BOARD DUTIES
LEMBAGA KOMISARIS DAN DIREKTUR INDONESIA
Disusun oleh :
Mas’ud Machfoeds
TABLE OF CONTENTS
TABLE OF CONTENTS................................................................................ i
MASSAGE FROM CHAIRMAN AND EXECUTIVE DIRECTOR LKDI..ii
PROFILE LKDI.................................................................................................iii
BAB I BASIC CONSEPTS
A. Development of Corporation...........................................................2-6
B. Agency Theory................................................................................. 6
C. The Complexity of Relations in a Modern Corporation....................8
D. Summary.........................................................................................8
BAB II TUGAS DEWAN KOMISARIS
A. Anticipation, Advocation, Autonomi, Accountability,
Advice, Assitance............................................................................ 11-18
B. Summary.........................................................................................18
BAB III BOARDS RESPONSIBILITY
A. Accountability.................................................................................. 22
B. Information Transparency.................................................................23
C. Shareholder Voice Function............................................................. 24
D. Empirical Studies of Boards’ Responsibilities..................................24
E. Summary......................................................................................... 28
BAB IV EMPOWERING THE BOARD
A. Demand for Empowering................................................................32
B. Invalid Asumptions About Empowering Directors...........................33
C. The Sources and Limit of Directors Power...................................... 34
D. Theory of Friendly Boards................................................................36
E. Summary......................................................................................... 37
BAB V THE NEW TOOLS FOR BOARD
A. The Elements of a Strategic Audit................................................... 40
B. Summary.........................................................................................43
BAB VI AUDIT COMITEE AND OTHER SUPPORTING COMMITEES
A. Financial Reporting...........................................................................46
B. Others Supporting Commitees........................................................50
C. Summary.........................................................................................53
CASE STUDIES.............................................................................................. 55
BIBLIOGRAPHY............................................................................................. 59
LEMBAGA KOMISARIS DAN DIREKTUR INDONESIA
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MASSAGE FROM CHAIRMAN AND
EXECUTIVE DIRECTOR LKDI
L
embaga Komisaris dan Direktur Indonesia (LKDI) dibentuk pada tahun 2001
dengan tujuan untuk menjadi wadah bagi para komisaris dan direktur dalam
meningkatkan kompetensi, pengetahuan dan integritas dalam menerapkan
prinsip-prinsip good corporate governance (GCG). Untuk itu sejak awal
tahun 2005, LKDI secara intensif telah menyelenggarakan program “Training and
Directorship Certification for Commissioners and Directors”. Disamping itu LKDI juga
menyelenggarakan program pendidikan profesional berkelanjutan bagi para komisaris
dan direktur yang muatannya menekankan pada pembelajaran masalah-masalah yang
fundamental dan mutakhir berkaitan dengan praktek GCG terkini baik di tingkat nasional
maupun internasional.
Dalam upaya meningkatkan kualitas program “Training and Directorship Certification for
Commissioners and Directors”, LKDI menerbitkan modul yang didukung pelaksanaannya
oleh Center for International Private Enterprises (CIPE) yang berkedudukan di Amerika
Serikat. Dukungan CIPE ini merupakan bagian dari suatu kerjasama dengan LKDI
dalam melaksanakan serangkaian program yang bertajuk “Strengthening Corporate
Governance in Indonesia”.
Modul tersebut merupakan acuan bagi para fasilitator dan peserta program pelatihan
LKDI sehingga menjadi suatu referensi yang telah terstandarisasi dengan perbandingan
pada kurikulum program kedirekturan yang juga diselenggarakan oleh UK Institute
of Directors, Australian Institute of Company Directors, dan Singapore Institute of
Directors.
Pada tahap pertama ini, LKDI menerbitkan lima modul yaitu: “GCG Concepts, Principles
and Practices”, “Boards’ Duties, Liabilities and Responsibilities”, “Enterprise Risk
Management”,“Corporate Social Responsibility”,dan “High Quality Corporate Reporting”.
Penyusunan modul-modul tersebut dilakukan oleh para akademisi senior yang tergabung
dalam Academic Network Indonesia on Governance (ANIG) yang dibentuk dan berada
dibawah naungan Komite Nasional Kebijakan Governance (KNKG).
Akhirnya LKDI mengucapkan terimakasih kepada CIPE, KNKG dan ANIG atas
dukungannya dalam penerbitan modul pelatihan ini, dengan harapan kerjasama yang
baik ini akan dilanjutkan dalam rangka melaksanakan program-program penguatan GCG
di Indonesia.
Salam hormat,
Hoesein Wiriadinata
Ketua
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BOARD DUTIES
Antonius Alijyo
Executive Director
LEMBAGA KOMISARIS DAN DIREKTUR INDONESIA
LKDI Profile
D
irectors and Commissioners have strategic role in successful implementation
of Good Corporate Governance. The crisis of 1997 brought valuable lessons
for Indonesia as it has shown beyond any reasonable doubt fragility of
economic structure and prevalence of irregular corporarte practices.
However it is very encouraging that many companies have taken the initiative to
reform themselves toward better governance.
To ensure business sustainability and to cope with international governance challenge, it
is important that Directors and Commissioners are competent and empowered in order
to efectively complete their responsibility. Based on that comprehension, Lembaga
Komisaris dan Direktur Indonesia – LKDI (Indonesian Institute for Commissioners and
Directors) was established by the National Committee on Governance in 2000. It was
founded by notarial act of Notary Imas Fatimah, SH No.10 on July 6, 2001.
LKDI was aimed to enchance the quality of members who become the avant garde of
corporate governance practices by providing networking opportunities and continous
professional education programs.
Founder : National Committee of Corporate Governance
Advisor : Mar’ie Muhammad
Advisory Board
: Amrin Siregar Kartini Muljadi
Gunarni Soeworo Ratnawati Prasodjo Mas Achmad Daniri
Executive Board
: Hoesein Wiriadinata (Chairman)
Eva Riyanti Hutapea (Vice Chairperson)
Fachry Aly
Fred B.G.Tumbuan
Jos F. Luhukay
Partomuan Pohan Irwan M. Habsjah
Adi Rahman Adiwoso
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CHAPTER 1
BASIC CONCEPTS
B
oard of Directors is a term used in the United States to collectively
describe a company’s supervisors and managers, consisting of majority
shareholders, the company’s founders, major creditors, and people
employed by the company. The model of American corporate structure
is illustrated in figure 1-2. It is a one-tier system. From among the members of the
board of directors, at least two will be elected to the positions of chief executive
officer (CEO) and chief financial officer (CFO). Often, a third is elected to the position
of chief operating officer (COO). Unlike the American model, the European model
follows a two-board system (see figures 1 and 2), such as is adopted in Indonesia.
In this two-tier system, shareholders appoint a group of managers to operate the
company (management) and a group o management supervisors and advisors, who
are referred to as commissioners. This concept of corporate supervision developed
over time as companies and their ownership expanded.
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Development of Corporations
Supervision and operation of companies started to get complicated with the industrial
revolution in Europe in the 18th century, and later that century in the United States,
with the introduction of public ownership (Hendriksen 1995, p 18). Prior to that, most
companies were owned and supervised by families. Management and supervision in
a family-owned company lay in the hands of one person: the owner. This managementowner system was neither complex nor complicated.
Public ownership was introduced for the first time in Europe in the 16th century, with
the establishment of a company called South Sea Limited Inc. This company was
involved in the slave trade, transporting slaves from Africa to be sold in the slave
markets in London. In need of substantial funds, the company began offering shares
to the royal family and to members of parliament. Public companies meant public
ownership, and a market was needed to operate trade in shares. So, the world’s first
stock market, the London Stock Exchange, was born in 1873.
With the export of the industrial revolution from Europe to America came the first
corporation, the Santa Fe railroad company. In need of massive funding, the company’s
founders invited the public to own shares in the company by purchasing stocks, which
sparked the idea of setting up the world’s second stock exchange. The New York Stock
Exchange began operations in 1892.
Following the introduction of corporations, both in America and in Europe, supervision
and operation of companies became increasingly complex and complicated. In
America, the company’s founders and controlling or majority shareholders, and the
company’s major creditors would decide who would supervise and decide on the
company’s strategic direction. So, the company’s founders, majority shareholders,
major creditors and representatives of minority shareholders formed a group of
company supervisors and controllers, which was called the board of directors. From
among the members of the board of directors, two or three were elected to hold the
positions of chief executive officer (CEO), chief financial officer (CFO), and, in many
cases, chief operating officer (COO). The CEO in turn would choose several people as
senior managers who would be part of a management team under the command of
the CEO. This is what is referred to as one tier management.
The European, two-tier management model divides corporate power between two
groups of managers. The first is called the board of commissioners, which is chaired
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by a president commissioner or chief commissioner; and the second is the board of
management, which is chaired by a managing director. These two boards are elected
by a general meeting of shareholders. The board of commissioners has the job of
supervising and advising, and its members are appointed by the majority and minority
shareholders and management (the two-tier model is shown in figure 1-2).
Figure 1-1 shows the contractual relationship between the principals and agents. The
principals are the company’s owners and founders; the agents are management. Under
these conditions, the principal-agent contract is in fact between the chief executive
officer and the managers and employees, not between the board of directors and the
chief executive officer.
Conflict between agents and principals will lead to opportunistic behaviour at the
expense of the owners. Minority stockholder representation is very limited. To
protect the rights of stockholders requires a person with no direct association with
management and stockholders, an independent director.
Brown and Caylor (2006) analysed the relationship between good corporate governance
and company operating performance. Samples were taken from 1,757 firms. The
presence of independent directors, audit committee and nomination committee in
a company were associated with high return on equity and return on assets. This
suggests that independent directors play a part in adding value to the company. The
greater the number of independent directors, the better one would expect corporate
governance to be in terms of protecting stakeholders’ interests.
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Common stockholders
Public shareholders
Institutional Investors
Large Block Holders
Other Corporations
BOARD OF DIRECTORS
Creditors:
lFinancial Institution
lBond Holders
CEO
Managers And Employees
Suppliers
Customers
Government :
lLocal
lState
lNational
lForeign
Source: Fred R.Kaen, p. 18
Figure 1-1. A Contracting Schematic of The Modern Corporation (one tier system)
Civic Republicanism
Civic republican is a concept that is closely associated with property ownership
and the owners’ social responsibility as members of society. So, owners of wealth
in general will move into politics to protect their property from the opportunistic
tendencies of others, because, it is argued, humans are inherently opportunistic.
Based on this assumption, expansion of ownership to the general public will create
political protection for owners of wealth. And that means wider ownership of wealth
is one way of making humans less opportunistic.
