Corporate Governance

“Lehman Brothers is considered to be an example of a company that failed during the financial
crisis of 2008 in large part due to ineffective oversight by the board of directors.”
Larcker and Tayan (2010).

They ascertained that board quality and poor oversight played a greater role in the company’s
failure than structure and composition.

Corporate governance is at the centre of attention in today’s business world. This is greatly due
to the large number of stakeholders whose wealth and interests are at stake in the business.
With out sound corporate governance a business cannot survive.

Corporate governance in Pakistan is still at the developing stage. The regulators mainly; the
Securities and Exchange Commission of Pakistan and the State Bank of Pakistan, are
constantly engaged in developing corporate governance in the country. The government has
formed an institute of corporate governance which promotes good corporate practices through
various means.

The major components of corporate governance comprise of company policies, Board of

Directors, the role of the CEO, creditors, Stockholders, regulators, reporting and maintaining
overall transparency about the business operations.

In March 2002, the Securities and Exchange Commission of Pakistan issued the Code of
Corporate Governance to establish a framework for good governance of companies listed on
Pakistan's stock exchanges. In exercise of its powers under Section 34(4) of the Securities and
Exchange Ordinance, 1969, the SEC issued directions to the Karachi, Lahore and Islamabad
stock exchanges to incorporate the provisions of the Code in their respective listing regulations.
As a result, the listing regulations were suitably modified by the stock exchanges.

The Code is a compilation of “best practices”, designed to provide a framework by which

companies listed on Pakistan's stock exchanges are to be directed and controlled with the
objective of safeguarding the interests of stakeholders and promoting market confidence; in
other words to enhance the performance and ensure conformance of companies.

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Cases of poor corporate governance can be found around the world. They are mostly connected
to fraudulent practices. The other major malpractices were; irregularities in accounts, non-
compliance with law, nepotism, and exploitation of minority shareholders. Pakistan has also
had its share of corporate frauds and scandals however the government has taken several steps
to reduce such malpractices and their effects. Corporate governance is a relatively new area
and its development has been affected from a number of disciplines including finance,
economics, accounting, law, management and organizational behaviour. The main theory
which has affected its development, and which provides a theoretical framework within which
it most naturally seems to rest, is the agency theory. However, stakeholder theory is coming
into play as soon as companies become aware that they cannot operate in isolation but need to
have regard to other stakeholders. This and many other ideas got well known over the last few
years with the term “Corporate Social Responsibility (CSR)”

Definition of Corporate Governance:

‘Rules and regulation that govern the relationship between the managers and shareholders of
companies as well as stakeholders like employees and creditors.’ OECD (2004)
• “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.” OECD
(2010)
Cadbury (1992) states that “Corporate Governance is the system by which companies are
directed and controlled.”
• According to Aoki (2001), corporate governance is defined as “structure of rights and
responsibilities among the parties with a stake in the firm.”
• Becht, Bolton and Roell (2002) define corporate governance as being ‘concerned with the
resolution of collective action problems among dispersed investors and reconciliation of
conflicts of interest between various corporate claimholders.’
Fahy et al (2006) states that “corporate governance is the systems and processes put in place to
direct and control an organisation in order to increase performance and achieve sustainable
shareholder value.”
Berle and Means (1932), recognized need to separate the issue of control and ownership and
called for more transparency, voting rights and accountability.

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This became the basis of the Principal-Agent Theory which tries to explain the conflict arising
from the varying interest of the principal (owners) and the agent (managers). Jensen and
Meckling (1976).
Fama and Jensen (1983) explained this relationship in terms of legal contracts and the
mechanisms that are needed to maintain this relationship.
Corporate Governance may be defined as ―A set of systems, processes and principles which
ensure that a company is governed in the best interest of all stakeholders.
It ensures Commitment to values and ethical conduct of business; Transparency in business
transactions; Statutory and legal compliance; adequate disclosures and Effective decision-
making to achieve corporate objectives. In other words, Corporate Governance is about
promoting corporate fairness, transparency and accountability. Good Corporate Governance is
simply Good Business.
Principles of corporate governance include:
 Rights and equitable treatment of shareholders: Organizations should respect the
rights of shareholders and help shareholders to exercise those rights. They can help
shareholders exercise their rights by effectively communicating information that is
understandable and accessible and encouraging shareholders to participate in general
meetings.
 Interests of other stakeholders: Organizations should recognize that they have legal
and other obligations to all legitimate stakeholders.
 Role and responsibilities of the board: The board needs a range of skills and
understanding to be able to deal with various business issues and have the ability to
review and challenge management performance. It needs to be of sufficient size and
have an appropriate level of commitment to fulfill its responsibilities and duties. There
are issues about the appropriate mix of executive and non-executive directors. The key
roles of chairperson and CEO should not be held by the same person.
 Integrity and ethical behaviour: Ethical and responsible decision making is not only
important for public relations, but it is also a necessary element in risk management and
avoiding lawsuits. Organizations should develop a code of conduct for their directors
and executives that promotes ethical and responsible decision making. It is important
to understand, though, that reliance by a company on the integrity and ethics of
individuals is bound to eventual failure. Because of this, many organizations establish

