A blueprint for good governanceBuilding better boards by designStructures to address the rootcauses of poor governancePage 2

Global strategy faces local constraintsThe varying influence of stakeholders around the worldPage 4

Ratings add fire to the governance debateQuestioning the link betweengovernance and performancePage 6

When earnings managementbecomes cooking the booksThe audit committee mustlearn to make the distinctionPage 10

Friday May 27 2005 In association with

Corporate governance

PART TWO

of a four-part weekly seriesMastering

the roles and responsibilities mustbe clearly defined and agreed.

Regardless of the structure, theperson who is in the chair often hasdifficulty creating agendas and lead-ing discussions to reach consensus inthe time available. To some extent,this may be due to a lack of leader-ship skill on the part of chairs, but Ithink the more important reason isthat all board members legally areequal and they expect to be treatedthat way by each other. This makes ithard for a chair to control the meet-ings effectively and requires self-discipline on the part of all the mem-bers.

◆ Board concerns and their causes

These impediments to board effec-tiveness underlie the concerns thatso many directors express. For exam-ple, complaints that too much time isbeing spent on compliance and notenough on matters of strategy usu-ally arise because the board has notpaid explicit attention to its role. Asboards are asked to do more, theysimply try to cram more into thesame size container, and this doesnot work.

Additionally, because boards areunclear about their role, directors’complaints about lack of strategicinvolvement, while heartfelt, areunclear and vague. How do theywant to be involved in strategy?What contribution to strategic deci-sions do they have the knowledge tomake? Where should the line bedrawn between the board and man-agement on strategic matters? Howcan the board provide effective over-sight of the company’s strategicdirection and progress within thelimits of time and knowledge? All areimportant questions that are toorarely addressed.

I recently encountered an exampleof this with the board of a financialservices company that operates inseveral distinct businesses. Becausealmost all the directors were inde-pendent, they were unfamiliar withthe complexities of these financialservice businesses and their underly-ing economics. Further, the informa-tion that management was providing,while well intentioned, was complexand not well organised. On top of all

knowledge to perform their jobs well. A director’s lack of knowledge is

complicated by another problem – thequality of information they receivefrom management. Oddly, it is notthat they receive too little, but thatthey receive too much, which is oftenpoorly organised and does not illumi-nate the most significant issues.

Another problem is that boardsare often unclear about what rolethey should be undertaking and, inmost countries, their legal duties andresponsibilities are broad and vague.The one exception is Germany, wherelaws are quite specific, but boardsthere have other difficulties becauseof their size and the emphasis on co-determination.

Rather than considering carefullywhat their focuses should be, toomany boards simply do what theyhave always been doing, and respondreflexively to new requirements, suchas the Sarbanes-Oxley Act, withoutexplicit attention to how to deal withthe additional duties. As a result,directors lack clarity of purpose.

As the old saying goes: “If youdon’t know where you are going, anyroad will get you there.” This is theproblem too many boards have. Theyhave no clear criteria to use in deter-mining how to allocate their precioustime together. Rather, they focus onwhatever issues management feelsare most pressing and on what theyhave traditionally done.

A third problem stems from thebasic fact that boards are groups ofindividuals who must work co-operatively to get things done. Theadvantage of having many individu-als on a board is that there should bediverse perspectives, healthy debateand sound decisions. The difficulty,as anyone who has worked in a groupsetting or studied social psychologywill immediately recognise, is thateffective group decision-making takestime and requires skilful leadership.

Achieving effective leadership is acomplicated and related matter.First, there is the question ofwhether the board chair and theCEO should be two individuals (asthey are in most European, Aus-tralian and Canadian companies) orwhether the functions should be per-formed by the same individual (as iscommon in the US). My own view isthat either structure is workable, but

with company strategy.” Obviously,this is related to a second worry: “Weare spending too much time focusedon issues related to complying withnew laws and rules.” This is a partic-ular concern in the US because of theSarbanes-Oxley Act. Directors arealso often troubled that they are soregularly criticised about their CEO’scompensation. Finally, they oftenadmit that the trend to bring in morenew CEOs from outside is the resultof their failure to do an adequate jobin ensuring sound managementdevelopment and succession plan-ning. All these concerns are impor-tant because they are about mattersthat directors consider their coreresponsibilities.

◆ Limits on board effectiveness

Boards are experiencing these diffi-culties for several reasons. The first isthe increasing emphasis on indepen-dent directors. While the precise defi-nition of independence varies fromcountry to country, as does thedesired proportion of such directorson each board, the basic idea is thesame. Most directors should not haveany other connection with the com-pany, past or present.

The goal, which certainly is a wor-thy one, is to ensure that boards areobjective and have no conflicts ofinterest. However, the problem isthat, with this emphasis on indepen-dence, boards are usually made up ofdirectors with little current or pastknowledge about their company’sindustry or businesses. Further, inde-pendent directors are truly part-timers. They have other day jobs thatlimit the time they can realisticallydevote to each board. Consequently,well-intentioned directors find thatthey have insufficient time and

or 20 years, I have beenobserving and working inboardrooms, as a directorin the US and Europe, asa consultant to boards inthose continents andLatin America, and as aresearcher and author. Ihave also been leading

education programmes for corporateboard members at Harvard BusinessSchool for the past decade.

My perspective on the currentstate of boards is that there has beena significant improvement in theirfunctioning in the past two decades.New laws, regulations, guidelines andrising investor and public expecta-tions have had a positive impact. Thegreat majority of boards are lessunder the thumb of their CEOs thanthey once were, and are seriously try-ing to govern their companies. A setof best practices has emerged that aredocumented in country corporategovernance codes, stock exchangelisting requirements and companyannual reports.

For sure, boards are being asked todo more because of these new expec-tations. It is also true that too manyof these demands focus on mattersthat are visible from public docu-ments but are not central to whatactually takes place in boardrooms.Nevertheless, I find individual direc-tors are willing to accept these addi-tional duties and spend more time onthem. Further, I see no evidence thatthere is a shortage of suitable newcandidates for board seats.

This is all good news. However,because so many directors are tryingto do more and do it better, they arealso frustrated by difficulties thatthey encounter. The most commonconcern I hear is: “We don’t spendenough time considering and dealing

Mastering Corporate Governance2

JAY LORSCH

Building better boards by design

Important board decisions are often hampered by constraints of time, knowledge and group process. Toaddress these difficulties, directors need to pay carefulattention to performance, leadership and structural issues

F

Jay Lorsch is the LouisKirstein professor of humanrelations at HarvardBusiness School. He is theauthor, with Colin Carter, of“Back to the Drawing Board:Designing Corporate Boardsfor a Complex World”(Harvard Business SchoolPress, October 2003).jlorsch@hbs.edu

Consideration of the board’s roleinvolves being explicit about whichdecisions the board should take andwhich should be the purview of man-agement. It also involves understand-ing which aspects of company andmanagement performance the boardintends to monitor. These are mattersthat should be considered periodically– perhaps every few years – as com-pany and management circumstanceschange. Once the board has a clearerunderstanding of what it wants toaccomplish, it then becomes possibleto clarify other aspects of its design.

Design choices begin with the sizeof the board, the proportion of man-agement and independent directors,and the mix of talent and experiencethe board needs. Explicit attentionmust be paid to the question of whatdirectors need to know for a board tobe effective.

Boards also need to consider theirleadership structure – for example,whether they have one person as CEOand chair or two, whether there is alead director and what the role of com-

mittee chairs should be. Of course,this also includes the matter of whichcommittees the board needs – justthose required, or others additionally.