Wider ownership of wealth will result in collective ownership, which in turn will grow
commitment to public welfare and a harmonious relationship with the environment.
The civic republican also believes that wider ownership of wealth is the way to achieve
liberty and equality. Liberty in the sense of freedom from tyranny and oligarchy, and
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the ability to determine one’s own fate in general and economic self-reliance in
particular, to avoid being dependent on a group of rule makers or those with power.
Under these conditions, the price of labour, and of other factors of production, would
be determined by market forces and not by an aristocracy or a clique of investors.
The market, here, is the media that sets optimum prices, freeing individuals from
dependency and oppression. In other words, the market is the media that creates
love of life, the freedom to choose one’s own values without having to depend on
others, and that, ultimately, creates welfare.
Stock Holders Meeting
Board of Commissioners
Executive Directors :
lPresident Director
lOperating Directors
Creditors
Government
Others
Managers And Employees
Suppliers
Customers
Source: Mas’ud Machfoedz
Figure 1-2 Typical Indonesian Contracting Schematic
The market will determine a price that balances supply and demand for economic
resources. The market will also increase efficiency through arms length transactions, a
process of price determination that disregards social status and class. The market will
allow people to make transactions freely and responsibly, and in this way all market
players will hold equal positions and enjoy the same freedoms. This in turn will create
democracy, freedom, and social responsibility through market mechanisms.
To create these ideal market conditions, ownership of wealth must be spread wide,
not concentrated in certain individuals or stakeholders. In addition, the market itself
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must be efficient and free from manipulation by market players. If these conditions
are met, the market will be what is known as a perfect market; otherwise there
will be market failure, with monopolies doing the selling, oligopolies setting prices,
and monopsonies doing the buying, which would be harmful to civil freedoms and
liberties.
Liberalism
Another concept of business is liberalism. Unlike the civil republican, the liberal does
not believe that human nature can be changed by distributing wealth to the public
through property markets. Humans, they argue, are basically opportunistic and selfseeking when it comes to property ownership, and because of this they cannot be
motivated to become socially responsible citizens. Liberalism focuses on the creation
of institutional-procedural structures, and management systems, to create conditions
that prevent concentration of economic and political power in the few. In other words,
liberalism does not seek to eliminate human’s opportunistic tendencies. They seek only
to control that human trait. This means that markets need to be created to facilitate
economic transactions because barter is no longer efficient, and that property is used
to create economic welfare and generate economic growth. For liberals, economic
growth is the goal, not changing human nature.
The key aspect of liberalism is how growth can be maintained through efficient
markets by controlling the opportunistic and self-seeking nature of humans.
Agency Theory
Jensen and Meckling (1976) offered an explanation of the principal-agent relationship.
The principal is represented as stockholders and the agent is represented as
management. The two parties, principal and agent, in normative and empirical terms,
share several characteristics: moral hazard, bounded rationality, and risk averse or
opportunistic. They are self seeking at the expense of others: shareholders want the
value of their shares to rise, thus increasing their wealth, by asking management
to maximise earnings per share (EPS), because EPS has a positive correlation with
share price (Machfoed and Sugiri 2002; Ou and Penman 1990). With the target of
maximizing EPS, management will implement earnings management (Machfoedz
and Fajrih 2005) to ensure high bottom line earnings and attractive incentives for
management.
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These conditions pose problems for the agent. The principal, who wants share price
to rise continually, will pressure management to focus their efforts on maximizing
profits. Managers will retain their positions or receive attractive bonuses or benefits,
and so continue to try to maximise profits by seeking fit accounting methods.
Stockholders do not necessarily realise that adopting earnings management can
endanger the company’s sustainability, as in the case of Enron. This is what is
referred to as bounded rationality. Another problem concerning agency is information
asymmetry. The management operating a company has far more information than do
stockholders or other stakeholders. This will mean that stockholders do not receive
adequate information and adverse selection will be made as a result.
• MORALE HAZARD
• BOUNDED RATIONALITY
• RISK AVERSE
EVERY EFFORT TO REDUCE
THE INFORMATION
ASSIMETRY WILL INCREASE
AGENCY COSTS
INFORMATION
ASSIMETRY
ADVERSE
SELECTION
Figure 1-3 Agency Theory
In the one-tier system adopted by America, the game of information asymmetry can be
played by majority shareholders along with management, because they are members
of a group of corporate decision makers. If this happens, those that suffer most are
the minority shareholders, because they could make adverse investment decisions
and suffer investment losses as a result. So, a system of good corporate governance
is needed, such as increasing the number of outside directors or independent
commissioners. Information asymmetry is even worse in two-tier systems, such
as in Indonesia, where shareholders are outside management (though in many
cases majority shareholders sit on the board of commissioners). So, to ensure good
corporate governance, a company must have independent commissioners.
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The Complexity of Relations in a Modern Corporation
Today we are all connected.
Today is a time of shifting paradigm, in which corporations consist of relations between
management and owners, such as stockholders, but encompass wider relations too.
Extended enterprise includes relations between investors, customers, suppliers,
competitors, regulators and networks (stakeholders’ paradigm). From the corporate
governance perspective, understanding these relations is vital.
Good corporate governance begins by paying heed to the interests of the company’s
owners. Investor confidence is essential for the company to get the capital it needs
for corporate development. An understanding of the company’s consumers is needed
to make market strategies that will add value to the company for its consumers. In
the same vein, an understanding of suppliers is an integral part of creating value
for the company. Failure in selection of the company’s suppliers, for example, could
cause delays in the production process. Corporate governance is a mechanism that
understands and accommodates the interests of these stakeholders.
As an example, not having good relations with stakeholders may result in substantial
losses, or even ruin a company. Newmont, Freeport and Lapindo are examples of
companies that have failed to accommodate the interests of stakeholders. Newmont
ignored the environmental problems caused by its poor waste management, and as
a result received several claims, including from NGOs concerned with health issues.
Investor confidence in the company decreased because it was thought not to have
taken into account stakeholders’ interests. This suggests that today companies
have to be concerned not only with maximising profits for its investors, but must
also accommodate the interests of other stakeholders that have relations with the
company, including the public, consumers and other stakeholders.
Summary
Concepts of good corporate governance must take into consideration the relationships
between the organs of the company and its structure, whether two tier or one tier.
There are two models of business management, the United States adopts a onetier system, and the countries of Europe, a two-tier system. The one-tier system
is a concept inspired by liberalism; the two-tier system by civic republicanism. The
civic republican believes that everyone who holds wealth has a pubic responsibility,
and for this reason ownership of corporations is shared with the public. This one8
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tier system is concept inspired by liberalism. Liberalism says that responsibility for
ownership of wealth is not to the public, but to increasing welfare, so managers of
corporations must be able to enhance welfare. Indonesia adopts a two-tier system. As
a consequence of the country’s long experience of operating state enterprises during
Dutch colonial times, its statutes and social regulations tend towards Dutch law. In
some companies, such as PT Sampoerna, PT Gudang Garam and PT Polytron, where
the owner is also the company’s majority stockholders and founder, the positions
of company president and chief executive officer are found. Though this may seem
similar to the one-board system adopted in the United States, Indonesian corporate
law and regulations do not allow this. Under these circumstances, independent
directors are required to keep the opportunistic tendencies of the owners in check,
and to avoid moral hazard and information asymmetry in management. Independent
directors are a media for achieving good corporate governance. Today, corporations
focus not only on stockholders, but on stakeholders, too. Corporate governance is
a mechanism that understands and accommodates the interests of these various
stakeholders. Accommodating the interests of stakeholders will increase the value
of the firm.
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CHAPTER 2
COMMISSIONERS’ DUTIES
For many people, especially medium and small size business, a
company directorship is simply a status symbol. Often it is up to the
accountant to ensure that clients understand the complexities and
magnitude of directors’ responsibility.
Mark J.Warner (Executive Excellence, September 8, 1997)
I
n this module, the term ‘board’ is used to mean ‘board of commissioners’. This
term in fact comes from the country where the system originates, the United
States. Board refers to those appointed by a general meeting of shareholders
whose main task is to represent the company’s shareholders by undertaking
specific duties described in this chapter.
The main duty of board is to supervise and advise the company’s executives. But
in a broader sense, boards’ duties go beyond supervising and advising executives
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to include several other important duties. Patrick (2001) identifies six main duties of
boards:
1. Anticipation:
Boards must be able, using certain tools, to anticipate what will happen to a company
in the future. To do this, potential problems must analysed. Boards must build
appropriate corporate visions and missions, and be visionary. That done, boards must
actively participate in developing the company’s programmes.
VISI MISI
STRATEGY
Board’s Responsibility
and Directing
PROGRAMING
BUDGETTING
REALIZATION
Supervision and Advising
VALUE COMPANY
Customers
Source: Mas’ud Machfoedz
Figure 2-1 Flowchart of Board of Directors’ and Board of Commissioners’ Duties
The processes involved in the operation and execution of a company’s vision and
mission in a management control system (Anthony and Govindarajan, 2005) are
illustrated in figure 2-1. At the highest level, the company must develop a vision and
mission. Strategies to execute the vision and mission must then be outlined. The
responsibility of boards is to determine the direction of the company and participate
directly in formulating strategies. At this stage, boards (not necessarily boards
of commissioners) will determine the direction of the company in the context of
achieving the company’s goals, which bottom line will be increasing the value of the
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firm. In companies that sell shares to the public, the value of the firm is determined
by market capitalisation per share, that is, share price times number of shares issued.
Vision, mission and strategy can be well formulated if boards have the vision and
experience to anticipate what will happen to the company in the future.
For boards to be able to anticipate what will happen in the future, they need to able
to manage risk.
Many boards fall short when it comes to anticipating what might happen in the
future, leaving them powerless to deal with crises in the firm. This is where an ideal
composition of board members is an advantage. In particular, independent members
of boards should be selected for their competence in their field. To help anticipate
what might happen in the future, a board may be assisted by a risk management
committee, or form a team of experts that can perform analysis of the industry in
which the firm operates.
Empowering the directors of firms to focus on the bigger picture of what management
should be doing is another factor associated with the duty of anticipation. Firms
adopting a one-tier system are better able to supervise corporate strategy than those
employing a two-tier system. In the one-tier system, the positions of chief executive
officer and chief finance officers, and sometimes chief operations officers, are held
by members of the board. This dual function makes execution of mission and strategy
easier. In the two-tier system, because the board of commissioners cannot be directly
involved in the operation of the company, board members are not such an inspiration
in the company’s vision, mission and strategy.
