Within a business there are usually internal controls to prevent this from happening including internal auditing but in the Enron case these measures weren’t sufficient enough. In this case the auditors were lied to by the directors of the company. The lack of independence of professionals that work for an organization leads to fraudulent accounting. For example if the lawyers that work for a company have close relationships with its members and are not entirely independent then this can lead to conflict of interest. If the auditors are not entirely independent and have other interest in mind then the accounts won’t be prepared properly. In the case of Enron the senior manager Ms Sherron Watkins forwarded her concerns to the Enron chairman who passed her complaints on to a law firm to be examined. However the law firm had very close relationships with Enron and their independence of judgment was said to be doubtful. So her concerns were ignored because the law firm was not entirely independent.
We can see that the major scandals in recent years have been caused by the nature of senior executives acting out of their own interest due to a lack of internal controls and close relationships between professionals that have led to conflict of interest that have resulted in company failure.
The response to the scandals
Major scandals in recent years such as Enron and WorldCom shook the world and the response from the media and the government was heavy handed but fair. Heavy sentences were handed out to those involved and new legislation was introduced. “The former Enron chief executive Jeffrey Skilling was sentenced to 24 years and four months in jail yesterday” http://www.guardian.co.uk/enron/story/0,,1930051,00.html, Andrew Clark (03/11/06)
In response to these scandals a legislation titled The Sarbanes Oxley Act was introduced. “Sarbanes-Oxley was a result of the Enron and WorldCom collapses.” Accountancy, Lesley Bolton (Mar 2006). The main aim of the act was to ensure tighter controls within an organistaion to ensure fair trading and in order to prevent fraud. “Regulates the internal controls that firms use to reduce the risk of fraud or error in their financial statements.” The Economist (Apr 22, 2006).
Importantly the act would create a feeling of security amongst the business world and investors that such a big scandal wouldn’t occur again. “SOX packaged together five different categories of reforms intended to protect investors from future Enrons.” The Economist (Apr 22, 2006).
As well as legislation being passed on to protect investors, whistleblowers were also offered more protection, as we recall it was the voice of a whistleblower that led to the exposure of the Enron scandal. Sherron Watkins the senior manager for the company realised that the accounts were being largely overstated. She reported this to the Enron chairman Kenneth Lay. “Sherron Watkins' life was turned upside down after she sent a memo to Lay in 2001, warning that the firm could "implode in a wave of accounting scandals". http://news.bbc.co.uk/1/hi/business/5335214.stm (03/11/06).
As a result of previous difficulties faced by whistleblowers a section of the Sarbanes-Oxley act focuses on this issue. “America has had a Whistleblower Protection Act in force since 1989, and after the Enron and WorldCom disasters the Sarbanes-Oxley act added further protections.” The Economist (Mar 25, 2006)
In response to the scandals I think the government acted well, even though some of the new laws are said to be heavy handed and financially costly. It was necessary to impose new laws to ensure that disasters such as Enron and WorldCom wouldn’t occur again. As well as the laws having more control over firms’ internal operations they also deter anybody to carry out such acts and give assurance to potential investors. And because of the protection offered to whistleblowers this will encourage more people to speak out which will result in more cases being unveiled. “Provisions to protect whistleblowers and ensure full disclosure are also likely to increase the number of cases that come to the surface. Dan Roberts, Financial Times, (20 April 2005).
How adequate are the current codes
The first code of practice was The Cadbury report dating back to 1992 and many attempts followed which led to the construction of The Combined Code in 1998 which was later refined in 2003, 2005 and more recently in 2006. “Following a review of the implementation of the Combined Code in 2005, the FRC consulted on a small number of changes to the Code. These changes were incorporated in an updated version of the Code published in June 2006.” http://www.frc.org.uk/corporate/combinedcode.cfm (08/11/06)
The most up to date rules are put together in The Combined Code which focuses on a number of key points. It emphasises on the independence of directors within the board and states that the board should have a balance of executive and non- executive directors and particularly emphasises on a company having non-executive directors in their remuneration committees. “The code states that the majority of the members of the nomination committee should be independent NEDs”. PensionsWeek (Oct 2, 2006). The act also encourages shareholder involvement in order to keep their interests at heart.
In my opinion The Combined Code is a good deterrent for directors acting out of their own interest. It ensures more independence within an organistaion by distancing professionals to avoid conflicts of interests that can help to prevent company failure.
The Sarbanes-Oxley act was introduced in 2002 by the US government in response to the Enron and WorldCom scandals. The key points of the act aim at the independence of the audit committee in order to ensure the auditors’ independence from their clients. It outlines the responsibilities of auditors and encourages increased disclosure of the internal control structure of firms and procedures for financial reporting.
If the auditors are entirely independent of the board then this can help to ensure that the accounts show a fairer view and can also help prevent fraud. An increase in disclosure of information of the internal structure can help to determine if the company is operating according to the law and how it is producing its financial statements. This can help to asses if the organization is complying with the requirements of financial reporting and can help prevent fraud.
I think that the current rules on governance are quite adequate as they aim to encourage independence within the board and the audit and remuneration committees to ensure that there aren’t tight relationships within these parties. This can help to ensure tighter controls within a firm and makes it difficult for anyone to act against the best interest of the organization.
The benefits and costs of complying with governance
The Sarbanes-Oxley act was aimed at making relationships between auditors and their clients more distanced by establishing independent audit committees. The costs of complying with this act have been significant. “According to one study that has attracted a lot of attention, the net private cost amounts to $1.4 trillion. “The Economist (May 21, 2005). The combined code emphasises a company to have non-executive directors in its board and remuneration committees which would also require more employees driving up costs.