Decisions also need to be madeabout the length and number ofmeetings, including those of inde-pendent directors in the absence ofexecutives. This, of course, dependson the role the board wants to playand the fullness of meeting agendas.A process must be defined for howthe annual cycle of the board’s busi-ness is to be defined and by whom,and also who will determine theagenda for each meeting.

Design should also include explicitand thoughtful attention to whatinformation the directors need inorder to play their role, and when itwill be transmitted. Attention mustalso be given to how to organise theinformation, so that busy directorscan comprehend what is happeningwithin the limits of the available time.

Finally, when I speak about design,this includes explicit consideration ofthe best procedures for the board touse in handling its major tasks –approving and assessing strategies,evaluation of the CEO and ensuringcompliance with laws and regulations.

Making all these choices mayseem like a large effort for a group ofpeople who already feel overtaxed.However, in my experience, it isalways a pleasant surprise howquickly directors can agree on thesematters. And in any case, theimproved results always seem to beworth the effort.

worse unless we can find a way to getdirectors to step back and reflecttogether on how they can be moreeffective and efficient. Fortunately,there is good news on this front.Some new regulations, such as theNYSE and Nasdaq listing require-ments in the US and the CombinedCode in the UK, are requiring boardsto undertake a self-evaluation of theirperformance on an annual basis. Else-where, many boards are doing this ontheir own initiative. These assess-ments are like an annual physicalexam. The purpose is to identify prob-lems and what should be done aboutthem. They also enable directors toidentify opportunities to worktogether more effectively. I havebeen involved in many such assess-

ments and I am confident that theycan be powerful catalysts for boardimprovement.

In the case of boards, what isneeded is attention to the way theboard has been designed and how thatdesign can be improved (see figure 1).The first consideration, as I havealready emphasised, must be whatrole the board wants to play in majorissues, such as ensuring compliance tolaws, principles and regulations,involvement in strategic questions,and in ensuring healthy managementdevelopment and succession.

and other top managers from workingwith them over years of board service.They appreciate the efforts they haveput in and the results they haveachieved and they want to rewardthem for their efforts as well as theirresults. In deciding what is the “right”amount, they usually have only onesource of information – the “marketsurveys” provided by compensationconsultants, which are usually flawedbecause they do not recognise com-pany performance. Further, since thesurvey information is always organ-ised by quartile, it is difficult for anydirector to recommend that his CEOshould fall below the mean of otherCEOs. So we end up with almost allCEOs being in the top half, and morethan 25 per cent being in the top quar-

tile. As a result, CEO and executivepay in general keeps rising.

A further problem arises becausedirectors, despite having this connec-tion with management, are too oftennot aware of the desire of sharehold-ers. In essence, there is an informa-tion asymmetry. Directors understandand empathise with what top execu-tives expect but are less aware ofshareholder concerns. In the UK,where shareholders are now given anadvisory vote on the past year’s direc-tor compensation, this has changed,as directors at GlaxoSmithKline,WPP and some other UK companieswill doubtless confirm.

◆ Board design

It seems clear that the constraints oftime, knowledge and group processmake it difficult for many boards toaccomplish what the public andshareholders expect of them, andwhat they, themselves, are trying todo. In my judgment, all the new rulesand guidelines in the world will notsolve such problems. Rather, the keyto improving the board’s capacity todeal with such problems rests in thehands of each board.

These difficulties are likely to get

this, the board was intent on comply-ing with the requirements of the Sar-banes-Oxley Act. The directors werefrustrated and anxious to get moreinvolved in strategy, but unclear howto do so in the time available andwith their limited understanding ofthe company’s businesses.

◆ Succession planning

While there are a few examples ofcompanies (and boards) that handlemanagement succession well, such asGeneral Electric and Unilever, theseare certainly the exceptions. In myexperience, when directors complainthat they do not effectively monitormanagement development and succes-sion, the problem is not that they areunclear about the role they shouldplay. Rather, the difficulty is that thetopic is not properly addressed due tothe constraints of time. It is a longer-term issue and its consideration canalways be postponed because of moreurgent matters.

For example, on one board withwhich I am familiar, the question ofhow to ensure a smooth transitionbetween the current CEO and the nextinitially came up at meetings fiveyears before the incumbent’s retire-ment. The topic was put on theagenda of meeting after meeting, butit always was squeezed out by a newacquisition opportunity, or a crisis ina particular business. Suddenly, or soit seemed to the board, the old CEOwas going to retire in 18 months, andthere was only one internal candidatethat he believed could replace him.The other directors did not considerhis candidate satisfactory, but theyhad done nothing in the previousyears to address the issue. Not sur-prisingly, the situation evolved into abitter dispute between the CEO andthe rest of the board.

The root cause of the problem wassimply that the topic, which all recog-nised was the board’s responsibility,was never given priority. It is alsotrue that the lack of time to addressthis issue (as so often happens) wasthe result of allowing other discus-sions to wander about with little or noattempt by the chairman to keep themon track and the inability of otherdirectors to help manage the board-room dialogue.

◆ Executive compensation

The issue of executive compensationcan also be a problem for boards.Many reasons have been put forwardto explain why boards end up reward-ing their CEOs so richly. Some evensuggest that directors, who are them-selves CEOs, conspire to make surethat the CEO in question is highlycompensated, so that the general levelof pay for corporate leaders keeps ris-ing. Perhaps such things go on insome compensation committees andboardrooms, but I have not seen them.

In my experience, the causes aremore subtle. The directors involved incompensation decisions, even if techni-cally independent, often find theirindependence is hard to sustain psy-chologically. They know their CEO

Mastering Corporate Governance 3

Company situation

Board’s role

Structure MembershipProcesses

Culture

Behaviour

Figure 1 Designing the board

“Boards are often unclear aboutwhat role they should be undertaking and, in most countries,their duties are broad and vague”

stronger voice within the companywill get more involved in global strat-egy decisions. Generally speaking,these employees will seek to keeptheir jobs domestically as opposed tomoving them around the globe.

In 2004 for example, employeeopposition to job losses prevented therestructuring, via a merger with a for-eign partner, of France’s financiallytroubled Alstom, a major producer ofships and trains. In the same yearVolkswagen, despite suffering fromvery high labour costs, had topromise its western German employ-ees job security until 2011 inexchange for a wage freeze until 2007and more flexible working hours. Thecompany’s workers wield consider-able power, partly through co-determination rights, which requireemployees to be consulted on corpo-rate decisions.

◆ Top management teams

Cross-national variation in top man-agement teams is mostly reflected intheir functional background and theirinternational experience, as well asthe patterns of managerial careermobility. Managers in the US and UKtend to have professional back-grounds (often with formal businessschool education) and strong func-tional backgrounds in finance or mar-keting. This is not the case inGermany, where managers are moretechnically oriented. In France, man-agers often share a common grandesécoles background and ideology, fre-quently linking them back to govern-ment positions that they havepreviously held.

There is also variation in the inter-national experience and backgroundof managers, with US managers hav-ing the most foreign-born individualsin their management teams andFrance, Italy and Japan the least.Managerial career mobility tends to bevery fluid in the US and UK due toopen labour markets whereas, inJapan and France, managers tend toremain with a company for a longperiod of time.

The presence of foreign nationalsand managers with prior internationalexperience, combined with openlabour markets, means that teams willbe more likely to push global

◆ Employees

Two main variables differentiateemployees, as a collective group,across countries. First, the country’slabour market will influence the flex-ibility and mobility of employees.Countries such as the US that haveemployment at will, whereby a con-tract can be terminated at any time,are likely to have flexible labour mar-kets and short-term labour commit-ment. Generally, the consequence isthat labour training is done outsidethe company and employees havegeneral and portable skills.

