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Corporate Governance Mechanism Essay

Executive Summary

This paper will reviews the extent to which corporate governance acts as efficient tool to protect investors against corporate fraud, thus contributing to summarize the literatures on role of corporate governance on preventing occurrence of corporate fraud. In a more recent study, corporate fraud is part of earnings manipulation done outside the law and standards. Whereas, the activities covered by the terms earnings management (such as income smoothing and big bath) and creative accounting (or window dressing) normally remain within the regulations. In this regard, corporate governance mechanism, particularly effective boards, audit committees, and auditors, decrease the likelihood of corporate fraud occurs. At very last contemplation, vigilant structure within corporation as holding stakeholders interests with shift in ethics and values will likely stop greedy executives to take personal advantages.

Keywords: Corporate fraud, earnings management, corporate governance, board effectiveness, audit committee effectiveness and auditor effectiveness.

1. Introduction

There are a number of legal cases involving the accounting manipulation in leading companies in the United States of America (USA) and also other countries, such as Enron and WorldCom in USA, and HIH Insurance and One.Tel in Australia. These have led investors, regulators, and academics to focus on improving dimension of corporate governance to unveil that unethical financial reporting practice. Scholars commonly attribute that poor corporate governance in such companies caused their earnings manipulation. For instance, Lavelle (2002) asserts that Enron’s bankruptcy was caused by the audit committee’s lack of independence, which determined from poor governance, which is part of corporate governance mechanism.

This paper will reviews the extent to which corporate governance acts as efficient tool to protect investors against corporate fraud, thus contributing to summarize the literatures on role of corporate governance on preventing occurrence of corporate fraud. In addition, from the practical point of view, this paper is expected to provide information on how board and audit committee, auditor and regulator indicate and anticipate which firm’s corporate governance mechanism that cause the likelihood to fail to prevent commit corporate fraud and loose stakeholders.

In general discussion, corporate governance mechanism assures a crucial role in improving the efficiency of capital market through its impact on corporate operating efficiency and effectiveness, sustainable growth, and integrity and quality of financial report. Blue Ribbon Committee (1999) asserts good governance promotes relationship of accountability among primary corporation participants to enhance corporate performance.

This mechanism holds management accountable to the board and the board accountable to stockholders. The key element of board oversight is working with corporation management to achieve corporate legal and ethical compliance. Board oversight mechanism can be taken in place to deter fraud, anticipate financial risk, and promote high quality, accurate, and timely disclosure to the board, to the public market and to the shareholders.

This paper is organized as follows. In the next section, it will be presented the literature review regarding the corporate fraud and earnings management. It is continued by discussing the effectiveness of board oversight and audit committee, role of external auditor and closing thoughts at curbing fraud.

2. Fraud and Earnings Management

In this section, it will be distinguished between corporate frauds from earnings management. Existing literatures seem no clear agreement on differentiating both those two event in corporate reporting.

2.1 What is Corporate Fraud?

In the beginning of 2000s, US investors has been hit by intentionally falsify of financial reporting in the biggest and prominent public company. The companies such as Enron, Worldcom, HIH Insurance and One.Tel, to name but a few, has perpetrated and resulted a monumental losses for the investing public. For instance, Enron that recorded as the seventh largest corporation by its market capitalization in US, averaging $90 per share and worth US$70 billion in 2000, was suddenly collapsed in late 2001. Morrison (2004) asserts that the cause of the collapse is the largest corporate fraud and audit failure. Then, it can be understood that the massive corporate fraud caused by fraudulent financial reporting have contributed to a very sharp decline in the US stock market.

Many of these corporate scandals include such as action of account manipulation, earnings management, restatement and other failing to report the significant events to investing public. Then, what corporate fraud does really mean? One of the answers, corporate fraud is defined as an intentional or reckless conduct, whether by act or omission, that results in materially misleading financial statements (National Comission on Fraudulent Financial Reporting of the United States, 1987). Many prior studies (Persons, 2006; Bédard, Chtourou & Courteau 2004; Uzun, Szewczyk & Varma, 2004; Abbott, Parker & Peters, 2000; Beasley, 1996) have found that corporate fraud generally involves the accounting irregularities notion, such as:

* Manipulation, falsification or alteration of accounting records or supporting documents from which financial statements are prepared. * Misrepresentation in or intentional omission from, the financial statements of events, transactions, or other significant information. * Misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure.

