Emerging Issues in CorporateGovernance

Chapter XV

Chapter Objectives: • Understand emerging issues and the challenges, opportunities, and improvement

they present to corporate governance.

• Realize the importance of maintaining investor confidence worldwide.

• Understand the initiatives being taken toward convergence in corporate governance.

• Recognize the importance of SEE performance.

• Understand the emerging shareholder issues pertaining to the nomination process,

voting system, proxy statements, and regulations, and possible improvements to these

processes.

• Illustrate the challenges to director independence, nomination, compensation,

composition, and evaluation, and how those challenges can be met.

• Show the challenges that arise from unresolved financial reporting issues, including

financial restatements, enhanced business reporting, forward-looking financial reports,

and stock option accounting, and how they can be addressed.

• Understand antifraud programs and controls designed to strengthen the reliability of

financial reports.

• Define the emerging audit issues in the post-SOX era and solutions to these issues.

Key Terms Basel Committee for Banking SupervisionCorporate social responsibility (CSR)Corporate sustainability reportingEnhanced business reporting (EBR)Global Reporting Initiative (GRI)Governance Metrics International (GMI)International Corporate Governance Network (ICGN)International Financial Reporting Standards (IFRS)International Monetary FundKey performance indicators (KPIs)

Investor Confidence and Global Financial Markets

Investor confidence in the global financial markets is the key driver of economic growth, global competition, and financial stability.

Generally speaking, investors are considered to be confident when stock prices are on an upward trend and the news about future stock performance is optimistic.

And the Main TASK is to restore investors confidence.

Many of these recommendations such as convergence to IFRS and corporate codes of ethics have already been implemented or are in the process of being implemented.

Global Financial Markets

The speed with which financial transactions can be conducted and money can be moved around the world encourages regulators to establish a global financial infrastructure.

Different types of corporate governance structure are exposed to different financial misconduct and scandals. For example, the dispersed ownership

system of governance in the United States is prone to earnings management schemes (e.g., Enron, WorldCom), whereas concentrated ownership systems are more vulnerable to the appropriation of private benefits of control (e.g., Parmalat).

COVERGENCE needed !!!!!

Corporate Governance Reporting

The framework of corporate governance reporting and assurance that can be used is the AA 1000 Framework and itsGlobal Reporting Initiative (GRI) guidelines, which promote accountability reports.

Corporate governance reporting changes one-dimensional financial reporting to multidimensional bottom lines.

MBL reporting goes one step beyond the corporate sustainability reporting prepared according to the guidelines of the GRI. The GRI focuses on the three sustainability dimensions of SEE performance, whereas corporate governance reporting emphasizes multidimensional sustainability of governance, economic, ethical, social, and environmental performance.

Accountability: The New Business Imperative

Accountability is the cornerstone of corporate governance in continuously monitoring best practices and being accountable to shareholders.

Although the primary focus and goal of accountability reporting in the foreseeable future will continue to be an economic issue to create sustainable long-term shareholdervalue, the issues of SEE performance of companies will gain momentum.

Social, Environmental, and Ethics Performance

Corporate Social ResponsibilityTotal assets managed by a socially responsible investing (SRI)portfolio have increased more than fiftyfold in the past two decades in the United States, and an increasing number of mutual funds fall under the SRI definition.

Environmental PerformanceEnvironmental matters, particularly climate change, are receiving a considerable amount of attention from the SRI community. Institutional investors, including the nation’s largest public pension plans such as CalPERS and CalSTRS have traditionally supported initiatives to ensure that companies in their portfolios provide adequate disclosures of their environmental liabilities.

Ethics Performance

The established codes of conduct and ethics programs address the following:

1. Avoidance and resolution of conflicts of interest between the company and employees2. Compliance with all applicable laws, rules, regulations, standards, and policies3. Emphasis on customer relations to enhance the company’s reputation4. Proper use of confidential information5. Encouragement of whistleblowers to reveal dishonesty and wrongdoings

Social, Environmental, and Ethics Performance

Shareholder Challenging Issues There are several challenging shareholders issues :

1. Nomination process. Not all shareholders have a full access to the proxy statements and existing SEC rules allow companies to reject any proposal pertaining to director election.

2. Voting System. The prevailing plurality voting system also makes it difficult for shareholders to monitor their companies.

3. Proxy Statements. Shareholders of public companies with dispersed ownership have few, if any, incentives or opportunities to monitor their company’s business affairs and managerial activities.