In more rigid labour markets, suchas Germany and Japan, companiesinvest a great deal in bespoke, in-house training, which tends to result

in more highly skilled labour forcesand company-specific skills. These, inturn, are less transferable from onecompany to another.

Second, the strength of labourunions and unionisation rates variesfrom one country to another. Forinstance in France, where unionrights are extended to all employeesregardless of union affiliation, unioni-sation will have a much greater influ-ence on corporate decision-makingthan in the US or UK, where onlyunion members benefit from collectivebargaining agreements. Japanese com-panies tend to have enterprise union-ism, which leads to collectivebargaining at the company level andgrants a strong voice to employees.

We consider that employees whoare less mobile and who have a

The top management team ischarged with day-to-day responsibilityfor strategy and operations.

Shareholders exercise their voicethrough their shareholder rights,such as cumulative voting or proxyvoting, but they can also exit the com-pany by selling their shares if they donot agree with globalisation strategiesor other decisions.

Finally, governments set andenforce the overall rules of nationalcorporate governance; they designspecific norms about internationalbusiness, such as trade policies; andthey can selectively intervene in indi-vidual globalisation decisions, such asmoving operations abroad, or subsi-dising a given company because of itsnational strategic relevance. Supra-national governments, such as theEuropean Union, also play a role inregulating corporate governance, theconsultation rights of workers, bank-ruptcy procedures and the like. Weexclude other stakeholders, such ascustomers, suppliers and competitors,because they tend to be less involvedwith corporate governance.

◆ Cross-national differences

Corporate governance systems varyby country, as do the roles and powerof the five corporate governance play-ers. Figure 1 summarises these differ-ences for some major countries andtypes of corporate governance sys-tems: the “Anglo-American” systemsof the US and UK; the “Continental”systems of Germany, France and Italy;and the “Extended” system of Japan.

In the rest of this article, webriefly describe the main characteris-tics of these corporate players acrosscountries and their potential influ-ence on global decision-making.

orporate governancesystems vary acrosscountries, and thesedifferences directlyaffect both the processfor developing globalstrategies and thekinds of strategies thatcan be adopted. In this

article, we examine how different cor-porate governance systems mightinfluence decisions about companyglobalisation and, in particular, deci-sions to take operations abroad.

Global strategy decisions pose avery tough test for the effectiveness ofcorporate governance systems in thatthey seek to maximise profits andglobal competitiveness, often at theexpense, at least in the short term, ofsome corporate governance players.By definition, a global strategy meanstaking a global, rather than a single-country, view of strategy, and this canbe hard for those players with strongties to the company’s home country.Moreover, some aspects of global strat-egy, particularly the overseas reloca-tion of jobs, mean real sacrifices forsome, especially employees.

◆ Players in corporate governance

We identify five critical stakeholderplayers that most affect the company’sdecisions about global strategy:

Employees and their collectiveorganisations, such as unions andwork councils, have various legis-lated, statutory, contractual or negoti-ated rights, such as employmentconditions, that must be considered.

The board of directors is the ultimate governing body of an organ-isation and, as such, it must approveall company strategies, includingglobal ones.

Mastering Corporate Governance4

RUTH AGUILERA & GEORGE YIP

Global strategy faceslocal constraints

Variations in national corporate governance systems andthe degree to which groups of stakeholders influencestrategy decisions can have a substantial impact on a company’s efforts to look beyond its borders

Ruth Aguilera is an assistant professor in theCollege of Business at theUniversity of Illinois. Sheconducts research on comparative corporate governance and cross-bordermergers and acquisitions.ruth-agu@uiuc.edu

George Yip is lead fellowof the Advanced Institute ofManagement Research and aprofessor at London BusinessSchool. He is the author of“Total Global Strategy”(Prentice Hall, 2003) and“Asian Advantage” (PerseusPublishing, 2000). He is writing a book on managingglobal customers. gyip@london.edu

C

system is a source of competitive advantage. A manager in a Continen-tal system faces many constraints,especially from the legal involvementof employees. But, committed employ-ees can also be a major source ofglobal competitive advantage.

In the Continental system, man-agers have to align, trade off and meetother stakeholders’ interests halfway.They have to craft their language andrhetoric to meet the other players’expectations. The watchwords hereare consensus and social cohesion.

In the Extended (Japanese) system,companies have generally capitalisedon their export-oriented model andhigh innovation driven by employeeloyalty. But because of the rigidity oftheir corporate governance system,they have not exploited as much as

they could the different dimensions ofglobal strategy. We would recommendthat the system becomes more open interms of the diversity of the top man-agement team and more flexible intheir governance by introducingleaner boards as well as allowinggreater levels of shareholder activism.

In sum, if governments care to sus-tain national competitiveness and tohelp their companies to globalise,then they should assess the degree towhich the players in their corporategovernance system are aligned witheach other and with their intendedglobal strategies. For example, Francemight need to upgrade its compensa-tion policies to recruit and retainworld-class talent in the top manage-ment teams of its global companies.

Government policies should alsobecome less inimical to foreign own-ers and use such capital to provide themuch-needed global knowledge. Thiscan only be accomplished if the rightmechanisms are in place to give avoice to these foreign owners. Wethink that governments have theresponsibility as well as the policytools to gear the country’s corporategovernance system so that itenhances national competitiveness.

takeovers in many continental European countries continue to makeit difficult for foreign companies tomake acquisitions across borders inEurope. In 2001, plans for a Europeantakeover code, which would guaran-tee the right of shareholders to beconsulted during bids, were shelvedfollowing objections from the Germangovernment. The previous year Voda-fone, the UK telecoms company,made a successful hostile bid for Man-nesmann, a German telecoms com-pany, and the German governmentwas worried that other local compa-nies might fall into foreign hands. Forexample, Volkswagen is protectedfrom takeover by special law and theEuropean code threatened to under-mine this protection. Nevertheless,individual countries, including Ger-many, are now making gradualchanges to make takeovers easier.

Sweden, which falls in the Conti-nental governance model, is one ofseveral countries that use multiplevoting rights to help prevent its com-panies from becoming vulnerable totakeover. The Wallenberg family, forinstance, owns only 7 per cent of Eric-sson, the telecoms company, yet con-trols the company by owning a class ofshares that carries 1,000 times therights of ordinary shares.

France is also particularly activein preserving national ownership ofmajor companies. In 2004, the Frenchgovernment brokered the takeover ofAventis, a French-German pharma-ceutical company, by France’s Sanofi-Synthélabo, while blocking a bid fromSwitzerland’s Novartis. Similarly,France blocked Germany’s Siemensfrom bidding for Alstom’s railwayoperations, which manufacture thehigh-speed TGV trains.

◆ How managers can use their corporate governance systems

Top managers need to recognise thatthey are not in sole charge. Global(and other) strategy is an equilibriumgame among corporate governanceplayers. Managers need to work onbuilding coalitions and aligning inter-ests behind a common approach.

Assuming that you want toimprove your use of global strategy,then how can you do this from thevarious countries? If you are a man-ager in an Anglo-American system,then you are generally in luck. Yourcountry’s corporate governance

stakeholders represented in the upper(supervisory) board, such as employ-ees, industrial banks and suppliers. InNovember 2004, a commission con-vened by BDA, the German employ-ers association and BDI, the industryfederation, concluded that the Ger-man co-determination system hadbecome a hindrance to German com-panies operating internationally anda barrier to inward investment. It rec-ommended changes to the laws,which were last revised in 1976.Under this proposal, individual com-panies would be free to choose a sys-tem of employee representation,taken from three options, rangingfrom retention of the current systemto a looser consultation system sepa-rate from the supervisory board.

