The Role of Corporate Scandals in Enhancing Financial Reporting

Recent corporate scandals have enhanced financial reporting especially of Enron, Worldcom, Tyco, and HealthSouth have collapsed at the beginning of the new millennium, which enhances to enacted of several legislation and financial reporting all over the world. Such as the US law, Sarbanes-Oxley Act 2002 has been enacted to protect the accountants, to ensure the scopes of management accounting, and to solve other corporate governance problems. Though in the UK, there were several financial reports the Combined Code 2006 and Combined Code 2008 have reported because of the recent corporate scandals. Before attempt to answer this question, it should require to find out the reason for these corporate scandals. Director’s remuneration, lack of corporate social responsibility, increase of non-audit activities, and no provision of punishment are the main reasons for corporate collapse. In order to answer this question, it is necessary to discuss, whether the role of corporate scandals in enhancing financial reporting or not.

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Corporate governance is an internal system encircling strategies, procedures, and the public, which determine corporate direction and performance and serves the desires of shareholders as well as other stakeholders, by directing and controlling organizational activities with excellent business confidence, independence, and honesty. It should require operating and controlling the companies, fixing the share price and the cost of raising capital

Romano, R. (2005) identified that at the beginning of the 21st century the biggest corporate scandals of accounts have elevated arrogantly the question of whether a company should manage their activities without accounts. In 2001 Enron has emaciated affirming that it has been incapable to maintain predictable accounting follows and disastrous to set up a financial statement for 1997 to 2001 when accountants embittered $586 million with underground connection with some of its management. The share price of Enron goes down at US$ 1.00 as of US$ 87.00 and the investors faced all-embracing losses. The UK legislation has experienced the accountant’s functions in the organization and emphasized putting into practice the Corporate Social Responsibility to guard accountants from non-executive tasks. In 2002 the accountants of WorldCom has commenced similar deception of extra than $7 billion, which affected the company that its market value of US $200 billion has slumped to $10 billion and thrown to the case of bankruptcy.

Latham & Watkins (2002) said that SOX[1] 2002 has achieved the statutory effects in the US in reaction to these two scandals and it is valid to all United States and outsides of these vicinity businesses that are requisite to file periodic reports with the USSEC[2]. Therefore, it introduces much more general financial reporting necessities for UK corporations listed in any US stock exchange otherwise with registered debt safeties in the US. It is necessary to mention that it also applies to British subsidiaries of US Corporations and British corporations with 350 or more U.S. shareholders. Under s.906 of the Act, every periodic report containing financial statements filed by reporting companies have to be accompanied by written statements by the corporation’s CEO and CFO confirms that:

  1. Firstly, the report entirely complies with the requirements of s 13(a) or 15(d) of the SEA[3]1934;
  2. Secondly, the information contained in such periodic report reasonably presents, in all substance respects, the financial condition as well as the results of operations of the reporting corporation.
  3. Thirdly, they must analyze the report;
  4. Finally, the report must not contain any false statements of material facts or any omissions of material facts[4].

On the other hand, in the decade 1970, there has definite unrest beyond the capability of UK corporations to compete internationally. From the beginning of 1980, UK has been in recession. Most recently much big business has been collapsed for not following the measures designed for the expense of remuneration paid to the directors’ guided in the Companies Act 1985. During the year 1980, in order to remove remuneration difficulties, the Bank of England shaped PRONED which encourage the NED[5] in several ways, which was the predecessor of the Cadbury Committee. The first financial report in the UK was the Cadbury Committee report, which was introduced in 1992 on the Financial Aspects of Corporate Governance recognized by the FRC[6], the London Stock Exchange (LSE), and the combined accounting bodies to conquer such troubles. Its Chairman, Adrain Cadbury, highly recommended that the quality of financial reporting could simply be ensured if the boardroom accountability was enhanced by the companies and governments. This report had provided many recommendations in light of the 1980s recession of UK and they suggest that only NED can solve the problem of corporate governance system, therefore, the foremost suggestion was discussed as follows:

  1. In this report, the Committee had highlighted the major responsibility of the board in the corporation’s decision-making procedure and suggested that the most important dealings must be determined by the board. It might look noticeable but Committee was worried that senior executives more willingly than the board will take these key decisions through the resultant retreating of board dependability.
  2. The keyboard ought to have NED ample in number as well as the ability to carry important influence on board’s assessment and they should be independent of the company. In addition, a committee configuration must be placed in order to advance the responsibility of the selection of the executives, the salary of the directors as well as the audit procedure.
  3. As a result, a listed corporation must have three sub-committees in the panel in order to control the appointments process, salary decisions, and finally audit procedure. However, the remuneration committee must be included entirely by the NED who determines the executive’s salary and a minimum of three NEDs must exist in the audit committee.
  4. Finally, among three committees, the audit committee is vital toward the monetary responsibility of the organization because it has to supervise the audit procedure and it should observe the quantity of non-audit performance, which the auditors were functioning. Colley J.L., et al (2005) argued that if the auditor exposed any inconsistency in the financial records might pressure to provide the profitable non-audit job to a different company of accountants if they exposed these irregularities. These kinds of force on the auditor have presented at the middle of several of the British company fall downs.

Monks A.G., Minow N., (2007), argued that the greater parts of the Cadbury Committee suggestions were executed by the LSE[7] but these were not executed like effective listing regulations; nevertheless, it was registered as an odd method of appending these in the listing regulations. Therefore, there has no stipulation of punishment for disobedience except if the corporation did not obey it had to make clear why it did not follow the report. Though this justification must also be evaluated by the auditor. It depends on the UK corporation to make a decision them what should consider since there was no exterior safety was specified to the clarifications for disobedience.

However, Cadbury report left several major aspects unfinished for example it did not point out that NEDs be a greater part of the mainboard and it had not provided the definition of independence, therefore, corporations sustained to choose relatives or friends of administration, ex-managers & managers of another corporation in the remuneration board as NED.

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Though Cadbury’s report had failed to provide proper solutions, therefore, there was a huge public outcry at large executive salary increases for directors of the privatized utilities. Consistent with the Greenbury report 1995 acknowledged evidently the matter at the spirit of directors’ remuneration difficulties. There exists an intrinsic conflict of interest in executives deciding on their own reimburse. This report therefore recommended:

  1. Cadbury A., (1992) suggested that in the wage committee, there must be consisted with NED for the reason that of their intrinsic divergence of interest and these committees must take the explanation of the wider financial scene inside as well as outside the corporation while taking executive remuneration decisions.
  2. Committee suggests that there ought to be superior levels of remuneration disclosure on the annual financial records. It would facilitate closer safety of executives’ remuneration.
  3. It also suggests that share-options should be substituted by long time (3 years) presentation connected criteria that place to the shareholders: share-options were trouble because once approved it was not possible to notify how much they will be worth in the future-leaving, the corporation open to criticism for overpaying their executives.
  4. Preferably, executives ought to have 1-year rolling agreements; however, 2 years may be acknowledgeable. This would permit directors to be discharged easier without having to pay off the residue of their long-period contracts.

As with the Cadbury report, the suggestions of the Greenbury report were approved by the London Stock Exchange in the equal non-binding approach.

Colley J.L., et al (2005), argued that even if the Greenbury report was effectual in classifying the difficulties intrinsic in remuneration aspects the resolutions the report provided, by using NED committees to reflect on directors’ salary and wider discloser of remunerations in the accounts, were basically ineffective. Though the committee provides suggestions, directors’ salaries were continuously ascended as well as has increased by the more open disclosure atmosphere formed by the Greenbury approvals. Lowry, J. & Dignam, A. (2007), argued that if executives were capable to access the wage information of their comparables in other corporations wage negotiations started to made allegations to provide the similar if not over the maximum paid executive of an equivalent business organization. Another problem in the continual increase of directors’ wages has been the well-known practice of boardrooms choosing pay consultants to recommend this committee.