An example is the role of the board of directors in the collapse of Enron, declared by
the United States Senate’s Permanent Suborindatee on Investigation and based on
an in-depth review that found evidence of the board’s failure to monitor. The board
occasionally “chose to ignore” problems, and also allowed Enron to engage in “risky”
practices. This was a problem of corporate governance. The problem originated from
the company’s “progressive” organisational strategy, known as “redesign corporation”.
In a redesigned corporation, projects are implemented bottom up, not top down. In
some firms, executive monitoring means analysing risk management reports. Power
Report concludes that the Enron board was and should be found guilty because it
failed to request information and failed to review and analyse information not given to
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board members. This indicates a failure on the part of the Enron board to anticipate
future events.
2. Advocacy:
Advocacy refers to individual support given by board members to stakeholders. Board
members can communicate with stakeholders, shareholders and the public in several
ways. Board members can shape perceptions of the company, public education
and knowledge, and understanding of the company’s business. In this way, board
provide not only emotional and intellectual support, but also financial management
and investment policy support.
One way in which board members can influence perceptions of the company is
through disclosure policy on corporate social responsibility (CSR). Today, CSR is a
major trend. CSR is legally required action taken by the company in the interests of
the workforce, environment, and society. CSR can increase the value of the firm.
Rubin and Barnea (2006) analysed the relationship between CSR expenditure and the
value of the firm. When CSR expenditure is low, a positive contribution to the value
of the firm will be made by increasing the productivity of the workforce or avoiding
costs and fines associated with reputation and pollution. But at the same time, each
increase in CSR expenditure will reduce the welfare of stockholders. If corporate
decisions are made to maximise the value of the firm, the level of CSR expenditure
is a significant decision for boards to make. Insider managers (corporate managers,
directors, blockholders) may want to increase CSR expenditure to level higher than
that which would maximise the value of the firm if there are personal gains to be
made from doing so. For example, if a certain level of CSR enhances their reputation
as individuals who care about the environment, society and workers. While high CSR
expenditure may be advantageous to the firm’s insiders (affiliated shareholders), nonaffiliated shareholders may not approve of high CSR expenditure if it reduces the
value of the firm. Thus, CSR can be a cause of conflict between shareholders. This
conflict can be seen from two normative perspectives. On the one hand, there is
evidence for choosing CSR expenditure higher than that which would maximise the
value of the firm. This has a negative connotation because it reduces shareholder
value. On the other hand, high CSR expenditure promotes a social agenda, which
is perceived as positive. Most would interpret the problem as action by managers
seeking to profit from share prices, and would be very surprised that CSR conflict has
implications for the balance between corporate goals and social goals. From the social
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welfare perspective, whether this conflict will increase welfare depends on whether
the company stands to benefit from making a contribution to social welfare.
(what did the lapindo board do?). How did Lapindo’s CSR contribute to social
welfare? Was Lapindo transparent in its communication of the condition of the
company to stakeholders?
3. Autonomy:
Engaging boards in formulating and implementing corporate strategy is a sensitive
issue. Although boards also direct CEOs in formulating the corporate structure and
strategy, it is understandable if there is problem concerning the “ownership” of
strategies that are in the hands of CEOs and their management teams. To increase
effectiveness, an organisation not only needs clear, unambiguous strategy, but also
the confidence that top management has the authority and capacity to implement it.
By their very nature, boards do not have the leadership needed to manage products
and markets, because the majority of their members do not have specific experience
and knowledge of industry, and more importantly, do not have the capacity to translate
corporate vision and strategy into concrete operations. Thus, boards cannot make
decisions alone, but need the help of competent CEOs.
To implement the company’s vision, mission and strategy, the board must work
with the CEO to run the company drawing on their individual expertise and creating
synergy. Although boards have the legal right to monitor and evaluate the performance
of CEOs, they must give CEOs the freedom to do their work properly. Given this
autonomy, CEOs feels they are trusted to manage the firm properly, and will try not
to abuse that trust. But without the autonomy and freedom to do their jobs, CEOs
will feel useless and increasingly frustrated. At the very least, it will generate negative
feeling.
4. Accountability:
Autonomy must be balanced by accountability. Boards must ensure that while giving
autonomy to executives, in return they require accountability from the executives.
Given fiduciary, executives must be monitored to ensure that they are able to maintain
public trust, advance the company, and carry out and execute the company’s mission.
To monitor the accountability of the executives, boards can form several committees,
such as an audit committee, risk monitoring committee, and a remuneration and
nomination committee. It should be noted that formation of these committees can
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create tension in relations with the executives, and here the role of boards is to
alleviate such tension.
Independence will reduce agency cost by making boards responsible to shareholders
for the company’s performance. Independence ensure that they evaluate management
decisions objectively. The accountability function includes passive monitoring. For
independent boards, to reduce agency cost, they must actively grow a culture of
responding to shareholders’ interests. Though independent boards cannot and need
not make the best decisions about a company’s problems, this allows managers to
ensure the basic integrity of management actions.
In recent times, there has been more and more focus on corporate accountability,
largely as a consequence of economic crises, accounting and remuneration scandals,
and suspicion surrounding firms’ social and environmental implications, and as a result,
there is growing transparency regarding corporate practices. This growing demand for
transparency comes from two different angles, which appear to overlap. On the one
hand, accountability is required in the context of corporate governance, and began
by covering matters related to staffing and ethics. On the other hand, separate from
the traditional corporate governance framework, are sustainability reports. Generally
focusing solely on environmental issues, the scope of these reports has begun to
expand to include ethical and social issues, such as problems related to society and
company employees, which the corporate structure must address, and to financial
aspects.
Sustainability reporting is broadly defined to include environmental, social/ethical, and
financial aspects (or triple bottom line “people, plant, profit” reporting). The number
of constituents and potential readers of sustainability reports has expanded to include
internal and external stakeholders, including shareholders. Sometimes referred to as
CSR reporting, sustainability reporting is perceived as fulfilling the company’s CSR
role, a concept seen as fulfilling a company’s economic, legal, ethical and philanthropic
responsibilities to stakeholders and the public in general. On this basis, the implication
is that accountability in the sustainability reporting and corporate governance
frameworks tends to converge. What is interesting is that the sustainability reporting
framework raises questions about the nature of accountability and the concept of
transparency. Whether accountability should be part of the annual report or a separate
sustainability report needs to be made. Although an integrated report—an annual
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financial report including social and ethical information, otherwise referred to as
“sustainable stakeholder accounting”—has been recommended, it should be noted
that attention must be given to ensuring proper integration. Sustainability measures
in the annual report in some cases are kept separate, though incorporated into the
corporate governance section related to sustainability. When corporate governance
and sustainability are properly integrated and reported together, this provides an
opportunity to adopt integrated accounting. Also important is determining the level
and detail of information provided, because while parts of this information are
provided voluntarily, other parts are required, particularly information about risk and
management control (including social, ethical and environmental aspects), reputation
and trademarks, and the ethical dimensions of remuneration and auditing.
Sustainability reporting is a way for companies to meet the wants of a variety of
stakeholders. If it is integrated with corporate governance, the relationship between
the company and shareholders and between the company and society, will be covered.
How to give stakeholders (including shareholders) the information they want, and at
the same time accommodate the different interests (which can lead to conflict)? The
auditor verifying the report can act as liaison in identifying the areas that need more
attention.
5. Advice:
Boards have legal authority when it comes to decision making in a firm. This means
that boards must review and approve operations fundamentals, finances, strategy,
and other corporate plans. To reduce moral hazard, boards must participate actively in
decision making. In their role as advisor, boards must adopt a variety of approaches.
Boards use the expertise of their members to direct management, in keeping with
the direction of company strategy. When board members have full-time jobs in other
companies, they rely on the company’s CEO to provide the necessary information
to evaluate, for example, whether the company should enter a new line of business.
The more information provided and the better managers synthesise the information,
the better advice will be given by the boards. When a board acts in its advisory role,
it is better for shareholders if the board’s preferences correspond to those of the
company’s managers. This means that other constituents than shareholders will not
reduce the value of shareholdings by allowing the board’s preferences to override
those of management.
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Board members are people who have expertise, experience and skills in a variety of
fields. With their expertise and experience, a board should be able to give advice to
management about operating the company efficiently and effectively. Boards should
comprise people of various backgrounds, notably finance, accountancy, the industry
in which the company operates, and politics.
6. Assistance:
A more important duty of boards than giving advice is giving assistance. There are
interesting lessons to be learned from the game of football about the importance of
assistance. The aim of football is the same as that of business: to beat the competition
by scoring goals. In a World Cup match, the Brazilian eleven was losing right up to the
closing minutes. At this critical time, Ronaldinho, the ace Brazilian striker took the ball
into left field and carefully passed the ball to Ronaldo, who was standing unmarked
on the right of the English goal. Ronaldo took the pass from Ronaldinho and kicked
the ball into the net with ease – GOAL! The commentator said, “Ronaldinho was
assisting Ronaldo to create a spectacular goal”. In other words, with the assistance of
Ronaldinho, Ronaldo was able to score and win the match for Brazil. Assistance for
company executive is crucial, because executives have to realise company strategy
and the need the direction or assistance of the board to really achieve what the board
wants.
Summary
In practice, the duties of boards vary widely from one country to another, depending
on the organisational structure adopted (one tier or two tier). Following is a summary
of boards’ duties in several countries:
First, boards must ensure that good corporate governance is implemented. Second,
they monitor the performance of management and of the company. Boards have
responsibilities related to control of management performance, evaluation, and
remuneration, management development, and personnel policy. Boards should pay
attention not only to current performance but to long-term performance, too. Indicators
used to evaluate management performance must be fair and relevant, so that
management is motivated to execute its functions properly because its performance
is fairly evaluated. Third, boards should pay attention to financial reporting, the
integrity of internal and external control systems, management information systems
and risk management. Boards should understand corporate risk and monitor the
balance between risk and return, ensure that effective risk management systems are
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running properly. Appointment of external accountants is another duty entrusted to
boards as a way of exercising control over the company’s financial reporting. Fourth
is the board’s duties related to corporate strategy. Boards should provide missions,
strategic direction and long-term goals. Without long-term goals, a company will lost
its direction. Boards must also evaluate implementation of strategy. Fifth is the board’s
duties related to allocation of financial resources. It is a duty of boards to monitor the
adequacy and allocation of financial resources and to approve business plans and
budgets. Finally, there is the communication role of boards. Along with management,
boards are responsible for the continuity of communication between the company
and the outside world, such as the press, consumers and shareholders. Last but not
least, boards play a pivotal role in crisis and conflict situations.