France Telecom provides an exam-ple of how board representation can bedistorted by national interests.Although privatised in 1997, FranceTelecom still has significant interven-tion by the French government. Out of15 members of the board of directors,only seven are elected by the share-holders meeting, while three representemployees and five members repre-sent the French government.

The most active boards are in theUK and US, in part due to theenforcement of corporate law. In theUK, the Cadbury Report and subse-quent codes of good governance havehad a great deal of influence indesigning efficient boards. In the US,the Sarbanes-Oxley Act of 2002 hasalso introduced pressure for a higherpercentage of outsiders on boards.

◆ Government

Finally, countries also differ in termsof the degree of government interven-tion in their economies and protec-tionism of their markets. Governmentintervention is usually in the form ofmarket regulation. A representativemeasure for government interventionin the economy is regulation aroundtakeovers. The US and, to a lesserdegree, the UK have weak takeoverbarriers and it is mostly up to individ-ual companies to design anti-takeovermeasures. Conversely, in countriessuch as France, Germany, Italy andJapan, government intervention oftenprovides strong takeover barriers,such as golden shares, which bestowon the holder veto power over changesto the company’s charter.

The various hindrances to hostile

strategies. In the US, more and more companies have or had foreign-bornCEOs, including Charles Bell ofMcDonald’s, who is Australian, E.Neville Isdell of Coca-Cola, who isIrish, and Carlos Gutierrez of Kel-logg’s, who was born in Cuba. There isalso wide acceptance of leaders fromacross borders in the UK – considerAmericans Marjorie Scardino at Pear-son and Rose Marie Bravo at Burberry,Indian-born Arun Sarin at Vodafone,and French-born Jean-Pierre Garnierat GlaxoSmithKline.

Conversely, management teamsdominated by closed labour marketsand ties to government, or foundingor controlling family, will be morereluctant to engage in global strate-gies, mostly due to their preferencefor keeping control domestically. Forexample, Germany’s Bertelsmann,one of the world’s largest media com-panies, is controlled by the Mohn fam-ily. In 2002, the company fired its chiefexecutive, Thomas Middelhoff, forpursuing global expansion strategiestoo vigorously and for what was per-ceived as an abrasive US-styleapproach to management. Middelhoffwas replaced by Gunter Thielen, whohad long-term ties to the Mohn family.

◆ Shareholders

Countries vary in their mix of types ofshareholders. At one extreme, the USand UK have mostly arms-length, neu-tral shareholders, who are focused onshareholder value maximisation.Although many UK shareholders arelarge institutions, such as pensionfunds, these generally play passiveroles, compared with the shareholderactivism that arose in the US amonginstitutional investors such asCalpers. Japan has plenty of institu-tional shareholders, but these tendnot to be neutral and often act as partof a network, or keiretsu, that sup-ports the role of the company and,hence, incumbent management. Ger-many’s main trait is that banks play aleading role in influencing corporatepolicy at many companies, both aslenders and shareholders.

Employee shareholders typicallyuse their ownership to block the globalrelocation of jobs. This applies even inthe US where United Airlines providesa rare example of a large public com-pany with majority ownership by itsemployees (55 per cent owned by anemployee stock ownership plan). Thisemployee stake and, hence, controlhave greatly constrained the ability ofthe airline to relocate jobs overseas.For example, United’s flight atten-dants’ union has been able to blockplans to staff more flights from itslower-cost Taiwan base.

◆ Boards of directors

The composition of boards of directorsalso shows strong contrasts acrosscountries. For instance, Japanese com-panies are renowned for having verylarge and inefficient boards, some-times with more than 50 members.Japanese boards also have very fewoutsiders to monitor managers and thestrategic direction of the company.

Italian and French boards are con-sidered medium-sized, although stillquite inefficient due to the lack of out-siders. Germany is unusual because ittends to have a wide variety of

Mastering Corporate Governance

“Managers need to build coalitions and align interestsbehind a common approach”

5

United States United Kingdom Germany France Italy JapanEMPLOYEES • Flexible labour • Flexible labour • Work councils • Work councils • Long-term contracts • Enterprise union • Low unionisation market • Co-determination • Low unionisation • Rigid labour market • Life-time employment • Employment at will • High skills • Short-term contracts • Medium skills • Medium skills • Non-flexible labour market

SHAREHOLDERS • Institutional investors • Institutional investors • Other non-financial • Foreign investors • State • Other non-financial and individuals • Dispersed companies • State • Families firms • Dispersed • Banks • Banks GOVERNMENT • Liberal policies • Liberal policies • Protectionist policies • Protectionist policies • Protectionist policies • Protectionist policies • Arms-length • Arms-length • Medium takeover • Interventionist • Interventionist • Strong takeover • Weak takeover • Weak takeover barriers • Medium takeover • Strong takeover barriers barriers barriers barriers

BOARDS OF • High activism • High activism • Moderate activism • Moderate activism • Low activism • Low activism DIRECTORS • High % of outsiders • High % of outsiders • Stakeholders as a • Minority outsiders • Large % of insiders • Large % of insiders due to investor determined by law significant minority • Medium size • Medium size • Large size pressure • Medium size

TOP • Professional • Semi-professional • Technical background • Common educational • Non-professional • Common educational MANAGEMENT (Finance/MBA) background • Few foreign-born backgrounds • No foreign-born backgroundsTEAM background • Some foreign-born managers • State links management • No foreign-born • Some foreign-born management • Closed labour markets • Few foreign-born • Closed labour markets management management • Open labour markets (long term) managers (long term) • Closed labour markets • Open labour markets • Closed labour markets (long-term) (long term)

Figure 1 Main characteristics of corporate governance players in six countries

Ratings add fire to thegovernance debate

hat is thisthing called“corporategovernance”that is occu-pying moreand moretime in theboardroom?

Does having more of it create value forstakeholders in the company? Areinstitutional activists, politicians, reg-ulators and media pundits justified intheir efforts to reform it? And are thecostly changes they are proposinglikely to be socially desirable?

Corporate governance clearly mat-ters to shareholders, customers,employees and parties that interactwith the company. Moreover, there islittle doubt that governance mecha-nisms are a necessary and vital part ofeconomic growth and the functioningof a liquid capital market.

The separation of ownership andcontrol that characterises the struc-ture of the corporation means thatmanagers can potentially make self-serving decisions at the expense ofstakeholders. It is therefore importantto put in place a set of mechanisms toconstrain such managerial decisionsin a way that maximises the net bene-fits to stakeholders. As well as givinggeneral protection to stakeholders, anappropriate governance structureshould lead to better performance.

In order to understand whetherthere are indeed net benefits from cor-porate governance, it is necessary totake an agnostic and scientific look atthe data and assess the merits of theclaims made by the business press,ratings agencies and many others. Forexample, are companies with more

independent directors on the board ora separate CEO and chair priced at apremium in the market? And do man-agers of these companies make higher-quality reporting, investing andfinancing decisions?

There is substantial variation ingovernance structures across differentcountries and even across companieswithin a country. One interpretationof this observation is that each com-pany faces a unique set of problemsand costs to institute various mecha-nisms, and thus a different gover-nance structure is optimal. In otherwords, governance should not be con-sidered a “one size fits all” proposition.

