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Some slides were adopted from different readings, Wahid (2019), and Rankin (2012)

For reference purposes, please cite the following:

Shauki, E.R., “Corporate Governance, Corporate Failure, and Disruption Technologies”,
Handout, (Elvia R. Shauki, PhD), Universitas Brawijayaa, November, 2019, Print.

 Interest in corporate governance appears to be

driven by:

◦ Highly publicised corporate misconduct

◦ Agency problems
◦ Realisation of other benefits

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 Management self interest

◦ Fraud
◦ Perquisites
 Anti-social corporate behaviour
 Hiding or falsifying information
 Perceived gap between performance and
remuneration

 These problems, real or perceived, can have wider

ramifications/consequences.
 Poor governance is linked to
◦ Poorer firm performance
◦ Increased regulation for all companies
◦ Decreased consumer confidence
◦ Reduced economic growth
◦ It has even been implicated in a number of national and
global financial crises

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 In a globalised and competitive environment good

governance can be a significant advantage.
 Good governance can
◦ Reduce the cost of capital
◦ Increase shareholder base
◦ Manage increased scrutiny
◦ Increase consumer confidence
◦ Facilitate economic growth

 The procedures and processes according to which

an organisation is directed and controlled.

 The corporate governance structure specifies the

distribution of rights and responsibilities among the
different participants in the organisation — such as
the board, managers, shareholders and other
stakeholders — and lays down the rules and
procedures for decision-making.

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 By doing this, it also provides the structure

through which the company objectives are
set, and the means of attaining those
objectives and monitoring performance

 Whose interests are to be protected and what

are ‘appropriate’ objectives of the
corporation?

 Traditional or ‘Anglo-Saxon’ Model

◦ The key role for corporate governance is enabling
the efficient use of resources by helping financial
markets to work properly and gives priority to
shareholder value

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 Summarised by Milton Friedman:

Corporate governance is to conduct the
business in accordance with the owner or
shareholders’ desires, which generally will
be to make as much money as possible
while conforming to the basic rules of the
society embodied in law and local customs’.

 Alternatives to the traditional view suggest

that corporate governance must go beyond
the narrow interests of shareholders and
should be extended to a wider group of
stakeholders.

 European Models
◦ Multiple stakeholders

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 The corporate structure requires governance

◦ Separation between capital contributors and
management
 Under the best circumstances managers
should act as though they had contributed
the capital
 It would appear this does not happen and
managers may ‘bias’ or distort the financial
statements

 Positive accounting theory explains that for

efficiency reasons companies are formed and
can be viewed as a network of contracts or
agreements that determine the relationships
with and among the various parties involved.
 One important agency relationship that arises
from this nexus is that between the managers
and the capital contributors who authorise
the managers to make the key business
decisions.

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 It is generally acknowledged that there is no

‘one’ system of corporate governance.
 The practices and procedures required or
desired will be affected by:
◦ The nature of the particular corporation and its
activities.
◦ The environment in which the corporation operates.

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 Key elements
◦ Controlling and directing the directors (and senior
management)
 ensure that the key managers make appropriate
decisions
◦ Role of shareholders (and other stakeholders)
 ensure that shareholders have the ability to protect
their interests in the corporation
◦ Transparency and accountability
 ensure that the stakeholders (including shareholders)
are sufficiently informed about the activities of the
company and its management

 Summary of ASX 8 Principles of Corporate

Governance
1. Lay solid foundations for management and
oversight
2. Structure the board to add value
3. Promote ethical and responsible decision making
4. Safeguard integrity in financial reporting
5. Make timely and balanced disclosure
6. Respect the rights of shareholders
7. Recognise and manage risk
8. Remunerate fairly and responsibly

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 The Rules-Based Approach to Corporate

Governance
◦ Prescribe precise practices that are required or
recommended to ensure good corporate
governance.
◦ Associated with enforcement by legislation or
listing rules, with imposition of penalties if the rules
are not followed.