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CHAPTER 3
BOARDS’ RESPONSIBILITIES
‘
Too much emphasis on monitoring tends to create a rift between non-executive
and executive directors, whereas the more traditional job of forming strategy
requires close collaboration. In both activities, though, independent directors face
the same problem: they depend largely on the chief executive and the company’s
management for information.’ The Economist (February 10, 2001 p 68) describing a
survey by PWC of British boards.
A characteristic of public companies in Indonesia is the separation of owners and
managers. This makes it difficult for owners to directly monitor all actions taken by
managers. The main problem is information asymmetry, or the difference in information
provided management as an internal organ of the company, and that held by owners.
Managers, as full-time company employees, have a great deal more information
about the company than the owners do. Management can behave opportunistically,
in their own interests, by not giving reliable information to owners, for example about
an accounting profit based bonus contract. Management could manipulate profit
figures, among others by changing accounting methods or manipulating receivables
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loss reserves, guarantee costs and other discretionary expenditure. Profits are
manipulated to achieve the targets required to receive a bonus. Profit manipulation
will diminish the reliability of accounting information, and less than reliable information
will result in adverse selection by information users. What is needed to prevent
this is an independent party, in this case the board of commissioners. Boards are
responsible for building build appropriate corporate visions and missions, and ensuring
the company is visionary. This done, the commissioners must actively participate in
developing company programmes and ensuring that the company’s programmes are
run properly (figure 2.1). In short, the responsibility of the board of commissioners
includes: accountability, information transparency and shareholder voice function.
1. Accountability
Corporate governance theory states that the function of the board of commissioners
is to identify mechanisms and reduce agency cost. Management has information
superiority that allows managers to distort information. In game theory, the players in
a game try to work out the strategy of each of the other players. Likewise investors,
having anticipated opportunistic behaviour by management, will ask managers to use
the services of an auditor to conduct a special purpose audit, for example to improve
information transparency. Employing the services of an auditor will incur a cost that will
be deducted from company profits, thus reducing shareholders’ dividends. The board
of commissioners is responsible for developing mechanisms to prevent management
domination by reviewing corporate decisions and reducing management misbehaviour
to protect the interests of shareholders.
Boards of commissioners can reduce agency cost because they are accountable to
shareholders for improving company performance. Boards of commissioners perform
accountability by monitoring. A wide spread of shareholders means that they are
unable monitor and get close to managers to detect management negligence, so
delegation of monitoring is crucial.
Accountability is not only about passive monitoring. Boards of commissioners must
actively respond to shareholders interests. Although commissioners do not always
act as policy makers in a company, their closeness with managers should guarantee
integrity of management actions. In other words, boards of commissioners are not
only accountable after the fact, but are also involved in decision making. In this way,
boards of commissioners can assure investors, and regulation and law makers that
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the company is being run in the interests of the company.
2. Information transparency
Boards of commissioners are responsible for improving the transparency of information
produced by management. The main problem with agency is information asymmetry:
investors need information to make investment decisions, but management tends to
provide information that is less than accurate, for example by manipulating profits. As
an example, a company makes profits of 500 M by capitalising a portion of costs (i.e.
capital leasing), so expenditure will be lower and profits inflated. Window dressing like
this results in misleading information and makes investors make inaccurate decisions.
To address this problem, investors need a mediator that can guarantee the quality of
corporate information. This function can be performed by boards of commissioners,
because the closeness between boards and management allows boards to function
as transformers of information from management to investors. In this function, the
reputation of the board of commissioners is a guarantee that its closeness with
management does not undermine its independence.
The reputation and competency of boards of commissioners ensures that management
will improve information transparency. There are two mutual conditions to information
transparency: information forcing and information validation. Information forcing
prevents management from distorting information, because mandatory disclosure
alone is not enough to ensure that investors get reliable information. Here, boards
of commissioners have a responsibility to adopt information forcing, which means
increasing the volume and quality of information in the form of mandatory and voluntary
disclosure. Competent boards will be able to motivate management to provide reliable
information so that management report users have enough information to make
economic decisions. To give an example from the business world, if a company has
high legal risk, it would help provide investors with a picture from which they could
predict the future condition of the company if the board executed this responsibility
by asking management to disclose this legal risk. An example would be a company
that could face legal charges because of the nature of its business (such as a mining
company producing waste that could pollute the environment).
Information validation is the function of monitoring management to ensure that accurate
information is provided to stakeholders. In this position, boards are responsible for
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monitoring the presentation of information before its publications, to ensure that a high
degree of accuracy and validity. Boards of commissioners not only ask management
to publish accurate information, but also ensure the reliability of information. A very
relevant example of information validation is when a board of commissioners asks an
audit committee to review the work of the internal auditor who performed a particular
audit to ensure that the information presented by management is valid and accurate.
For firms that sell their shares to the public, accurate and reliable information will help
create efficient capital and real markets. If the information presented by management
is valid and accurate, transaction costs will be more efficient because investors will
not need to spend more to locate additional information. Likewise in the real sector,
valid and accurate information from management will make creditor funding costs
and covenants more efficient, and attract more efficient production costs. It is here
that boards help to create capital markets and real sectors that are efficient and will
create a value of the firm that is reliable.
3. Shareholder voice function
Shareholder voice function illustrates that boards are also responsible for improving
the value of the voice of investors in increasing the value of a firm. A board’s
responsibility in terms of voice function is to create equilibrium conditions by
minimising communication constraints between investors and managers. Boards
must be able to assure that optimal decisions about company operations will result
in an equal share of welfare between management and investors. Investor welfare,
which is measured from the value of the company’s shares, will be affected by the
book value of the company; when per share book value increases, it has been proven
empirically that share price will also rise, increasing investor welfare. On the other
hand, increasing investor welfare will cause investors to make decisions at meetings
of shareholders to retain management, and increase their remuneration, including
in the form of management stock ownership plans (MSOP) and employee stock
ownership plans (ESOP). If the board’s responsibility as the balancer of these two
voices is well executed, there will be a significant decrease in tension between
management and investors and an increase in investor value.
Empirical Studies of Boards’ Responsibilities
Accounting figures are used to assess the health and sustainability of a company.
Managers have an incentive to manipulate accounting figures using certain accounting
methods, and by making changes to receivables loss reserves, guarantee costs and
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so on. From the creditor’s perspective, bond holders and creditors will protect their
investments. A key element in protection their investments is to look at accounting
figures. Creditors use accounting figures to assess management diligence to loan
contracts.
Boards have a responsibility to monitor the financial reporting process. Boards meet
regularly with accounting staff and external auditors to review financial reports, audit
procedures and internal control mechanisms. Investors see boards as a key element
in the process of presenting relevant and reliable financial reports.
Anderson et al. (2003) tested the relationship between boards’ characteristics,
integrity of financial reports, and cost of debt. The sample of 252 industrial firms was
taken from the Lehmnan Brothers Fixed Income and S&P 500 databases. The results
of the analysis indicated that cost of debt in firms with independent commissioners
tended to be lower than in companies that had fewer independent commissioners.
The researchers also found that there was a negative relationship between the size of
the board of commissioners and cost of debt. Overall, these research results indicated
that bond holders and creditors perceive auditor independency as a key element in
determining interest expense. Creditors believe that independent commissioners can
enhance the validity of financial reports.
Dalton et al. (1998) carried out a meta-analysis to review research on the composition
of boards, management structure, and financial performance. Meta-analysis is an indepth study of previous research to identify factors suspected of influencing financial
performance. This meta-analysis was carried out because there inconsistencies
in the results of previous research on the influence of the composition of boards
and management structure on financial performance. A sample was taken from 54
researches on the influence of the composition of boards and 31 researches on
the influence of management structure on corporate performance. According to
agency theory, separating the owners of a company from its management will cause
managers to behave in a morally hazardous way. Managers, with their knowledge
of the company and their expertise, can profit from the company at the expense of
investors. Independent board members play a key role in monitoring managers to
protect investors’ interests. Stewardship theory, on the other hand, says that managers
will work in the interests of investors, and for this reason the control function is
delegated to management. According to this theory, insider directors executive the
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supervisory function more effectively because they have good quality information,
thus better able to evaluate mangers’ performance. Research findings indicated that
there is no relationship between the composition of boards (independent and internal
directors) and financial performance.
Corporate governance has to do with providing security for investors so they receive
the returns on investment that they expect. Investors use corporate governance
mechanisms to minimize or eliminate financial and non-financial fraud in companies.
An example of financial fraud is using accounting methods to manipulate profits
or produce financial reports that do not reflect the true financial condition of the
company. Non-financial fraud includes not only fraud of shareholders, but also fraud
of consumers and government, and other crimes. Karposs and Lott (1993) showed
that there is a significant decrease in share price in companies that commit fraud.
Decreases in share price will have a significant effect on return on investment.
The main duty of boards is to protect investors’ long-term interests. Boards assume
responsibility for performing internal control and making decision for shareholders.
This responsibility is delegated because shareholders generally diversify the risk on
their investments by investing in more than one company. Diversification gives rise to
the problem of free-riders, shareholders have no way of ensuring that management is
acting in the shareholders’ interest.
Persons (2006) identified characteristics of corporate government that help to
reduce the possibility of non-financial fraud occurring. The characteristics of
corporate governance tested in this research were the level of independence and the
effectiveness of boards. Fama and Jensen (1983) note that boards have a responsibility
to monitor the actions of management. The more independent boards are, the better
they execute their monitoring function. This research used four variables to measure
the independency of boards: (1) percentage of independent commissioners, (2)
whether the chief executive officer (CEO) was also a commissioner, (3) the period of
office of managers and commissioners, (4) percentage shares held by independent
commissioners relative to total shares owned by all directors. The independency of
boards is low if the composition of independent commissioners is low, if managers
double as commissioners, if the period of office of commissioners and manager sis
low, and if the percentage of shares owned by independent commissioners is small.
The effectiveness of boards was measured from the size of boards and the frequency
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of meetings. Effectiveness is low if the number of commissioners is large and the
number of meetings is few. This research also incorporated other variables that could
potentially affect non-financial fraud.
Non-financial data on reported fraud were taken from the Wall Street Journal Index
1999-2002. The sample consisted of 83 firms listed on the New York Stock Exchange.
The results of the research indicated a relationship between low levels of fraud and
small sized boards, large percentage shareholdings by independent commissioners,
long periods of office of managers and commissioners, high profitability, and, notably,
an a corporate code of ethics. This suggests that regulators should not only ensure
that companies have codes of ethics, but that they implement them.