By contrast, there is a widely heldbelief among consultants, politiciansand ratings agencies that there is asingle, optimal governance structure,and that any company that deviatesfrom this has a governance problem.This type of “boiler-plate” governance

benchmark is obviously simple toapply. At face value, recommenda-tions such as the appointment of amajority of independent directors tothe board and the separation of theroles of CEO and chair seem reason-able. However, adopting these “boiler-plate” recommendations is a costlyprocess and it is far from clearwhether these changes will producebetter-managed companies as well assatisfy stakeholder objectives.

◆ Measuring corporate governance

Before attempting to assess the impactof governance or managerial decisionson company performance, it is neces-sary to come to grips with how to mea-sure corporate governance. Can acomplex structure of governance bereduced to a summary statistic? Howdoes one go about identifying which of

the myriad governance mechanismsshould be included?

As might be expected, researchersand ratings services use a multitude ofmeasures. For example, the Institu-tional Shareholder Services CorporateGovernance Quotient is based on 61variables and the Governance MetricsInternational Corporate GovernanceScore is based on 450 data points.Regardless of the precise computation,most of the ratings examine factorsrelated to board and committee struc-ture, executive pay, anti-takeover pro-visions, concentration of equityownership and other measures.

Any external assessment of thequality of corporate governance is lim-ited to what can be observed. Thismeans that the majority of measurescaptured by the various ratings agen-cies and academic research is based oncharacteristics, such as board struc-ture and processes, disclosed executivecompensation, distribution of owner-ship, various anti-takeover provisionsand so on.

However, these simple measures donot include insights into the innerworkings of the corporate board.There are no detailed interviews withmanagement and board members toassess whether their objectives areconsistent with stakeholder goals, andno assessment of whether various con-stituencies are directing the rightquestions to top management. As aresult, ratings based on observablegovernance characteristics do notanswer questions such as: “Are thenumber of board meetings, the compo-sition of the board and sub-committees, the age of the directorsand other structural measures suffi-cient to capture the complex nature ofhow an effective board should work?”Yet, these are the types of measuresthat are the focus of the businesspress, customers, employees, investorsand regulators.

◆ Analysis of governance measures

We obtained data from four majorintermediaries that specialise in ratingcorporate governance practices ofcompanies: Governance Metrics Inter-national (GMI), Investor Responsibil-ity Research Center (IRRC),Institutional Shareholder Services

Mastering Corporate Governance6

DAVID LARCKER, SCOTT RICHARDSON AND IREM TUNA

There is a widespread belief thatgood governance ratings generally lead to improved stock market performance. But is there any evidence to back up this assertion?

WMATTHEW HERRING

Scott Richardson is an assistant professor at theWharton School of theUniversity of Pennsylvania.

David Larcker is the Ernst &Young professor of accountingat the Wharton School of theUniversity of Pennsylvania.

Irem Tuna is an assistant professor at the WhartonSchool of the University ofPennsylvania.

How do you say corporate

governance in Djibouti?

It’s hard enough to know what you’re

getting into with mergers and

acquisitions in your own country. But

what about when your new affiliate is

based in Tadjoura? Or Turkmenistan?

Or the Côte d’Ivoire? Just how much

do you know about their corporate

governance regulations?

Today, it’s as important to know

business regulations abroad as it is at

home. Can your business deliver good

governance across 42 different offices

in 29 different countries? Ignorance

simply isn’t an excuse. The penalties

for an innocent mistake can be severe.

As the world continues opening up to

more and more opportunities, at Ernst

& Young we think it’s critical that

people start talking about conformance

and the impact the many other aspects

of corporate governance are having on

the way they do business. Whether

governance regulations are central or

marginal to your investment decisions,

we believe it is an essential debate

to have.

Effective corporate governance can

lead to better controls, better market

understanding, and ultimately, better

performance. At Ernst & Young we

believe a proper dialogue with all

stakeholders is the key ingredient to

delivering that value. And we think

that’s a conversation worth having.

But if that’s something you’re not

interested in, just remember

“ ”. That’s “not guilty”

in Arabic. Just in case.

To carry on the conversation, visit us at

www.ey.com/conformance

(ISS) and The Corporate Library(TCL). For each of the agencies, weanalysed the association between theirratings, and subsequent companyoperating performance and stockreturns. A potential benefit of thesemeasures is that they presumablyreflect not only formal structural mea-sures of governance but also theexpertise of the analysts working forthe ratings agencies.

Overall, the results of our analyseswere similar regardless of the sourceof the ratings. We found no evidencethat the summary ratings were associ-ated with stock returns. Alternativelystated, an investment strategy basedon the governance ratings was not aprofitable one. We did, however, findsome evidence that governance rat-ings are associated with the level offuture operating performance. The

results for operating performancewere strongest with data from TCL, sowe explain the analysis of these spe-cific ratings in more detail below.

The analysis for the TCL data wasdrawn from 2,012 companies for theperiod 2002-2004. The overall TCL“board effectiveness” rating is basedon the following components: boardcomposition, CEO compensation,shareholder responsiveness, account-ing quality, strategic decision-making,litigation problems and takeoverdefences. Thus, the TCL ratingappears to be a relatively comprehen-sive and broad-based measure of cor-porate governance.

Each of the components is given arating between A and F, and the com-bination of the categories also yieldsan A-F overall score for board effec-tiveness. Companies receiving an A, B

or C grade are considered to be have“good” governance and those with a Dor F rating to have “bad” governance.

We utilised the discrete (good ver-sus bad) distinction in the TCL ratingsand examined stock price performanceafter issuance of their reports. Theanalyst reports are compiled after theend of each proxy season. To ensurethat the information in the reports isavailable to investors, we tracked the

Mastering Corporate Governance8

“There is still a strong interest fromequity investors in the governancerisk of their portfolios”

suggests that there is not much evi-dence supporting recent claims thatgovernance is associated with perfor-mance.

A limitation of our analysis is thatwe have only used overall scores. Fur-thermore, these governance ratings aresomewhat unsophisticated aggregatesof multiple measures of governancestructures. To address this limitation,we conducted our own study on therelation (or lack thereof) between cor-porate governance and company value.This involved a detailed statisticalanalysis of 2,106 US companies with fis-cal years ending between June 2002 andMay 2003. Our sample spans many sec-tors of the economy and represents over70 per cent of the market capitalisationof the Russell 3000 as of the end of 2003.

In order to be included in our sam-ple, we required companies to haveavailable data (much of which was pro-vided by TrueCourse Inc. and EquilarInc.) on the characteristics of the boardof directors, stock ownership by execu-tives and board members, stock owner-ship by institutions, stock ownership byactivist holders, debt and preferredstock holdings, compensation mix vari-ables and anti-takeover provisions. Inall, we used 39 different structural mea-sures of corporate governance. There issubstantial overlap between the mea-sures that we use and those used by theratings agencies.

Using a variety of statistical tech-niques, we assessed whether these 39measures actually explain differencesin managerial behaviour and organi-sational performance. We found thatcompanies with a lead director experi-enced higher stock returns. Similar tothe analysis with the governance rat-ings, we did not find any associationbetween our governance measuresand changes in operating perfor-mance. We did, however, find evi-dence that companies with activistshareholders, more accounting-basedincentive compensation and withoutpoison pills and staggered boardsexperienced a higher level of operat-ing performance in fiscal 2003.

What is most interesting about ouranalysis is that, of the 39 governancemeasures examined, only a small frac-tion was connected with the level ofoperating performance and, often, thedirection of the associations was unex-pected. For example, companies withlarger boards and more control by insid-ers via dual class stock and fewer out-siders on the board exhibit a higherlevel of operating performance.