 Advantages
◦ Provides a set of minimum corporate governance
practices that must be followed by all corporations.
◦ Aids enforcement and clarifies potential liability.
 Disadvantages
◦ Lowest common denominator approach
◦ Encourages form over substance
◦ Focus on legal liability not stakeholder interests

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 Identifies general principles or objectives for

the corporate governance system to aim to
achieve.

 Responsibility is placed on the managers to

consider which practices are appropriate,
given their circumstances.

 Advantages
◦ Places a higher level of duty on directors to
determine which corporate governance practices
are required.
◦ Its flexibility means that practices can be adapted
for the particular circumstances and environment of
the entity.
 Disadvantages
◦ Directors must interpret these principles and decide
which corporate governance practices are needed.
◦ It relies on their honesty, integrity and commitment
to good governance.

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 In most countries, corporate governance

involves various combinations of both the
rules and principles-based approaches.
◦ Specific legislation that requires certain corporate
governance practices to be followed by law.
◦ Codes of corporate governance practice issued by
government or industry groups and also by stock
exchanges.

 The global financial crisis has provided an

impetus for regulators, corporations
themselves and other organisations to
reconsider aspects of corporate governance.
 An OECD review concluded that while the
espoused principles of corporate governance
were sound, there was a ‘gap’ between the
principles and their implementation.

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 The failure of many corporations to manage

and control risk has been identified as a
cause of the financial crisis.
 Risk management deficiencies noted include:
◦ Risk was not managed or monitored at the entity
level, but rather at individual activity level.
◦ Information about risks were not reaching the
board.
◦ Organisational culture encouraged risk taking
◦ Disconnect between the corporation’s overall risk
strategy and related procedures

 Risk management in many codes of corporate

governance is not given prominence.
 Many corporations are now endeavouring to
introduce more formal and comprehensive
risk management policies and procedures
and integrate these into their existing
corporate governance frameworks.
 The task of ‘business’ risk management is
now often delegated to the audit committee.

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 This is a contentious issue regularly

scrutinised by public and the media.
 Concerns have been raised about
◦ The size of executive remuneration.
◦ The apparent disconnect between performance and
pay.
◦ The use of public (bail-out) money to pay bonuses.
◦ The connection between remuneration packages
and rewarding short-term focus

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 In response to the financial crises and

concern about remuneration there have been
a variety of legislative responses.
◦ In the US, the Dodd-Frank legislation includes:
 ‘Claw back’ provisions if it is found that compensation
paid was based on inaccurate financial statements
◦ In Australia, recent legislation includes
 Increased disclosure
 A ‘two-strikes’ rule where if more than 25% of
shareholders vote against the remuneration report for
two consecutive years, the board itself can be put up
for re-election.

 Accounting clearly has a central role in

directing and controlling a corporation.
◦ Management accounting provides a signi cant part
of the information on which company operations
will be decided.
◦ Financial accounting provides the means for
outsiders to monitor the corporation and to assess
how well those responsible for managing the
corporation have performed.

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 There are two key ways in which accounting

is used to direct and control the managers of
a corporation.
◦ Encourage appropriate decisions
 Linking managers performance to rewards
◦ Transparency and disclosure
 Requiring specific disclosure about areas relevant to
corporate governance. E.g.
 AASB 124 Related Party Disclosures
 AASB 2 Share-based Payment

 The key role for financial reporting in corporate

governance is to provide the information needed
to assess the performance of the corporation and
its managers.
 To be useful the financial statements provided
must be transparent, unbiased and complete.
 Financial statements are a crucial link enabling
shareholders to monitor directors’ actions and to
assist in identifying any deficiencies in the
effectiveness of corporate governance

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 Historically and recently there are many

examples of financial reporting failures.
 The choices of accounting policy may not be
neutral or unbiased.
 Two key drivers are
◦ Maximising remuneration bonuses
◦ Meeting market expectations
 Also instances of outright fraud

“At the core of good governance is ‘doing the

right thing’ by acting with honesty,
impartiality, integrity, trustworthiness,
respect for the law and due process. A
commitment to ethical values is fundamental”
Peter Achterstraat,
Auditor-General in New South Wales

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 Good corporate governance cannot exist

without ethics.
◦ The Sarbanes–Oxley Act in the United States
requires disclosure of whether or not there is a
code of ethics for senior financial officers.
◦ CPA Australia argues that implementation of a
corporate governance structure is not sufficient and
will only work if the culture of the corporation
supports good governance.
◦ The Hong Kong Institute of Certified Public
Accountants guidelines for public bodies places
emphasis on the personal qualities of individuals as
the foundation for good corporate governance.