The cost however depends on the size of the firm but this gives an idea of how costly it is to comply with the current codes. More expertise is required to establish independent audit committees as more employees would be needed which would drive up the firms’ wage costs substantially. “Sarbanes-Oxley Act requirements have driven up costs for all public companies, but smaller organizations are experiencing greater percentage increases.” Ann Pomeroy, HRMagazine. Smaller companies will find it more costly to comply with the rules as they are less likely to have as much money to invest in employment.
An organistaion would have to adjust the internal structure of its organistaion and change its methods of practice in order to comply with the current codes which would be time consuming and costly as it takes time to implement change effectively within a business.
The benefits derived with compliance are that the auditors within the organistaion will be working more independently and in the best interest of the firm. “Research has concluded that audit committees are more active since the Act.” Dana R Hermanson, Internal Auditing (Jul/Aug 2005)
The financial statements of the business will be more precise and accurate and show a fairer view. This can help to safeguard the public interest as the accounts can be trusted. Investors are more likely to invest in a company that complies with rules and is properly governed. If a company has a good record of compliance then investors will feel more secure investing in that company and customers are likely to take more interest in firms that they can trust.
There will be less chance of company failure if firms comply with the rules as there will be more control and independence within the organisation. If all firms comply with the same set of rules then this will create more comparability and understandability between firms.
Overall the costs of compliance are more likely to be high in the short-run and give more benefits to firms in the future. “With time, no doubt, the law's balance of costs and benefits will improve significantly: some of the costs have been once-and-for-all.” The Economist (May 21, 2005).
The best way of dealing with governance
It is hard to define and determine what the best method of governance is. Two alternative approaches exist; self-regulation and government legislation.
Self-regulation is important to help determine what standards are required as companies have the better understanding of what improvements are needed in order to ensure the business operates efficiently. But when this method of regulation fails then there is no choice but for the law to intervene. Self-regulation consists of so-called hard/soft law which includes statements of accounting practice and the stock exchange listing rules. Self-regulation is likely to be less costly as its alternative. A self-regulatory approach however is not usually approved by the publics’ confidence as government legislation. “Self-regulatory structures are prone to a number of criticisms - that, for instance, they favour the regulated group and ignore the broader public interest” John Farrar, New Zealand Management (Aug 2005).
However it depends on the nature of the organisation. In EU member countries all nuclear power plants are government regulated because the risks that the plants impose are extreme. ”The risks associated with malfunctions of nuclear power plants are simply too great not to regulate through legislation.” John Farrar, New Zealand Management (Aug 2005). The greater the risk an organistaion imposes on the public and shareholder interest the greater the need for the government to intervene in order to assure that the standards required are met so that company failure does not occur.
“Corporate failures such as Enron can be avoided only when companies are forced to comply with legislation. “John Farrar, New Zealand Management (Aug 2005). The recent major scandals of Enron and WorldCom brought about the Sarbanes-Oxley act which was considered by many as a heavy legislation due to the heavy cost associated with its compliance. A drawback with government legislation is that firms may need to adjust their organizational structure and change their methods of practice which can be time consuming and costly. This can have a negative impact on the financial situation of firms which can have a knock-on-effect within the economy in which the business operates.
I think government legislation is the best way to deal with governance as it provides companies with rules that can give them guidance to help them operate fairly and efficiently and can give them a competitive advantage. Compliance with legislation can help improve a company’s’ reputation and helps to boost investor confidence. It also helps safeguard the public interest and is more likely to be supported by the public. Self-regulation is seen as a weaker approach in today’s changing business world. “Should self-regulatory organizations even exist today? They are historical creations that don't suit the needs of the current investment.” Pensions & Investments (Sep 29, 2003).
Overall summary
Throughout this report I have examined the various issues that concern corporate governance. My findings are that the standard of corporate governance has improved considerably since the late 1980’s where it became a major concern. This is mainly due to the number of major scandals that have led to better rules being introduced. However there is still need for improvement in a rapidly changing business environment where even after new rule being introduced and enforced new scandals arise to the surface.
I have found that the main reason behind corporate governance is the corruption within organisations. The realisation of this issue has led to the levels of corporate governance being raised. “To contribute to high standards of corporate governance, public governance must be effective, transparent, and accountable—hence the serious concern with bribery and corruption.” Iskander Magdi R, Chamlou Nadereh (2000)
Another issue that has caused controversy is the value of the shareholder, “It is sometimes noted that shareholders are the 'missing link' in corporate governance.” Steger Ulrich, George Bill (2004). In the past the importance of the shareholder has been ignored but new rules introduced are aimed at putting shareholders’ interests at hearts such as The Combined Code encourages shareholder involvement.
The role of governance plays an important part to ensure that the organistaion runs fairly. However in order for a good governance system to operate, directors and shareholders should get involved, but in reality this model is not always used. Often it is the case of just an enforcement of power over controlling the organization. “Corporate governance is not about power but about ensuring that decisions are made effectively… What is needed is a system in which senior managers and the board truly collaborate on decisions and both regularly seek the input of shareholders.” Harvard business review on corporate governance (2000). Governance is more than just enforcing power and legislation it is about effectively managing a corporation with the input of its members to ensure fair and efficient operations. It is an important issue which affects the business world and will continue play an important role in the future.
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