Overall, our results imply either thatcorporate governance is of modestimportance (which is difficult tobelieve) or that the available structuralindicators and ratings are not especiallyuseful for measuring it.

◆ Discussions with asset managers

We also interviewed several leadingportfolio managers representing largeactively managed US and internationalequity portfolios about their evaluationof governance ratings. We received con-sistent reports that measures of gover-nance are not effective in generatingexcess returns (or alpha) for equity port-folios. These responses are likely toreflect several issues. First, as we dis-cussed above, governance is a multi-dimensional construct that is difficult tomeasure and reduce to a summary

stock performance from July 1 in theyear that the rating is disseminatedthrough to June 30 the following year.TCL’s analysts conduct their analysisin conjunction with other sources dur-ing the proxy season period (up to themiddle of 2003 for the 2002 fiscal year).Therefore, examining stock returns forthe period of July 1 2003 through toJune 30 2004 will capture the 12-monthperiod following the issuance of theTCL rating. We repeated this processfor the three years for which we havedata and rebalanced the portfoliosevery year on July 1.

In Figure 1, we illustrate the aver-age returns that would have beenearned for $1 invested in companieswith “good” ratings for board effec-tiveness and those with “bad” ratings.As is evident from our analysis, thereis very little difference in the returnsto an equity investor based on the TCLboard effectiveness rating. Indeed, sta-tistical tests revealed no differencebetween the two portfolios. We founda similar lack of stock return pre-dictability for the composite ratingsfrom GMI and ISS, as well as theshareholder rights provisions collectedby IRRC.

A potential explanation for thestock return results is that the marketcorrectly anticipates the future perfor-mance of “good” and “bad” gover-nance companies, and thus thereshould be no differential stock pricereturns for these two groups. How-ever, if governance is important to per-formance, we should be able to detectperformance differences using mea-sures of operating performance. Thus,a more direct way to assess perfor-mance is to see whether “good” gover-nance companies have higher returnon assets (that is, the ratio of operat-ing income to total assets).

In our research, we examined theability of the TCL board effectivenessratings to predict both the change inand the level of one year-ahead returnon assets. Consistent with our stockreturn results, we found no evidencethat the TCL board effectiveness rat-ing is associated with change in oper-ating performance. We did, however,find some evidence that companieswith “good” TCL ratings have a higherlevel of operating performance in theyear following the release of the ratingrelative to those with “bad” ratings.Companies receiving a “good” TCLrating experienced higher return onassets in the order of 1.5 per cent inthe year following the release of theboard effectiveness rating.

Collectively, the evidence suggeststhat there may be a modest associa-tion between governance scores andfuture operating performance, but thisassociation does not translate intofuture company value (as measured bychanges in stock price).

While not necessarily damning ofmeasures of governance, the lack of arobust pattern between popular gov-ernance ratings and future perfor-mance should raise questions aboutthe assertion that governancechanges will improve shareholderreturns. Of course, the time period weexamined for these ratings is quitelimited (July 2002 through to Decem-ber 2004), and it may take a longerperiod for the valuation effects of gov-ernance to materialise. Nevertheless,our empirical analysis is based on themost current data and collectively it

statistic. The failure to find an associa-tion with stock returns may simplyreflect measurement error. Second,there is only a limited period for whichgovernance ratings are available andthis makes it impossible to do the typeof back-testing that quantitative equitymanagers typically undertake. Third,the signals that these portfolio man-agers are already using in their assetallocation decisions may be subsumingany ability of the governance measuresto predict future returns. Finally, formeasures of governance to be associ-ated with future stock returns, it mustbe the case that these measures providepredictive information that is notpriced by the market in a timely andefficient fashion.

Although governance ratings havebeen given a very lukewarm receptionby some leading actively managedequity funds, there is still a stronginterest from equity investors in gov-ernance risk of their portfolios. Portfo-lio managers at some of the larger USpension plans, such as TIAA-CREFand Calpers, have been strong advo-cates of governance reform. Indeed,their proxy voting has been signifi-cantly influenced by perceived gover-nance crises. The ratings agenciesthemselves are selling ratings andgovernance advice to a broad base ofclients including institutionalinvestors. The fact that there are buy-ers for these ratings must mean thatthere is some value to having accessto this information. However, thevalue of these ratings is not related totheir ability to predict future companyperformance.

◆ Conclusions

The relation between corporate gover-nance and organisational perfor-mance is of fundamental importance.As might be expected, many conjec-tures about the features of superiorcorporate governance have beenadvanced. In addition, various governance-rating schemes have beenproposed as the basis for the design ofgovernance structures. While theseideas make for interesting discussion,there are few compelling results thatclearly demonstrate how corporategovernance produces the outcomesdesired by stockholders or, morebroadly, stakeholders. Thus, there islittle evidence that the costly gover-nance changes that are currentlybeing imposed on companies will pro-duce expected net benefits in terms ofimproved performance.

We certainly believe that appropri-ate governance mechanisms are a nec-essary and vital part of a capitalisticeconomy. However, we have consider-able concern about whether any of theexisting structural measures of gover-nance or governance ratings provide auseful basis for identifying good gover-nance. Before imposing some gover-nance structure on a company, it seemsnecessary to verify scientifically thatthe changes are likely to produce theexpected outcome. This statement, ofcourse, assumes that we are interestedin learning about the value that can beproduced from making costly changesto governance mechanisms. If instead,the debate continues to rage based onrhetoric, we should be aware thatcostly policy decisions are being madewithout a careful and rigorous analysisof the data.

“Good” governance portfolio

“Bad” governance portfolio

1.8

1.6

1.4

1.2

1

0.8

0.6

0.4

0.2

0

Jul 02

Dec 02

Jun 03

Jun 04

Dec 03

Dec 04

Cum

ulat

ive

retu

rn

Figure 1 Return to $1 invested in companies with "good" and "bad" governance

Avoiding the issue?

Corporate governance isn’t a simple

subject. And as we all know, when faced

with a difficult matter, the tendency

is to not talk about it. The problem is,

when it comes to corporate governance,

communication is essential – both

internally and externally.

According to a recent study, there is a

clear connection between the quality

of a company’s earnings and financial

transparency and its corporate

governance practices. Meanwhile, the

Financial Standard Authority say that as

many as 50% of UK FTSE companies

have not communicated the full impact

of reporting under International

Financial Reporting Standards to their

shareholders. How can you make sure

every single stakeholder is aware of

exactly what is at stake? Are you

telling your shareholders what they

need to know?

We think it’s time people started asking

questions about their communication

strategy, and talking about the impact

of the many other aspects of corporate

governance on the way they do

business. Effective corporate governance

can lead to better controls, better

market understanding, and ultimately,

better performance. At Ernst & Young

we believe a proper dialogue with all

stakeholders is the key ingredient

to delivering that value. And we think

that’s a conversation worth having.

For more insights, visit us at

www.ey.com/communication

measures, to holders of options andWall Street analysts. Earnings man-agement efforts require co-operationalong reporting lines, and will ofteninvolve boards and senior manage-ment at some level. Testifying in therecent trial against Bernie Ebbers, for-mer chief executive of WorldCom,Scott D Sullivan, the company’s for-mer chief financial officer, admittedthat he “falsified the financial state-ments to meet analysts’ expectations”.And as a lower-level former WorldCom employee, who was jailedfor fraud, observed: “When boardsopen the door a crack to unethicalbehaviour . . . then it leaves a lot ofinterpretation for everyone down theline.” In this respect, it would seemthat the title of Bob Garratt’s 2003book, The Fish Rots from the Head,may be an accurate metaphor.