To address those issues SEC has adopted a few initiatives.

Challenges Facing Directors Roles of boards are expanding to both advisory and oversight functions.

Several prevailing challenges facing directors remain unresolved:

(1) director accountability and personal liability,(2) the separation of chair and CEO roles, (3) director stock ownership, (4) board diversity,(5) director interlocks, (6) director performance scorecard, (7) rotation of audit committee members.

Sox Compliance Challenges It has been argued that the emerging corporate governance reforms, including SOX, SEC related implementation rules, and listing standards, have caused smaller companies to (1) incur compliance costs that are disproportionate to the induced incremental benefits, and (2) divert the attention of company management away from strategic decisions and operationalactivities.

To address those concern COSO in 2005 issued “Guidance for Smaller Public Companies Reporting on Internal Control over Financial Reporting.”

The new guidance is intended to assist small companies to implement, assess, and report on ICFR in compliance with Section 404 of SOX and PCAOB AS No. 2.

The MAIN CHALLENGE is the cost of compliance.

Some of rules, for example, rules concerning internalcontrols of Section 404, cost at least one hundred times more than what was originally estimated by the SEC (e.g., estimated cost of $91,000 per company to the first-year actual cost of, on average, $9.8 million).

Sox Compliance Challenges

Financial Reporting Challenges 1. Financial restatements The persistence of financial restatements adversely affects investor confidence. The substantial decline in the number of restatements by large public companies suggests that Section 404 is working well in reducing the number of financial restatements and thus improving financial reporting quality.2. Enhanced Business ReportingEnhanced business reporting (EBR) focusing on both financial and nonfinancial information about current and future KPIs is suggested as an alternative to improve the quality, transparency, and integrity of financial reporting3. Stock Options AccountingThe two pricing models commonly used in determining the real value of a stock option are Black-Scholes and indexing of similar publicly traded companies.the current pricing models are being criticized for not properly determining the value of stock options

Antifraud Program and Practices

(SOX Sections 302, 404, and 906, PCAOB AS No. 2, PCAOB’s new AS No. 5, discovered fraud should be reported to ICFR )

An effective antifraud program should address corporate culture, control structure, and fraud procedures:

1. Corporate culture—Corporate culture should create an environment that sets an appropriate tone at the top

2. Control structure—An effective control structure should eliminate opportunities for individuals to engage in fraudulent activities.

3. Antifraud procedures—Adequate fraud procedures should be developed and performed to ensure prevention and detection of potential fraud.

Financial Reporting Challenges (Cont)

Global Financial Reporting Standards

We should expect significant changes in financial reporting as both the FASB and IASB are moving toward convergence in their standards, and the SEC is promoting the idea of giving U.S. companies the choice between U.S. GAAP and IFRS compliance in their filings with the SEC.

The SEC is expected to remove the reconciliation requirementfor international firms traded on U.S. exchanges to file using IFRS by 2009. The move by the SEC can be regarded by many as the first step by the SEC to eventually allow listed companies to use IFRS in place of U.S. GAAP.

Emerging Auditing Issues The emerging auditing issues in the post-SOX period are:

(1) auditor independence, (2) auditor changes, (3) engagement letters, (4) audit failure,(5) integrated audit approach, (6) concentration of and competition in public accounting firms,(7) electronic financial reporting and continuous auditing, (8) confirmations, (9) audit report, (10) auditor liability.

Conclusion• Investor confidence in the global financial markets is the key driver of economic growth, global competition, and financial stability worldwide.• U.S. regulators and their counterparts in Europe and on other continents should work together to assess the feasibility of convergence to improve the efficiency, effectiveness, and integrity of the global capital markets and prevent a global crisis that would eventually affect the economy and financial markets of countries worldwide.• Corporate governance reporting should assist companies to restore investor confidence and public trust in governance, economic, ethical, social, and environmental performance.• The higher the shareholdings of independent directors, the more incentives for them to monitor management activities to protect their own interests as well as the interests of other shareholders

• Companies should integrate SOX compliance process into their corporate governance structure, risk and compliance process, internal controls, financial reports, and audit activities.• The risk-based approach for assessing and auditing ICFR has been suggested for public companies, particularly for smaller companies using the COSO internal control framework.• Antifraud prevention and detection controls and assessments addressed by SOX, SEC rules, and PCAOB auditing standards are only to relevant financial statement fraud.• Several initiatives are taken toward an ultimate convergence of both accounting and auditing standards.

Conclusion