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 Compliance and Ethics Programs to minimize the risk that the firm steps outside of
ethical and legal boundaries.
 Disclosure and transparency: Organizations should clarify and make publicly known
the roles and responsibilities of board and management to provide shareholders with a
level of accountability. They should also implement procedures to independently verify
and safeguard the integrity of the company's financial reporting. Disclosure of material
matters concerning the organization should be timely and balanced to ensure that all
investors have access to clear, factual information.

Transparency can be achieved through three key market elements:

 Openness
 Accounting standards
 Compliance reporting.

Difference between Accounting and Auditing

Accounting and Auditing are two very important processes related to the financial activities
and records of an organization.
What is Accounting?

Definition of Accounting:
Accounting refers to the process of capturing, classifying, summarizing, analyzing and
presenting the financial transactions, records, statements, profitability and financial position of
an organization or entity. Accounting is the specialized language of business.

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Accounting work for an organization is done usually by its own employees. Accounting is
carried out almost continuously. Accounting is categorized in various branches like cost
accounting, management accounting, financial accounting, etc.
Definition of Auditing:
Auditing refers to the critical examination of the financial records or statements of a business
or an organization. It is obligatory for all separate legal entities. Auditing is carried out after
the final preparation of the financial statements and accounts.
Auditing involves carrying out the inspection and statutory audit of the financial statements,
and giving a fair and unbiased opinion on whether the financial statements and records provide
a true and fair reflection of the actual financial position of the firm. The auditors, usually
external, carry out the task of auditing under the provisions of the applicable laws on behalf of
shareholders or regulators. The scope of auditing work is determined by the applicable laws.
Auditing has two main categories viz. internal audit and external audit. Internal audit is
conducted by an internal auditor, usually an employee of the organization. External audit is
conducted by an external auditor, appointed by the shareholders.

Similarities between Accounting and Auditing:

Many of the basic processes of both accounting and auditing are similar. Both need a thorough
knowledge of accounting basics and principles. Both are generally done by the persons with an
accounting degree. Both use essential procedures and techniques of book-keeping, computation
and analysis.

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 Both accounting and auditing strive to ensure that the financial statements and records provide
a fair reflection of the actual financial position of an organization.
Difference between Accounting and Auditing:

Criterion Accounting Auditing

Accounting is keeping records of the Auditing is critical examination of the

Definition financial transactions and preparing financial statements to give an opinion on their
financial statements fairness

Continuous with daily recording of Periodic process and carried out after the
Timing
financial transactions preparation of final accounts

Beginning Starts where book-keeping ends Starts where accounting ends.

Concentrates on the current financial

Period Concentrates on the past financial statements
transactions and activities

All transactions, records and statements

Coverage Final financial statements and records.
having financial implications

Very detailed and captures all details Uses financial statements and records on
Level of Detail
related to financial transactions and records sample basis.

Type of Checking details related with all financial Carried out through test checking or sample
Checking records checking.

To accurately record and present all To verify the accuracy of the financial
Focus
financial transactions and statements. statements

To determine the financial position,

Objective To add credibility to the financial statements
profitability and performance.

Legal Status Governed by Accounting Standards Governed by Standards on Auditing

Performed by Accountants Auditors.

Carried out by an external person or

Status Carried out by an internal employee
independent agency

Appointment By the management By the shareholders

Qualification Specific qualification is not compulsory Some specific qualification is compulsory

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Remuneration
Salary Auditing fee
Type

Remuneration
By the management By the shareholders
Fixation

Scope
by the management by the relevant laws
Determination

Necessary for all organizations in the day-

Necessity Not necessary in the day-to-day operations
to-day or routine operations

Financial statements e.g. Income Statement

Deliverables or P/L, Balance Sheet, Cash Flow Audit Report
Statement, etc.