Regulators began paying seriousattention to the use of earnings man-agement techniques in the 1990s,when the market’s short-term focusand the importance to management ofincreasing the value of stock optionsand share prices swayed companies touse them more widely. In 1998, at anaddress at New York University, thethen-chairman of the Securities andExchange Commission, Arthur Levitt,spoke of the emergence of a “grey areawhere the accounting is being per-verted; where managers are cuttingcorners; and where earnings reportsreflect the desires of managementrather than the underlying financialperformance of the company.” Hereferred to the following techniques,which were being used by some com-panies inappropriately to manageearnings in response to analyst andmarket pressure:

● Deliberately overstating one-time “big bath” restructuring chargesto provide a cushion to satisfy futureWall Street earnings estimates;

● Misusing acquisition account-ing, particularly improper write-offsof acquired in-process research anddevelopment, to overstate futureearnings inappropriately;

● Over-accruing charges for itemssuch as sales returns, loan losses orwarranty costs when the company isprofitable and using those reserves tosmooth future earnings when thecompany is not so profitable – knownas “cookie jar reserves”;

● Prematurely recognising rev-enue – for instance, before a sale iscomplete, before a product is deliv-ered to a customer or at a time whenit is possible that the customer maystill terminate, void or delay the sale;

● Improperly deferring expensesto improve reported results;

● And misusing the materialityconcept to mask inappropriateaccounting treatment.

Mr Levitt asked the New YorkStock Exchange and the NationalAssociation of Securities Dealers tocreate a committee to study inten-sively audit committee effectivenessin discharging their oversight respon-sibilities and then make recommen-dations aimed at improving USpractices. I co-chaired the committee,along with John C Whitehead, formerDeputy Secretary of State and retiredco-chairman and senior partner ofGoldman Sachs. We drew on previousstudies and gathered input from reg-ulators and members of the business,accounting, legal and academic

in a quarter). Others might includenot replenishing inventories, or forfinancial organisations, selling securi-ties for a gain or loss during a periodof high or low earnings. As you getcloser to the line between legitimateand less legitimate, some companiesopt for disclosure.

The line between appropriate earn-ings management techniques and“cooking the books” can be a blurryone, notwithstanding the plethora ofdetailed rules that are currently inplace to deter malfeasance. If auditcommittees fail to make this distinc-tion, further intrusive regulationcould follow.

There will always be a temptationto manage earnings inappropriatelybecause meeting projections and“guidance” suits everyone, from exec-utives whose compensation may bebased on earnings-driven performance

“Earnings management” includesboth legitimate and less than legiti-mate efforts to smooth earnings overaccounting periods or to achieve aforecasted result. It is the responsibil-ity of the audit committee membersto identify, by appropriate question-ing and their good faith judgment,whether particular earnings manage-ment techniques, accounting esti-mates and other discretionaryjudgments are legitimate or operateto obscure the true financial positionof the company.

Examples of legitimate earningsmanagement efforts include postpon-ing an acquisition or a disposal ofassets or other transaction until alater period, or otherwise acceleratingexpenses when earnings are high andpostponing expenses when earningsare low (for example, by acceleratingor deferring advertising expenditures

he polestar of theaudit committee isshifting – rather thanfocus exclusively onmechanics, structuresand controls (whichare necessary but notsufficient), it is turn-ing towards the over-

riding policy issue, namely whether ornot financial disclosure presents a“true and fair” view of the company’sstate of affairs. Faced with intensepressure to meet earnings estimatesfrom analysts and investors, execu-tives at many companies use a varietyof “earnings management” techniquesto help them “make the numbers”.These techniques will frequentlyexploit loopholes in generally acceptedaccounting principles (GAAP) tomanipulate deliberately the com-pany’s revenues.

Mastering Corporate Governance10

IRA MILLSTEIN

T

NEIL WEBB

When earnings managementbecomes cooking the booksThe line between legitimate and inappropriate accounting techniques can be ablurry one, but the audit committee must endeavour to make a clear distinction

controls and compliance with account-ing rules. However, this approachdeals inadequately with the fact thatquestionable earnings managementcan still occur within a sound networkof internal controls and within theboundaries of GAAP. Recent restate-ments by companies such as KrispyKreme, Nortel, Fannie Mae and SunTrust Bank, combined with theincreasing number of fraud-relatedenforcement actions, indicate thataccounting irregularities are still rela-tively commonplace. Pressure to“make the numbers” is still being felt– for instance, the stock prices of Ama-zon and eBay dropped 16 per cent and19 per cent respectively in recentmonths after the performance of thosecompanies failed to match forecasts.

Rather than focus exclusively onprocess and mechanics, it is importantto bring attention back to the sub-stance of financial reporting or riskeven more regulation. The audit com-mittee has a key role to play in thisprocess by focusing committee mem-bers on looking beyond GAAP whenevaluating discretionary judgments.

Guidance as to how to achieve thismay be gleaned from the approachtaken in the UK. The United King-dom’s Companies Act of 1985 requiresdirectors to prepare accounts for eachfinancial year that give a “true andfair view of the state of affairs of thecompany” (sections 226 and 227).Directors of listed companies mustalso comply with the Combined Coderequirement to “present a balancedand understandable assessment of thecompany’s position and prospects”(Code provision D.1), or explain whycompliance has not been achieved.

The annual report of a companylisted in the UK will include a state-ment signed by the board. This out-lines the responsibility of thedirectors to prepare accounts thatgive a true and fair view of the stateof the company, confirms that suit-able accounting policies have beenused, and states that reasonable judg-ments and estimates were made. Theadvantage of the UK model is that itsquarely focuses board attention onthe integrity of financial reports,compared with the more limited roleof the management certificationapproach recently adopted in the USunder section 302 of the Sarbanes-Oxley Act.

Although useful, the UK approachis not suitable for wholesale adoptionin the US due to the differently con-stituted nature of UK boards, whichusually include many company man-agers who are knowledgeable aboutthe details. Moreover, as noted above,directors in the UK are responsiblefor preparing the accounts, in con-trast to the US, where managementprepares the accounts under thedirection of the board.

However, a US audit committeecould achieve a similar result byrequesting assurance from the outsideauditor that the report gives a trueand fair view of the state of affairs ofthe company, and that reasonable andprudent judgments and estimateshave been made, especially regardingrevenue recognition, expenses andother items that may involve earningsmanagement. This will bring the focusback to quality and fairness in sub-stance, and beyond mechanics andstructure. Audit committee members

communities to produce our February1999 report entitled “Improving theEffectiveness of Corporate AuditCommittees”.

The report focused on the reformsthat were needed to ensure “disclo-sure, transparency and accountabil-ity”. We recommended that generallyaccepted auditing standards requirethe outside auditor to discuss with theaudit committee the auditor’s judg-ments about the quality, not just theacceptability, of the company’saccounting principles as applied in itsfinancial reporting.

The report also emphasised that thediscretionary nature of much financialaccounting work means that there can-not be a “one size fits all” solution topreventing accounting irregularities. Itencouraged each audit committee tothink deeply about its role and todevelop its own guidelines to assistwith supporting and monitoring bothresponsible financial disclosure andactive oversight. The NYSE and theNASD embraced many of the sugges-tions set out in the report, by mandat-ing that they be included in auditcommittee charters. However, thoserules do not require audit committeesspecifically to think about earningsmanagement and the resultant abilityto move financial disclosure away froma true and fair representation of thestate of the company.