The Hampel Report

The Cadbury report had suggested that a committee ought to be selected to review the outcome of its references as well as maybe update them. A committee had been formed under Sir Ronald Hampel with the purpose of providing a new proposal. In 1998, it provided its recommendations, which usually consisted of the report of the Cadbury & Greenbury Committee. Its major suggestions are:

  • It is important to mention that the recommendations of Cadbury, Greenbury, and Hampel Committee report will be integrated into one marvelous code which would be treated as the combined code,
  • According to Hemple’s report, NEDs ought to have a chief. This, as a result, creates 3 influences bases on the board, the MD, the Chairman, and the head of NED, and salary information would be transparent including secreted costs to the business, for example, the entire cost of pension condition of the NEDs. Payment details ought to be even clearer. Sometimes companies can have combined Chairman & MDs.
  • From the observation of the whole scenario, this report was suggested that executive directors must not have to provide an opinion on the performance of internal management since the Turnbull Committee, which was investigating whether executives ought to have to create various types of risk measurement announcement about the corporation’s inside economic controls. This report was conflicted with Hampel while it finally accounted in 1999.

Dellaportas S., et al (2005), has pointed out that the Hampel-Committee strongly redundant any deliberation of two-tiered panels where the directors are examined by a full panel of NEDs like in Germany and like the EU Draft 5th Directive on the company law procedure. The grounds for refusing the proposal were that they establish no support for their report amongst those it campaigned. However, the Committee discarded the obligatory voting for institutional shareholders. It also measured that stakeholders were best served through the panel pursuing profit-increasing strategies in addition that an eternal board on corporate governance issues was meaningless. Wearing R., (2005), suggested that in all the report was more active in rejecting thoughts than it was at recommending positive improvements.

Hills, G (2008), argued that under the present recessionary economy the issues of corporate risk management have been emphasized more widely both in the UK and in the rest of the world. The corporate world is in serious threat to keep upheld corporate governance as well as an internal control. If the internal control fails, the opportunity to sustain by using bailout should be ruined. Turnbull Report is mainly concerned with internal control and effective corporate risk management. In September 2008, the UK’s largest mortgage lender Bradford & Bingley collapsed by the hit of a credit crush in Europe. The government of the UK announced to nationalizing B&B and funded £ 18 billion to rescue troubled Bradford & Bingley as an auxiliary part of the US bailout.

With the aim of risk management in 1999, “Institute of Chartered Accountants” published a report named “Turnbull”. This report is a guide for Directors on the Combined Code. In this report, risk management is clearly identified as justifying risks not removing risks. Factors focused in “Turnbull” report in the context of risk management is explained as bellow:

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  • Internal control-as per the Turnbull report, risk management can improve the internal control system effectively. As a result, conflict among the inter-administrative group would reduce competently.
  • Internal control system-Risk management develops the internal control system in such a way thus a company as well as B & B perform at best and motivate their employees for extraordinary performance.
  • Make revise system effective-continuous development of product and adopt new product is a creation effective risk management system. So, risk management is a method to revise the manufacturing system.
  • Appropriate risk response strategy– adopts strategies in order to identify whether risks would be a response or to be taken.
  • This report commending that executives uphold & have principal accountability for a method of internal-controls to assess and agree with both economic as well as non-financial risks between other items, the danger that executives can destroy the corporation’s reputation by their public declarations.
  • Efficiently manage risks– the cultural environment of an organization builds up the method of managing risks. In the Turnbull report, there are a set of steps that would be effective in managing risks.

The Higgs Review

In 2002, as a consequence of the serious fall down of Enron and the inference from that consequence the NED was considered as an unsuccessful scrutinizes of administration. However, the DTI pronounced an assessment of the NED with a view to amplification the excellence, independence, and usefulness of British NEDs. The appraisal was carried out by Derek Higgs who consulted broadly and in January 2003 he has formed this final report.

  1. Higgs, D., (2002) argued that at least 50% of the board excluding the Chairman ought to be independent non-executive directors.
  2. The Chairman has a vital function in the effective action of the board. As such the position of the CEO[9] (managing director) and chair must not be combined. In addition, their personal duties ought to be described and the Chairman must meet up the independence provisions.
  3. Lee T.A. (2006) said that the NED must arrange a meeting each year at least one time a year without any Chairman and directors. However, the company has to state whether they can do so in the annual report.
  4. The responsibility of the NED should cover 4 areas and these are strategy, performance, risk as well as people.
  5. The higher independent executives have to be selected who congregate the test of independence, which is put out in the reports. That person[10] must be maintained an extra connection with the shareholders.
  6. This report set out a classification of independence and it is a main positive site in this review. Higgs, D., (2003), argued that the NED will be treated as independent in nature, decision and most important matter is that they should not have any personal relationships or any conditions which may influence, or appear to affect, the executive’s decisions. These types of situations occur where the executive was the employee of another organization, or he/she has any business links with another corporate house. It may also happen where he/she has family relationships to the corporation or to its staff or they may benefited from other organizations, or have any cross-directorships, or treated as special creditors or an important shareholder and if a staff engaged with another company for ten or more than ten years.