 The Anglo-Saxon model placing emphasis on

shareholders interest dominates in the United
States, Australia, Canada and the United
Kingdom.
 Asia is increasingly adopting the Anglo-
Saxon shareholder model.
 In Europe, there is more direct recognition of
alternative stakeholders (such as employees
in France and creditors in Germany).

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 It is likely that corporate governance will

increasingly consider broader stakeholders.
 The principles-based approach prevails at the
moment, backed by legislation for particular
practices.
 Future crises, collapses and financial
reporting failures will influence future
directions and approaches.

 Corporate failure is difficult to define.

 Often referred to a bankruptcy or insolvency.
◦ Also sometimes terms failure or default.
 In research the point of failure can be
considered to be:
◦ Filing for bankruptcy
◦ Delisting for whatever reason
◦ Ceasing to trade
◦ Entering into receivership

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 A significant indication of corporate failure

could be the appointment of voluntary
administrators.
◦ In the US this is called Chapter 11 bankruptcy
◦ In Australia can be initiated by directors or secured
creditors
 It entails the appointment of an administrator
who
◦ Investigates the affairs of the company.
◦ Tries to find a way to save the business.

 Dunn & Bradstreet, a global entity that

researches business failures adopts a wide
definition of business failure:
businesses that cease operation following
assignment or bankruptcy; those that cease with loss
to creditors after such actions or execution,
foreclosure, or attachment; those that voluntarily
withdraw, leaving unpaid obligations, or those that
have been involved in court actions such as
receivership, bankruptcy reorganization, or
arrangement; and those that voluntarily compromise
with creditors.

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 There are many reasons why companies fail.

 Most fail for multiple reasons.
 Corporate decline can stem from multiple
sources both inside and outside the
organisation.
 These multiple elements often make it
difficult for managers to comprehend and
address the causes of corporate failure.

 Outside factors can include:

◦ Changes in technology
◦ Recession
◦ Competitors’ actions
◦ Deregulation or changes in import protection in an
industry
◦ Interest rate changes

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 Inside factors can include:

◦ Weak strategy
◦ Financial mismanagement,
◦ Dysfunctional culture

 While there are many factors that can

contribute to corporate failure, research of
some high profile failures has identified
specific management inadequacies that
appear to contribute significantly.
 Prominent corporate failures include
◦ Enron, HIH, Barings Bank, WorldCom, ABC Learning,
Tyco and Parmalat.

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 Hamilton and Micklethwait believe that the

main causes of failure can be grouped into
six categories:
1. Poor strategic decisions.
2. Greed and the desire for power.
3. Overexpansion and ill-judged acquisitions.
4. Dominant CEOs.
5. Failure of internal controls.
6. Ineffective boards.

 The role of cash flow has been noted by a

number of observers.
 There needs to be enough cash to pay staff,
GST obligations, debtors and other
operational expenses.
 Businesses are more likely to fail because of
poor cash flow than poor sales.

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 Direct costs include

◦ Expenses to hire various professionals
◦ Additional interest on holding debt that cannot be
discharged
 Indirect costs are more difficult to identify,
but may include
◦ Reputation costs
◦ Opportunity costs

 A range of methods have been used to assess

corporate financial performance and to
search for signs of financial distress.
◦ Ratio Approach
 Liquidity
 Profitability
◦ Bankruptcy prediction models
 Altman’s Z-Score is one of the best known

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Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 +

1.0X5
Z = Overall Index or Score
X = Working Capital/Total Assets
1

X = Retained Earnings/Total Assets

2

X = Earnings before Interest and Tax/Total Assets

3

X = Market Value of Equity/Book Value of Total Liabilities

4

X = Sales/Total Assets
5

 A Z-Score of 3.0 or more is healthy.

