Ilovepdf Merged

By: 1. Kenneth A.
Kim
John R. Nofsinger
And
2. A. C. Fernando
 Chapter outline
◦ Studying global political system from business
point of view
◦ Goal of business i.e. profit maximization
◦ Forms of businesses
◦ What is corporate Governance
◦ Investors influence on management
◦ How to monitor management
◦ Corporate governance: An integrated and complex
system.
 Introduction
◦ There are two major political systems in the world
from business point of view
 1. Communism
 refers to a political system that stresses
the primacy of collective goals over
individual goals
 Characteristic of Communism
◦ Needs of the society are viewed as a whole than
individual freedom.
◦ State-owned enterprises are managed to benefit
society as a whole, rather than individual capitalists
◦ Examples are:
 Cuba
 Vietnam
 China (market based economic reforms)
 Capitalism
◦ Capitalism is an economic system based on the private
ownership of capital goods and the means of production,
with the creation of goods and services for profit.

 Characteristics of Capitalism
◦ Ownership belongs to “YOU”
◦ Freedom of own economic growth
◦ Suitable environment for business
◦ Profit in your “Pocket”
◦ Reward based system
◦ Creative and innovative environment
 Goal of a Business
◦ Maximum profit by increasing business
◦ How?
 1. Increasing sales in the existing
market
 2. Creating new markets for the
existing products.
. Enhancing business requires
capital which brings risk.
 . So, the ability to access
capital and control risk are
important in the success or
failure of a firm.
 Forms of Business Ownership
 Sole proprietorship – a business own by a single
person
 . Easy to start
 . More than 70% of all US business
 . But limited lifespan
 . Die with the owner’s death or retirement
 . Limited ability to obtain capital
 . Owner bears unlimited personal liabilities for the
firm
 . Less trustworthy
 Partnership – similar to sole proprietorship but
there is more than one owner.
 .The ability to pool capital
 But may not be as important as combining service-
oriented expertise and skill, especially for larger
partnerships, for example;
 Accounting firms
 Law firms
 Investment banks
 And advertising firms
 Corporation –
the corporation is its own legal entity, as if it
were a person.
Advantages
 . The owner of the corporation enjoys limited financial
liabilities
 Which is very hard in the case of sole proprietorships
and partnerships.
 For example
 Bill Gates of Microsoft
 Tim Cook of Apple
 Larry Ellison of Oracle
 Fewer than 20% of all US businesses are corporation but
are generating approximately 90% of the country’s
business revenue.

 . The most important advantage of corporation business
is access to capital market and can raise money by
issuing stocks and bonds to investors.
 . It doesn’t die when its owner do because corporation is

not in single person ownership, it has many owners.
Example
 “Between 1977 and 1980, Apple Computers sold
a total of 121,000 computers. To meet the
potential demands for millions of computer per
year, Apple needed to expand operations
significantly. As a result, in 1980, Apple became
the public corporation and sold $65 million
worth of stocks”.
 Main disadvantages of corporations are;
 . Corporate profits are subject to business taxes
before any income goes to share holders in the form
of dividends.
 . Subsequently, shareholders must also pay personal

taxes on dividend income.
 Which means shareholders are exposed to double
taxation.
 Running corporation cab be expensive. For
example
 The cost of hiring accountants
 Legal experts
 Cost of communicating with all shareholders
 Cost of complying with Regulations and so forth.
 Perhaps the main disadvantage is of governance
problems.
 Small stake and lack of true sense of ownership
bring RISK and lack of CONTROL
 What is Corporate Governance?
“Problems that result from the separation of
ownership and control
 Focusing on
 The internal structure and rules of the board of
directors;
 The creation of independent audit committees;
 Rules for disclosure of information to shareholders
and creditors
 And control of the management
 This explain how a corporation is structured.
Corporate Governance
Separation of ownership and
 Separation of ownership and management
management
Shareholders
Board
Management
Employees
Separation of Ownership and Control
 . Stockholders own the firm and officers (or

executives )control the firm.
 . Hundreds of thousands of investors can’t

collectively take decisions. So firms hire
managers for that work.
 .The shareholder’s main focus is toward business

performances and return of their stock, rather
than in decision making process.
 Why should managers should care about the
owners?
 Satisfactory profit for the stockholders and

massive perks for themselves (principal-agent
problem or the agency problem)
 Managers may be tempted to use the firm’s assets

for their own ends.
 Secretaries may take the supplies
 Managers may take extra food or fancy furniture for
their offices
 Executives can use expensive jets for travelling
 Etc;etc
 Ability to steel from the shareholders, the
most are the executives.
 This problem can be solved by

 Incentives
 Common incentives
 Offering stocks, restricted stocks or stock options
(normal practice in US companies)
 And monitoring
Lecture 2
Can Investors Influence Managers?
 Theoretically, managers work for owners but

in reality, firms actually seems to belong to
management.
 There is a race of win-lose between

shareholders and management but most of
the time, management has always having the
upper hand.
 Different proposals are made by the
shareholders but are defeated when it comes
in the annual shareholders meeting.
 There are normally two types of proposals;

 . Those relate to governance (e.g. suggesting
changes in board structure)
 . Those relate to social reform (e.g. proposing to
stop selling chemicals to rogue countries) etc; etc.
 . Without management approval, proposals
have little chance of succeeding.
 . Shareholders have to trust management and

must go with their wants which leads to chaos
in the firms.
 Example
 Carly
Fiorina’s Takeover of
COMPAQ (2002)
◦ Carly Fiorina (CEO Hewlett-Packard) announce
acquisition of Compaq on Sept 4, 2001 for
$25.5Billion.
◦ Faced negative reaction by stock market, industry
experts and the business media.
 Cont:
◦ Hewlett-Packard stock was down by 18% and
Compaq’s stocks by 10% following the
announcement.
◦ Two major shareholders i.e David W. Packard and
Walter Hewlett were against this decision.
◦ They placed their pressure on other shareholders
but all in vain.
◦ Fiorina went ahead with her plan.
Monitoring
 . Investing public doesn’t know about the firm’s
operational level.

 . Only managers know.
 . Consequently managers may not act in the

shareholder’s best interest which demonstrates
the need for MONITOR.
Monitoring
 . Investing public doesn’t know about the
firm’s operational level.
 . Only managers know.
 . Consequently managers may not act in the

shareholder’s best interest which
demonstrates the need for MONITOR.
Monitors Controllers
Stakeholders
Within Company
BoDs
Stockholders
Outside Company
Auditors
Creditors
Analysts
Managers
Investment Banks
Credit Agencies
Employees
Government
SEC
Society IRS
 . Similarly market force is helpful in monitoring.
 . Stakeholders can also monitor by participating.
 . Creditors can also check by ensuring that the
firm is properly handling its debt processing.
 . Employees, such as, internal auditors can play a
vital role in monitoring.
 . Society can inject a sense of responsibility at the
executive level by acting as a noble corporate
citizenship.
 . Unfortunately, all of these mechanism can fail at
one time or another.
 AnIntegrated System of
Governance
◦ The corporate governance system is integrated and

complicated.
◦ Every concern stakeholder is keen to get the perks

i.e. executives, auditors, boards, banks, analysts
and so on.
Board
 MGT
Investment Banks
Regulator
s
Consultants
Analyst
s
Credito Accounta Auditor

rs nt
 Summary
◦ corporate form of business allows
firm to have excessive capital
◦ it contributes a lot toward
country’s economy
◦ main disadvantage lies in the
relationship between the owner and
controller
 Cont:-
◦ The shareholders and executives interest can be

aligned through incentives involving stock options.
◦ these incentives can’t guarantee to reduce the level

of RISK.
By: 1. Kenneth A. Kim
John R. Nofsinger
And
2. A. C. Fernando
3rd Lecture
 Lecture Outline
◦ Briefly discussion on principle-agent or agency
problem.
◦ How manager can effect different stakeholders.
◦ Examples of management self-serving activities
◦ Types of executive compensations
◦ There are advantages and disadvantages of bonuses and
permanent increases to salary.
◦ But the question is whether these incentives based
compensation really work or not.
 Corporations are separated in between
◦ Owners ( Stockholders)
◦ Controllers ( Officers and executives)
 This is the main cause of emerging problems.
◦ i.e. principal-agent problem or agency problem
 So effective solution is required i.e.
◦ Incentives ( in this chapter)
◦ Monitoring
 Incentives solution means;
◦ Tying executives wealth to the wealth of share
holders to share the same goal.
Potential Managerial Temptations
 Manager’s action can affect the following;

◦ Investors and lenders
◦ The firm’s customers and suppliers
◦ The firm’s employees
◦ And of course himself
 Good manager always think for the

stakeholders first-not in common practice.
 Examples of self-serving managerial actions
include;
◦ Shirking ( not working hard)
◦ Hiring friends
◦ Consuming excessive perks
◦ Building empires ( making the firm as much as
possible, even though it may hurt the firm’s per
share value)
◦ Taking no risks or chances to avoid being fired; and
◦ Having a short-run horizon if the manager is near
retirement-very dangerous
Types of Executive Compensation
 Company executives are compensated
through different ways
1. Base Salary and Bonus

 The CEO salary is determined through the
benchmarking method-surveying the peers
CEO salaries for compensation.
 CEO salary has drifted upward, getting nice
raises-competitive edge.
 New CEOs making more than current CEOs.
 Basic pay depends upon the characteristics of

the firm, rather than the characteristics of the
CEO.
 So, large firm CEO will get more than small

firm CEO.
 Small firm can’t afford large firm CEO and

vice versa.
S.No Company CEO Year Package
1 CHESAPEAKE ENERGY CORP Aubrey K. McClendon 2008 100,069,201
2 NABORS INDUSTRIES LTD Eugene M. Isenberg 2008 59,834,630
3 ORACLE CORP Lawrence J. Ellison 2009 56,810,851
4 MERCK & CO Fred Hassan 2009 49,653,063
5 GAMCO INVESTORS INC Mario J. Gabelli 2009 43,576,932
6 CBS CORP Leslie Moonves 2009 43,238,875
7 THERMO FISHER SCIENTIFIC INC Marc N. Casper 2009 34,283,774

 Cash bonuses depends upon the firm’s
previous year’s performance.
 Based on;
◦ Earning per share
 Net Income-Dividend on Preferred Stock
Average Outstanding Shares
◦ Earnings before interest and taxes
 Operational Revenue – Operating Expenses + Non
Operating Income
◦ Economic Value Added
 Earnings – Cost of Capital
 An advantage of awarding bonuses, as
opposed to giving large raises, is that
bonuses are one-time rewards for past
realised performances, while raises are
permanent additions to salaries for future
unrealised performances.
 Average bonus payments for CEOs in large

firm was $1.5 million in 2004.
 Advantages of Bonus
◦ Appreciation for past performance
◦ Motivation for future goals
◦ Focus on quality
◦ Focus on individual output
◦ Bring innovation and creativity
 Disadvantages of Bonus
 Costly for company
 Taxes from employees
 Fairness and Jealousy Issues
 Advantages of Permanent Addition to salary
◦ Brings loyalty to organization.
◦ No fairness and Jealousy issues
◦ Increase is not on the basis of past performance-
it’s a routine work of organization for employees.
 Disadvantages
◦ Discourage innovation and creativity
◦ No past performance appreciation.
2. Stock Options
 The most common form of market-oriented
incentive pay
 It allows the executives to buy shares of stock
at a fixed price, called the exercise or the
strike price.
 The executives can get benefits from the
differences of prices i.e. Market price of the
stock minus strike price.
 That’s how you can align manager’s goal with
shareholder’s goals.
 This alignment will, somehow, overcome the
problem with the separation of ownership
and control.
 The most common length of the options
contract is 10 years.
 The median option-based award realized for
CEOs in large firms was $2.7 million in 2004.
 2.1. Options and Accounting
◦ Stock option is a cost for company, if there is a

difference between strike price and current stock
price.
◦ This cost was amortized over the life of the options.
◦ But if there is no difference between the strike price

and current stock price, then company need not to
report it as a cost in the income statement.
 “Thisaward is treated as
capital gain, not as income,
which is an advantage to the
CEO because capital gain taxes
are lower than regular
personal income taxes.”
 Main Problem with the Grant Options
◦ Even if the stock options are no appeared on the firm’s
income statement, means no cost for company but a real
economic lose.
 A firm has 100 million outstanding share in the market ($1
per share)
 If the executives exercise their options and sell their options
(e.g. 10 million) in the stock market.
 Now this will increase the numbers of outstanding shares in
the market i.e. 100 + 10= 110 million shares.
 Cont:-
◦ This will directly effect the share price.
◦ Simple rule of demand and supply.
◦ Supply will directly effect the demand of share.
◦ $100 millions are available (by having 100 million shares
@ $1 per share)
◦ Now $100 millions are available ( by having 110 million
share @ $0.91 per share)
◦ So it’s a lose for shareholders.
3. Stock Grants
 Because of the governance failure in late
1990s and early 2000s, many firms have
been looking for alternative forms of long-
term incentive compensation.
◦ A) Restricted Stock
 Includes limitation that requires a certain length of
time to pass or a certain goal to be achieved before the
stocks can be sold.
◦ B) Performance Sharing
 Company’s stock given to executives only if certain

performance criteria are met.
 It could be viewed as bonuses for past performances.
 More valuable for the CEOs because the firm stock

