150 accounting and auditing academics, practitioners and research degree students from around the world attended the 4th Asia-Pacific Journal of Accounting and Economics (APJAE) Symposium co-organized by City University of Hong Kong, from 6 to 8 January at the Shanghai National Accounting Institute (SNAI). This is the first time the annual symposium has been held outside Hong Kong.

The symposium's opening ceremony was held in the heart of Shanghai, an emerging financial centre in the mainland, at the Shanghai Futures Exchange. Officiating at the ceremony, Shanghai Futures Exchange Chairman Ms Wang Lihua said, "This annual meeting is a very important academic activity that will inspire the development of the Shanghai Futures Exchange and the enhancement of Shanghai as an international financial centre."

"The symposium helps strengthen ties between scholars, industry leaders, and policy makers in the Pacific Rim," said Professor Peter Wilson, President of the American Accounting Association. Also officiating at the opening of the symposium were SNAI President Professor Xia Dawai, and Chair Professor Ferdinand Gul, Head of City University's Department of Accountancy and Director of the Accounting and Corporate Governance Centre.

In the aftermath of Enron

The conference kicked off with a forum titled "Corporate Governance: In the Wake of Enron." The Enron scandal in 2001 dealt a blow to public confidence in capital market and financial reporting. Governments, practitioners and academics in the field are currently examining how to restore effective corporate governance and public confidence. To prevent the recurrence of an Enron-type disaster, the US Congress enacted the Sarbanes-Oxley Act in July 2002, which created an oversight framework for the accounting profession and established new corporate guidelines. The Act has a far-reaching impact on the different constituents, such as publicly traded companies, standard setters, auditors and investors. Four speakers from the US, China and Hong Kong were invited to share their views, from the perspectives of standard setters, academics, regulators and practitioners, on the significance of the Sarbanes-Oxley Act, the role of auditors and new ways to improve corporate governance.

The Sarbanes-Oxley Act (see Bulletin No.27, page 90), for example, requires a company to establish an audit committee composed solely of independent directors who should have some degree of financial literacy. Audit committees can strengthen the quality of financial reporting by assisting the board in carrying out its own independent review of the financial reports, said Mr Richard George of Deloitte Touche Tohmatsu's Technical Department, one of the four speakers. "But the mere existence of the audit committee is inadequate," he said. "The presence of independent directors as stipulated by the Act makes the committee more effective."

Realignment of interests

In the past, auditing firms tended to take on non-audit services that resulted in a conflict of interests within a company. Professor Joshua Ronen, Professor of Accounting at New YorkUniversity's Stern School of Business, said the Act remedies this by limiting the scope and extent of non-audit services. But there is another way to achieve auditors' independence, he proposed: financial statement insurance, which realigns the interests between the capital market, auditors, the insured and the insurer.

It is widely known that one of the failures of corporate governance, Professor Ronen said, is that while shareholders appoint auditors and approve their non-audit services nominally, it is management that really gives approval. This creates a principal-agent relationship in which the management acts as the principal who hires the agent, that is, the auditor, and this gives rise to an inherent conflict of interests.

Professor Ronen suggested changing the principal in this relationship: instead of the company doing the appointing, a principal whose interests align with those of the shareholders should appoint the auditors. "What I am proposing is to have the insurance companies that insure financial statements against omissions and misrepresentations act as principals," he said. As the insurance company aims to minimize claim losses, its interests are on a par with those of the shareholders, who want to minimize losses resulting from omissions and misrepresentations in financial statements.

In this scenario, to determine the coverage and the premium the insurance companies would undertake a risk assessment of the company, which is when the quality of the financial statement becomes critical. The premium and coverage, which would be publicized, would provide a credible signal to the market. Companies with high quality financial statements would attract higher coverage and lower premiums and, vice versa, companies with lower quality financial statements would face higher capital costs. In order to keep their capital costs low, these companies would try to improve the quality of their financial statements. "As a result of the realignment of interests, the audit quality would be improved," said Professor Ronen. There would be better quality financial statements, greater confidence in financial statements and fewer incidences of shareholder losses.

Auditors as gatekeepers

For his part, Mr George proposed another key to maintaining audit quality: audit firms should be selective about who they take on as clients. They should accept assignments with those companies whose board and management possess integrity and commitment to accurate and reliable financial reporting. Audit firms should also ensure that auditors are technically qualified for each audit, not only in regard to their professional qualifications but also their experience in relevant fields. "A bank auditor, for example, is unlikely to be qualified to audit a client in the telecommunications industry and vice versa," he said. "Auditors are the cornerstone of the overall corporate governance system," Mr George said. According to the International Standards on Auditing 260, "governanceE describes the role of the person entrusted with the supervision, control and direction of an entity." The company should establish a governance structure that enables the board of directors to exercise objective and independent judgement on corporate affairs, including financial reporting. Although external auditors do not have the same direct responsibility as the board of directors, they have a very important role in the corporate governance framework, as they conduct an independent examination of the financial information to be released by the corporation. "They act as gatekeepers who are responsible for checking the reliability of financial information prepared by the board and ensuring that the reporting conforms to the accounting and disclosure rules," he said.

