Introduction To Corporate Governance PDF

Module 1 Introduction to Corporate Governance Global perspective Learning objectives After studying this section, you should • Understand the role of efficient capital markets in corporate governance • How other governance institutions may take the role of inefficient capital markets in governance...

Module 1 Introduction to Corporate Governance Global perspective Learning objectives After studying this section, you should • Understand the role of efficient capital markets in corporate governance • How other governance institutions may take the role of inefficient capital markets in governance • Understand the role of accounting standards, enforcement of regulations and societal and cultural values in governance 2 Governance systems • Governance systems vary across countries due to the characteristics of business environments in a given country: 1. Efficiency of local capital markets 2. Level of the legal system 3. Reliability of accounting standards 4. Enforcement of regulations 5. Societal and cultural values • These factors affect the level of the agency problem and the control mechanisms needed to prevent the agency problem 3 1. Efficiency of local capital markets • When capital markets are efficient, prices of labor, capital, and natural resources are correct, which improves decision making • Efficient capital markets “discipline” firms ˗ Poor decisions are punished ▪ Stock prices decline ▪ Cost of capital increases ▪ Risk of bankruptcy or being taken over increases • Efficient markets protect against ˗ Adverse Selection: One party in a transaction has an information advantage, and uses this advantage to receive preferential pricing or risk transfer ˗ Moral Hazard: One party does not bear the full risk of its actions and so engages in excessively risky transactions 4 1. Efficiency of local capital markets • If a country lacks an efficient capital market, something must take its place: ˗ Wealthy families ˗ Large banking institutions ˗ Other companies ˗ Governments • These institutions “discipline” firms in order to protect their investment just like efficient capital markets do • However, the interests of these institutions may be different from those of minority shareholders and stakeholders (an agency problem, again…) • On average, private parties are less effective at monitoring companies than capital markets 5 2. Legal tradition • A country’s legal system has important implications on the rights of those who own businesses ˗ Protection of property against expropriation ˗ Predictability of how claims will be resolved (e.g. in a court) ˗ Enforceability of contracts ˗ Efficiency and honesty of judiciary • A strong legal system strongly mitigates agency problems because self-interested managers know illegal actions will be punished • A corrupted political system reduces economic development by discouraging investment 6 3. Reliability of accounting standards • Accounting standards give investors confidence that financial reports are correct and can be used a basis for decision-making • If accounting standards are compromised, manipulated, or lack transparency ˗ Investment decisions will suffer ˗ Oversight of management will suffer ˗ Management incentives will be inappropriate • Adoption of International Financial Reporting Standards (IFRS) globally was a major advance ˗ Harmonization of IFRS and US GAAP 7 4. Enforcement of regulations • Even if legal system is strong, officials must be willing to enforce regulations in a fair and consistent manner. • Regulatory enforcement signals that management is being monitored, which contributes to investor confidence that their interests will be protected • “Good” firms in “bad” countries may emphasize other governance elements to convince especially foreign investors that their interests will be protected Research evidence: • Companies apply more conservative accounting when enforcement of securities regulations is strong (Bushman and Piotroski, 2006; Florou and Pope, 2012) • Participation in equity markets increases when countries adopt insider trading laws (Brudney, 1979; Leland, 1992) 8 5. Societal and cultural values • Managerial behavior is influenced by the society in which the company operates • Activities that are acceptable in one culture may be unacceptable in another (such as conspicuous consumption). • Executives in a country that values “individualism” may be more likely to take selfinterested actions than executives in a country that values “collectivism,” because they do not risk the same level of scorn for their behavior. • Societal values will also influence whether the company takes a more shareholder-centric or stakeholder-centric approach 9 Bibliography • Leland, H. E. (1992), “Insider trading: Should it be prohibited?”, Journal of Political Economy, 100(4), pp. 859-887. • Bushman, R. M., & Piotroski, J. D. (2006), ”Financial reporting incentives for conservative accounting: The influence of legal and political institutions”, Journal of Accounting and Economics, 42(1-2), pp. 107-148. • Brudney, V. (1979), “Insiders, outsiders, and informational advantages under the federal securities laws”, Harvard Law Review, pp. 322-376.“ • Florou, A., & Pope, P. F. (2012), “Mandatory IFRS adoption and institutional investment decisions”, The Accounting Review, 87(6), pp. 1993-2025 10