Marciukaityte et al. (2006) examined whether, after fraud has occurred, companies
change their corporate governance structures, and whether these changes in
corporate governance affect company performance. Fraud data was taken from the
Wall Street Journal for the period 1978-2001. Three types of fraud were used: (1)
fraud of stakeholders, which happens when a firm implicitly or explicitly deceives in
contracts with suppliers, employees or consumers; (2) fraud of government, which
happens when firms contravene contracts with government; and (3) financial reporting
fraud, which happens when managers do not reveal the real financial condition of the
firm. The results of the research indicate that after fraud has occurred, firms increase
the number of independent commissioners on their boards, audit committees,
compensation committees, and nomination committees. Share prices improve after
changes have been made to corporate governance structure and improvements are
made to internal control systems.
The main function of board is to minimise costs arising from the separation of owners
and managers in a modern firm. Boards have a responsibility to exercise internal
control and make other decisions on behalf of shareholders. The composition of the
board is a key factor in making monitoring of the actions of managers more effective.
Fama and Jensen (1983) argue that the effectiveness of boards in monitoring
management is a function of the mix of insider and outsider board members. Boards
are not an effective instrument of internal control of there is no limit on the spread
of management. Managers are better informed about the condition of the firm than
owners are, and boards could be used as a tool by management to take action in
their interests, to the detriment of shareholders. The solution to this agency problem
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is to have independent directors. Independent commissioners have an incentive
to build their reputations as experts in decision control, so they will execute their
responsibilities properly, unless they want their reputations destroyed. Research by
Rosenstein and Wyatt (1990) indicates that investors react in a positive way to input
from independent commissioners on the board. This suggests that investors believe
that the presence of independent commissioners will protect investors’ interests.
Input from independent commissioners on the board will enhance the company’s
internal control function and prevent fraud.
Beasly (1996) analysed the relationship between the composition of boards of
directors and financial reporting fraud. Data were taken from 150 public companies
for the period 1980-1999. The sample consisted of 75 firms that had committed
fraud and 75 companies that had not committed fraud. The cases of fraud covered
contraventions of the rules of the Stock Exchange Commission (SEC). The results of
the research indicated that there were differences in the composition of boards of
companies that had committed fraud and of those that had not. Boards of companies
that had committed fraud had fewer independent commissioners than the boards of
companies that had not committed fraud. Having independent commissioners will
enhance the effectiveness of boards in detecting and preventing fraud. This research
also indicated that having audit committees reduces the likelihood of managers
committing fraud.
Fama (1980) indicated that incentive for independent commissioners to undertake
monitoring also comes from the job market. Independent commissioners perform their
monitoring function well because they wish to maintain their reputations as experts
in the job market. Corporate failure is the responsibility not only of management but
of boards, too. The reputation of commissioners in the job market will be tarnished
if commissioners failed to execute their responsibility to work in the interests of the
firm and increase the value of the firm.
Summary
The main responsibility of boards is assure stakeholders that management is
implementing the vision, mission and strategy of the company to optimise the value
of the firm. More specifically, the main responsibilities of boards are to ensure a
high degree of management accountability, improve information transparency, and
execute the shareholders’ voice function.
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Accountability means that boards must assure stakeholders that management are
not taking moral risks that could harm stakeholders in general, and stockholders in
particular. Boards should be able to detect all actions by management that could
increase agency cost and immediately monitor these actions to minimise the increase
in agency cost.
As well as being responsible for ensuring management accountability, boards
also have a responsibility to assure stakeholders of the importance of information
transparency. Transparency of information from management will reduce information
asymmetry and minimise distortion of the quality of information so that management
information can be used to help information users make economic decisions, such as
investment and bond purchase decisions.
The third responsibility of board is to represent the voice of shareholders. Shareholders
are the owners of the company. They are limited in the extent to which they can
participate in controlling the company. Control and monitoring by shareholders is
limited to shareholders’ meetings. Under these conditions, commissioners must
function as the shareholders’ voice in increasing the value of the firm.
In both normative and empirical terms, there is evidence that execution of the three
responsibilities of boards described above will make stakeholders, and particularly
stockholders, trust management and boards more as a consequence of increases in
the value of the firm, indicated by increases in share price.
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CHAPTER 4
EMPOWERING THE BOARD
Ten or 15 years ago, if you were invited to sit on a company’s board
of directors, it meant that you had reached a certain level in the
business world and were being rewarded for your achievements.
Today, being a board member involves much more than just rewards:
the board member must now not only show a strong track record,
but must also bring to the table the proper skills and competencies,
a strong commitment to the firm, and a willingness to share some of
the risks-It’s still prestigious to be a director; but now you’ve got to
know your stuff
(Christian Bellavance, ca Magazine)
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A
managing director of a public company communicates with a minister to
ask the minister to make a public statement about plans with a high risk
of loss, to the effect that this is not a result of negligence by the firm. The
considerable influence this director has over a minister lies in relationship
previously nurtured by the director by doing a great deal to help the minister with
his job. This non business related expenditure was incurred without the knowledge
of the company’s board of commissioners. The board did not have a complete
understanding of the expenditure incurred as a consequence of the managing director
having more power than the board. This illustration indicates that a major weakness
in corporate management today lies in the concentration of authority in the hands of
management. An imbalance of power is one of the root causes of fraud, manipulation
of financial reports, and other improprieties. The systematic problems facing Enron
were a consequence of an imbalance of this kind.
To ensure a balance of power, boards need to be empowered. Empowering the board
means that the board has the capacity and independence to monitor the performance
of management and the company. An empowered board can also influence
management to change the direction of strategy if its performance does not meet the
board’s expectations; and, in the extreme, replace the company’s management.
Management and boards must have a synergetic relationship. A board as an internal
organ of the company must be empowered to carry its functions as supervisor and
advisor of management. A synergetic relationship between the board and management
will strengthen the position of the board, so that it is not simply following the wishes
of management which may well be influenced by the self interests of the company
managers. The job of management is to manage the firm, while the function of boards
is to implement control mechanisms to ensure that there are checks and balances.
Strengthening the board-management relationship will strengthen the board’s ability
to advise and to monitor company performance. Without a balance of power, the
check and balance function of boards will not operate properly.
Demand for empowerment
There is a correlation between the weakness of the position of a board and the level
of misuse of authority by company managers. When a board has insufficient power,
this provides opportunities for management to take action that may be detrimental
to the company or that could trigger conflict between the board and management,
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undermining company performance. There is pressure from various quarters on
companies to empower boards.
First, most investors do not want to participate directly in management of the company,
but prefer to encourage boards and the media to monitor management. Second, with
adequate power, boards have the power to replace managers who perform poorly.
Third, there is a correlation between good corporate governance that places board in
a strong position and the competitive success of a company.
Invalid Assumptions About Empowering Directors
In companies where directors are empowered, CEOs do not find their power
diminished
Managers often perceive empowering boards as a threat. Managers feel that boards
intervene where their behaviour is concerned and in the decisions they make regarding
management of the company. Managers feel that empowering boards will diminish
their power. But one can obtain power without the other losing it. Management fears
that empowering boards will diminish the management function in the company
need to be erased. The fact is that empowering boards will help managers to run
the company, provided that managers recognize that everyone in the company
shares a common vision and mission. Empowering boards must be seen as a way of
achieving the common goal of improving company performance. Balance of power
in The management-board relationship and synchronisation of vision and mission are
essential to achieving good corporate governance.
The assumption that boards participate actively only if a company is in crisis is mistaken.
Boards that do not participate in monitoring company performance will fail to detect
problems facing the company in a timely fashion. Problems that are not immediately
addressed and allowed to pile up will turn into an iceberg, and when it melts, it will
submerge the company. Enron is a case in point: the downfall of this company was not
only the result of mismanagement, but also of the board’s failure to execute its functions.
The boards’ role as monitor varies with the complexity of the duties facing managers.
There are at least three factors that influence the processes and procedures used by
boards to monitor management: first, the board’s view of managers’ ideas. If boards
do not like management’s ideas, they will monitor management more frequently
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and more carefully. Second, the problems and complexity of the company. If the
board feels that the company is having problems, it will make more of an effort to
understand management’s decisions and way of thinking than it would if the company
were not having problems. Third, market and technology changes in the company’s
line of business. Firms in the technology industry are of higher complexity because of
rapid changes in technology and rapidly changing markets. Boards must have all the
necessary information to determine the direction of the company and to give useful
advice. A board’s ability to continually update its knowledge and understanding of the
company’s business increases the power of the board.
The question is when and to what extent should boards intervene in corporate
strategy? A line has to be drawn between boards, which contribute ideas for corporate
strategy, and management, which manages the company. Boards have to approve
company strategy and review and evaluate its results. The extent of the board’s
intervention depends on the specific environment of the company, for example, in
making decisions pertaining to acquisitions, takeovers, and so on, boards must be
actively involved because these will have a significant bearing on the company’s
future performance.
The Sources and Limit of Directors’ Power
The source of directors’ power depends largely on: the directors’ knowledge and
the solidarity of the board as a unit. Directors work part-time in a company, while
managers are full-time company employees. Seen in terms of hours worked, it is
hardly surprising that managers have a better understanding of the complexities of
the company than directors do. From the managers’ perspective, meetings with
boards are generally seen as an instrument for boards to obtain information about
the company from management. Directors do need to have data about the company,
but this data needs to be translated into information that can be used for decision
making. Financial data and other data is only a small part of the real picture. The
ability to process data into useful information and knowledge depends largely on the
directors’ knowledge of the company’s business. Superior knowledge is a source of
power for boards.
The knowledge that directors have comes from written information, such as financial
reports, and from oral information that comes from discussions with managers. The
challenge for boards is how to process this information into useful knowledge at
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the appropriate time. Directors must also be able to understand external factors that
affect company performance, such as changes in market conditions, technology and
the economy. To be able to carry out effective evaluations of management and approve
corporate strategy, directors need not only financial information, which provides an
indicator of historical performance, but also information about the company’s progress
in implementing strategy. Knowledge of technological developments, new services
and products, changes in consumer demand, and what the company’s competitors
are doing is crucial.
The information that directors use must be a balance of financial data, which focuses
on the past, and strategic information, which focuses on the company’s future
prospects.
Solidarity among board members is a source of power. Board consensus is a powerful
tool for controlling management; board consensus can replace the management of a
company that is performing badly.
What Makes an Empowered Board?