Report
To the management To the shareholders
Submission

Accountants may make suggestions for the

Guidance improvement of accounting and related Auditor usually does not make suggestions
activities

Generally ends with the preparation of the Liability after preparation and submission of
Liability
accounts the audit report

Shareholders’
Accountant does not attend Auditor may attend
Meetings

Professional Accountant is not usually prosecuted for Auditor can be prosecuted for professional
Misconduct professional misconduct misconduct

Removal By the management By the shareholders

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Business Ethics
Organizational Factors:
The Role of Ethical Culture and Relationships

* Organizations are much more than the structure in which we work.

* Although not alive, but behave like alive human character.
* Excluding sleeping, people spend 50% of their time in their second home i.e, work
place.
* It is therefore important to know how the structure of the organization influence the
ethical decision made with in the organization.
_________________________________

* In ethical decision making framework organizational factor (corporate culture and

interpersonal relationships) influence the ethical decision making process.
* In this chapter we will discuss affect of corporate culture and values and traditions of
the company on the ethical behavior of the employees.
 Two organizational structures and their influence is discussed here.
____________________________________

The Role of Corporate Culture in Ethical Decision Making

 Corporate Culture a set of values, beliefs, foals, norms, and ways of solving problems
shared by the members of an organization.
 A Founder and his values can also create corporate culture e.g. MacDonald’s founder
Ray Kroc.

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  Although customers have different complaints.
 Corporate culture includes the behavioral patterns, concepts, values, ceremonies, and
rituals that take place in the organization. When these values are accepted, shared, and
circulated through out the organization it becomes its culture.
 Many definitions of Corporate Culture e.g. 1)The way we do things around here. 2)The
collective programming of the mind. 3)The social fiber that holds the organization
together. 4)The Shared beliefs top managers in a company have about how they should
mange themselves and other employees, and how they should conduct their business.
 Mutual of Omaha defines corporate culture as “personality of the organization, the
shared beliefs that determine how its people behave and solve business problems” Table
7-1 page 176
 History of the organization and unwritten rules are a part of its culture. IBM sales people
adhered to a series of unwritten standards for dealing with clients. History or stories
passed down from generation to generation.
 Ford Motor Company, left a legacy that emphasized the importance of the individual
employee and the natural environment.
 Some cultures are very strong. Like. Levi Strauss, Ben & Jerry ice cream company are
widely perceived as casual organizations with strong ethical culture.
________________________________________________________
Ethical Framework and Audit for Corporate Culture

Mary Ann Von have proposed two basic dimensions to describe an organization’
culture : 1) Concern for people 2) Concern for performance. The organization efforts
to focus on output and employee productivity. A two by two matrix represents the for
general types of organizational cultures.

Concern for people High /Low

Caring Integrative

Apathetic Exacting

Low High
Concern for performance

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Apathetic culture:

Shows minimal concern for either people or performance. In this culture, individuals focus on
their own self interests. Apathetic tendencies can occur in almost any organization. Steel
companies and Airlines were among the first to freeze employee pensions to keep their
businesses operating, now Fortune 500 companies such as Sears, IBM, and Verizon are
engaging in the same behavior.

Caring Culture.

Exhibits high concern for people but minimal concern for performance issues. From an ethical
standpoint, the caring culture seems to be very appealing. Southwest Airlines, for example, has
a long standing reputation of concern for its employees.

Exacting culture

Shows little concern for people but a high concern for performance; it focuses on the interest
of the organization. United Parcel Service (UPS) has always been very exacting.

Integrative Culture

Combines high concern for people and for performance. An organization becomes integrative
when superiors recognize that employees are more than interchangeable parts—that employees
have an ineffable quality that helps the firm meet its performance criteria.

_____________________________________

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Cultural Audit.

Companies can classify their corporate culture and identify its specific values, norms, beliefs,
and customs by conducting a cultural audit. A cultural audit is an assessment of the
organization’s values. It is usually conducted by outside consultants but bay be performed
internally as well. Table 7-2 page 179 . Audit of a corporate culture should address these.

Statement Describing Ethics Related Percentage of

Actions Employees Strongly
Agreeing or Agreeing
(2005)
Top Mgt provides information 80
Top mgt keeps commitments 81
To mgt communicates thics 91
Middle mgt keeps commitments 90
Supervisor keeps commitments 94
Coworkers consider ethics in 92
decisions

__________________________________________________________

Ethics as a Component of Corporate Culture

* Ethical culture, the ethical component of corporate culture, is a significant factor in

ethical decision making. If a firm’s culture encourages positive ethics its employees
behave in positive manure vice versa.
 Some companies or managers may have a culture of wining at any cost. This could
harm the good reputation of the business. This is often found in marketing persons, as
some time they insist to their customer to buy a thing that is not needed.
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  Microsoft on the other hand having a culture of helping people in solving their business
problems.
 An organization if failed to monitor or manage its culture may foster questionable.
 A federal Judge reprimanded the company for destroying the evidence in “bad faith”.
 Management’s sense of the organization’s culture may be different as per employees.
 Audit sample at page 181 table 7-3

Answer Yes or No To each of the following questions

Yes No Has the founder or top management of the
company left an ethical legacy to the
organization?
yes No Does the company have methods for detecting
ethical concerns within the organization and
outside it?