Stolowy and Breton (2004) proposed the framework to understand the classification of account manipulation. They classify the manipulation that is outside the law and standards constitutes as fraud (known as corporate fraud, financial fraud, and accounting irregularities, interchangeability). Whereas, the activities covered by the terms earnings management (such as income smoothing and big bath) and creative accounting (or window dressing) normally remain within the regulations. Figure 1 presents that framework for understanding account manipulation (adopted from Stolowy and Breton 2004).

Figure 1 Framework for Understanding Account Manipulation

Fraud, in large extent, occurs when somebody commits an illegal act. In accounting notion, for example, fabricating false invoice to increase revenue number is fraud, while interpreting consignment sales as ordinary sales is errors. This different sometime does not clear to everyone, particularly who does not really understand how accounting treatment is. In short, it can be conclude that fraud exists when the account manipulation done outside the limit of the regulations (law and standards).

2.2 Earnings Management

It is always hard to frame a useful definition to such a broad subject ‘earnings management’. Account manipulation done within law and standard is categorized into earnings management and creative accounting. The objective of this type account manipulation is to alter the wealth transfer mechanism: earnings per share (EPS on income statement side) and debt to equity ratio (balance sheet side). Based on figure 1, earnings management is a reporting activity done by manipulating the income statement into two ways: first, by presenting item before or after the profit used to calculate EPS and second, by removing or adding particular revenues or expenses (modification of total net income).

In addition, ‘creative accounting’ term has been developed mainly by practitioners and commentators on market activity. The chartist concern comes from observing the market, not from any fundamental analysis. Windows dressing activities are done by manipulating structural risk to influence the level of firm’s debt to equity ratio. For example, interpretation at off balance sheet transaction such as leasing.

Earnings management can be beneficial, neutral, and pernicious (Ronen & Yaari 2006). It is beneficial since it signals long term value. Managers take advantage of flexibility in the choice of accounting methods to signal internal information on future company’s cash flows. Then, it can be neutral when it reveals short-term true firm value. Managers can chose the accounting treatment either economically efficient or opportunistic behaviours. On the contrary, it is pernicious since it conceals short- or long term performance. This practice usually involves tricks to mislead or reduce the transparency of the financial information.

Since the last decade, US Securities and Exchange Commission (SEC) had stated its concern about earnings management (Levitt 1998) and other scholar wonders the condition of the audit committees’ incapacity to deal with earning management which using accounting tricks to camouflage a firm’s true operating performance (Warrick 1999). As account manipulation is done outside law and standards, indeed it constitutes fraudulent financial reporting (Stolowy & Breton 2004). In this regard, scholars commonly find association between less fraudulent financial reporting and good corporate governance mechanism (Beasley 1996; Abbott, Parker and Peters 2000).

3. Governance Mechanism in Preventing Fraud

In this section, it will be reviewed role of corporate governance in describing and preventing such as occurrence of corporate fraud. A vast number of previous literature reveal that company in default (fraud) have less effective boards, audit committees, and external auditors.

3.1. Board and Audit Committee Oversight Effectiveness

The board of directors and its audit committee play a prominent role in corporate governance particularly in controlling top management. Back in 1983, Fama and Jansen argue that the board as a corporation’s highest level of control mechanism with ultimate responsibility over the way company is run. The literature review on fraudulent financial statement, restatement and financial reporting quality commonly indicates that characteristic and composition of the board do influence its effectiveness.

A vast number of study examining proxies for the board’s power, independence and competence by: * The presence of financial expert; this characteristic of boardroom prevent the accounting fraud and minimize their seriousness (Farber 2005). * Proportion of independence directors on the board; the percentage of independent directors in fraudulent firms is likely to be smaller than in compliant firm. In the same way, the presence of non-affiliated block holder on the board will be negatively associated with the level of non-compliance of accounting manipulation outside law and regulation (fraud) (Beasley 1996, Beasley et al. 2000 and Abbott et al. 2004). * The number of seats directors; board size increases the likelihood of corporate fraud increases. The rational of this finding is a smaller board provide more of controlling function than do a larger board (Beasley 1996 and Jensen 1993).