The following can empower boards:
a. The majority of board members come from outside the company and have no
links with the company.
b. The number of board members is kept to a minimum to foster unity among the
group. Board members should understand goals and want to achieve them.
c. Board members have experience in leadership and business, and understand the
company’s business.
d. Board members communicate freely with other board members, at committee
meetings with or without management.
e. Directors receive data on the company’s finances and industry performance that
enables them to understand the relative performance of the company vis-à-vis its
competitors.
Effective Empowerment
Routine management evaluation, through regular meetings and empowerment of
existing committees, is central to effective monitoring, because it is the first step
towards empowering boards. Evaluations of management will give a clear message
to directors about the company’s performance and enhance their understanding of
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the company. A good understanding of the company will further empower boards.
These evaluations will be beneficial for management, too, because the direct
communication between managers and directors will flag areas of concern and
generate recommendations for making improvements. Managers will also be able to
discuss their reactions.
There are several criteria for effective evaluation:
a. Evaluation must be performed continuously, through mechanisms established by
the company’s articles of association.
b. Evaluate annual and long-term performance, and compare these with other
companies in the same industry
c. Evaluate the appropriateness of management goals to the goals of the company
d. Managers must have individual performance evaluations
e. Boards must evaluate management performance.
Theory of Friendly Boards
Boards have the legal authority to make decisions in the company. Boards must
review and approve operations, financial and strategic plans. To reduce the moral
hazard that arises when managers select projects that do not maximise shareholder
value, managers must have approval from the board. Under these circumstances,
the boards participate actively in decision making and monitoring. But this does not
negate the responsibilities of directors, and management may not hide behind the
board. The remain responsible both institutionally and individually.
As well as being responsible for monitoring the firm, a board must also give advice
to managers about the direction of company strategy. Because directors do not work
full time in a company, they need to get financial and non-financial information from
managers. If managers provide reliable information, the directors will be able to offer
good advice.
Boards assume the dual role of monitoring and giving advice to manages. When
boards implement the monitoring function intensively, managers are faced with a
trade off in sharing information. On the one hand, boards will provide better advice if
mangers provide them with reliable information. On the other hand, the information
the managers provide will help the board to better understand the condition of the
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firm. And if the board knows that the company is slipping or is below the industry
average, it will intervene in managerial decision-making.
The board’s role as supervisor and advisor complement each other, because boards
use information from managers to make better recommendations and implement
better policy. To motivate managers to provide information, shareholders would be
best off electing friendly directors who focus not only on the supervisory function but
on the advisory function, too.
Adams and Ferreira (2005) tested the theory of friendly boards. Emphasis on the
control function by independent directors will have adverse consequences, because
managers will tend to reduce the amount of information they provide, and in turn, the
advice they are given will not be the best. Thus, increasing the number of independent
directors will reduce shareholder value. Shareholders will benefit if increasing the
number of independent directors leads to better disclosure practices. Adams and
Ferreira showed that the model of management-friendly boards could be optimal.
An interesting finding from the Adams and Ferreira study was that independent
directs are not influenced by company performance. Contrary to research by Ezzamel
and Watson (1993), Pearce and Zara (1992), Rosenstein and Wyatt (1990) showed
that there is a positive correlation between the composition of boards and company
performance. The inconsistency in the results of research on the effect of independent
directors on corporate performance may be because definition of ‘independent’ is
ambiguous. Is an independent director one that has no contractual relationship with
managers, or someone who is not a major shareholder? The independence of directors
cannot be defined in terms of whether or not there is a contractual relationship with
mangers, but in terms of whether they are independent in action.
Summary
There is an invalid theory about the power of boards: that empowering boards will
undermine the authority of management. This is not, in fact, the case. A competent
board will create a positive synergy. When boards have adequate authority,
management will be better able to improve its performance. A close relationship
between management and board make it possible to realise the company’s vision,
mission and strategy.
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The time has passed when directors were just bodies in chairs, given facilities without
contributing to the value of the firm. They must have adequate authority and power to
advise and supervise management. There is abundant evidence that an overpowered
management and underpowered board will diminish both internal performance and
market performance. Just look at the state-owned enterprises of the past with their
powerless and incompetent boards: their management were uncontrollable and
distorted corporate performance, and in some instances, even destroyed the firm
completely.
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CHAPTER 5
NEW TOOLS FOR BOARDS
T
oday, the presence of institutional investors, regulatory bodies, the press,
and the fear of legal retribution has made the boards of directors of public
companies search more actively for practical steps for strategic management.
There is a difference in perspective between that of boards of directors
and that of boards of commissioners. Boards of directors/managers are expected
to translate strategic vision into actual operations. They must focus on the strategic
path to maximising corporate profitability. Therefore, optimal performance standards
are needed to motivate members of the organisation. Boards of commissioners, on
the other hand, are responsible for representing the investors’ perspective. Boards of
commissioners evaluate the validity of strategies that are implemented, by comparing
current returns on a particular strategy with possible returns on other feasible
strategies. Although they have different perspectives, the difference diminishes when
boards of directors and boards of commissioners build strategy.
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Strategic Audit
A strategic audit, which is designed to give credibility to management leadership,
is an effective strategy for anticipating problems and showing to shareholders that
the board of directors is committed to and is implementing good governance. A
strategic audit must be directed by independent commissioners, and the board of
commissioners must set the key criteria for monitoring strategic results.
The elements of a strategic audit are:
1. Setting criteria
It is important that in setting criteria for a strategic audit, the criteria are objective.
The criteria must also be familiar and easily understood, and use acceptable
financial performance indicators. This is because; a) the responsibility of the board
of commissioner is to understand the impacts of strategies adopted in appraising
shareholder value, and this requires a financial-based performance evaluation;
b) managers are familiar with the product market and the company’s particular
problems, and have access to a phenomenal quantity and range of data, giving them
an advantage over the board of commissioners.
These criteria must also focus on sustainable levels of shareholder return and
investment, and allow for income flow comparisons across companies, and comparison
of investment alternatives across firms in the same industry and in other industries.
The criteria must also reflect fundamental economic realities, such as shareholder
loyalty depending on competitive ROI (return on investment). Other criteria commonly
used to evaluate alternative strategies are CFRIO (cash flow return on investment),
EVA (economic value added), and TSR (total shareholder return). However, since each
of these measures has its own strengths and weaknesses, a board of commissioners
must make the best analysis possible and use only one.
2. Designing and maintaining databases
The process of identifying effective strategies requires boards of commissioners to
control not only the performance criteria but also to maintain a database of these
criteria. There are several options here. One is to ask the CEO to employ staff to
do this. But this could result in conflict of interests arising from staff working with
sensitive data. Another option is to request the services of an external consultant to
design a database and collect data the board of commissioners wishes to monitor.
The best solution is to engage an external auditor, who will evaluate the design and
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data collection carried out by the external consultant. This will ensure that there is
consistency in maintenance, documentation and reporting in the long term.
3. Strategic Audit Committee
The audit committee must select the criteria for auditing strategic performance,
including database design, and establish the audit process. This will improve the
integrity and continuity of data collection and reporting, and identify problems to be
discussed with the directors. The strategic audit committee is the equivalent of the
audit committee in Indonesian legislation pertaining to organizational structure. The
strategic audit committee focuses on reviewing corporate strategy, which can also be
done by an audit committee.
4. Relations with directors
The review process aims to discuss strategic performance with the CEO, in order to
alleviate any hostile atmosphere within the organisation.
5. Readiness to do the task
The board of commissioner must watch out for signs of weaknesses in the company’s
strategic mission, and for events that indicate opportunities for adjusting strategic
direction. There are several events that may require special meetings with the strategic
audit committee include:
On this basis, the board of directors cannot work alone to operationalise corporate
strategy. Maximising performance requires evaluation of their performance by the
audit committee and independent commissioners.
Research results show that the size and composition of boards affects the
company activities. The size and composition of the boards of directors can affect
the effectiveness of monitoring. The size and composition of boards of directors
also affects the relationship between managerial and institutional investors and
company performance. According to Pfeffer (1973), expanding the size and diversity
of membership of the board of directors will be beneficial to the company because it
creates networks with external stakeholders and guarantees a supply of resources.
Hermalin and Weisbach (1988) stated that outside directors, as well as being more
effective in monitoring management, are also tools for disciplining managers, and
minimizing inefficiencies and low levels of performance. Outside directors contribute
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to the value of firm through evaluation and strategic decision making (Brickley and
James, 1987).
Fama and Jensen (1983) claim that brining in outside directors will enhance the
performance of the board and reduce the likelihood of managers expropriating
shareholder wealth.
Beasly (1996) showed that firms that engage in fraud have a significantly lower
percentage of outside directors than firms that do not engage in fraud.
Forensic Accounting
Several empirical studies have shown that bad corporate governance will undermine
a company’s performance. Sliding company performance will prompt management
to behave in an opportunistic way, by manipulating reported profits to ensure they
receive their bonuses. As a consequence, the reliability of the financial reports will
be in doubt. Boards function to prevent opportunistic behaviour by management that
would be detrimental to investors.
Forensic accounting is expertise in financial and non-financial auditing exercised to
investigate problems that cannot be solved by conventional accounting or auditing
methods (Bologna and Lindquist, 1995). As a discipline, forensic accounting requires
financial expertise, knowledge of fraud, and an understanding of the realities of
business and of the prevailing system of law or legislation. This implies that forensic
accountants are equipped not only with expertise in financial accounting, but in internal
control systems and the law, as well as with investigatory and interpersonal skills.
Forensic accounting can be used as a tool to protect shareholders from management’s
opportunistic behaviour. By helping the firm to prevent and detect fraud, forensic
accounting can help a firm adopt good corporate governance, as follows:
First, corporate governance. Forensic accountants can help formulate and develop
governance policy, establish appropriate responsibilities for boards and audit
committees, ensure a fair allocation of power among management, boards and
investors, and ensure that there are codes of ethics for employees and managers.
Codes of ethics need to be enforced if managers display unacceptable behaviour.
Second, fraud prevention. Forensic accountants know that the best way to prevent
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fraud is to set up efficient control systems, including a good environmental control
system that are based on management philosophy about ethical behaviour and
corporate governance policy, good accounting systems that guarantee the accuracy
of recording, classifying and reporting of relevant transactions, and strong control
procedures that provide security of assets, appropriate authority, and appropriate
audit mechanisms.
Third, creating a positive working environment. A fraud prevention programme will
also create a positive working environment. For example, highly motivated employees
will not be tempted to misuse their authority. Forensic accountants can guarantee
that governance policy is created to avoid high risk environments.
Fourth, creating effective communication. Communication is a key element in ensuring
that employees and investors, management and boards have exercised their rights
and responsibilities. Effective communication must flow not only from the top down,
but also among employees. Forensic accountants can support the dissemination of
information on governance and ethics policy to the relevant people.
