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
The symposium's opening ceremony was held in the heart of
"The symposium helps strengthen ties between scholars, industry leaders, and policy makers in the
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 atIt 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
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
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
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,
The Symposium was co-organized by CityU's Department of Accountancy and the Accounting and Corporate Governance Centre, the