prises has been increased.
Does Incentive-Based Compensation Work In
General
 Two ways to examine
◦ 1. Positive relation between firm’s performance and
management compensation (ex post evidence)
 The evidence show that the answer is pretty much “no”
(study conducted over 2000 CEOs)
 If the CEO have to increase the firm’s value by over $300
million to increase his/her compensation by a mere $1
million.
 So the pay for performance sensitivity is very low.
 2. Positive relationship between management
compensation and firm’s performances (ex ante
evidence)
 Perhaps CEOs or managers are risk-averse and their
salaries are already large so why should they take risk.
 But if CEOs or managers are risk-takers where risk
sometimes pays off and sometimes it does not.
 Finally, its difficult to relate the firm’s performances with
the management compensations.
 Summary
◦ We discuss briefly principle-agent or agency problem.
◦ There are advantages and disadvantages of bonuses and
permanent increases to salary.
◦ But the question is whether these incentives based
compensation really work or not.
John R. Nofsinger
And
2. A. C. Fernando
Lecture 4
 Lecture Outline
◦ Problems related with incentive based
compensation.
◦ Normal perception about how stock market works.
◦ Basic problem related with executive stock options.
◦ Expensive executive options- An easy solution.
◦ Other compensation to management.
◦ CEO club membership qualifications.
◦ Retirement (or resignation compensation).
◦ Crime and punishment.
◦ International Perspective
Potential “Incentive” Problems with Incentive
based Compensation
 Dilution can be disgustingly costly over the
long term. Many companies routinely issue
stock options and shares, which can easily
dilute shareholders by 10% over a 10-year
period.
 Stock option is only affected by price
appreciation. Therefore, the CEO might
forego increasing dividends in favour of using
the cash to try to increase the stock price.
 CEO is more likely to go for the risky
business to increase the stock prices.
 Stock options lose some incentive for the CEO

if the stock price falls too far below the strike
price.
 Price manipulation can be used by the CEOs

for their benefits.
 Example: Management Behaviour at Xerox
◦ Xerox management improperly accelerated leasing
operations revenue from 1997 to 2000.
◦ The accounting manoeuvring increased revenue by $3
billion and profit by £1.5 billion over that period.
◦ That’s wasn’t the actual financial position of the
company.
◦ This artificial profit helped drive the stock price from
$13 at the end of 1996 to more than $60 in 1999.
 Cont:-
◦ Xerox CEO Paul Allaire sold stocks and profited by
$16 million.
◦ In April 2002, Xerox admitted to the SEC that they

improperly recorded the earnings and agree to pay
a $10 million fine.
◦ Obviously, that fine was paid by the firm.
◦ So, Xerox management earned millions of dollars

by doing accounting manoeuvrings.
 Cont:-
◦ The stock price fell to less than $10 per share.
◦ So, who are the ultimate loser?
◦ The stockholders……
70
Xerox executives sell $48 million worth of
options and $31 million in other stock.
60
Xerox Stock Price ($)
50
40
30
20
10
period of phony profits
0
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
 Incentive Stock Options are generally not tax
deductible for companies. Incentive Stock
Options (ISOs) are often a key component of
option plans issued by companies to
employees. If a company and employee follow
basic ISO rules, the company CANNOT claim a
corporate income tax deduction at any time
for the ultimate value given to an employee.
 Economy plays a vital role in controlling the

stock prices-CEOs always keep this in mind.
 Normal Perception about how stock market works
◦ Stock market boom is the reflection of the progressive
economy.
◦ As the economy improves, companies make more money
and their stock value rises in its accordance.
◦ In fact, the only real force that ultimately makes the stock
market or any market rise or fall, over the longer term is
simply changes in the quantity of money and the volume of
spending in the economy.
 Stocks rise when there is inflation of money
supply (i.e. more money in the economy and in
the markets).
 Similarly, stock markets can fall by having decline
in the quantity of money and spending.

 Another problem with Executive Stock
Options
◦ Aligning managers incentives with the stockholders
goals constitute a major problem
◦ Employees will work their best unless the stock
prices are higher than the strike prices.
◦ But if the stock prices get down than the strike
prices (may be because of poor economic
condition), its very hard to re-establish the
motivational level of executives.
◦ As a result, we’ll see again the race between the
owner and controller and no aligned goals.
Expensive Executive Options: An Easy Solution
 Treat it as an expense, should appear in the
financial statements.
 Granted options must now be deducted from
the firms reported income.
 Three advantages
◦ Would identify that there is a cost to the firm for
issuing options.
◦ It may reduce the amount of options executives
receive and thereby reduce their total
compensation.
◦ Contribute to corporate scandals.
 What happens to these compensation
systems if options are expensed?
 The reduction in reporting earning may cause

the companies to curtail option programs.
This could inhibit the growth of new
companies
 It could even have an impact on the economy.

Other Compensation
 CEO’s club membership
◦ CEO Club Membership Benefits
 Free access to an online forum allowing executives
to post questions and share insights and resources
on strategic business issues.
 Explore collaboration and business opportunities
with other senior executives
 Find job candidates or look for the next career
move.
 CEO Club members receive free access to quarterly
executive seminars that address strategic
management and leadership issues.
◦ CEO Club Membership Qualifications
 The membership is limited to senior executives
including the following level of managers:
 Board of Directors
 Chief Executive Officer (CEO)
 Chief Operation Officer (COO)
 Chief Finance Officer (CFO)
 Chief Marketing Officer (CMO)
 Chief Information Officer (CIO)
 Chief Technology Officer (CTO)
 Chief People Officer (CPO)
 Vice Presidents (VPs)
 Directors
 Retirement (or resignation) compensation
◦ E.g. Chairman of FleetBoston, Terrence Murray,
receives a pension of $5.8 million per year.
 Executives receive millions of dollars as

company loans at extremely low interest
rates, sometimes even interest free.
Crime and Punishment
 Increase the penalty for managers
◦ E.g. In July 2005, Bernie Ebbers, founder and former

chief executive of WorldCom, was sentenced to 25
years in prison for his involvement in WorldCom’s
$11 billion accounting fraud.
 International Perspective- CEO Compensation
around the world:
◦ Paying the top officer in the company with long-
term incentive awards is most common in the US.
◦ Normally, compensation of CEOs around the world
split into three categories
 Fixed pay (base salary and benefits)
 Variable pay (incentive-type instruments like stock
options)
 Perquisites (addition to salary etc)
◦ 63%, on average, of a US CEO’s pay is variable in nature.
◦ Singapore and Canada CEOs have 59% and 52%, on
average, the variable pay respectively.
◦ In China (except Singapore), 79% of the CEOs
compensation is fixed.
◦ India, one of the five countries with less than 50%
composition is fixed pay, pays an extraordinary 38% of
total compensation in perquisites.
Percent of Total Pay
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0%
Fixed Pay
Perquisites
Variable Pay
Argentina
Australia
Belgium
Brazil
Canada
China-Hong Kong
China-Shanghai
France
Germany
India
Italy
Japan
Mexico
Netherlands
Singapore
South Korea
Spain
Sweden
Switzerland
Taiwan
United Kingdom
United States
Venezuela
Summary
 Main problem in the corporations are separation of
ownership and control.
 Managers are supposed to work for the best interest

of the shareholders.
 Managers try to take the advantage of their control

power.
 Stocks and options benefits can’t guaranteed to

reduce the conflict.
John R. Nofsinger
And
2. A. C. Fernando
5th Lesson
 Main problem in the corporations are
separation of ownership and control.
 Managers are supposed to work for the best

interest of the shareholders.
 Managers try to take the advantage of their

control power.
 Stocks and options benefits can’t guaranteed

to reduce the conflict.
 Lecture Outlines
◦ Difference between Accountants and Auditors (A &A).
◦ Importance of Accountants and Auditors (A & A).
◦ Accounting for Inside use.
◦ Accountants answers for inside users Qs.
◦ Accounting for outside use.
◦ Difference between Financial Accounting and Managerial
Accounting.
◦ Advantages & Disadvantages of Financial Accounting.
◦ Advantages & Disadvantages of Managerial Accounting
◦ Summary
 Difference between Accountants and Auditors
◦ Accountants
 An accountant is a practitioner of accountancy or
accounting, which is the measurement, disclosure or
provision of assurance about financial information that helps
managers, investors, tax authorities and others make
decisions about allocating resources.
◦ Auditors
 An auditor is a professional who is responsible for evaluating
some aspect of a project, business, or individual. The term
most commonly refers to audits in accounting.
 Difference between accounting and auditing
◦ Scope:
· Accounting is related with preparing financial statements.
· Auditing is concerned with checking financial statements.
◦ Data:
· Accounting is related with current data.
· Auditing is concerned with past data.
◦ Purpose:
· The purpose of accounting is to show performance and
financial position of a business.
· The purpose of auditing is to certify true and fair view of
financial statements.
◦ Time:
· The time period of accounting is usually twelve months
(one year). It takes twelve months (one year) to complete
records.
· The time period of auditing is less than one year. It may
be completed within one month or may be more than one
month.
◦ Start:
· When the work of bookkeeper ends then the
accountant work starts.
· when the work of accountants ends Then the auditor
work starts.
◦ Necessity:
· Accounting is necessity of every entity having any
size.
· Auditing is not the necessity of every business.
◦ Report:
· Accounting work involves no report to any party.
· Auditing work requires separate report to owners.

 A & A are important part of any corporate
monitoring system.
 Accountants keep tracks of financial
information and auditors make a review and
monitor.
 Information can only be obtained by auditors.
 Banks, creditors and other rely on these
statement to the firm’s accurate picture and
financial health.
 Good for the investors to assess the value of
the company.
Accounting Functions
 Gathering, compiling, reporting, and

archiving a firm’s business activities.
 Accounting information helps making

decision
◦ either for insiders
◦ or outsiders.
Accounting for Inside Use
 Managers use these information to measure the

progress toward their goals and highlight any
potential problems in advance
◦ E.g. Managers wants to know their product’s sales
situation.
◦ How to manage the inventory.
 Inventory comprises of work in process, stores and spares
etc.
◦ What about cash?
◦ Have the firm enough cash to pay its upcoming debt
payments?
Accountants answer these Qs with;
◦ Budgets
 An estimation of the revenue and expenses over a
specified future period of time. A budget can be made
for a person, family, group of people, business,
government, country, multinational organization or
just about anything else that makes and spends
money. It may be either surplus budget or deficit
budget
 Surplus Budget
 A situation in which income exceeds expenditures.
 Deficit Budget
 A financial situation that occurs when an entity has more
money going out than coming in
◦ Variance reports
 In business, a variance report is prepared to evaluate the
operating efficiency of different aspects of (usually) a
manufacturing company.
 Three main sections with two subsections each:
1. Materials price variance & materials quantity variance

If the company is paying too much for materials or using too much materials
for a product, that is an unfavorable variance.
If the company is getting materials for less than the standard cost or is using
less than the standard materials for a product, that would be favorable.
2. Labor rate variance & labor efficiency variance.

Labor rate variance measures deviation from standard in the average hourly
rate paid to direct labor workers.
Labor efficiency variance attempts to measure the productivity of direct labor.
3. Variable overhead spending variance & variable overhead efficiency variance.
◦ Sensitivity analyses
 A technique used to determine how different values of
an independent variable will impact a particular
dependent variable under a given set of assumptions.
The sensitivity analysis can answer the following
questions:
 "WHAT" would be my forecasted net income, "IF" my sales

forecast is 30%, 20%, or 10% toohigh?

forecast is 30%, 20% or 10% too low?
RESUME SERVICES
FORECASTED SENSITIVITY ANALYSIS
FOR YEAR ENDING DECEMBER 31, 200X
15% 10% 200X 10%

Decline Decline Original Incline
in Sales in Sales Forecasted in Sales
Figures
Sales $88,400 $93,600 $104,000 $114,400

Cost of $10,200 $10,800 $ 12,000 $ 13,200
Goods Sold
GROSS $78,200 $82,800 $ 92,000 $101,200

PROFIT
◦ Revenue reports
 Daily
 Monthly
◦ Cost projections and

 Cost estimates (five years, less or more)
◦ Even analysis of competitors

 The assessment of SWOT analysis of potential
competitors.
 SWOT stands for Strength, Weakness, Opportunities, and
Threads.
Accounting for Outside Use
 Who are outsiders for a firm
◦ Investors
◦ Banks
◦ The government
◦ Other stakeholders
 Most companies have a corporate website
with a section entitled "Investor Relations",
which should have a wide range of company
documentation, including quarterly
and annual reports.

