Introduction
This paper reviews existing literature on how corporate governance has affected financial reporting.
After a number of financial reporting scandals in some of the major firms in the world in the early 2000s, the US Congress and the securities exchange ordered that boards and audit team of firms must be independent. In addition, they also eliminated the use of audit clients for non-audit services. The aims of these initiatives were to reduce cases financial reporting scandals. On the other hand, critics claimed that such actions would not have any meaningful impacts on financial reporting fraud and were merely window dressing approaches.
Reforms have provided frameworks for firms to create and maintain a proper internal control mechanism and effective procedures for financial reporting. It is necessary for executives to make voluntary disclosure of financial information in order to eliminate risks and develop shareholders’ returns. However, previous scandals have proved that managers are not willing to make such disclosures to shareholders and securities exchange.
Ownership, Independence of the board and the influence of the CEO
Studies have also shown that “ownership structure and board composition affect the depth of disclosure” (Eng and Mak 325). Diversity in terms of ownership structures enhances disclosure of information to relevant stakeholders of organizations. Donelson and colleagues examined the impacts of stringent rules introduced by the Congress and securities exchange on firms’ financial reporting scandals (Donelson, McInnis and Mergenthaler 1).
Under the guidance of Duchin et al model of 2010, they examined whether organizations were successful in implementing these reforms and their subsequent outcomes. These researchers concluded that firms, which changed their overall board independence reported, had positive impacts by noting declines in the rate of financial reporting scandals (Donelson et al. 26). Such firms were able to realize positive outcomes because the new regulations mandated them to have most of the directors as independent actors.
Aiyesha Dey notes that organizations can achieve high standards of financial reporting credibility by incorporating effective corporate governance in their structures (Dey 1). However, ownership structures in firms have significant impacts on financial reporting of most organizations (Eng and Mak 325; Klai and Omri 154). As a result, structures of firms may contribute to corporate scandals. Klai and Omri note that scholars have debated the “relationship between governance and information quality in the context of developed countries” (Klai and Omri 154). In the recent past, the issues of effective corporate governance and financial disclosure have reached in emerging economies.
Klai and Omri found out that governance mechanism in Tunisia firms had significant impacts on the levels of financial reporting quality. These researchers focused on listed companies in the Tunis Stock Exchange in order to understand the composition, ownership structure, and characteristics of the board of directors between 1997 and 2007. They noted that governance mechanism in Tunisia firms had significant impacts on financial information. Specifically, they noted that powers of “foreigners, families, and block holders reduced the reporting quality while the control by the State and the financial institutions was associated with a good quality of financial disclosure” (Klai and Omri 154).
On the other hand, some studies have demonstrated that some of the mandated reforms in organizations have not had the intended outcomes. For instance, Donelson and other researchers noted that the requirement to have a full independent audit committee in organizations had undesired weak outcomes (Donelson et al. 26). On the same note, April Klein examined the relationship between “characteristics of the audit committees and boards and earning of management” (Klein 375). The author noted that there was a negative relation between the “audit committee independence and abnormal accruals” (Klein 375).
In addition, board independence and abnormal accruals also showed negative relation. In other words, an attempt to reduce independence or autonomy of the board or audit committee resulted in massive increments of accruals. Such large increments were severe in situations where organizations’ boards and audit committees consisted of minorities who were also outside directors. Klein concluded that boards whose structures were independent from “influences of CEOs were effective in managing accounting processes in organizations” (Klein 375). Therefore, it is important to formulate a board that is free from influences of the CEO in order to reduce cases of financial reporting fraud in firms. Still, this result may allude that CEOs have considerable influences on their boards, and such CEOs may influence their earnings.
Cristina Gonçalves Góis analyzed the relationship that existed between “the composition and characteristics of corporate governance on the financial reporting quality of Portuguese firms” (Góis 1). The researcher established that the board composition “changes and its degree of independence did not produce any influence on the quality of the accounting information” (Góis 22). However, he also noted that such international guidelines on effective corporate governance existed in the country, but firms did not engage in the actual implementation of such rules.
The board of directors of a firm has the highest responsibility of ensuring accountability of every decision that senior executives make in the company. Organizations have directors to meet regulatory requirements. However, the main role of such directors is to address the issue of conflict of interest that may arise from senior executives. In this case, they purposefully monitored actions of the CEO. The composition of the board of directors is critical for its function and overall performance.
Some authors have noted that internal directors shall always be the dominant force within the board because they have “specific and measurable” (Góis 22) data about operations of the firm. The CEO is a member of the board, who has critical information about the firm’s operations. As a result, many scholars have noted that several conflicts occur between the CEO and other directors. The CEO aims to influence the board in order to preserve his job and earnings.
At the same time, the board also aims to control the CEO and replace him if necessary. Therefore, performance of the board may depend on influences and bargaining power of opposing members. In other words, principles of effective corporate governance are not important in this case and merely act as basis for management practices.
Other studies have concentrated on the level of independence of the board of directors. Such studies have noted that organizations, which have high-levels of the board’s independence, tend to have high-level of disclosure relative to other organizations with low-levels of the board’s independence. Such directors must protect their reputation by avoiding any potential faults in the financial reporting system.
The low quality of information and a call for change
James Abiola and Solomon Ojo reviewed a number of studies and found mixed results. For instance, they noted that some authors claim that information disclosed in financial reports did not serve their intended purposes and were deteriorating in quality because investors constantly demanded “relevant information and persistent regulatory efforts to improve on the quality and timeliness of reported information” (Abiola and Ojo 247).