Many of our recommendations werebeginning to be put in place before theSarbanes-Oxley Act was enacted, butprivate sector reform did not happenfast enough. Companies such as Enronand WorldCom continued to engage inimproper earnings management tech-niques such as those outlined above,and worse. The private sector’s failureto adopt reforms voluntarily led to thebulk of our recommendations eventu-ally being enshrined in regulations,rules and practices by the SEC, theNYSE, the NASD and prosecutors.

Broadly, NYSE and NASD listingrules now require audit committeesto adopt a formal written charter andbe comprised solely of “independent”and “financially literate” directors,including at least one member withspecial expertise. In addition, SECregulations require the outside audi-tor to report to the audit committeeall critical accounting policies andpractices that are to be used anddetails of the alternative treatmentsof financial information withinGAAP that have been discussed withmanagement.

SEC regulations also require theaudit committee to prepare a report forinclusion in the company’s annualproxy statement, outlining whether ithas reviewed and discussed theaudited financial statements with man-agement, discussed audit difficultiesand accounting adjustments with theoutside auditors, and recommended tothe board that the audited financialsbe included in the annual report. More-over, professional standards set by thePublic Company Accounting OversightBoard require the outside auditor todiscuss with the audit committee cer-tain information relating to the audi-tor’s judgments about the quality, notjust the acceptability, of the company’saccounting policies.

The enactment of the Sarbanes-Oxley Act, and section 404 in particu-lar, has increased attention on processand mechanics, such as internal

Mastering Corporate Governance

Ira Millstein is a senior partner at the internationallaw firm Weil, Gotshal &Manges and the Eugene FWilliams Jr visiting professorin competitive enterpriseand strategy at the YaleSchool of Management. Healso serves as chairman ofthe private sector advisorygroup to the GlobalCorporate GovernanceForum founded by theWorld Bank and theOrganisation for EconomicCo-operation andDevelopment. ira.millstein@weil.com

11

can, in good faith, question the outsideauditor about discretionary judgmentsresolved in management’s favour toeffect a better earnings picture bothcurrently and looking forward,notwithstanding compliance withGAAP.

The audit committee shouldencourage the outside auditor to becandid and prepared to risk manage-ment displeasure. Anecdotal evidencesuggests that outside auditors, nowdirectly employed by the audit com-mittee, are increasingly comfortablewith challenging management. Forexample in January, outside auditorsat Eastman Kodak issued an “adverseopinion” citing “material weak-nesses” in the company’s internalfinancial controls for 2004.

This increased dialogue betweenaudit committees and outside auditorsin the quest for quality financialreporting should be the next majorstep in the long road of audit commit-tee improvement. Audit committeeshave been evolving in the US since thelate 1930s and early 1940s, but did notemerge as a major feature of large cor-porations until the 1970s, after finan-cial manipulation led to the collapse ofPenn Central – then the largest rail-road company and sixth-largest indus-trial corporation in the US. An SECinvestigation that followed the col-lapse specifically criticised the outsidedirectors’ passivity and lack of finan-cial acumen, as well as the dearth ofopportunities for outside directors toengage in discussions among them-selves. The investigation also revealedwidespread inappropriate financialreporting practices.

These shortcomings ushered inthe audit committee as a corporatemainstay. In a 1972 release, the SECrecommended “the establishment byall publicly held companies of auditcommittees composed of outsidedirectors.” Then, Stanley Sporkin,director of enforcement at the SEC,began to insist that companies estab-lish audit committees comprised ofoutside directors as a condition to set-tling enforcement proceedings.

In 1974, the SEC required issuersto disclose in their proxy statementswhether they had an audit committeein place and, if so, to state the namesof the committee members. Finally, in1977, the NYSE issued rules requiringall listed companies to establish auditcommittees “comprised solely of direc-tors independent of management andfree from any relationship that . . .would interfere with the exercise ofindependent judgment.” The NASDfollowed suit with rules requiring Nasdaq-listed companies to establishaudit committees comprised of amajority of independent directors.

At this initial stage, outside

directors satisfied the then-prevailingdefinition of “independence,” whichwas far less rigorous than the currentstandard. Since then, our report, theNYSE and NASD listing rules, the Sar-banes-Oxley Act and SEC regulationshave further refined audit committeerequirements.

The development of requirementsfor independent audit committees inthe UK and continental Europe hasgenerally lagged behind the US. Inthe UK, audit committees comprisedof non-executives were recom-mended in the 1992 Cadbury Report.This recommendation has sincebecome part of the Combined Code,according to which UK listed compa-

nies are required to “comply orexplain”. In continental Europe,audit committee requirements gener-ally have not developed to the sameextent, although many Europeancodes of best practice recommendthat independent audit committeesbe established.

The current wave of reforms inthe wake of recent scandals hasnecessitated audit committee mem-bers training the bulk of their atten-tion towards mechanics andstructural improvements. However,it is clear that technical compliancewith GAAP is not, by itself, enoughto ensure quality and fairness infinancial reporting.

Audit committee members shouldnow take a step back from the detailand refocus on ensuring that the sub-stance of financial reports is true andfair, and reflects the performance ofthe company. To achieve this, auditcommittees should select outsideauditors with whom open and candiddialogue can take place in relation toearnings management. Committeemembers should view the outsideauditor as an information resource sothat inappropriate earnings manage-ment practices can be either vetoedor ferreted out before the booksbecome “cooked”. This approachshould reverse the trend of restate-ments and corporate fraud, andresult in a higher degree of integrityassociated with financial reporting. Ifthis happens, we may ward off evenmore regulation.

“It is important to bring backattention to the substance offinancial reporting or risk evenmore regulation”

Week 1 May 20● Introduction● The role of the CEO● Shareholder activism● Governance decisions

Week 2 May 27● Board composition● Governance and global strategy● Corporate governance and performance● Role of the audit committee

Week 3 June 3● Corporate social responsibility● Mergers and acquisitions● Family businesses● Executive compensation

● Governance in emerging markets

Week 4 June 10● Board performance evaluations● Diversity in the boardroom● The role of non-executive directors● Risk management● Governance and non-profits

Your guide to Mastering Corporate GovernanceEditor: Rob MitchellDeputy editor: Ravi Mattu Design: Tony MullinsBusiness development executive: Kate HarrisCover illustration: Alastair TaylorDirector: Richard Fosterwww.ft.com/masteringcorporategovernanceBack issues +44 (0)20 8763 6363 or e-mail: ft@remember-when.co.ukBooks of previous FT Mastering series:all good bookshops or +44 (0)1279 623928

We think it’s critical that people start

talking about their control procedures

and the impact the many other aspects

of corporate governance are having on

the way they do business. Effective

governance can lead to better controls,

better market understanding, and

ultimately, better performance. At

Ernst & Young we believe a proper

dialogue with all stakeholders is the

key ingredient to delivering that value.

And we think that’s a conversation

worth having.

To carry on the conversation, visit us at

www.ey.com/change

How much detail do you give

your stakeholders?

It’s easy to take internal controls for

granted. When you’ve got clients to

cater for and shareholders to please,

they’re often the last item on your

agenda. But there are some very serious

questions that need to be asked.

Should your internal controls be narrow,

but deep, or broad, but shallow? The

cost of detailed processes can be

extremely high – so what value does this

kind of internal control create? How can

you monitor any return on investment?

How can improving the controls on

what you did help improve what you do

in the future?

Companies are currently spending

on average, $8 million each every

year on internal control reviews in

response to Section 404 of Sarbanes-

Oxley. And our research shows that

ongoing expenditure could be as

significant – as much as 75% of the

first year’s implementation costs. Is

your organisation ready?