 Difference between financial accounting and
managerial accounting
◦ provide information to two different user groups.
Financial accounting primarily provides information

for external users of accounting data, such as investors
and creditors.
On the other hand, management accounting provides

information for internal users of accounting data.
Internal users include employees, managers, and
executives of the company.
 Advantages of Financial Accounting
◦ Access to Information
 Important information for all stakeholders
 Preview of a company
 Help to decide about the investment in a company or not.
◦ Compliance
 Financial accounting information is an element of
transparency and business ethics, requiring honest and
accurate information for investors, competitors and market
analysts to review.
 Disadvantages of Financial Accounting
◦ Cost
 Expensive part of doing business, especially for large
businesses in shape of having professionals who earn
handsome salaries and require benefits.
◦ Timing Problems
 Accurate accounting can benefit the business but selecting
wrong accounting type can be just a time wasting activity.
 E.g simple cash methods can’t handle large businesses
outstanding payments and accounts receivable.
 Advantages of Managerial Accounting
◦ Since it is focused on making future decisions with

the help of past financial data, it is forward looking
and therefore progressive in nature.
◦ It is meant for internal users like top management

and therefore it is not necessary that it is made by
following strict guidelines which is the case with
financial accounting.
◦ It is flexible in nature and therefore it can be
prepared anytime and they are not required to be
made yearly they can be made monthly or on
weekly basis.
◦ It takes all the data and then present it in such a

way that a proper analysis about the feasibility and
profitability of any business decision can be made.
 Disadvantages of Managerial Accounting
 It is dependent on cost accounting and

financial accounts and therefore the accuracy
of it is also dependent on how accurate that
data is, hence it is one of the limitations as
far as its usability is concerned.
 It is affected by the bias of top management
and therefore it is likely that they may tweak
it in such a way so as to benefit themselves
rather than shareholders.
 Since it does not follow accounting principles,
it cannot be compared with other company’s
and hence proper evaluation about the
management may not be possible on the
basis of management accountancy.
 Summary
◦ A & A play very important role in corporations.
◦ Companies are legally bound to hire A & A to have
crystal clear financial position of a company
because its not their money.
◦ Companies face two types of interactions as far as
accounting practices are concerned. Accounting for
management and for outside world.
◦ Normally company keeps two types of records in
the shape of Financial Accounting and Managerial
accounting- which normally do not match.
 A single company always must have single
financial position, so how is it possible to
have two different accounting records.
 Lastly, different accounting records means

the element of frauds in the company
THE END
John R. Nofsinger
And
2. A. C. Fernando
6th Lesson
 Last Lecture Review
 Normally company keeps two types of records in the
shape of Financial Accounting and Managerial
 A single company always must have single financial
position, so how is it possible to have two different
accounting records.
 Lastly, different accounting records means the
element of frauds in the company.
◦ Financial statement/position explanation.
◦ Accounting records are different for Managers and
Public Financial Statement.
◦ Reasons for differences in Financial Accounting and
Managerial Accounting.
◦ Problems that may occur in accounting.
 Unintentional errors
 Problems with receivables
 Intentional Errors.
 Understated liabilities
 Overstated assets.
 Who are Responsible
◦ Accountant or Manager
 Audit Role
 Types of Auditors
◦ Independent Auditor
◦ Internal Auditor
◦ Government Auditor.
 World largest 4 Audit Firms
 Summary.
 Financial statement can be explained through;
◦ Income statement
 A financial statement that measures a company's financial performance
over a specific accounting period. Also known as the "profit and loss
statement" or "statement of revenue and expense.
◦ Balance Sheet
 A financial statement that summarizes a company's assets,
liabilities and shareholders' equity at a specific point in time.
These three balance sheet segments give investors an idea as to
what the company owns and owes, as well as the amount invested
by the shareholders.
The balance sheet must follow the following formula:
Assets = Liabilities + Shareholders' Equity
◦ Statement of Cash Flow
 The document provides aggregate data regarding all
cash inflows a company receives from both its
ongoing operations and external investment sources,
as well as all cash outflows that pay for business
activities and investments during a given quarter.
◦ Popular press articles

o And analysts (financial) recommendations
o Financial analysts help people decide how to invest
their money. They work for banks, insurance
companies, mutual funds, and securities firms. They
often meet with company officials to learn more about
the firms in which they want to invest. After the
meetings, the analysts write reports and give talks
about what they found out. Then, they suggest buying
or selling that firm's stock.
 That’s how outsiders can easily determine the
firm’s value, profit and its risk.
 However, SEC is looking for the uniform set

of standards for public companies i.e. GAAP
(Generally Accepted Accounting Principles).
 These statements are prepared by the

accountants of the firms and reviewed by the
auditors.
 Accounting records are different for;
◦ The managers
◦ Public financial statements

 Reasons for Differences in Financial
Accounting and Managerial Accounting
◦ If Financial Accounting shows favourable financial

position as compared to Managerial Accounting
 1. Company’s management is showing fake financial

position of the company i.e. company doesn’t have
enough financial position ( as managerial accounting
shows) but showing the wrong face of the company to
the stakeholders.
 If Managerial Accounting shows favourable financial
position as compared to Financial Accounting
 Company’s management is trying to use the hidden
money for their personal interests
 i.e. 1. having more perks for themselves
2. using that money for further business,
trying to increase the share prices ( trying to
gain the maximum benefit from the
stocks/shares they hold)
Problems That May Occur In Accounting
 Unintentional Errors
◦ An accounting-related item is unintentionally
misrepresented or is measured inaccurately.
 Problems with receivables

◦ Accounts receivable is money owed to a business by its
clients (customers or debtors) and shown on its balance
sheet as an asset. It is one of a series of
accounting transactions dealing with the billing of
a customer for goods and services that the customer has
ordered.
 Intentional Errors
◦ Overstate income statement
Impact of Error on
Error in Inventory Cost of Goods Sold Gross Profit Net Income
Ending Inventory 10000 20000 18000

=30000 (Actual)
Understated Overstated Understated Understated
20000 12000 8000 7000
Overstated Understated Overstated Overstated
40000 8000 32000 30000
Beginning 10000 10000 8000
Inventory= 20000
Understated Understated Overstated Overstated
15000 4000 11000 10000
Overstated Overstated Understated Understated
25000 17000 8000 6000
◦ Understate liabilities
 Understated liabilities will automatically show the
improves financial position of the company
 Assets= Liabilities + Owners’ Equity
◦ Overstate assets (receivables)

 Overstated Assets will show the fake financial position
of the company.
 Who are responsible
◦Accountants
◦Managers
Auditing
 The general definition of an audit is an
evaluation of a person, organization, system,
process, enterprise, project or product.
 Audits are performed to ascertain the validity

and reliability of information.
◦ 1. Independent Auditors
 Independent auditors are usually CPA’s (Certified
Public Accountants) who are either individual
practitioners or members of public accounting firms
who render professional auditing services to clients. In
general, licensing involves passing the uniform CPA
examination and obtaining practical experience in
auditing.
 2. Internal Auditors
Internal auditors are employees of the organization
they audit. This type of auditors is involved in an
independent evaluation of evidence, called internal
auditing, within an organization as a service to the
organization. The objectives of internal auditing is to
assist the management of organization in the
effective discharge of its responsibilities.
 3. Government Auditors
Government auditors are employed by
various local, state, and federal governmental
agencies. Government auditors are specialists
in tax and disclosure regulations.
Internal Auditor
 Internal auditor is responsible;
◦ To oversee the firm’s financial and operating
procedures
◦ To check the accuracy of the financial record-
keeping
◦ To implement improvements with internal control
◦ To ensure compliance with accounting regulations
◦ And to detect fraud.
 Firms are not required to have internal
auditors but many firms have them to
enhance their accounting and internal control
efficiency.
 In fact, the people who initially detected

financial fraud at WorldCom were the
company’s own internal auditors.
External Auditor
 External auditors are the accountants from

outside the firms
 They review;
◦ The firm’s financial statements
◦ The fairness of the statement
◦ Assess the system and procedure used by internal
auditors
 To conduct external audit, the auditor’s
might;
◦ Conduct interviews with the firm’s employees to
assess the quality of the internal audit system.
◦ Make their own observations of the firm’s assets.
◦ Check sample balance sheet transactions
◦ Meeting with the firm’s customers and clients to
assess the firm’s short-term assets and liabilities.
◦ Conduct their own financial statement analysis such
as comparing ratios from one period to the next.
◦ In the end they generate the report.
largest Audit firms are;
(BIG FOUR)
 Price Waterhouse Coopers (HO in UK)
 Deloitte & Touche (HO in US)
 Ernst & Young (Ho in UK)
 KPMG (HO in Netherland)

 Summary
◦ We have discussed how financial position of a
company can be examined through different ways.
◦ Accounting records are different for managers and
public financial statement.
◦ Reasons for the difference between financial
accounting and managerial accounting are either to
show the wrong financial position of the company
or to use the company’s money by the management
for their personal interests.
◦ Normally, we face different problems that may
occur in accounting.
 Here come the role of an auditor to check
there errors by the accountants.
 There are different types of auditors
◦ Independent auditor
◦ Internal auditor
◦ Government auditor
 Big 4.
The End
John R. Nofsinger
And
2. A. C. Fernando
7th Lesson
Last lecture review
their errors by the accountants.
 Big 4.
◦ The changing role of accountants-managing
earnings i.e. accountants will act as a profit-centers
◦ Through managing earning methods, accountants
can release the pressure of managers as well as
analysts.
◦ Window dressing and smooth earnings are another
technique used by accountants to show the
favourable financial condition of the company.
◦ Price manipulation is acceptable to some extend
but it should not violate the law becoming
fraudulent acts.
 End of the story is that investors as well as stock
holders will have to suffer with all these techniques
used by accountants and management.
 Single accounting firm should not allowed to conduct
audit as well as consulting activities for a single firm
 Main reason is the conflict of interest between
auditors and consultants.
The Changing role of Accounting – Managing
Earnings
 Accountants role has been changed for the last
two decades i.e.
◦ Instead of simply providing information to insiders and
outsiders, accountants act as a profit- centers.
◦ Accounting departments are asked to increase profits
through implication of accounting methods.
◦ Different methods often lead to different levels of
reportable profits.
 This process of reporting of profit is called managing
earnings.
 E.g. 1. Pressure on accountants from managers to
meet internal targets.
 Managers wants accountants to show increase revenue
and decrease cost because it may lead to a raise or a
bonus for the CEO and other managers.
 2. Pressure on accountants from Analysts to meet
external targets.
( Company_____Investment Banks-Financial Analysts_____Investors)
◦ Analysts make predictions about firms profitability

measured by earning per share (EPS).
◦ If firm fails to meet these expectations, then the share
price will decline.
◦ So, the pressure is on accountants to make any sort of
arrangement which can be “window dressing”.
 What is window dressing?
◦ Window dressing is a set of actions or
manipulations with financial or other information in
financial documents (financial statements, reports,
etc.) to make this information look more attractive
to its users. Even though window dressing can
occur at any time, it is commonly used at the end of
a period e.g. normally banks managers ask their
friends to deposit their money for a short period of
time to have attractive financial position etc; etc.
 Other examples of window dressing by
companies may include advertising, selling, and
marketing. In these cases, window dressing
occurs when positive characteristics of products
or services are a little exaggerated to increase
demand for them while negative characteristics
are not mentioned or kept hidden.
 Another example of variations in accounting
method is called smooth income.
◦ An erratic pace profit generated by business is
being divided into number of years.
 Give shareholders a sense reduced risk.
 Can easily handle with the analysts predictions.
 Good for managers to show consistent revenue on the
board meeting.
 Good to deal with the government regulations like
taxation.
 etc; etc.
From Manipulation to Fraud
 A question often asked is how much can
companies manipulate accounting figures
before they cross the line into fraud?
◦ E.g. Selling goods/assets at high price to its own
subsidiary, where as the book value is very low and
so on.
◦ Therefore, the firm book large capital gain and
profits go up, which is not actual.
 The subsidiary capitalizes the cost of the
truck by reporting lower earning in each of
the future years in which the truck cost is
depreciated.
 Accountants are under pressure from the

management side;
◦ To show maximum profit by any mean
◦ To show less shortfalls
 What about the investors or stock holders?

 There is a difference between capital investment
and operating expenses e.g. On June 25, 2002,
WorldCom disclosed that roughly $3.8 billion had
been improperly booked as capital investments
instead of operating expenses.
◦ Capital investment
 Capital investment may also refer to a firm's acquisition of
capital assets or fixed assets such as manufacturing plants
and machinery
◦ Operating expenses
 A category of expenditure that a business incurs as a
result of performing its normal business operations.
 There is a clear line between legal accounting

manoeuvring and accounting fraud.
 Accountants and auditors are responsible for

this fraudulent act but one should not ignore
the role of management in all this.
Auditors as Consultants
 Business consulting firms typically advice firms
on tactical issues, such as how to enter a new
market and strategic issues, such as acquiring or
spinning off other firms.
 For example, McKinsey & Company

◦ Advises more than half of the Fortune 500 firms
◦ 7,700 consultants in 84 locations worldwide and
generated $3.4 billion revenue
◦ Representing more than 40 percent market share of the
consulting business.
 One potential problem for a firm’s
shareholders occur when a consulting firm
conducts auditing services for the company.
 The income for conducting an audit is far

lower than the fees earned for consulting.
 It is intended to separate auditors and
consultants, prohibit accounting firms from
providing both auditing and consulting
activities to the same company.
 The conflict of interest of consultants and

auditors are the main reason.
 International Perspective
◦ Compared to accounting systems used
internationally, the system in the US is quite
rigorous to protect shareholders rights.
◦ In the recent study of 31 countries, the US was

found the best legal environment to discourage
earnings manipulations and smoothing.
◦ Australia, Ireland, Canada, and the UK also have

good investor protection and enforcement histories.
 Summary
 Normally company keeps two types of records in the
shape of Financial Accounting and Managerial
 A single company always must have single financial
position, so how is it possible to have two different
accounting records.
 Different accounting records means the element of
frauds in the company.
there errors by the accountants.
 Big 4
 The changing role of accountants-managing
earnings i.e. accountants will act as a profit-
centers
◦ Through managing earning methods, accountants
can release the pressure of managers as well as
analysts.
◦ Window dressing and smooth earnings are another
technique used by accountants to show the
favourable financial condition of the company.
◦ Price manipulation is acceptable to some extend
but it should not violate the law becoming
fraudulent acts.
◦ End of the story is that investors as well as stock
holders will have to suffer with all these techniques
used by accountants and management.
 Single accounting firm should not allowed to
conduct audit as well as consulting activities
for a single firm
 Main reason is the conflict of interest
between auditors and consultants.
The End
CHAPTER
ll
a italism is an economic system of business based on _private, enterprise.