They also noted that other scholars have supported such claims by noting the “subjectivity of financial reports and their failure to present accurate portrayal of the underlying realities” (Abiola and Ojo 247). As a result, these authors note that corporate governance disclosure should provide guarantee to shareholders that the financial reporting system is beyond reproach. In this regard, other scholars like Bush and Smith have noted that accounting information should act as source of extra control systems because of its influence on “economic performance and corporate governance” (Abiola and Ojo 247).
Scholars like Alles and Vasarhelyi have called for the change of the financial reporting system through allowing only people with advanced knowledge to gain access to “raw financial information available within the company rather than the handover audited financial statements that have inherent weaknesses due to lack of transparency and reporting fraud” (Alles and Vasarhelyi 204). One can attribute such recommendations to the failure of the approaches used in corporate governance and reporting systems.
Abiola and Ojo note that there are two major strategies to corporate governance (Abiola and Ojo 247). First, the rule-based strategy provides minimum corporate practices, which firms and executives must observe. For instance, an organization may set the structure, size, and composition of the audit committee and the board directors. Such rules may also ban or restrict provisions on executive loans, use of company assets, and investment policies among other loopholes in the reporting system.
The rule-based method of corporate governance seeks to provide the minimum standards set of rules, which firms should observe in order to ensure effective compliance. It is important to note that the rule-based approach only offers the minimum standards, but the concrete obligations may differ from firm to firm based on the size, structure, ownership, and complexity of the institution. This form of approach to corporate governance is not effective because some executives may consider it as a mere checklist or a means of meeting legal standards and requirements. From such a point of view, the rule-based approach may fail to protect and promote interests of a firm’s shareholders and stakeholders.
Second, the principles-based strategy to corporate governance provides standards that should guarantee accurate and adequate “disclosure of information, but it is the responsibility of the managers to identify exact practices or processes that will ensure compliance” (Abiola and Ojo 247). This strategy of corporate governance is flexible, and it shifts the responsibility of corporate governance to directors of the company. One major shortcoming of this strategy is the great dependence on the “honesty, integrity, and commitment to good corporate governance of the directors, which may not exist” (Abiola and Ojo 247). Expectations of institutional investors may also have effects on the issue of corporate governance.
For instance, a study established that institutional investors generally preferred “a deregulated environment for corporate risk disclosure and their perception of corporate governance is influenced by their investment horizon” (Abiola and Ojo 247). Moreover, the board of directors needed to be independent, have appropriate expertise, and experiences in order to perform its roles effectives. Such characteristics of the board are critical to effective operations of the capital market and development of investors’ confidence in the company. The fundamental role of corporate governance is to protect interests of investors and other stakeholders like “committees, management, staff, customers and suppliers, government and other external stakeholders” (Abiola and Ojo 247).
Globally, various countries have strived to formulate effective corporate governance based on their corporate environment. The Combined Code of the UK as noted that the board could be effective when there is separation of the chairperson and CEO, unbiased, independent, and correctly constituted board members. Therefore, scholars have suggested the use of corporate governance with some fundamental compositions. The board should have “oversight, management, compliance, audit, advisory, assurance, and monitoring functions” (Abiola and Ojo 247). In addition, other scholars have also observed that the board of directors must adopt the best practices of corporate governance in its operations and practices.
Conclusion
The aim of reforms by introducing stringent corporate governance was to control financial reporting fraud. Most studies indicate that firms can achieve effective corporate governance if they adopt the best practices. However, not all scholars agree that corporate governance reforms have enhanced financial reporting fraud. Instead, they consider such reforms as window dressing approaches to conceal deep mess in the corporate world. The barriers to best practices in corporate governance are in the composition of the board of an organization. In most cases, CEOs have significance in the board’s performance. This usually affects financial reporting scandals of most corporations.
On a positive note, some scholars have noted that firms with high-levels of effective corporate governance have reported an increment in disclosure and financial reporting scandals. Other studies have noted that organizations are not keen on practical implementation of the best practices for effective corporate governance.
Works Cited
Abiola, James and Solomon O. Ojo. “Compliance with Regulatory Financial Reporting and Corporate Governance Practices in Selected Primary Mortgage Institutions in Nigeria.” International Journal of Business and Social Science 3.15 (2012): 246-254. Print.
Alles, Michael and Miklos Vasarhelyi. “The need to reengineer the business reporting process.” International Journal of Disclosure and Governance 4.3 (2007): 204- 216. Print.
Dey, Aiyesha. Corporate governance and financial reporting credibility. Ph.D., Northwestern University (2005): 1-180. Print.
Donelson, Dain, John M. McInnis and Richard Mergenthaler Jr. The Effect of Corporate Governance Reform on Financial Reporting Fraud. 2012. Web.
Duchin, Ran, John Matsusaka and Oguzhan Ozbas. “When are outside directors effective?” Journal of Financial Economics 96 (2010): 195-214. Print.
Eng, LL and YT Mak. “Corporate governance and voluntary disclosure.” Journal of Accounting and Public Policy 22.4 (2003): 325-345. Print.
Góis, Cristina Gonçalves. Financial Reporting Quality and Corporate Governance: The Portuguese Companies Evidence. n.d. Web.
Klai, Nesrine and Abdelwahed Omri. “Corporate Governance and Financial Reporting Quality: The Case of The Tunisian Firms.” International Business Research 4.1 (2011): 154. Print.
Klein, April. “Audit Committee, Board of Director Characteristics, and Earnings Management.” Journal of Accounting and Economics 33.3 (2000): 375-400. Print.