 A score of 1.8 to 2.9 is in the ‘danger zone’.
 A score below 1.8 indicates a high probability of
failure.

 Studies have shown that Altman’s Z-Score

has validity in assessing Australian
companies.
 A variety of other models have been
developed
◦ Though most simply refine Altman’s original work.
◦ One such model is the CAMEL (Capital adequacy,
Asset and Management quality, Earnings, Liquidity)
mode.

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 The Australian Securities and Investments

Commission (ASIC) has set up the National
Insolvent Trading Program, which aims to:
◦ Make directors aware of their company’s financial
position.
◦ Make directors of potentially insolvent companies
aware of their responsibilities.
◦ Encourage directors to seek external advice from
accountants, lawyers and insolvency professionals.

 ASIC has identified some key operational and

financial practices which, in combination with
other practices, indicate a company is at
significant risk of insolvency. Some include:
◦ Poor cash flow, or no cash flow forecasts
◦ Disorganised internal accounting procedures
◦ Absence of budgets and corporate plans
◦ Continued loss-making activity
◦ Accumulating debt and excess liabilities over assets
◦ Loss of key management personnel

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 Corporate governance practices are often at

the heart of corporate failure.
 Corporate governance relates to the ‘duties
and responsibilities of a company’s board of
directors in managing the company and their
relationships with the shareholders of the
company and the stakeholder groups’

 Strong corporate governance, at a company

level, will have the following characteristics:
◦ Boards are active in setting and approving the
strategic direction of the company.
◦ Boards are effective in overseeing risk and setting
an appropriate risk level for the entity.

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 BusinessWeek annually rates boards on their

corporate governance. The principles of good
governance they look for include:
1. Independence.
2. Stock ownership.
3. Director quality.
4. Board activism.

 Significant corporate failure has consistently

led to a focus on corporate governance and a
demand for corporate reform.
 In Australia, corporate failures in the 1980s
were thought to result from inadequate
accounting disclosures.
 Perceived limitations in corporate governance
legislation that led to the collapse of Enron,
led to the US’s Sarbanes-Oxley Act in 2002.

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 Subsequent corporate failures in Australia

have been used to justify:
◦ The Financial Reporting Council introduced
International Accounting Standards from 1 January
2005.
◦ Establishment of the ASX Corporate Governance
Council and publishing best practice corporate
governance guidelines for listed companies in
2003.
◦ The Corporate Law Economic Reform Program

 There is often not one indicator that a

company is likely to become distressed or
fail.
 Cash flow has been seen to be a major
contributing factor to corporate failure.
◦ This is particularly evident in the retail sector.
 Deficiencies in the audit process have been
found to play a role in a number of collapses.
◦ These can be compounded by conflicts of interest.

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 Other factors include

◦ Lack of independence of the audit committee.
◦ Ownership structure dominated by a single
shareholder.
◦ Lower than average proportion of the remuneration
package for CEO ‘at risk’.
◦ Significant related party transactions.

Causes and consequences of the GFC

◦ The GFC is said to have started in the US housing
sector.
◦ Leading up to the financial crisis there were
 Substantial increase in housing prices
 Historically low interest rates
 Subprime mortgages increasingly being used
◦ This created an asset bubble

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 Towards the end of 2006 house prices

started declining, with significant defaults
and foreclosures on mortgages following in
early 2007.
 This quickly turned into a financial crisis
which affected credit markets and
jeopardised the banking system.
 The financial and economic effects of the GFC
were then transferred to other countries.

 Both the Australian and New Zealand

governments responded to the GFC by
announcing stimulus packages to ‘kick start’
the economy and to avoid a full recession.
 The health of Australian Authorised Deposit-
taking Institutions (ADIs) following the GFC,
as a result of regulation by the Australian
Prudential Regulatory Authority (APRA) is
seen as a model for corporate governance of
financial institutions around the world.

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