ua s and businesses own land, farms, factories, and equipment, and 'they
use those assets in an attempt to earn profits. Capitalism is a good eco- .
nomic system because it can provide rewards for those who work hard and who are
inventive and creative enough to figure out new or improved products and services. One
potential reward for creating value in an economy is the accumulation of per-.
sonal wealth.The wealth incentive provides the fuel to generate new ideas and to
foster economic value that provides jobs and raises our standard of living,.
The main goal of a company is to create an environment conducive to
earning long-term prEifiti fiiaisTErirfaim .two main sources. First, a business -
'nit:1st-provide products and/or services toa customer base. A large portion of a firm s
vilife—creli fi-Om the current and future profits of its business activity.
Finding ways to increase profits from core operations can increase economic
value. Second, increased profits can come from growth in_the_sales of arte;dstin
product or sales resulting from the introduction of anew
—--Expansion usually requires. additional money, or,capital,Dusiness activities
alsoentaile irfiSk. The abilities access capital and to control risk are important in the
success or failure of a firm. Such abilities are influenced by the manner in
this chapter, we first describe different forms of
which a firm is organized. In business,
rporation. We then describe the people involved
with emphasis on the co in the
usiness, and the separation of owners and managers
corporate form of b that this
on is problematic, and we describe how corporate
entails. This separati
ss this problem.
governance can addre
SS OWNERSHIP
FORMS OF BUSINE
be a soleproprietorship, a partnership, or a corpora-
In general, a business can
but we will focus on these three as this is the most
tion. Other forms exist,1
ch organizational form involves different advantages and
general dist: fiction. Ea
orations and Corporate G Ol ' el l 1 a l1C2
2 CHApTER 1 Corp
y a single person.
rittorsh s a business ip owned b
disadvantages. A splo rop i uted at
relatively easy to start up and business tax is comp
These businesses are
simplicity, sole proprietorships are ubiquitous,
the personal level. Due to its
ent of all U.S. businesses .2 However, there.are
representing more than 70 perc
sev-
lifespan (they die with
eral signifiCant draWbacks. Such fit ifi'§-6fte1-1. ital, and
they have a)_-_-I-rriliTqabiliyitoTObtain cap
the owner's death or retirement), the
or the firm.
owner bears unlimited persona l liability f
ole proprietorship but there is more than one
1- partnership is similar to a s owner,
es the advantages and disadvantages of the
As such a partnership shar sole
us advantage of a partnership is the ability to
proprietorship.While one obvio pool
ot be as important as combining service
capital, this advantage may n oriented
larger partnerships. Examples of such
expertise and skill, especially for partnerships
firms, investment banks, and advertis
include accounting firms, law ing firms.
ion. Fewer than 20
This book focuses on the third business form , the corporat
tth-e-Y. generate approximately
percent of all U.S. businesses are corporatio.ns bu
orporation is its own legal
.-1)0-percentorthecoUntry's business revenue.3 The c
an engage in business
entity, as if it were a person. For example, the corporation c
ate officers act
transactions and other business activities in its own name. Corpor as
agents for the firm and authorize those activities.
Perhaps the mostimportant_advantage,of_ the ...co rpo ratq business form_is
access to capital markets. Public companies can raise money by issuing stocks and
bonds investors. While sole proprietorship8 and partnerships may access millions
—of dollars through the business owners' wealth and through banks, cor-
porations may be ableto,access billions of dollars. Access to this capital causes
entrepreneurs sucl-FaS Bill Gates of Microsoft, Steve Jobs of Apple, and Larry
Ellison of Oracle, to take their companies public so that their businesses can
become corporations. To raise money for expansion in the capital markets, the
business sells stock to investors.
For example, between 1977 and 1980, Apple Computer sold a total of
121,000 computers. To meet the potential demand for millions of
computers per year, Apple needed to expand operations significantly. As a
result, in,1980 Apple became a public corporation and sold $65 million worth of
stock: Steve Jobs, cofounder' of Apple, still owned more shares than anyone selse,
but he owned less than half of the firm. He gave up a great deal of owner-
(Incihip to new investors in exchange for the capital to expand thdental i rf me
haunt Jobs.) ack toly, as
we will describe later, this decision would later come b
Stockholders or shareholders are the.,owners of a public corporation. These

shareFiolifeigteteive.any value thatis created by the firrn,'Cui they can also lose. their
investments if the'firm goes bankrupt. Th e process has
two benefits. First,
any individual, as long as she has some money, can inves
t in business and
increase her wealth over the long term. Second, businesses with growth potential and
can obtain the capital needed to expand, which creates economitaxes. A oi val1uebs,
ac
porationhas an_ infisite.,,life. unless terminated by bankruptcy
Corporate Governance
CHATTER I Corporations a,:d 3
m i t e d f i n a n c i a l
or merger with n
a other f ir m „Th e o w n e r s o f c o r p o
r a t i o n s e n j o y l i
o f t h e ir o wn e r s h i p s h a r e s .
liability-because they can lose only, at m o s t , t h e v a l u e
s t a k e s c a n b e
Fu r t h e r , c o r p o r a t e o wnersh ip is us ually liqu id, an d o wn e r s h i p
s h e N ew Yo r k S t o c k
easily boughL and sold a., stocks in a m a r k e t p l a c e , s u c h a t
E x c h a n g e ( N YS E) or N A S D A Q
g , b u t t h e r e ' a r e
Tn e a d v a n ta g e s o f th e c o r p o r a te b u s i n e s s f o r m a r e a p p e a l i n
ess at axes before

a l s o m a j o r d i s a d v a n t a g e s . C o r p o ra te pr o f its ar e s u bj e c t to busin
u b s e q u e n t l y ,
a n y i n c o m e goes to s ha r e h o l d e r s in the for m o f d i v i d e n d s . S
c o a -
s h a r e h o l d e r s m u s t . a l s o p a y p e r s o n a l t a x e s o n d i v i d e n d i n v ., T h e r e f o r e , s h a r e -
u n n i n g a c o r p o r a t i o n c a n b e
1- - : ; I d e r s a r e e x p o s e d f o ' d o U b l e t a x a t i o n . I n a d d i t i o n , r
n t a n t s n d l e g a l e x p e r t s , th e
e x p e n s i v e . Fo r e x a m p l e , t h e c o s ts o f h i r i n g a c c o u a
o f c o
costs of co m m u n i c a t i n g w i t h a l l s h a r e h o l d e r s , t h e c o s t s m p l y i n g wi t h r e g u l a -
p s h e
tions, and so forth, can cost m illio ns of do lla rs per year. Fi n a l l y , a n d p e r h a t
m ost i m p o r t a n t d i s a d v a n t a g e , c o r p o r a t i o n s s u f f e r f r o m p o t e n t i a l l y s e r i o u s
e o v e r n a n c e p r o b l e m S. M ost investors only o w n a s m all stake of a la

rge
public
corporation, so they consequently do not feel any true sense of
o
w n e r s h i p o r c o n -
trol over the fir m s in w hich they o wn s t o c k .
SEPARATION OF OWNERSHIP AND CONTROL

In 1932, Adolf B er le an d Ga r d i n e r
M eans,; w r o t e
wh a t wa s to becom e a fa m o u s
b o o k a b o u t t h e c o r p o r a t e f o r m o f b u s i n e s s . ` Th e y p o i n t e d o u t t h a t c o r p o r a t i o n s
w ere be c o m ing so large that the o w nership and control w as separated. Th e
stockholders o w n the fir m and officers (or executives) control the..firm. Th i s

_ _
situation co m es about because the thousands, or even hundreds of thousands, of
i n v e s t o r s wh o o w n public firm s could not collectively m a ke the daily dec ision s
n e e d e d t o o p e r a te a b u s i n e s s . F ir m s hire m a n a g e r s f o r th a t w o r k .
M o s t s h a r e h o l d e r s part in
d o n o t wi s h to take a fir m 's bu sines s a c t i v i t i e s . T hese
shareholders act like passive investors,.not active.owners:The difference is
Owners focuson the business perfor m ance of the fir m a n d
i n v e s t o r s f o c u s o n t h e r i s k a n d r e t u r n o f t h e i r s t o c k p o r t f o l i o s . Wh i l e d iv e r s if y in g
r e d u c e s r is k f o r th e in v e s t o r , o w n e r s h i p o f m a n y c o mp a n i e s also m a k e s p a r t i c i p a -
tion and influence in those co m panies less likely. Th e r e f o r e , in ve s to r s ten d to be
i n a c t i v e s h a r e h o l d e r s o f m any f i r ms .
Th e r e is a proble m w ith th is se pa ra tio n o f o w n e r s h i p a n d c o n t r o l . Why w o u l d
t h e m anagers care about the o w n e r s ? B erle and M e a n s p o in te d o u t that w ith
m anagers being freed fro m v ig ila n t o wners, they_ w o u l d o n l y p u r s u e e n o u g h
profit to keep stockholders satisfied while t h e y s o u g h t s e l f - s e r v i n g - gr a t i f i c a t i o n i n
hTe-foetreof perks, po w
er, and/or fame. In acade
m ic ter m s , this situation is kno wn
as the O ntipa9-ng.e..1-al proble m or the agent)/ proble m , Th e o w ners are the princi-'
--p-ari n d th e m a r i a g e i - Ts the a iel t wh o is supposed to w ork for the o w ner. If share-
h o ld e r s c a n n o t e f f e c ti v e ly m o n ito r th e m a n a g e r s ' b e h a v i o r , t h e n ma n a g e r s . s n a y
b e te m p t e d t o u s e t h e f i r m ' s a s s e t s f o r t h e i r o wr e e n d s , : a l l a t t h e e x p e n s e o f s h a r e -
.holders.,This should riot be hard to i m a g i n e . S e c r e t a r i e s m ay take ho m e office
supplies. Wh e n t r a v e l i n g , m i d - l e v e l m a n a g e r s m
ay order as m uch food as allo we d
4 e-1 rHA ora/F, Governancc
PTER 1. Corporations and Corp
ht prefer fancy oak furniture for their

on their expense accounts. Executives mig actions are at the
raveling,. A ll of these
offices and the use of corporate jets when t
they can get away with these minor
expense of shareholders. If people feel offenses,
what else might they try? greatest ahilityto_steal from
Among all employees, the ones who have the
have the most power and control`
shareholders the most are the executives. They in the
bosses who look at expense reports.
corporation:-Mid-level managers have Who watches
ves have temptations, and if executives
the executives? If executi have a serious problem.
are not watched by engaged owners, then we
ategories, incentives nd moni-
Solutions to this problem tend to come in two c a
of the executive to the wealth of the
toring,The incentive solution is to tie the wealthant the same thing.This is called
ers
shareholders, so thatexecutive's and sharehold w es. tanagers Would then act and
alicmina executive incentives with shareholder desirolders. How can this be done?
behave in a way that is also best for the other shareh For
ted stock, stock options,
most U.S. companies, executives are given stock, restric or
pensation..The advantages
combinations as' a significant component of 'Heir com in the next chapter. Suffice and
disadvantages of this incentive sohition are explored problem.
to say, there are troubles with this solution to the agency
oring the behavior of
The second solution is to set up mechanisms for monit
in this chapter,
managers. Several monitoring mechanisms are discussed shortly and
they are importantly discussed throughout this book.
_Theoretically, managers work for owners (shareholders). In reality, because share-

liolderS are usuallyinactive, the firm actually_ seems to belong to management. Some
active shareholders have tried o influence management,but they are often Met with
defeat. Recent evidence of unsuccessful outcomes of shareholder proposals is quite
telling. Shareholders have the power to make proposals that can be voted on at the
annual shareholders meeting. There are generally two types of proposals, those
related to governance (e.g. suggesting changes in board structure) and those ori-
ented to social reform (e.g. proposing to stop selling chemicals to rogue countries).
About half of all shareholder-initiated proposals progress far enough in the process
to reach the voting stage:When there is a vote, such proposals usually are defeated.'
A huge factor in whether a proposal is successful depends on manag_emet;t's
opinion. Without management approval, proposals have little chance of succeed-
Trig. Tiaditionally, shareholders have trusted management to know what is best
for the firm, Most shareholders will go along with whatever management wants.
Monitors
Generally speaking, the investing public does not know what goes on at the firm's
operational level. Managers handle day-to-day operations, and they know that
their work is mostly unknown to investors. Consequently, managers may not act in
the shareholder's best interest, which demonstrates the need for monitors.
porate Governance 5
CHAPTER 1 Corporations owl Cor
EXAMPLE 1.1
FE CARLY HOEIN.NS TAKEOVE►!R OF COMPAQ

re also
For an illustration of management sons of HP's founders, we
ui on.
control and influence, consider the strongly opposed to the acq siti
2002 merger between Hewlett- In fact, they took out newspaper ads
to
Packard (HP) and Compaq.6 Carly asking other HP shareholders
T'iorina, the Fle‘,,lect -IlacLard CEO, vote against the merger.
announced on September 4, 2001, However, Fiorina went ahead
that HP would acquire Compaq for with her plan, despite attacks from
75.5 billion. The stock markets, both Packard and Hewlett, and on
industry experts, and the business March 19, 2002, most of the other
media reacted negatively to the shareholders voted in favor of the
news. Hewlett-Packard stock was acquisition. Despite the controversy
down 18 percent following the and the drop in stock prices, most
announcement, and even Compaq's shareholders voted with manage-
stock declined by 10 percent, which ment's wishes and approved the
is rare for a target firm. Of particu- acquisition. This example reinforces
lar note, David VT. Packard and the idea that even though some
Walter Hewlett, bath significant investors may want to influence
shareholders (when including the business strategy and direction,
Packard Foundation, the pair management controls the firm.
owned 18 percent of HP stock) and
Figure 1.1 illustrates the separation of ownership and control between stock-
holders and managers. In addition, the figure shows that monitors exist inside the
corporate structure, outside the structure, and in government.
The monitors inside a public firm are the board of directors who oversee man-
age-frient-and aCe-suppos-ed to represent shareholders' interests. The board evalu-
ates management and .can also design compensation contracts to tie management's
salaries to the firm's performance. You may remember that Apple Computer was
cofounded by SI..eve jobs.When the firm became a public corporation, Jobs was the
largest shareholder, and he also became CEO, However, the Apple board of direc-
tors felt that Jobs-was not experienced enough to steer the firm through its rapid
expansion. Therefore, they hired John Sculley as CEO in 1983. In 1985, a power
struggle ensued for control of the firm, and the board backed Sculley. Jobs was
forced out of Apple and no longer had a say in business operations even though he was
the largest shareholder. (Interestingly, when Apple Computer experienced dif-
ficulties in the late 1990s, the board hired Jobs back as CEO!)
As shown in the figure, outsiders—including auditors,analysts,_investment:
banks, credit rating agencies, and outside:leialcounselH inntteerraacctt with the firm and
monitor manager activities, Auditors examine the firm's accounting systems
and Corporate OVernaliCe
CHAPTER 1 Corporations G
Controllers
St3k27101(1224's
Monitors
- i:,SiockhOld!Ze$
Creditors, -,
-ft
77:7'r7Y
1.
e • lf
3.75.1447ivi4&
%-,r7ry73P3 '1'571
„ -21ZLiff::=
. 4_r1.,4,Vg-11k;',it41J11 rtfIrtfti• "TiratW , 11.,s,
°l P., 1
a
and comment on whether financial statements fairly represent the financial
position of the firm. Investors and other stakeholders use the public financial
statements to make decisions about the firm's financial health, prospects, perfor -
mance, and value. Even though investors may not have the ability or opportunity to
validate the firm's activities, accountants and auditors can attest to the firm's
financial health and verify its activities.
Investment analysts who follow a firm conduct their own independent eval-
uations of thecompany's business activities and report their findings to the
investment community. Analysts are supposed to give unbiased and expert
assessments. Investment banks also interact with management by helping firms
access the capital markets. When obtaining more capital from public investors,
firms must register documents with regulators that show potential investors the
condition of the firm. Investment banks help firms with this process and advise
managers on how to interact with the capital markets.
The government also monitors,. business activities through the Securities and
ExchaTiFerOm missroii(SECTaTid the Internal Revenue Service (IRS). The SEC
regulates public firms for the protection of public investors, and it makes policy and
prosecutes violators in civil courts. However, for criminal prosecution the SEC
must turn to the U.S. Justice Department. The IRS enforces the tax rules to ensure
corporations pay taxes, just as it does with individual U.S. citizens.
In response to the corporate and investment community scandals; the U.S.
government responded with the enactment of the SarbareAzaxley Ac t goL2W2.
p o regtt ate audito --- —Overall, the
Act created a new oversight body to rs, created laws
ertaining to corporate responsibility, and incre ased punishments for corporate
whi
own. govete-collar crime. Both the NYSE and NASDAQ developedrnancef ad
don pted theia r
ocused listing standards to address the proble ms.