Lee T.A. (2006) said that listed organizations were disappointed with the decisions of the Higgs reports though after a long discussion, negotiations and meet various problems the views of these reports were approved by the London-Stock-Exchange throughout the combined code. This Higgs report is partly in the tradition of the previous corporate governance committees in that Higgs was the main insider in the financial services segment in the United Kingdom. However, Higgs’s assessment has lefts numerous loopholes in the Cadbury committee and subsequent committees. This report specifically described the definition of independence and other important issues, as a result, it should implement as an effective recommendation in LSE.

However, to protect the corporate collapse like Enron, the London Stock Exchange had applied its proposals and at the present, the main four recommendations of Cadbury-report (1992), Greenbury-report (1995), Hampel final report (2003), and Turnbull committee report considered as the key elements of the Best Combined Code and Combined Code 2008 has followed these recommendations. The report recommended that it should essential to have a balance between executives and NED in the board, as well as no individual or small group of individuals can control the board’s decision-taking which is the key principle of this report and it has been pursued by Cadbury report. The board should be of sufficient size that the balance of skills and knowledge is appropriate for the necessities of the business, and the committee Chairman and members are entitled to be present at a meeting of the nomination, audit or remuneration committee and there should be a strong presence on the board to ensure power and information.

Lowry, J. & Dignam, A. (2007), said that from October 2008, the Companies Act 2006 has achieved statutory effects, and from section-171 to 177 precisely fixed the directors duty; as a result, directors may liable for their activities if they act under the conflict of interests.

After discussing the several financial reports, it can be said that it should require more modification because these reports were registered as an odd method of appending these in the listing regulations, therefore it should provide statutory effects. From the above discussion, it can be said that recent corporate scandals such as Enron, Xerox, WorldCom, Parmalat, Shell, Eurotunnel have enhanced financial reporting both in the UK and in the US.

References

Colley J.L., Doyel J.L., Logan G.W., Stettinius W. (2005) What is Corporate Governance?, McGraw-Hill, ISBN: 0-07-144448-3

Colley J.L., Doyel J.L., Logan G.W., Stettinius W., (2003), Corporate Governance: The McGraw-Hill Executive MBA Series, 1st edition, McGraw-Hill, ISBN: 978-0071403467

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Dellaportas S., et al (2005) Ethics, Governance and Accountability – A Professional Perspective, 12th edition, John Wiley & Sons Ltd, ISBN: 978-0-470-80499-5,

Dignam, A., (2007), Capturing corporate governance: The end of the UK self-regulating system, International Journal of Disclosure and Governance Vol 4, 24–41, Web.

Financial Reporting Council (2008), The Combined Code on Corporate Governance, Web.

Greenbury Committee (1995), Directors’ Remuneration: Report of a Study Group by Sir Richard Greenbury, Web.

Hampel Committee (1998), Final Report: Committee on Corporate Governance, Web.

Higgs, D., (2002), Review of the role and effectiveness of non-executive directors, Web.

Hills, G (2008), Managing Principal: Business Risk Practice, Wills Technical Report, Web.

Lee T.A. (2006) Financial Reporting and Corporate Governance, 2nd edition, John Wiley & Sons Ltd, ISBN: 978-0-470-02681-6

Lowry, J. & Dignam, A. (2007), Company Law, 4th edition, Oxford University Press, ISBN: 0-19-928446-6

Latham & Watkins (2002), The U.S. Sarbanes-Oxley Act. Web.

Monks A.G., Minow N. (2007), Corporate Governance, 4 Edition, Wiley-Blackwell Publishing, ISBN: 978-1-4051-7106-9

Wearing R., (2005), Cases in Corporate Governance, Sage Websites, ISBN: 1412908779.

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