Differential Association

 Refers to the idea that people learn ethical or unethical behavior while interacting with
other who are part of their role-sets or belong to other intimate personal groups.
 Example 1. Two cahiers working different shifts at the same supermarket. Kevin, who
works in the evening, has seen his cashier friend to take money from the bag containing
change of the soft drinks. Although Kevin thinks it very bad but one evening when he
has noting for launch he also takes four quarters for soda.
 Example 2. Mark Hernandez, who worked at the NASA’s Michoud Assembly Facility
applying insulating foam to the space shuttles external fuel tanks. Within few weeks on

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 the job, coworkers taught him to repair scratches in the insulation without reporting the
repairs. Supervisors encouraged the worker to quickly finish the job to meet the target.
But the shuttle broke up on reentry, killing all seven astronauts on board. Investigators
focused on whether a piece of foam falling off a fuel tank during liftoff may have
irreparably damaged the shuttle.
 Several studies have found that employees’ especially young managers tend to go long
with their superiors moral judgments to demonstrate loyalty.

___________________________

Whistle Blowing

Means exposing an employer’s wrongdoing to outsiders (external to the company) such as the
media or government regulatory agencies. Term whistle-blowing is also used for internal
reporting of misconduct to management, especially through anonymous reporting mechanisms,
often called hot lines.
Whistle blowers may lose their jobs or may have action against them. Table 7-3 page 184

_____________________________

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Leaders Influence Corporate Culture

 Organizational leaders use their power and influence to shape corporate culture.
 Powers refers to the influence that leaders and managers have over the behavior and
decisions of subordinates.
 An individual has power over others when his or her presence causes them to behave
differently.
 The status and power of leaders is directly related to the amount of pressure.
 For example; a manage might say to his subordinate, “I want the confidential data about
our competitor’s sales on my desk by Monday morning, and I don’t care how you get
it” A subordinate who values his job or who does not realize the ethical questions
involved may feel pressure to do some thing unethical to obtain the data.
 There are five power bases from which one person may influence another:
 1) reward power, (something desirable, money, status, promotion etc)
 2) coercive power, (fear to change behavior, asked to leave organization etc)
 3)legitimate power, (belief that the person holds the power and others to accept)
 4) expert power, and (to manipulate others or to gain an unfair advantage)
 5) Referent power. (perceiving that other person’s goals are same so follow him)

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THE ROLE OF INDIVIDUAL FACTORS IN BUSINESS ETHICS
INDIVIDUAL FACTORS: Moral Philosophies and Values

Individual role in ethical decision making process is very important. Ethical decision making
model placed the individual moral perspectives as central component. Here we shall discuss
how individuals’ background and philosophies influence their decisions. It is important to
determine when one action is right and when another is viewed as wrong. To understand how
people make ethical decisions it important to know about major types of moral philosophies.

MORAL PHILOSOPHIES

 Generally philosophies are meant by people as the general system of values by which
they live.
 Moral philosophies on the other hand refers in particular to the specific principles or
rules that people use to decide what is right or wrong.
 Example: Production manager may encourage the employees to understand the product
they are manufacturing. But his moral philosophies come into play when he must make
decisions such as whether to notify employees in advance of upcoming layoffs.
 Moral philosophies present guide lines to make the ethical decisions for the mutual
benefit of the people living together in groups, and also guiding business people to
formulate strategies and resolve specific ethical issues.
 There are no single moral philosophies.
 Example: Some manager’s view profit as the ultimate goal of an enterprise and
therefore may not be concerned about the impact of their firms’ decisions on society.
Milton Friedman supports this viewpoint, that market will reward or punish companies
for unethical conduct without the need for government regulation.
 People who face ethical issues often base their decision on their own values and
principles of right or wrong, which are learned through the socialization process with
the help of family members, social groups, church, and formal education.
 Individual factors that influence decision making include personal moral philosophies.
 Moral philosophies are ideal moral perspectives that provide individuals’ with abstract
principles for guiding their social existence.