CI-TATTETI 1 Corporatio7:s and Corporate Governanct!
r_ _Market forces c :in also help discipline mana rn.ent. If a manager is not doing a
good job, either Lecause he is had at managing or because, he is abusing his
manaz,eri21 discretion, then his firm might get taken and he is subsequently
tirec2. In this stdse, the fear of L, potential takeover might represent a powerful
disci.plinary mechanism to m_ake sure that managers perform to the best of their
abilities and to make sure that managerial discretion is controlled.
Stakeholders also monitor the firm. Some stockholders, such as large institu-
tional iiirestoi.:3 like p2nsIon funds, are active monitors. Creditors will make sure tie:: firm
can handle its debt. Employees, such as internal auditors, might monitor the firm to make
S1.17,2 it is h.::.althy. And soc.i.2.ty could instill a sense of corporate citizenship to tile firm so
that firm executives feel a sense of responsibility toward their community.
As a group, this is a pretty impressive set of monitors. -Unfortunately, all of
these mechanisms can fail at one time or another. An important purpose of this hook
is to describe each of these corporate monitors and the problems that may e-,(:_ist with
ea7.11 of them.
AN iNTEGRATED SYSTEM OF GOVERNANCE

The corporate governance system is integrated and complicated. The potential
incentives for executives, auditors, boards, banks, and so on, to misbehave are
intertwined. By focusing on one part of the system, readers might not fully under-
stand how the governance system can break down. Consider the diagram of
corporate participants in Figure 1.2. The arrows show the relationships between the
groups. Note that these relationships are interconnected.
ge the prospects of the firm.
For example, analysts talk to management to gau
t analysts will recommend a "buy"
Managers want to paint a rosy picture so tha
However, this situation may also cause ana-
rating and the stock price will rise.
ecast for the company, and the managers may
lysts to predict a high profit for
ecast. If the business activities of the firm do not
struggle to meet the high for
• /- "ls.,
PI I
a IA
410.2
et•
4i
ut-"+:ccciurttgrti.51.'
••
d Corporate GOVC17101-1Ce
8 CHAPTER 1 Corporations an
nagers might then pressure their accounting
merit the high profit forecast, ma who reconinenda—Eres_
are hired
_depart_nlent tohelp. In some ow increased profits.
sive accounting techniques to help sh
ay have had a long and fruitful relationship
The public auditors for the firm m
for many years.,The auditorsareyroud to
with the company, auditing the books
lient and o ot want to end this relation
havea_prestiotous corporation as a c d n
too hard on limiting aggressive accounting
ship;
consequently they may not press methods.
ed with pushing hard for smooth and
Why are managers so obsess
ssed with gaining analyst favor? It is
increasing profits? Why are they obse
by the managers)awards them stock
because a. (which.islargely picked
n increase the price of the stock, then
options and stockiiiCe—ntives. If managers ca they
become rich.
can cash in their options and stock and
vior. However, regulators often
Regulators also monitor managers' beha have
diting firms, or law firms that
experience as partners in consulting firms, au are an
g in the corporate system, regu-
integral part of the system. By participatin
t also have their own conflicts
lators know how it works. Unfortunately,they migh of
interest.
oring mechansims:
- This book describes the following monitors or monit
e incentive contracts that supposedly align executive incentives with share-

holder interests;
® accountants and auditors who check the firm's financial statements; O
boards of directors who represent shareholders;
O investment banks and analysts that brings securities to the public for sale
and evaluates them;
O creditors and credit rating agencies who monitor the firm's ability to
handle debt;
shareholders themselves;
the corporate takeover market where supposedly good firms take over bad
firms;
O the Securities and Exchange Comission who are the official regulators of
the securities industry;
® new governance laws; and
O corporate citizenship that should instill a sense of corporate responsibility
to the executives.
INTERNATIONAL MONITORING
Other capitalist countries use the types of monitoring and incentives used in
the U.S. to align the interests of executives and shareholders. However, impo ta
r-
cont differences do occur. Some countries use different compensation the s
ntracts and have different accounting standards. Many coam rint es do not havu
e institutional investing environment as the U. e
S. Some countries
are bankoriented rather than capital markets-oriented. A country's legal
PTER
corporation's ownership and control are separated between two

parties—stockholders and officers. The stockhdlders own the firm _and
officers (or executives) control tb. firm. A simpleproblem exists with this
- - : -
separation of ownership and control. Why should the managers care about the
owners? Managers may put personal interests first, even at the expense of owners. `This
situation is known as the prIncipol-agent problem or the asency pobleln. The _
shareholders of a Corporation are the principals afiliThe Managers-who run the
company are the agents. If shareholders cannot effectively monitor managers' ,
behavior, then the lattermay be tempted to use the firm's assets to enhance their
-own lifestyles.
Solutions to *agency problems tend to fall in''tivo categories:incentives and
inonitoring, The board of directors, auditors, and other components of the gover-
nance system serve to monitor rnanagers,;. this is discussed in later chapters. The
incentive solution, covered in this chapter, ties an executive's wealth to the
Wealth of shareholders so that everyone shares the same goal. This is called align-
,in executive incentives with shareholders' desires. Managers should then act in
ways that also benefit 'other shareholders. To align manager and shareholder
interests, most executives receive stock options as a_ significant component. of
their compensatiort. In this chapter, we focus on the incentives of modern execu-
tive compensation.
A manager has a variety of stakeholders that are affected by his actions. These
include investors such as stockholders (owners) and lenders, the firm's customers and
suppliers, the firm's employees, and of course himself. A good manager should put the
needs of other stakeholders before his own but human nature may cause him to put
his needs first. Examples of self-serving managerial actions include:
).,a shirking (i.e. not working hard);
hiring fiiends;
11
Incentives
12 CHAPTER 2 Executive
-
ks (e.g. purchasing extravagent office- furniture,
consuming excessive per using
ng large expense accounts);
company cars, enjoyi
rm as large as possible even, though it
building empires (i.e. mak ing the fi may
re value);
hurt the firm's per sha nd
o avoid bein . fired; a
taking, no risks or chances t e manager
g is near retirement.
having a short-run horizon if th
nagers will not behave in these ways is to give
One way to make sure that ma them
act in the interests of their other stake-
the right monetary incentives to
cutive compensation that are aimed at
holders. We discuss various types of exe
accomplishing this task.
.,-..0'11713ES OF EXECUTIVE COMPENSATibil

rent ways. They receive a basic
Company executives are compensated in many diffe
salary that also includes pension contributions and perqu isites (company car, club
eceive a bonus that is
memberships, and so on). In addition, top executives might r
usually linked to accounting-based performance measures. Lastly, managers might
receive additional wealth through long-term incentive programs, usually in the
form of stock options, which reward the manager for increasing the company's
stock price. Stock grants are another common form of long -term awards.
Base Salary and Bonus

As with most jobs, CEOs are promised a specific annual salary.The base salary of a
company CEO is often determined through the benchmarking methodi'which
SiirVeys peer CEO salaries for comparison.1 Salaries less than the 50th percentile are
considered under market, while salaries in the 50th to 75th percentile are
competitive. CEO base salary has continuously drifted upward because CEOs
typically argue for competitive salaries. So each year we often see CEOs getting nice
raises and also we see new CEOs making more than current CEOs.
Interestingly, this basic pay results more from characteristics of the firm (e.g.
industry, size) than on characteristics of the CEO (e.g. age, experience). So a,. CEO of
a large firm often gets a salary higher than a CEO of a smaller firm, regardless of
the person's past success, age, and experience. Mercer Human Resource
Consulting, in conjunction with the TVall Street Journal, annually sur-
veys proxy statements for 350 of the largest U.S. companies to examine CEO
compensation trends.2 In 2004, the median base salary for CEOs of these large
firms has been about $975,000.".
At the end of every year,,CEOs often receive cash bonuses. The size of the,',
.paY-nientisliased'Odihe'performance of the firm over the past year and is typi -,tally based on the accounting profit measurements of earnings per share (EpSi and
earnings before interest and taxes (EMT). Measures of economic value.' added
(or EVA) are also common. These value-added measures are usually vaii-
atioas on earnings minus the cost of
capital.The idea is to measure the value
-added to the firm, in relation to the firm's costs ofrising different sources of
Stock Options .
Executive stock options are the most common form.ofr.a.arizet,orientd

pay.St..oc options are contracts that allow executives to buy shares o_f stock at a-
.fixed price, called the exercise,or strike pr therefore, if the price of thle stock-
rises above. the strike _price) the executive will capture the differ...nce as a-profit.:r
'or example, if the stock of a company trad.!s at $50 per share, the CEO-may be
given options with a strike price at $50. Over the next few years, if the stock price
rises to $75 per share, then shareholders would receive a 50 percent return on their
stockholdings. The CEO could buy stock for $50 per share by exercising the option
and sell it for $75 per share, thus making a $25 profit on each option owned. If the
executive has options for 1 million shares, then he could pocket $25 million. If the
stock price reaches $100 per share, the executive could cash in for $50 million. In
contrast, if the stock price were to drop to less than $50 per share, then the options
have no exercisable value and are said to be underwater. Executives treat stock
options as compensation; they nearly always exercise the
options to buy the stock and then sell the stock for the cash. Only rarely will an
executive keep the stock. _
Stock options give the executives of the firm the incentive to nimAgt the firm
in-sitch a way that the stock price increases, which is precisely what the stockhold-
ers want as well.Therefore, stock options are believed to align managers' goals with
shareholders' goals. This alignment helps to_ overcome Soave 90,4,..woblerns
the separation of ownership and controllThe typical executive option contract
ng stock price
assigns the strike price of the options to the prevaili when the option is
granted. The most common length of the options Contract is 10 years. That is, the CEO has
10 years to increase the price of-the stock and exercise the optionsAtitaci
or transfer their optio nd are"
10 years the options expire.txecutive,s cannot sell ns a
tiOn-based award
discouraged from hedging the stock price riskjhe median op
Executive stock options
realhed for Cl.!:Os in large firths was $2.7 million in 2004. were
not common prior to 1980.
. r. unting
0.ptiton:; rind A.-mo _.
orniansratiO-n itt.the.US. partlytame_
The popularity of stock options as incentive c from
e company.'Whea-
its favorable tax treatment for both the executive and th
an accounting cost
"options were granted, the company only needed to report
hen the cost was
..,whenthe strike price was less than the current stock price. T
anted with
ilT)01 Liza_ over the lifipt,tlip,vpl,iurlt13,r;cciop.149,avptions were v
EXAMPLE 2.1
EOs IN 2004 (INCLUDES