Fifth, vigilant oversight. For all systems to work properly, continuous monitoring and
evaluation is required to ensure that these systems are functioning properly. Forensic
accountants can monitor management commitment, management procedures, and
employee activity.
Sixth, establishing consequences. The possibility of punishment prevents a person
from committing fraud. Forensic accountants can hep prepare policy that prevents
criminal action.
Seventh, fraud investigation. Forensic accountants can ensure the integrity of financial
reports by actively investigating fraud, identifying areas of risk, and investigating
financial and accounting anomalies.
Summary
In the second millennium, business is very different from business in the first
millennium. The use of advanced technology totally changes the strategy and operation
of firms in competition. As a consequence, there has also been a shift in corporate
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fraud, from blue collar crime to white collar crime. Competition strategy has changed
too, with the shift in competition from the real world to the virtual world.
Two new tools have been introduced to handle this condition. First is the strategic
audit. This is an audit to determine whether a company’s operations are in keeping
with strategy outlined by top management. The second is forensic auditing. This is not
the same as a normal financial audit. In a forensic audit, the auditor goes beyond the
scope of a normal audit to include the possible impacts of the audit findings. Here,
corporate risk may be analysed, which means that the auditor must have knowledge
of accounting, strategy and law. In a forensic audit, the auditor is an audit team and
the audit is carried out together by the members of the team.
Forensic audits are useful for: building good corporate governance, preventing
fraud before it happens, creating a positive work environment, building effective
communication between organs inside and outside the company, and ensuring that
systems within the company operate properly.
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CHAPTER 6.
THE AUDIT COMMITTEE
AND OTHER SUPPORTING COMMITTEES
T
he audit committee has the separate task of helping the board of
commissioners to fulfil its responsibility to provide comprehensive
supervision. The audit committee helps the board of commissioners to
monitor financial reporting by management to enhance the credibility
of financial reports. In undertaking its duties, the audit committee sets up formal
communication between the board, management, external auditors and internal
auditors (Bradbury et al., 2004). The audit committee acts as liaison in the event of a
difference of opinion between management and auditors concerning interpretation
and application of the Generally Accepted Accounting Principles (Klien, 2002).
Members of the audit committee should be independent commissioners, who are
free from day-to-day managerial duties and whose main responsibility is to assist
the board of commissioners undertake its responsibilities, particularly with regard to
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corporate accounting policy, internal supervision, and financial reporting systems. In
general, the audit committee has responsibilities in three areas (FCGI, Volume II, p 12):
a. Financial reporting
The responsibility of the audit committee in the area of financial reporting is to ensure
that financial reports prepared by management give a true picture of the following: 1)
financial condition, 2) business results, 3) long-term plans and commitments.
The scope of implementation in this area encompasses:
1. Giving recommendations to the external auditor
2. Examining matters pertaining to the external auditor:
a. Auditor’s letter of appointment
b. Audit cost estimate
c. Auditor’s visit schedule
d. Coordination with internal audit
e. Monitoring audit results
f. Evaluating implementation of the auditor’s work
3. Evaluating accounting policy and policy-related decisions
4. Examining financial reports, including:
a. Interim financial reports
b. Annual reports
c. Auditors’ opinions and management letters
Evaluation of accounting policy and policy decisions can be effectively performed by
obtaining a brief summary from officers in the company’s accounting department.
b. Corporate governance
The audit committee’s responsibility in the area of corporate governance is
to ensure that the firm has been run legally, carried out its business in an ethical way,
and performed effective monitoring of conflicts of interest and of fraud by company
employees.
The scope of implementation in this area encompasses:
1. Evaluating company policy relevant to compliance with laws and regulations,
ethics, conflicts of interest, and investigation of fraud and deception.
2. Monitoring ongoing and pending judicial processes pertaining to corporate
governance where the company is a party to the process.
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3. Investigating major cases of conflict of interest, fraud and deception.
4. Requiring the internal auditor to report on corporate governance audit findings and
other key findings.
c. Corporate control
The audit committee’s responsibility in the area of corporate control includes having
an understanding of problems and potential risks and of internal control systems,
and monitoring control processes performed by the internal auditor. The scope of the
internal audit must include review and evaluation of the adequacy and effectiveness
of internal control systems.
d. A member of the audit committee:
• Has a high level of integrity, competence and knowledge, adequate experience
appropriate to their educational backgrounds, and good communication skills.
• Has an educational background in accountancy or finance
• Has sufficient knowledge to read and understand financial reports.
• Has sufficient knowledge of capital market legislation and other relevant
legislation.
• Has not been employed in a public accountant’s office, a legal consultant’s
office, or by any organization that provides audit, non-audit, or consultancy
services to the listed or public company concerned, during the 6 (six) months
prior to being appointed by the board of commissioners.
• Has not been authorised or responsible for the planning, management, or
control the operations of the listed or public company in the 6 (six) months prior
to being appointed by the board of commissioners, expect as an independent
commissioner.
• Has no direct or indirect shareholding in the listed or public company. In this
event that a member of the audit committee obtains shares as the consequence
of peristiwa hokum amaka, the said member is required to have disposed of
these shares within 6 (six) months of their acquisition.
• Has no:
a. Family relations, by marriage or descent to the second degree, either
horizontal or vertical, with members of the board of commissioners or
board of directors or with shareholders of the listed or public company;
b. Direct or indirect business relations associated with the operations of the
listed or public company.
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Pursuant to Decree of the Capital Market Supervisory Board No. 29/PM/2004, which
aims to reduce the lag in submission of the financial statements of listed companies
to the public and the Capital Market Supervisory Board as of the end of the 2002 fiscal
year, listed companies are required to make public financial reports as follows: 1)
annual reports, no later than three months after the date of the accountant’s opinion
of the financial report, 2) mid year reports: (a) one month after the date of the financial
report, if unaudited, (b) two months after the date of the financial report, if the audit
is limited, (c) three months after the date of the financial report, if there is an auditor’s
opinion. One task of the audit committee that lies within the scope of its responsibility
for corporate governance is to assess corporate policy with regard to its compliance
with the law. Thus, the presence of an audit committee as an institution will have
a bearing on the company’s compliance with Capital Marketing Supervisory Board
regulations concerning the timely publication of financial reports. In other words, the
reporting lag for a company that has a audit committee will be shorter than that of a
company that does not have an audit committee.
A company that has an audit committee that comprises entirely of independent
members, at least one of whom has knowledge of accounting and finance, and that
holds meetings three times a year, will have few problems with its financial reporting
(McMulen and Ragahunandan, 1996).
One of the tasks of the audit committee is to recommend an external auditor to audit
the company’s financial reports. According to De Angelo (1981), the quality of an audit
depends on the possibility of the auditor detecting fraud in the accounting system and
reporting fraud. Thus, a good quality audit can improve the quality of the company’s
financial reporting and reduce the asymmetry of information between management
and shareholders. Verschoor (1993) states that supervision of an external audit should
enhance auditor independency, thus making the audit more effective. The presence of
an audit board correlates with fewer claims from shareholders of fraud, fewer illegal
acts, and fewer changes of auditor when there is a difference of opinion between the
company and the auditor (McMulen, 1996).
On improving the effectiveness of audit committees, the Blue Ribbon Committee
(BRC) says that an audit committee will improve financial reporting it the committee
comprises independent, financially literate, fully committed members and convenes
regular meetings. Bryan et al. (2004) tested whether the BRC recommendation
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will improve the quality of profit reporting by analysing profit informativeness and
transparency of reporting to determine whether these were better in companies that
had audit committees, as suggested by the BRC. ERC was used as proxy for profit
informativeness, and the level of accrual mispricing (overpricing) as the proxy for
transparency. The sample was 1,291 firms listed in 1996 Fortune 500 for the period
1996 – 2000. It was found that ERC was stronger when the audit committee was
independent and financially literate, and accrual overpricing was smaller when the
audit committee was independent and held regular meetings. Overall, the results of
the research indicated that independent and effective audit committees will improve
the quality of financial reporting; a finding that supports the recommendations of the
BRC and the 2002 Sarbanas-Oxley Act.
Qin (2006) analysed the impact of the financial expertise of the audit committee on
quality of profit as measured in terms of profit-return. The sample used consisted of
92 firms from 43 public industries in the United States. The research findings indicated
that a company that had an audit committee with professional accounting expertise
had better quality of profit. There was a positive correlation between accounting
expertise on the audit committee and quality of profit.
The new NYSE regulations for corporate governance require audit committees to
discuss and review assessments of corporate risk and hedging strategies. They are
also additional requirements regarding the composition and financial knowledge of
the directors on the board and the audit committee. Dionne and Triki (2005) analysed
these new regulations in terms of more profitable hedging decisions for shareholders.
They found that the requirements pertaining to the composition and independency of
audit committees benefited shareholders, but that audit committee members having
an accounting background was not particularly important. Notably, they found that the
directors with financial backgrounds encouraged corporate hedging, and that active
directors with an accounting background did not play active roles in many policies. The
results of this research also suggested that there was a positive correlation between
hedging and company performance, indicating that shareholders were better off with
directors with financial backgrounds sitting on the board and the audit committee.
These findings support empirical evidence in favour of having directors with a
university education on the board and audit committee
In compliance with the 2002 Sarbanas Oxley Act, the NYSE requires that there be
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financial expertise on the audit committee. But the definition of financial expertise is
a controversial issue; one that reached a peak when the stock exchange adopted a
definition of financial expertise that was broad in scope. Dhaliwal et al. (2006) analysed
the relationship between three definitions of financial expertise pertinent to the audit
committee (accounting expertise, finance expertise, and supervisory expertise) and
quality of accruals. The sample used in this research consisted of firms on the Investor
Responsibility Research Center (IRRC) board practice database, from 1995-1998,
which were 1,114 firms from 53 industries. The research findings indicated a positive
correlation between accounting expertise and quality of accruals. This suggests that
the current definition of financial expertise is too broad, and in the future, the focus
should be on the accounting expertise of the audit committee.
Other Supporting Committees
In a complex business environment, delegation of tasks to committees will improve
time effectiveness and efficiency. Formation of committees on boards will increase
the effectiveness of boards because specialisation allows board members to carry out
tasks suited to their expertise and education, thus producing better policy and action.
Specialisation will also improve time efficiency.
However, in practice, specialisation can result in unwelcome consequences, for
example: committees are often able to make proposals, but not decisions; decisions
are made by the board as a whole. Another unfavourable consequence is that
the feeling of fellowship among board members is upset because of the limited
participation of board members who do not sit on a particular committee. One way to
address the problems that arise from the formation of committees within boards is
to have clear instructions regarding the operationalisation of the committees and full
reports on the committees’ operations to the board.