* Low board of director tenure; when turnover is high, so there will be a few employees (senior staff) who are still work with the company can memorize the corporation’s fraudulent activity. Few new employees are likely to join the line of power elite and therefore it will more foster insider power (senior staff) to institutionalize their position of power within corporation (Dunn 2004). * Separation of the CEO position and chairman of the board. Dunn (2004) argues that structural power, when managers also sit as key person in the board negates the advantages of a division of labour and can lead to adverse corporation outcomes.

These above characteristics show that excessive power of board, percentage of unrelated directors and presence of financial experts will likely determine the level of company’s compliance with law and regulations. Indeed, this governance mechanism has been incorporated into corporate governance guideline in some prominent organisation and regulators (OECD 2004 and ASX 2008). For instance, in second edition ASX under principle 2 ‘the structure the board to add value’ requires that ‘the roles of chair and chief executive officer should not be exercised by the same individual’. In some extent this empirical finding has been taken into account by some market self regulatory such as ASX.

It is important to note that audit committee effectiveness is negatively associated with the occurrence of corporate fraud (Farber 2005; Abbott et al 2004; and Agrawal and Chadha 2005). Its committee’s effectiveness commonly is measured by number of outside directors and number of financial expert on firm audit committee. In addition, ASX 2008 states the importance of independence and competence of audit committee. International practice is moving towards an audit committee only comprised of independent directors. Regarding technical expertise, audit committee should include members who are all financially literate (able to read and understand financial statements), which at least one have accounting qualification and one who understand the industry practise which corporation operates.

3.2. Auditor Effectiveness

Many previous studies argue that external auditor plays a crucial role in preventing and detecting accounting fraud (Farber 2005, Piot and Janin 2005, Myers et al. 2003, and Johnson et al. (2002). Farber (2005) finds that firms audited by one of Big 4 (PricewaterhouseCoopers, Ernst & Young, KPMG and Deloitte Touche Tohmatsu) are less often announcing fraudulent financial reporting compared to firms audited by non Big 4. Moreover, Piot and Janin (2005) states that the occurrence of restatement (low level of fraudulent financial reporting) is often proceeded by a change of external auditor. Then, it may be considered that auditor effectiveness can be measured by engaging Big 4 as external auditor and no suddenly change of auditor before their rotation period.

In addition, there is debate over the benefit of rotation period. Myer et al. (2003) find that longer auditor tenure constrains management’s discretion with accounting accruals, which suggests high audit quality. This is consistent with Johnson et al. (2002) that also find accruals are larger and less persistent for firms with short auditor tenure relative to those with medium or long tenure. They argue that longer tenure can improve auditor expertise from superior client-specific knowledge. However, proponent of mandatory auditor rotation argues that lengthy auditor tenure erodes independence, which in turn impairs audit quality.

Since independence is an abstract thing, regulators, practitioners, and academics often rely on the appearance dimension to operationalize the auditor independence (Dupuch et al. 2003). In common sense, auditor will be perceived less independence when provide such material amount of particular kinds of non-audit service to audit clients. Ladakis (2005) describes that in the year of 2000 alone, Enron as detected fraudulent corporation paid Andersen audit fees of US$25 million, and non-audit fees of US$27 million.

4. Closing Thoughts

There are so many regulatory efforts aiming to curb corporate fraud and any other accounting irregularities within company, then people will find inconclusive answer that all regulation is not enough to deter the fraud in the future. Dishonest people inside corporation will insist to commit fraud and other type of crimes within or outside standards and regulations. Those who have no commitment to firms and society may always find a way to do fraud for personal advantages.

They will override the regulations in even new creative practice to hide theft. Then, last hope to stop this is only good structure as holding between economic and social goal, individual and communal goal incorporated with shift in ethics and value. People must always remember that greedy executive who wants to acquire the personal benefit cannot be stopped by even best controls and regulations.

Companies would be perform better by addressing the fraud issues specific to their own firm, and then developing an ethical corporate values that will hold them well in the long run. Corporate governance compliance within company and proactive fraud prevention effort by professional can decrease the corporation’s likelihood of being victimized by fraud.