TEN HIGHEST PAID C STOCK OPTION GRANTS)
SALARY, BONUS, AND
Schar,
Dwight
Terry Sernel, $51,053500
NVR Inc.
Yahoo Inc. ratz,
Steven Jobs, Bruce Ka
KB Home
Apple Computer
Len' Frankfort, Robert Toll ,
rs
Coach Inc. Toll Brothe
n,
John Wilder, Paul Evanso
ergy
TXU Corp. Allegheny En
,
Ray R. Irani, Edward Zander
Occidential Motorola Inc.
Petroleum $52,648,142
Source: www.afIcio.orgicorporatewatch/
the strike price equal to the current stock price, the firm never had to report an
accounting cost. Also, the manager can pick the year in which she will exercise the
options and thus determine when the tax liability occurs: In addition, the
compensation was and still is treated as a capital gain, not as income, which is an
advantage to the CEO because capital gains taxes are lower than regular per-
sonal income taxes.
If an executive cashes in for $100 million, this cost does not appear on the
firm's income statement; the firm does not have to report an accounting cost.
However, the economic cost to the firm is real. Consider this simple examph% A
firm has 100 million shares outstanding and has given the executives options for 10
'million shares. The firm currently has earnings of $100 million, or $1 per share. If
the executives exercise their options, then they would buy 10 million shares from
the firm at the strike price and sell them on the stock market. At that point, there
would be 110 million shares outstanding, which means that the $100 million in
earnings becomes only $0.91 per share. The earnings per share have fallen by 9
percent and the firm has become less profitable to its shareholders.
Since July 2005, firms are now required to expense executive stock options
(this is referred to as FAS 123(R)). Even though stock options may have exer-
cise prices at or below the current stock price when they are granted, they are still
valuable. This value, which is estimated using a variation of a formula known
as the BlackScholes option pricing model, is now required to be deducted
later in this chapter.
from reported income, This new regulation will make
exec the granting of
in more detail
utive stock options less attractive, We discuss this regulation
Periormanze-saresorefer to a company's stock given to executives only. if cet-fr tain
performance criteria are met, such as earnings per share targets. In one sense, these
shares could be viewed as bonuses for past realized performance. If the firm's►l stock price
has increased, then these performance shares are more valuable to the/
EO when he receives them. Performance share plans increased to 20 percent of the.
long-term incentive pay mix in 2004 and was just shy of $1 million for CEOs of large
firms.
INCENTIVE-BASED COMPENSATION' e 1
II 0 K N GENERAL' 7 01■••1.14/11011 0- Y.11111.1.•■■••■•■••■•LAIM MUIII M 71 1=MIM•INPIIII
Tnere are two ways to examine whether or not incentive-based compensation

there is a positive relation between firm
works. First, one could try to see if
ensation. This would be defined as ex postr
,perfoemince and management comp
anagers been properly rewarded for increasing
.'evideric4. In other words, have m
wer is yes, then we could surmise that incentive com-
the firms' value? If the ans
ichael Jensen and Kevin Murphy provide the most
pensation works. ProTessors M
they examined the
well-known evidence tha t the answer is pretty much "no."3 ' total
ver 2,000 CEOs and they found that when the value of
compensation of o the firm
00, then those CEOs were paid $3,25 more on average.
increased by $1,0 Imagine a CEO
takes over a large firm. This CEO would _have Joincrease
who the firm's value b over
$300 million to increase their_compensoi9ub_y_A mere__
$1 million. In academ ic
y that the pay-for-performance sensi
jargon, we Nvould sa tivity is very low.
sess the efficacy of incentive-based compensation is to see
Another way to as if
ted these compensation mechanisms subsequently expe
those firms that enac n
rformance. This could be defined asisS eviclossfi
rienced superior pe
nagers are given incentives, then did the firms subse-
other words, once ma
ll? Intuitively we might expect the answer to be "yes" but
quently perform we
tIV(3
1 6 c:J. f ARITA 2 gxgettilve InCen
managers are risk-avne,
surprisingly tvidence is mixed, lkI lmon Korn"; Or if a firm relieq
hy should take riA,k57
Melt salaries are already large 30 w
inotr►tives, 1,11/"./1 ;Or, ftfri IT6AfiA••gers Are
he►ivily on, exttetnivc row* option..
takers whf;w the risk sometirneri pays off and sometimes it doe
excessive rifik- lt to rekite firm rAleforrrirInCf.: to not. Tn
addition, note that it in difficu rm well, how cmi we he reliably Sure
»ieni compensa t conirnts, if firms perfo that
ontract had anything to do With the
the incentive-based compensation c firm's
success'?
robierns with Stock Option,Inceatiyoi

There is a good possibility that stock options do not align managerial incentives with
shareholder goals. The following list cites potential incentive problems that
executive options creates:
1. Shareholder returns combine both stock price appreciation and dividends.

The stock option is only affected by price appreciation. Therefore, the Ch .0
might forego increasing dividends in favor of using the cash to try to increase
the stock price.
2. The stock price is more likely to increase when the CEO accepts risky pro-
jects. Therefore, when a firm uses options to compensate the CEO, she has a
tendency to pick a higher risk business strategy.
3. Stock options lose some incentive for the CEO if the stock price falls too far
below the strike price. In this case, the options would be too far underwater
to motivate the manager effectively
4. CEOs may try to manipulate earnings and thus maximize profits in one tar-
get year to make the stock price more favorable for exercising options. This
manipulation can reduce earnings (and consequently the stock price) after
the target year. In other words, managers may try to do what they can to time
stock price movements to match the time horizons of their stock options.
,orow
WI kat k‘i
The very a vantage that stock options have oi a igrung manager incentives with
s t o c k h o l d e r g o a l s a l s o c o n s t i t u t e s a ma j o r p r o b l e m . S t o c k o p t i o n s a r e t i e d t o t h e
firm's stock price, which helps align incentives but executives only have partial
influence on stock prices. Stock prices are affected by company perfor m ance but also
by many other factors beyond its control, particularly the strength or weak -
n e s s o f t h e e c o n o m y . Wh e n t h e e c o n o m y t h r i v e s , s t o c k p r i c e s r i s e . E v e n t h e s t o c k
price of a poorly run company may rise, although not as much as its m ore suc-
cessful competitors. This occurrence may richly reward executives of poorly run
firms through their opti ons when they do not deserve them.. Alternatively, the .
stock market m ay fall because of poor economic conditions or investor pes -
s i m i s m . A c o M p a n y w h o s e m a n a g e m e n t o u t p e r f o r m s i t s c o m p e t i t o r s m ay still
find that its stock is falling. In that case, managers should be rewarded but they are
not because their options go underwater when the market falls.
Opt i ons l os e t hei r e ffe c ti ve ne s s whe n t he st oc k pri c e fall s fa r be l ow t he stri ke p rice.
The s t o c k p r i c e d e c l i n e c o u l d b e e i t h e r r e l a t e d t o a c o mp a n y ' s p o o r p e r f o r -
m ance or to a general stock market decline. To re -establish motivation for the
executives, boards sometimes reprice previously issued options and lower the
strike price. Consider th e incentives listed above and how they create interesting
dynamics for CEO behavior. Executives may choose risky company projects that
have a c h a n c e o f d r a m a t i c a l l y i n c r e a s i n g t h e s t o c k p r i c e . I f t h e p r o j e c t s s u c c e e d , t h e
CEO becomes rich and the sto ckholders experience increased w e a l t h . Ho w e v e r ,
i f t h e p r o j e c t s f a i l , t h e s t o c k h o l d e r s l o s e mo n e y . M e a n w h i l e , t h e C E O s i m p l y a s k s t h e
b o a r d t o re p ri c e t he o pt i o n s a n d t h e C E O c a n t h e n re pe a t t h e strategy. Proponents
of option repricing clai m that it is necessary to keep execu -
tives at the firm. This argument has some truth but that does not change the
skewed incentives it causes.

I
EXAMPLE 2.2
MANAGEMENT'S BEHAVIOR AT XEROX
In a- civil action by the SEC against

Xerox, the SEC claimed senior man-
agement directed a scheme that
improperly accelerated leasing
operations revenue from 1997 to
2000. The accounting maneuvering
increased revenue by $3 billion and
profits by $1.5 billion over that
period. In subse4uent financial
restatements, Xerox shifted out
$6.4 billion of revenue for that time.,
The accounting actions violated gen-
erally accepted accounting practices
and were not disclosed to sharehold-
ers or regulators. Xerox perpetrated
the scheme to meet ever increasing
internal and analyst earnings expec-
tations and it became common for'
Xerox executives to assi n
numerical oals to e produced t
trough accountgin guniiiickry)
-11117eTroth the chic iiiincinri r
cer (CFO) and vice chairman of
Xerox, and the president of Xerox
Europe believed that, excluding
accounting maneuvers, the firm had
essentially no growth in the 199001
• •
CHAPTER 2 Executive It-iced-laves 19

70
Xerox ex.c.:cuti.,ea seal $48 million worth of '
ortions rind $31 million in other stock.
60 iNT------ ' \ •,., .. :4‘---
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Several organizations and people have suggested that the cost of stock options
issued to employees and executives should be treated as an expense on the grant-
ing firm's financial statements. Even when option exercise prices are at or below
current stock prices, they are still valuable. The more stock options granted, and the
longer the time allowed to exercise the option, the greater the option value. Using a
variation of a formula known as the Black-Scholes option- tieing model,.
the value of a granted option can be estimated.1 er new re ulation
e I ec ive since 17e*ftfrntirTgrgrartrr • tions- t
from_thelirres "..m.olted income, ome people, e egen ary investor Walreta
u eit,1avebreriTitmoting t is idea for some time. It appCars that there are
three reasons that expensing stock options was being promoted.
The first purpose is to have better disclosure and account for the real cost of
using options as compensation. The expensing would cause the compensatio'n to be
more directly observable to shareholders because it would be reported in the
income statements. Also, the expensing would identify that there is a cost to the
firm for issuing options, As we discussed earlier, there is a real economic cost (i.e.
dilution) to shareholders when executives convert tens, or hundreds, of
millions of dollars in options into common stock and then sell it in the stock mar-
or
ket. Prior to the push for expensing, this economic cost was not well accounted f on
sing
the financial statements of the firm. In other words, this reason for expen
nt.
options argues that the economic cost of options should be more transpare
hat
The second reason for some groups to be proposing option expensing is t it
may reduce the amount of options executives receive and thereby reduce their
20 e71-1A1)11,P, rxerrtrive inr entivey
on the fe rn tor (Jr ii►►ii")111 rit
lotal comprtimnijottilio mrtlia ►lirni tt►pili ire infr,
dollars ihni tiTeivril Ilan. inte 19900 in `0%Fil
e cost of soli 15 ontifilmitt ottnnt, Y, :11.04
publiciN recording th th 41- t)1.
pay. 111 n11(111100, if e L° °1111"nsi
mu mi
Arc better able to hide their e itri Pia 11 1011 eetilitno , then the tni ii itviy
(qrensed end t hereby refiner% the flrit
not be girlie so p,onrrons in waniing he improgion tlint options
P"Mirig 4104 (Illilt HIS is t
.111e trivIon for eX s rls tit s41Btg1kils, That is,
owned )5 anti other e.xrCIllivc OM led to eorpo
eitly,
CXCC.ItiVeff it IIIVI:111110111 fear bri►tlfitil►f! from using, neeour
options Wive rice of the con IlInny stock, If options 3re,
chicanery to artificially pi►►p lip the p
ybe there wail be 1031► of an incentive
not as attractive for firms to issue, thee ma for
executives to time the mnrket.
ot represent an env and at tom,. tic
However* the expensing of options might n
IOCk Some industries, like
solution to the problems inherent in executive B y employees, not jus xecutives.
technology, use options as compensation for man te For
ts employees. indeed, twiny
example, Microsoft issues options to most of i
ew FASI3 regulation." Even
technology firms are adamantly opposed to the n some
d lower managers, like
non-tech companies use options to pay middle an
stert,up companies to
'obis Corp, a department store chain, Also it is common for
low $13
partially pay employees in stock options to help compensate for 1uries.
f
Using this type of pay system, the young company can conserve one o most precious
resources, cash, and motivate employees to work hard, What happens to these
compensation systems if options are expensed? The reduction in reported earnings
may cause the companies to curtail option programs. This could inhibit the growth of
new companies. It could even have tin irtlpEla on the economy since new companies
are an important source of new jobs.
tinCOMMISAT1ONI
CHAPTER 2 Executive incentives 21
dhomes: Wells Fargo CEO Richard Kovaeevich borrowed $1 million for a honown
pay at
ment.The savings on low interest loans can quickly add up to tens or hun
-
dreds of thousands of dollars. Frequently, executives do not even pay back the
loans. Mattel Ccap. absolved ousted CEO Jill Barad from repaying a $7.2 million loan
and then paid her an adili Lima] $3,3 million to cover, the cost of resulting addi-
tional taxes. 14 The new CEO, Robert Eckert, received a $5.5 million loan and will not
have to repay it if he stays with the firm for two yaars. A similar arrangement exists
with Compaq Chairman and CEO Michael Capellas for his $5 million loan,
Earlier, we stated that managers will work hard on behalf of shareholders if they are
carefully monitored and if they have the right incentives. Moat of this book discusses
monitoring.This chapter has discussed manaserial incentives. _ However perhaps a
third way tv align thTTregETIWrcirinVieis with srarefioldera is to
e penalty formangers who intentionally anidilcrt
behave irri,Tiys-th-it'ilie not beneficial to'sharcholders.
I_Trider the new Sarbanes-Oxley Act, the firni's executives now have to sign off
certifying the appropriateness of the financial statements. In addition,„ehe4ct
incre'ised the scope and penalties for white-collar crimes. rriXtly 2005, Bernie
ers, f3iinTrrail atereirec:lrir767:WiTriMom, was se n tenCe d
,25 ears ip..:1)11S0r1 for. his involvement in Wejleelcaria:a$4billion„aspeoimatiagizaake.
"the iii � is writing, TAinis Kozlowski, former CEO of Tyco, is -awaiting
sentencing following his guilty verdict of grand larcencHEuaajnst.Tyco. Will punish-
misbehavior? Time will tell.
ment serve to deter managerial But it is often the case that
etter motivators than "sticks" or punishment.
"carrots" or rewards are b
AL PERSPECTIVE — EO COMPENSATION
INTERNATION C
ORLD eastAt)
AROUND THE W
fficer in the company with long-term incentive awards is OSE
Paying the top o M
the compensation of CEOs around the world,
common in the U.S. Figure 2.2 shows split
gories. nese categories are fixed pay (base salary and benefits),
into three cate variable pay
entive-type instruments like stock options), and perquisites. •[he
(inc data comes from
surveys conducted by Towers Perrin.° 1 he figure shows that
erage, of a U.S. CEO's pay is vai fable in nature.
63 percent, on av
component of CEO pay s uch higher in the U.S. than most
The variable i m other
nly Singapore (59 percent) and Canada (52 percent) have sim
countries. O ilar fractions
variable pay. In contrast, CEOs rom any countries earn most
or f m
ation from fixed pity. For example, for CEOs in China (except
of their
compens Hong Kong)
9 percent of their compensation is fixed. The percentages for
7
lgium are 73 percent and 73 percent, respectively. Variable pay is
Sweden and Be at
ent of total compensation for only fi of the 23 countries, India,
least 50 perc one of the
untries with less than 50 percent composition in fixed pay, pays
five co
ccountants and auditors are an important part of any corporate monitor-
ins system. Accountants keep track of the quantitative financial informa-,,
tion of the fin-n. Because mistakes and other problems (such as intentional,
fraud) may occur with accounting, there are auditors that review the financial'
information. As such, auditors may be in the best position to monitor cornpaniesAri this
process; auditors obtain private informatiOI about the company that others cannot
obtain, and they use this information to determine whether the company's public
financial statements .reflect the true level of business being conducted. Banks,
creditors, and others rely on these statements to get an accurate picture of the firm's
business activities and financial health. Investors use these public statements to
assess the value of the company. Therefore, the auditor's candid eval-
uation of those statements is crucial. This chapter first provides an overview of
accounting and auditing. Then it discusses how accountants and auditors might
contribute to financial fraud and how they might expose fraud.
n of gather
Historically, accounting has been the functio ing, compiling, reporting, and
archiving a firm's business activi ties.it This accounting
to make information
decisions..For helps those
convenience,
victuals in many roles who depend on
are categorized as either insiders or outsiders who
need accounting information of the firm.
Accounting for Inside Use development of information for insiders, such as