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 Example: Individual decision to recycle waste and to purchase recycled material are
influenced by moral philosophies and attitude towards recycling.
 Economic system on the other hand is fact made due to interaction of the individuals of
different nature and thoughts. So individual learn about the ethical decision making
approaches or philosophies through their cultural and social development.
 Many theories associated with moral philosophies refer to a value orientation and such
things as economics, idealism, and relativism.
 Economics: Associated with values that can be quantified by monetary means.
 Idealism: is a moral philosophy that places special value of ideas and ideals as products
of the mind, in comparison with the world’s view.
 Realism: Is the view that external world exists independent of our perception of it.
Realists work under the assumption that human kind is not inherently benevolent (kind,
helpful and generous) and kind but instead are inherently self-centered and competitive.

MORAL PHILOSOPHIES

There are many moral philosophies, but here we are discussing only two of them;

1) TELEOLOGY ( Refers to moral philosophies in which an act is considered morally

right or acceptable if it produces some desired result such as pleasure, knowledge,
career growth, the realization of self-interest, utility, wealth, or even fame).
2) DEONTOLOGY (Refers to moral philosophies that focus on the rights of individuals
and on the intentions associated with a particular behavior rather than on its
consequences. Fundamental to deontological theory is the idea that equal respect must
be given to all persons).

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WHITE COLOR CRIME

 Crimes like, rape, arson (deliberately setting fire), armed robbery, or murder.
 Crime like these are more appealing to the evening news.
 But the crimes do more damage in monetary and emotional loss in one year than crimes
of the street over several years combined are “White Color Crimes”.
 WCC creates victims by establishing trust and respectability.
 WCC are considered different than crimes of street.
 It is interesting to note in figure 6-1 (page 164) that deceptive pricing, unnecessary
repairs, and credit card fraud are the three victim categories that were found in the
national public household survey or consumers reporting over their lifetime.
 In the WCC Center’s survey nearly one in two households was victimized by WCC in
2005, and well over half of the individuals surveyed has been victimized by WCC over
their lifetime.
 WCC cost the USA more than $300 billion annually.
 Definition by main criminology literature: An individual or group committing an illegal
act in relation to his/her employment, who is highly educated (college), in a position of
power, trust, respectability and responsibility, within a profit/nonprofit business or
government organization and who abuses the trust and authority normally associated
with the position for personal and /or organizational gains.

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  Different examples of WCC on page# 165.
The Goal of the Firm:
* Maximizing the wealth of the owners.
* Share holder wealth represented by the value of stock in market.
* All three primary functions of the financial manager play
important role for market value of the share holder investment.
i. Value Creation:
* Earning per share depends on the profit earned.
* Earning can be increased by investing more, but this investment if
is coming from issuing more shares, this will decrease the earning
per share.
* A project producing Rs. 100,000 after five years is more valuable
than the project returning Rs. 15,000 in each of the next five years.
Decision involves the present value concept.
* Keeping risk factor in mind while deciding about one project out
of two for investing.
* Risk of company depends on the amount of t\debt in relation to
equity in its capital structure.
* Value of stock of a risky company and less risky may differ
although having the same EPS.
* EPS may increase if whole profit is to be kept by company and
nothing distributed as dividend( by investing the whole in any
profitable activity) but dividend is paid which effects the market
price per share.
* Market price depends on dividend paid, current dividend and
dividend expected in future. Also the risk factor, timing, duration
and dividend policy of the firm etc. Market price reflects how the
management is working on behalf of its shareholders.
* If management do not care about the market value or EPS the
dissatisfied shareholders may sell their shares which may build
pressure on management. So management always tries to raise the
value of shareholder investment and also to judge the alternative
investment, financing and asset management strategies in terms of
their effect on shareholder value.
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 * In addition management work for the market share and customer
satisfaction to raise shareholder value.
ii. Agency Problem
* Separation of ownership and control results conflicts.
* Widely held stock
* No influence on management.
* Management may act in its own benefits.
* Ideal position for shareholders that management works for their
interest.
* Monitoring and incentives are the only way to motivate the
management.
* Bonding, systematically reviewing management perquisites, audit,
and limiting management decisions are the tools to restrict
management.
* Monitoring activities involve cost and also less the ownership of
the managers less they will work for maximizing the shareholder
interest.
* Efficient capital market can check the efficiency of the
management, higher the VPS best the management.
iii. Social Responsibility
* Protecting the consumer, fair wages, fair hiring practices and safe
working conditions, supporting education and environment friendly.
* Caring all stake holders other than shareholders.
* Stakeholders include creditors, employees, customers, suppliers,
communities in which company operates.
* Corporation’s very existence depends on its being socially responsible.

Economic Systems

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