Principles-based vs rules-based standards

In addition to triggering a review of the role and independence of auditors, the Enron scandal also resulted in changes to the standards setting procedures. The US Financial Accounting Standards Board (FASB), established in 1973, is the private sector organization empowered by the US Securities and Exchange Commission (SEC) to establish financial accounting and reporting standards. After Enron, the FASB was publicly criticized for having laid down ineffective auditing standards in several areas, said FASB board member and speaker Professor Katherine Schipper. It was criticized for being too slow to reach decisions in important areas, such as consolidation policy and standards to distinguish liabilities from equities; for being inappropriately influenced by auditors to make auditing easy for auditors but less than useful for investors; for issuing too complex standards; for inappropriate emphasis on fair value measures; and for adopting rules-based instead of principles-based standards. In response to these criticisms, the FASB has implemented new measures to improve consolidation, to redefine liability to include certain share-settled obligations and ownership relationships, and to promulgate new standards to implement the new definition. While the Sarbanes-Oxley Act also requires the SEC to investigate the feasibility of implementing a more principles-based approach to accounting, the FASB is examining whether such an approach to the setting of accounting standards will improve the quality and transparency of financial reporting.

"The promulgation of principles-based standards is viewed by some people as a constructive response to financial reporting failures in the US," said Professor Schipper. "Limited or no implementation guidance, in my view, is what is intended by most of our constituencies when they suggest that we have principles-based standards. That is, they would like us to provide fewer explanations and examples of how to apply the standards." But she is concerned that principles-based standards may mean that there will be no or fewer exceptions to the scope and no alternatives to the treatment, and preparers and users of financial information will need to accept increased volatility in reported earnings. There is also a need to consider whether less detailed implementation guidance would have an impact on the comparability of financial information and the necessity for professional judgement, and whether the amount and nature of preparer and auditor expertise would have to change. Professor Schipper also raised the problem of whether less detailed guidance actually reduces cost, or leads to more litigation.

In fact, Professor Schipper believes that the Act's highly specific, detailed and prescriptive regulations about behaviour increase the demand for unambiguous, detailed and comprehensive financial reporting guidance. "The Act, with its prescriptive attitude towards corporate governance, may be inherently in conflict with the movement to principles-based standards," she said. Despite the fact that it is unclear whether the FASB would move to less detailed principles-based standards or to more detailed guidance, Professor Schipper said, "I believe that the FASB has an important role to play in restoring trust in financial reporting."

Impact on China

The Sarbanes-Oxley Act is not only important to the US but also to China and the rest of the world, said Dr Jesse Wang Jianxi, Deputy Secretary General, China Securities Regulatory Commission. The importance of the Act to China is threefold. "It is important to accounting practice, to the regulation of the capital market and to the Chinese companies listed in the US," he said. As the Act states that foreign firms are subject to its regulations, China, with 25 to 27 companies engaging in oil, telecom, power and Internet businesses that are listed on the New York Stock Exchange and Nasdaq, is not exempt from its impact. But the problem in China is more than a corporate governance issue. "The difficulty lies with China's failure to cope with the market economy, as state-owned enterprises still dominate the economy," said Dr Wang, "If the state does not make fundamental changes to become a more market-oriented system, no matter whether the enterprises are state-owned or private-owned, corporate governance alone cannot solve the problem."

The problem won't be solved unless attitudes change and the auditing structure is overhauled. More government regulations, improved regulations, new methods and policies will bring effective corporate governance, he believes.

The US corporate scandals and the steps taken to put things right have attracted world attention. "Each country, however, has its unique problems, the ways the capital markets evolve are different, ownership structures are different and there are political considerations in the way that governments want the corporate sector to move," said CityU's Professor Gul, in summerizing the discussion. The whole issue of restoring effective corporate governance and confidence is just beginning. "We have a long way to go and it is very difficult to come up with any clear prescription at this stage. What we need is to have more discussions, look at the issues more closely and facilitate more exchanges of ideas and move ahead very carefully."

In addition to the Corporate Governance Forum, the Symposium also included a Research Forum featuring Professor S P Kothari, Gordon Y Billard Professor of Accounting, Sloan School of Business, Massachusetts Institute of Technology, and Professor Terrence Shevlin, Professor of Accounting, University of Washington. The symposium also included paper presentations on various accounting topics such as taxes and earnings management, behavioural finance and capital markets research, and disclosures.

The Symposium was co-organized by CityU's Department of Accountancy and the Accounting and Corporate Governance Centre, the Hong KongPolytechnicUniversity, SNAI, FudanUniversity and the Shanghai University of Finance and Economics. It was supported by the American Accounting Association and sponsored by the Hong Kong Society of Accountants and Deloitte Touche Tohmatsu.

 

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