e:INIsmagement accountingisrs the
use this information to measure the progress toward
company managers. Manage roblems in advance. For example, managers their
goals and highlight any potential p est sales and which are selling poorly. want to
knew which products have the ow b is inventory being managed? What Which
products tend to sell together?
h cash H
to pay its upcoming debt ayments? about cash?
Will the firm have. enoug p
75
rem/Wants owl A ta/itors
26 cal A PTV R 3 A
wor Memo (iriestiOns With budgctii,rriar,pe:repoq'tsrse,n75itivity
Accoutimin:i
ePit
ons
,.When
.)f
cOnw ors f PuudySts
reports, ost projections,
.ind eVC l 4
rinalysis, revenue c F services, managerial accountants help
and
o expand roducts
firms consi&I' how t p
frOIT1 revenue and cost projection s. In short, manage_
formulate. profit projections
rically played a large part in the control and evaluation of
vial accounting has histo
ce.
the business and its performan •
Accounting for Outside Use counting inforjuati0li. :Investors, banks, the gov.
Outsiders of the firm also use ac
ve a keen interest in the financial health of
crnincrit and other stake'iolders ha the
nt to know if the firm will be able to pay its
firm. Banks and other creditors wa debts.
ofitable the firm is and how profitable it
Shareholders want to know how pr may be in the
a double interest because they have
future. Employees might have their careers and
employment at stake and they m ight be investors through their retirement plans as
WC-11.
Financial 2CCO4int11le, provides information for outs iders. Whereas managerial
y individual prod-
accounting reports may break down performance for managers b
sine
ucts or regions of the country, financial reports summarize the bu ss as a whole,
although they can be broken into business segments and regions. In the case of
publicly held companies, these reports are the quarterly and annual financial state-
ments that they must file with the Securities and Exchange Commission (SEC).
The three main financial statement _s (income statement, balance sheet, and state-
ment` 6f CaSh flows) and other pieces of iiii-POttatifififormation (e.g. popular press
articles and analyst recommendations) are used by outsiders to determine the firm's
value, profits, and its risk. Outsiders want to be able to compare firms easily. Thus the SEC
requires that these accounting statements adhere to a uniform set of standards known as
generally accepted accounting principles (GAAP) for public companiesi These
statements are prepared by the accountants of the firm and reviewed by inde-
pendent accountants from an auditing firm (more on auditors later in the chapter).
The Internal Revenue Service (IRS);also requires accounting information for
tax purposes. The accountants of the firm report profits or losses to the IRS and
determine the tax liability. Interestingly, accounting methods and business
recordkeeping can be very different for reports to managers, for public financial
statements and for the IRS. For example, there are
.record some transactions in GAM ambiguities regarding how to
'. when reporting business activities in an
annual report, choices are made that maximize earnings in order to make them
appear stronger than they would otherwise he, in the hope of driving up the
firm's stock price. When IRS forms are being completed,choicm es are made to
inimize earnings in order to minimize tax expenditures.'
PROBLFMS THAT MAY OCCUR IN C _

COLIN TINC
As with any kind of record-keeping there are poten
tial problem& First, uninten-
tional errors are possible. Sometimes these errors are due due to miscaluations or
to applying an expense to the wrong acc
ounting ledger. Another potential
AUDTTING
Internal A A itors
Many firms have intnpal nurliIrn.s. Their responsibility is to oversee the -firm's
financial and operating procedures, to check the accuracy of the financial record-
kee pine, to implement improvements with internal control, to ensure compliance
with accounting regulations, and to detect fraud. Firms are not required to have
internal auditors but many firms have them to enhance their accounting and
internal control efficiency. In fact, the people who initially detected financial
fraud at WorldCom were the company's own internal auditors.
EXAMPLE 3.1
EXERPTED STORY FROM THE WALL STREET JOURNAL2
Sitting in his cubicle at WorklCom corporate history. Their discoveries

n
_Inc-. headquarters one afternoo sent IsVorli-lConi into bankruptcy,
red at left thousands of their colleagues
in May, Gene Morse sta
an accounting entry for $500 mil lion without jobs, and roiled the stock
in computer expenses. He cou ld not market.
entation Behind the tale of accounting
find any invoices or docum
ber. chicanery lies the untold detective
to back up the stunning num
ttered to story of three young internal audi-
"Oh my God," he mu
ediately tors . .. Ms. Cooper, 38 years old,
himself. The auditor imm
his boss, headed a department of 24 auditors
took his discovery to
pany's vice and support staffers, many of whom
Cynthia Cooper, the com
udit ... viewed her as quiet but strong
president, of internal a
ad unearthed willed . . . Mr. Morse, 41, was known
By June 23, they h
ted expenses for his ability to use technology to
$3.8 billion in rnisalloca
ntries. It all ferret out information . . The third
and phony accounting e
ing fraud, member of the team was Glyn
added up to an account
mpany, Smith, 34, a senior manager under
acknowledged by the co
which turned out to be the largest in Ms. Cooper.
and Auditors
28 CHAPTER 3 Accountants
External Auditors eview the firm's

from outside the firm, who r
External :auditors are accountants
res for producing them. Their job is to attest to
financial statements and its procedu the
t they materially represent the condition of
fairness of the statements and tha the firm,
will assess the system and procedures used by
Often the external auditor internal
n rely on the intemally-gencrated reports when
auditors to see if they ca duct their external audit, the auditors might:
conducting their own andit.3 To con
employees to assess the quality of the
1. conduct interviews with the firm's
internal audit system;
m's assets such as inventory levels;
2. make their own observations of the fir
3. check sample balance-sheet transactions;
ts to check the accuracy of short-
4, confirm with the firm's customers and clien
term assets and liabilities; and
is such as comparing the firm's
5. conduct their own financial statements analys
financial ratios from one period to the next.
a report (see General
Once they have completed their audit, they will generate
Motor's example below).
m being
Because external auditors are supposed to be independent of the fir
audited and because their explicit job is to check for financial mis-statements and
adherence to GAAP, it is they who must ensure the accuracy of the firm's finan-
cial information for shareholders. Today, the four largest accounting firms, known as
the "Big Four," that provide external audits, are PriceWaterhouseCoopers,
Deloitte ee Touche, Ernst & Young, and KPMG.
EXAMPLE 3.2
1
INDEPENDENT AUDITORS REPORT FOR GENERAL
MOTORS/1
General Motors Corporation, its the Supplemental Information to

Directors, and Stockholders:
the Consolidated Balance Sheets
We have audited the accompa-
and Consolidated Statements of
nying Consolidated Balance Sheets
Income and Cash Flows (the finan-
of General Motors Corporation
cial statement schedules). These
and subsidiaries (the Corporation)
financial statements and finan-
as of December 31, 2004 and
cial statement schedules are the
2003, and the related Consoli-
responsibility of the Corporation's
dated Statements of Income, Cash
Flows, and Stockholders' Equity management. Our responsibility is
for each of the three years in to express an opinion on these
the period ended December 31, financial statements and financial
2004. Our audits also included statement schedules based on our
audits,
Vic conducted our audits in As discusLA in Note 1 to the
accordance vith the standards of consolislated financial statements,
th.e Public Company Accounting the Corporation:
Oversight Board (United States).
Those standards require that vie 1. effective from July 1,21;03, began
plan and perform the audit to consolidating certain variable
obtain reasonable assurance about interest entities to conform to
whiLther the financial statements are EASE Interpretation No. 46,
free of mtedal mis-statement. An Consolidation of Variable Intere.r:
Eniities; and
audit includes examining, on a test
basis, evidence supporting the 2. effective from January 1,2003,
amounts and disclosures in the began expensing the fair market
value of newly granted stock
financial statements. An audit also
options and other stock-based
includes assessing the accounting compensation awards issued to
principlr::s used and signidcant esti- employees to conform to
mates made by management, as well Statement of Financial Accounting
as evaluating the overall financial Standards No. 123, Accounting for
statement presentation. We believe Stock-Based Compettsation.
that our audits provide a reasonable
basis for our opinion. We have also audited, in accordance
in our opinion, such consoli- with the standards of the Public
dated firr.tricial statements present Company Accounting Oversight
ects, the Board (United States), the effective-
fairly, in all material resp
eral ness of the Corporation's internal
financial position of Gen
nd ub- control over financial reporting as
Motors Corporation a s
r 31, 2004 and of December 31, 2004, based on
Eic.iiaries at Decembe
lts of their opera- the criteria established in Internal
2003, and the resu
lows for each of Control — Integrated Framework
tions and their cash f
e period ended issued by the Committee of
the three years in th
004, in conformity Sponsoring Organizations of the
December 31, 2
ciples generally Treadway Commission and our report
with accounting prin
nited States of dated March 14, 2005 expressed an
accepted in the U
our opinion, such unqualified opinion on management's
fimerica. Also, in
nt schedules, when assessment of the effectiveness of the
financial stateme
elation to the basic Corporation's internal control over
considered in r d
ancial statements financial reporting and an unqualifie
consolidated fin the
present fairly, in all opinion on the effectiveness of
taken as a whole,
mation Corporation's internal control over
material respec ts, the infor
6.1 financial repor an&
stet forth therein
he LIT
Deloitte Pc Touc
n
Detroit, Michiga
March 14,2005
ntants and uclitors
30 CHAPTER 3 Accou A
Auditing Ilan EvolvcTd
How the Nature o f External
Since the Late 1 930s it
s have always wanted independm
While banks and other creditor
of monitoring a firin's finaneial statements \,,,;‘,1
a firm's financial health, the role
of 1933 and the Securities 1::,xclionge Act (it
cemented by the Securities Act
er the corporate ,speraling excesses of ow laic
During the Great Depression, aft
m business scandals. Congress reacted with IcT
1920s, the country was reeling fro
oversight and regulation and requited annual
r7Fation that calledioi-sir01;ger
panies.
independent audits of all public com
ent, in the late 1930s and 19410s account-
Because of this legislative requirem
emand for auditing services. 1 int Lilly the
ing firms flourished with the increased d high
that required independent verification
demand resulted from the new laws of a firm's
diting services continued to grow as
financial books.The demand for au the economy
ber of public firms increased.
eventually picked up and the num There was plenty
s and the environment was such
of business for auditing firm that they could play an
t monitors—even becoming
effective role as independen adversarial with the firm if
necessary.
egan to change. The
In the 1970s and 1980s, however, the auditing business b
r expand-
number of new companies that needed auditing services was no longe
ing. If auditing firms wanted to grow, they had to steal clients away from other
auditing firms. The code of ethics was changed to permit advertising and other
competitive practices. Auditing firms began to advertise and cut their prices to lure
new clients. The relationship between the auditing firm and the audited co m-
pany also began to change; with other audit firms_courting them and corporate
managers no longer tolerating adversarial auditors. Auditors becamefriendlier in
'-or-der-to keep their clients, especially the larger cor' npanics. Because of the pres-
tige associated with having Fortune 500 companies as clients, auditing firms
became less confrontational in order to keep them as clients. During thiS period-,
—arditing firms also developed consulting services to advise companies on how to
improve their accounting methods and business activities. This provided both
another source of income for accounting firms and a way to solidify their rela-
tionships with company management.
ACCOUNTING OVERSIGHT
Accountants are responsible for the firm's financial information and Auditors are
supposed to monitor and check the financial information for accuracy. However,
both accountants and auditors are governed by regulations and regulatory bodies. The
Financial Accounting Standards Board (FA.S1t), a non-government entity made
up of members of the accounting, business, and academic professions, sets
accounting standards known as Generally Accepted Accounting Principles(GAAP). The SEC recognizes FASB as authoritative, which means thar t the
SEC
theecognizes FASB decisions on creating and amending GAAP, though theU. anSEC
d
S. Congress have been known to influence FASB accounting policies.
CHAPTER 3 Accountants an,1 Auditors 3I
Associations in the accountina, profession sponsor FASB and, to promote indepen-

dence, its seven board members are required to serve full time and divest their
interests in their former employers. Even non-CPAs serve on the FASB bond.
External auditors are ,d by the SEC to make sure the finarcial state-
ments alhere to GAAP, An organization called the AfMriCallInstiruie of
Public A.ccont.arris (A.IC:P/-%.) had set auditing standards and had governed external
audits. However, with the passage of the 2002 Sarbanes-Oxley Act, a new board
called the Palk Company Accotaiting Oversight Board (P.CA0B) was estab-
lished that would, in effect, replace MUM role as the regulatory body overseeing the
auditing profession. Under the 2002 Act, all public ftrins have to be regise::re,f3 with
PCAOB and meet its standards.The PCAOB also oversees public accounting firms.
The example of General Motors' audit report indicates that the auditor con-
ducted its report in accordance to PCAOB standards. Li Chapter 9, we discuss the
relationship between the SEC and the accounting profession and in Chapter 10 we
discuss the new 2002 Act.
While the PCAOB now sets auditing standards, the AICPA still remains an
active organization. It is the largest association for CPAs, with over 330,000 regu-
hr members. In order to promote a high ethical standard for association naere-
bers, the AICPA maintains and distributes the AICPA Professional Code of
Conduct. The Code provides Principles and Rules that govern the professional
behavior of members.
THE CHANGING ROLE OF ACCOUNTING - MANAWIG