5. List of References
ABBOTT, L., PARK, Y. & PARKER, S. (2000) The Effect of Audit Committee Activity and Independence on Corporate Fraud. Managerial Finance, 26, 55-67.

ABBOTT, L., PARKER, S. & PETER, G. (2004) Audit Committee Characteristics and Restatements. Auditing: A Journal of Practice and Theory, 23, 69-87.

AGRAWAL, A. & CHADHA, S. (2005) Corporate Governance and Accounting Scandals. Journal of Law and Economics, 48, 371-390.

AUSTRALIAN SECURITIES EXCHANGE (2008) Corporate Governance Principles and Recommendations. ASX Corporate Governance Council, 2nd Edition.

BEASLEY, M. S. (1996) An Empirical Analysis of the Rotation Between the Board of Director Composition and Financial Statement Fraud. Accounting Review, 71, 443-465.

BEASLEY, M. S., CARCELLO, J. V., HERMANSON, D. R. & LAPIDES, P. D. (2000) Fraudulent Financial Reporting: Consideration of Industry Traits and Corporate Governance Mechanisms. Accounting Horizons, 14, 441-454.

BÉDARD, J., CHTOUROU, S. M. & COURTEAU, L. (2004) The Effect of Audit Committee Expertise, Independence, and Activity on Aggressive Earnings Management. Auditing, 23 (2), 13-35

BLUE RIBBON COMMITTEE (1999) Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, New York: New York Stock Exchange and National Association of Securities Dealers.

DUNN, P. (2004) The Impact of Insider Power on Fraudulent Financial Reporting. Journal of Management, 30, 397-412.

DOPUCH, N., R. R. KING, AND R. SCHWARTZ. (2003) Independence in Appearance and in Fact: An empirical investigation. Contemporary Accounting Research 65, 83-113.

FAMA, E. F. & JENSEN, M. C. (1983) Agency Problems and Residual Claims. The Journal of Law and Economics, 26, 327.

FARBER, D. B. (2005) Restoring Trust After Fraud: Does Corporate Governance Matter? The Accounting Review, 80, 539-561.

JENSEN, M.C. (1993) The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems. The Journal of Finance, 48, 831-880.

JOHNSON, V. E., KHURANA, I.K., & REYNOLDS, J.K. (2002) Audit-Firm Tenure and the Quality of Financial Reports. Contemporary Accounting Research,
Winter, 637-660.

LADAKIS, E. (2005) The Auditor as Gatekeeper for the Investing Public: Auditor Independence and the CLERP Reforms – a Comparative Analysis. Company and Securities Law Journal, 23.

LAVALLE, L. (2002) Enron: How Governance Rules Failed. Business Week, 3766, 28-29.

LEVITT, A. (1998) The Number Game. Address to NYU Centre for Law and Business, September 28.
MORRISON, J. (2004) Legislating For Good Corporate Governance: Do We Expect Too Much? The Journal of Corporate Citizenship, 121(13).

MYERS, J., MYERS, L. & OMER, T. (2003) Exploring the Term of Auditor-Client Relationship and the Quality of Earnings: A Case for Mandatory Auditor Rotation? The Accounting Review, 78 (3), 779-799.

ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT (2004) OECD Principles of Corporate Governance.

PERSONS, O.S. (2006) Corporate Governance and Non-Financial Reporting Fraud. The Journal of Business and Economic Studies,12 (1), 27-40.

PIOT, C. & JANIN, R. (2005) Audit Quality and Earnings Management in France. SSRN eLibrary.

RONEN, J. & YAARI, V. (2006) Earnings Management: Emerging Insight in Theory, Practice, and Research. Springer.

STOLOWY, H. & BRETON, G. (2004) Accounts Manipulation: A Literature Review And Proposed Conceptual Framework. The Review of Accounting and Finance, 3, 5-65.

UZUN, H., SZEWCZYK, S. H. & VARMA, R. (2004) Board Composition and
Corporate Fraud. Financial Analysts Journal, 60 (3), 33-43.

WARRICK, W. W. (1999) Post-Blue Ribbon Committee thoughts on developing the audit committee’s charter and annual report. Directorship, 25, 6.


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