Committees, other than the audit committee, that could be formed to lighten the
workload of boards include:
a. Nomination Committee
The duties of this committee are:
- selecting managers’ profiles
- selecting board members
- assessing the independency of directors
- evaluating management and boards
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- management development as a part of human resource development and
recruitment policy
b. Remuneration Committee
The task of the remuneration committee is to monitor managers’ salaries, including
performance rewards for managers.
c. Risk management committee
One of the principles of transparency in corporate governance is adoption of
enterprise-wide risk management. The purpose of risk management is identify risk,
measure risk, and deal with risk above a certain level of tolerance. In enterprisewide risk management, risk is not only specific/unsystematic risk such as financial
risks including non payments, industrial action and third-party claims, but also market/
systematic risk. Examples of market/systematic risk are inflation, recession and so
on. A rise in world oil prices as the result of a knock-on effect outside the control of
the company will have an effect on the firm’s performance. But can the company’s
managers be blamed for factors outside their control? The process of identifying risks
and setting up measures to minimise or manage risk are crucial. These measures are
a demonstration of the company’s responsibility to its stakeholders.
This committee aims to understand corporate risk and monitor the balance between
risk and returns, ensuring that an effective risk management system is in place.
a. Corporate governance committee
This committee is responsible for monitoring implementation of corporate governance
and compliance with corporate governance standards.
b. Financial committee
Formation of committees should be flexible, that is, appropriate to the needs of the
firm and the type of firm.
According to Murphy (2004), sufficient compensation is enough to attract a person
to a good, promising career in corporate management. Recent changes have made it
difficult to make remuneration systems fair. This is very complex problem. There will
be conflict at the firm level, and many difficulties will ensue. But today’s wise and
forward-looking managers can gain a competitive advantage by making difficult choices
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about remuneration, governance, and relations with the capital market. Appropriate
investment in the integrity of the organisation and systems will have short-term
and long-term advantages. Wise board members and CEOs will encourage this
type of investment because they understand that properly functioning monitoring
and governance systems will ensure not only the success of the organisation, but
also personal success. Damage to personal reputations and the reputations of
organisations make headlines in the USA and the world over.
Current scandals over the allowances and perquisites given to CEOs have fuelled
debate about limiting compensation for executives and improving the structure of
corporate governance. Several things can be done to improve in this area: require
that compensation committees be more independent, require executives to hold
equity in the company, require improved disclosure of executive compensation,
increase the participation of institutional investors in corporate governance (including
executive compensation), and require firms to make stock options an expense in the
profit and loss statement (Matsumara and Shin, 2005)
Gore et al. (2005) analysed the relationship between the monitoring environment
and the level of equity incentives for CFOs (chief financial officers). Data covered
3,628 firms with data on their CFOs in the ExecuComp database, from 1993 to 2001.
The research found a negative correlation between the CFO’s portfolio of options
and the existence of a finance committee and CFOs with a financial background.
These research findings are consistent with financial expertise on the board and
in the CEO being a significant factor in the determination of equity incentives for
CEOs.
According to Ferrarini and Moloney (2005), there has been a divergence among
the countries in the European Union (EU) when it comes to establishing structures
for executive remuneration. There are marked differences in the adoption of best
practices in paysetting and disclosure of executive pay. This divergence is in keeping
with the predictions of agency theory. Although in 2004 the EU adopted two key
recommendations on executive pay, the results of this research indicate that
reforms in the EU should proceed with caution. Harmonisation should be limited,
and the sole focus should be on disclosure. Disclosure is central to adopting
effective incentive contracts that can manage the agency cost of executive pay
between countries where corporate governance systems of dispersed ownership
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and blockholding are adopted, without intervention in governance structure and
options. Other intervention in the payment process could give rise to divergent
competitive risk.
Calcagno and Renneboog (2004) demonstrated that equity seniority and managerial
compensation have important implications for the design of remuneration contracts.
Traditional literature assumes that equity takes priority over remuneration, but this
has been proven otherwise, notably in the case of bankruptcy regulations and
observed practice. Theoretically, including equity risk will change the incentive to
give managers higher performance-related incentives (the contract substitution
effect). If managerial compensation is of higher priority than equity claims, the
greater the leverage the lesser the power of the incentive scheme, and the higher
the base wage. In the case of junior compensation, the focus is more on pay for
performance incentives. Empirical research suggests the remuneration seniority as
the base wage is significantly higher and performance bonuses lower in firms that
are financially distressed.
Summary
The adoption of good corporate governance requires that committees be set up to
help the board of commissioners perform its duties. These committees must be
independent and are responsible to the board of commissioners. One such committee,
which more than 90 percent of public companies in Indonesia now have, is the audit
committee, which helps the board of commissioners direct management to improve
the effectiveness and efficiency of the company. The audit committee is responsible
for performing reviews of internal audits and of work related to financial matters.
Committees that must adopt good corporate governance are the remuneration and
nomination committees. It is the job of the former to fact find and conduct analyses
to set appropriate remuneration for management and commissioners, while the latter
is responsible for helping the board of commissioners nominate people for strategic
positions in the company and whose names will be put forward at a general meeting
of shareholders.
Another key committee is the risk management committee. The Enron scandal left
stakeholders with no choice but to require that management anticipate risks that
could destroy the company. The risk management committee helps the board of
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commissioners to assess and anticipate corporate risk and find solutions to avoid
or minimise this risk. Another committee gaining in importance is the investment
committee. Many firms are less then prudent in their investments and this could be
harmful to the company. Thus, the board of commissioners needs help to monitor and
advise on all major investments.
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CASE STUDIES
CASE 1.
At a routine meeting between the board of commissioners and the board of
directors, the main agenda was to discuss three issues: the decline in the company’s
performance, a cooperation agreement with the Ministry of Agriculture, and the
findings of an internal audit on fraud in the regional office. Following are the minutes
of the meeting.
The meeting opened at 08.30, Monday, November 21, 2006, chaired by the
President Commissioner and attended by all directors and members of the board of
commissioners.
President Commissioner (PC) : The prognosis as of the end of 2006 for financial
performance shows that bottom line earnings did
not achieve the 2006 target.
Independent Commissioner /
Chair of Audit Committee (IC) : The audit committee’s analysis indicates that the
most significant deviations are a 20% increase
in marketing costs and personnel costs of 15%
higher than planned. These increases were not
offset in any way by an increase in revenue; in
fact revenue was down 6 percent. This resulted in
a decrease in bottom line earnings of Rp 48 billion
or 8 percent.
Commissioner/Chair of
Remuneration and Nomination
Committee (Co)
: The increase in personnel costs is accounted for
largely by an increase in non-target related production
bonuses, and by an increase in directors’ salaries.
This across the board allocation of production
bonuses should be reviewed. Directors’ salaries are
still below the market average.
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Managing Director (MD)
Human Resources
Director (HRD)
: From the start, I completely disagreed with these
across the board production bonuses; they must
be based on achievement of targets. But unions
union oppose switching to a merit system. If there
has been a decrease in revenue this is due to
two things: first, a shift in consumption patterns
resulting in a drastic reduction in demand for
ready-to-eat foods; and second, the cancellation
of a government contract cut from the national
budget.
: To add to what the MD said, as far as I’m aware,
our employees are overpaid. Our competitors
record far higher sales than we do, and their
employees are on lower wages than ours are.
PC: Could the board of directors not negotiate with the unions?
Discussion about financial performance and human resources continued for more
than an hour. Over the past two years the company’s performance has not been
satisfactory. The market has meted out its punishment, with a 10 percent fall in share
price.
Discuss how the board of commissioners could intervene, both in its advisory
and supervisory functions, in this situation.
From 09.45, the meeting continued with a discussion of the cooperation agreement
with the Ministry of Agriculture.
PC: We, the board of commissioners, have just received an invitation to sign a
cooperation agreement between our company and the Ministry of Agriculture. We
have no idea how this came about; the first we knew of it was when we received this
invitation.
IC: I’ve reviewed this cooperation agreement, which includes establishing a network
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of distributors of agricultural commodities and fertiliser, at the company’s expense.
As far as I’m concerned the outputs are not clear, and fertiliser distribution is not our
core business.
PC: Why were we, the board of commissioners, not involved in discussions about this
before now?
MD: The board of directors felt that this was a technical issue, so we regarded as
being within the jurisdiction of the board of directors.
PC: This is a policy issue, which requires the approval of the board of commissioners.
How did this happen?
Discussion of the cooperation agreement continued for 60 minutes and ended in
dispute. The secretary of the board of commissioners and the risk management
committee will discuss the issue and report the board of commissioners forthwith.
Discuss how the board of commissioners and board of directors should best
approach this relationship.
The meeting continued with discussion of fraud in the regional offices, which was
regarded as misuse of authority and corporate fraud. It was agreed that this would be
reported to the appropriate authorities. The meeting closed at 12.30.
CASE 2
PT ‘Transportasi Cepat Indonesia’ (PT TCI) is a publicly listed transport company,
operating since 1953. Up until the 1980s, PT TCI was a profitable firm with growing
assets and revenue. At the end of the 1980s, the government issued a policy
deregulating land, air and marine transportation. As a result of this policy, competition
in the transportation business became very tight. PT TCI was directly affected by
this policy and the ensuing business climate, and in the mid 1990s, began suffering
continuous losses and started having liquidity problems. In response to this
deteriorating condition, management began running up significant debts to continue
operating the business. Early in 2000, shareholders replaced the board of directors
three times. The latest board of directors was appointed in early 2004.
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The new board of directors adopted a new strategy of cost cutting and repairing
the company’s transportation equipment. In early 2006, the public accountant that
audited PT TCI published the audit findings, gave the financial report prepared by
management, which showed profits of Rp 38 billion, an unqualified opinion. Following
the publication of the accountant’s report, an independent commissioner who is also
chair of the audit committee, asked the audit committee to perform a review of the
findings of the public accountant’s audit. The outcome was that the independent
commissioner believed the accountant’s report to be in error. According to the
independent commissioner, the profit and loss statement prepared by management
should have reported a loss of Rp 8 billion. The independent commissioner stated this
openly and his comments were published in the press.
This sparked internal dispute between management and the public accountant
on the one hand, and the independent commissioner on the other. The dispute
continued and affected the operations of the company.
Questions:
1. Did the independent commissioner do the right thing?
2. What should management have done?
3. How should this problem be resolved?
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