EARN I NI GS
11-12.112glffirs5imings.
For example, accountants may feel pressure to meet internal targets.
mployees and the board of directors that they
Managers may want to show their e were
s discussed
able to increase revenue and decrease costs. A in the prior chap-
argets, such as tar may
ter, when firms meet internally set t get ROAs or ROEs, it
lead to a raise or a bonus for the CEO and other managers.
e
Accountants may also feel pressure to meet extexmil targets. Analysts mak
easured by PS),
predictions about firms' profitability m earnings per share (E If
the firm. fails to meet these expectations, then the share price will decline.
Therefore, accountants must use whatever methods possible to meet these
ountants' cutd Auditors
...I 2 CHAPTER 3 Acc
addition, accountants way be asked to wiandEoi\70(1:1:1
external expectations. In 7: the
ments to improve its chances of getting
firm's financial state loan. Accountants
could
ing arrangement, such as a low interest
external financ u stretch xistin liabilities.
ported income or redce e
assumpt ions to increase re
of variations in accounting method
Another example profits, that i
ut at an erratic pace,
rofits generated by business activities grow,
income. If the p bme. then Smooth earnings
sked to smooth out the earnings over ti
accountants are a
reduced risk. Accountants can defer or accelerate the
give shareholders a sense of
smooth reported income Iroin year to year.
recognition of some revenues to
EXAMPLE 3.3
EARNINGS
GENERAL ELECTRIC'S SMOOTH
General Electric (GE) has been
accused of using accounting manip-
ulations to manage its earnings.5
Notice in Figure 3.1 how steady the
growth in GE's earnings has been,
especially since 1995. The accusa-
tions claim that GE employs a
number of confusing but apparently
legal gimmicks to achieve its consis-
tent growth. For example, GE's
financing division, GE Capital, can
reduce current earnings for the firm by
being pessimistic in its estimates of
losses from problem loans. If those
loans eventually are repaid, future
profits will increase. The maneuver
effectively shifts some earnings into
the future. If the firm is in need of
more earnings in the present, it can
conduct a real estate sale and
leaseback. The transaction could
Work like this. GE sells a factory to
investors for $100 million.
GE signs a long-Lterm lease with
the investors so that GE still
uses the factory. However, because
the factory has been depreciated to
$50 million, GE can claim the
AllTVIZ 3 Accountants and Auditors 33
•‘•,1' 777 ; 4
) 11
J t,1 ‘k0
,'t., It
k...1.11,/ • k
Q16114-15
FROM MANIPULATION TO FRAUD

The accounting schemes that companies use can be either simple or complex.
Indeed, modern accounting and auditing firms recommend structuring deals in a
way that may not have any value in conducting business, but the deals spin off
either profits or losses that can he reversed in the future to manage earnings. A
question often asked is how much can companies manipulate accounting
figures before they cross the line into fraud? Where is the line?
For example, a firm could sell an asset, such as a truck, to its own subsidiary (e.g.
technically a special-purpose entity created as an off-shore partnership) for an
outrageously high price,The book value of the truck is lowTherefore the firm books a large
capital gain and profits go up. The subsidiary capitalizes the cost of the truck, which
means that the subsidiary will have to report lower earnings in each of the -; future
years in which the truck cost is depreciated. In effect, the hunt takes a profit et now that
it will have to offset as expenses in the future related to the sale of a truck it still owns!
euvers
While these types of man help to manage earnings, their effect is limited unless the
company crosses the line and uses them fraudulently.
The pressure on accounting departments to smooth earnings, or even pro-
duce earnings can be intense when the firm is not meeting investor (analyst)
f
expectations. pecnuse the role o accounting has changed and accounting depart-
ated
ments are .viewed as profit centcrs, they are pressed to make up sliort falls cre by the
business operations of the firm. Sometimes firms and their accountants and
s of
auditors cross way over the line to fraudulent practices. Recent example alleged
d Tyco:
accounting fraud are WorldCom, Enron, Rite Aid, Adelphia, an For example,
n had
on June 25, 2002, World( \-iin disclosed that roughly $$.8 billio been improperly
es
booked as capital investments instead of operating expens
EXAMPLE 3.4
RITE AD'S OVERSTATEMENT OF INCOME

On June 21, 2002, a federal grand jury
between quarterly and annual
indicted four former and current
reports.° Indeed, Rite Aid restated
executives of Rite Aid for conducting
earnings for its fiscal year 1998 in a
a wide-ranging scheme to overstate
way that caused $305 million in net
income.9 The SEC noted in its inves-
tigation of the matter that Rite Aid income to become $186 million in net
reported false and misleading infor- losses. The restatement in fiscal year
mation in 10 different areas, ranging 1999 was from a $143 million profit
from reducing its costs and accelerat- to a $422.5 million loss, and a total
ing revenue to manipulating numbers of more than $1 billion in earnings
disappeared.
CI I AY-FEE 3 Accountoffis aPit? Audijors
Rite Aid restated its earnings

for 1998 to 2000. The stock spent
the summer of 2002 at les; than
;6150 per share.
Fite Aid's stock price was arti-
ficially inflated in the late 1990;
because of fraud in financial report-
ing. The investors who purchased
Rite Aid stock hi 1999 did so bas,ed on
false information, thinking the firm
profitable and growing. As a result
they lost money. Existing investors
should also have been informed
about the extent of the firm's losses
so that they could
decide whether to keep or sell their
stock. After the truth finally
became public, it was too late—
shareholders had lost most of their
investments.
400
20U —
7.2
xa
far
ted Earnings
C:=) Sta -- 10
L'77
Restated Earn ings
rice
—0— Rite Aid Stock P s
Y1999 Y2000 Y2000 Y2000 FY2000

FY1997 FY1998 F F F F Q3 Annual
Annual Annual Annual Q1 Q2
Time Period
Consultants commonly advise com-
part, to conduct business, but to
panies on tax reduction strategies.
Consider the efforts that Tyco shelter income from the U.S. and to
International Ltd, makes to reduce avoid taxes. Tyco claims that these
its U.S. taxes. Tyco, an electrical strategies cut its 2001 tax bill by
manufacturing and services firm, $600 million and Tyco pays the
moved to the tax haven of most taxes to countries other than
the U.S. All
Bermuda in 1996,12 The company this happens beyond
has also created more than 150 sub- the eyes of the shareholder. The
sidiaries in other t ax-friendly annual report does not provide
places, such as Barbados and the information about its mysterious
Cayman Islands. The purpose of subsidiaries, which have names like
these entities is not, for the 111081 Driftwood, Bunga Bevaru, and
Silver Avenue Holdings.
CFEAPTKR 3 Accountants and A natters ::)",
iN77.RINATiONAL PERSPECTIVE
Compared
d to the accounting systems
t used internationally, the system in the I I.S.
is quite rigorous. Characteristics of a high-quality system are many shareholder
rights and strong protection of those rights. This protection comes from strong
laws that are enforced and accounting standards that are una
In a recent study of 31 countries, the U.S. was found to have the best legal
environment to discourage earnings manipulations and smoothitne •
Australia, Ireland, Canada, and the U.K. also have good proteetiun
and enforcement histories, Countries where earnings manipulatioes arc more
common include Austria, Italy, Germany, South Korea, and Taiwan. While
some shareholders might question the quality of the financial ;Haft:milts in
the U.S., the accounting numbers of some firms that are not based in the U.S.
could be of much lower quality. The scandals in some U.S. firnei parallel some
recent international scandals (see Parmalat example below).
'he In►ternanonal Accounting Standards l mart flAS11) is developing a sin-
gle set of high-quality, understandable, and enforceable global accounting ffiun-
dards that require transparent and comparable information in general-ptirpme
financial statements. In addition, IASB wants to encourage convergence in
accounting standards of individual countries around the world. Whether the SEC
wHI accept financial statements using these international standards rather than
U.S. GAM", remains to be seen.
EXAMPLE 3.6
PARN1ALAT'S ACCOUNTING SCANDAL

do not have a
Apparently U.S. firms companies to generate .fake profits.
venue. On
monoply on ficticious re Parmalat's external auditor, up-and-
n and Tyco
the heels of the Enro coming firm Grant Thornton, might
have assisted Parmalat with some of
industry giant
scandals, a non-U.S. its accounting fraud. Under Italian
ts own shocking
also experienced i law, a firm must change its external
dal. The eighth
accounting scan auditor every nine 'years. So when
rial firm in Italy, it
largest indust Grant Thornton's time was up,
aps best known in
Parmalat, is perh suggested to Parmalat to spin off
asteurized Parmalat that it
the U.S. for its p several of its businesses so
cookies, and Black
milk, Archway various
ses. The firm was could continue to keep
Diamond chee
0 billion accounting Parmalat concerns as clien ts. These
exposed for a $1 ade fake pay-
Parmalat's fraudu- spun-off subsidiaries m
fraud. One of alat in the form
practices involved ments to Parm
lent accounting nwhile, these
of numerous shell of owed debt. Mea
the setting up
(Continued)
R 3 Accountants and Auditors
38 CHAPTE
(Continued)
document through the fax
false accounts ran this
subsidiaries created a few times to make it look
they could pay machine Parmalat was declared
to make it look like
ot all of "authentic."
the debt. However, n t in 2003. Carl isto Tanzi, the
this compli-
Parmalat's frauds were bankrup
rged a f Parmalat, and his son and
cated.Parmalat executives fo founder o
erica long with several other
document using Bank of Am daughter, a
alat malat executives, were
letterhead to claim that Parm former Par
They ancial fraud.
had a $5 billion bank deposit. arrested for fin
parm-j06.shtml
Sources: www.wsws.org/articlos/2004/jan2004/
littp://en.wikipeclia.orghviki/parrnalat
Hand outs
Corporations and Corporate Governance

Introduction
There are two major political systems in the world from the business point of view. These
are:
1. Communism
Communism refers to a political system that stresses the primacy of collective goals over
individual goals. Following are the characteristics of communism;
◦Needs of the society are viewed as a whole than individual freedom.

◦State-owned enterprises are managed to benefit society as a whole, rather
than individual capitalists
◦ Examples are:
 Cuba
 Vietnam
2. Capitalism
Capitalism is an economic system based on the private ownership of capital goods and
the means of production, with the creation of goods and services for profit. Following are
the characteristics of capitalism;
 Goal of the Business
In corporate world, the main goal of the business/corporation is to profit maximization and
this can be achieved through two ways;
◦ 1. Increasing sales in the existing market

◦ 2. Creating new markets for the existing products.
Enhancing business requires capital which brings risk. So, the ability to access capital and
control risk is important in the success or failure of a firm.
Before we discuss the relationship of capital, control and risk, let’s first discuss different
forms of business ownerships.
a. Sole Proprietorship- a business own by a single person
Following are the characteristics of sole proprietorship
1. Easy to start
2. More than 70% of all US business
3. But limited lifespan
4. Die with the owner’s death or retirement
5. Limited ability to obtain capital
6. Owner bears unlimited personal liabilities for the firm
7. Less trustworthy
b. Partnership – similar to sole proprietorship but there is more than one owner.
Following are the characteristics of partnerships

1. The ability to pool capital
2. But may not be as important as combining service- oriented
expertise and skill, especially for larger partnerships, for
example;
i. Accounting firms
ii. Law firms
iii. Investment banks
iv. And advertising firms
c. Corporation – the corporation is its own legal entity, as if it were a person.
Following are the characteristics of corporations

1. The owner of the corporation enjoys limited financial liabilities
2. This is very hard in the case of sole proprietorships and
partnerships. For example;
i. Bill Gates of Microsoft
ii. Tim Cook of Apple
iii. Larry Ellison of Oracle
Fewer than 20% of all US businesses are corporation but are generating approximately 90%
of the country’s business revenue. The most important advantage of corporation business is
access to capital market and can raise money by issuing stocks and bonds to investors. It
doesn’t die when its owner do because corporation is not in single person ownership, it has
many owners. For example
“Between 1977 and 1980, Apple Computers sold a total of 121,000 computers. To
meet the potential demands for millions of computer per year, Apple needed to expand
operations significantly. As a result, in 1980, Apple became the public corporation and sold
$65 million worth of stocks”.
Main disadvantages of corporations are;
◦ Corporate profits are subject to business taxes before any income goes to
share holders in the form of dividends.
◦ Subsequently, shareholders must also pay personal taxes on dividend
income.
◦ This means shareholders are exposed to double taxation.
Running corporation cab be expensive. For example

◦ The cost of hiring accountants
◦ Legal experts
◦ Cost of communicating with all shareholders
◦ Cost of complying with Regulations and so forth.
◦ Perhaps the main disadvantage is of governance problems.
◦ Small stake and lack of true sense of ownership bring RISK and lack of
CONTROL.
What is Corporate Governance?

“Problems that result from the separation of ownership and control
Focusing on
◦ The internal structure and rules of the board of directors;
◦ The creation of independent audit committees;
◦ Rules for disclosure of information to shareholders and creditors
◦ And control of the management
Separation of ownership and management

Shareholders
Board
Management
Employees
Stockholders own the firm and officers (or executives) control the firm. Hundreds of
thousands of investors can’t collectively take decisions. So firms hire managers for that
work. The shareholder’s main focus is toward business performances and return of their
stock, rather than in decision making process. Now the question is why should managers
care about the owners’ money? This creates problem between the management and
share/stock holders because it’s the shareholders money but in the hands of management.
So the management will always be looking for the satisfactory profit for the
stockholders and massive perks for themselves (principal-agent problem or the agency
problem). Managers may be tempted to use the firm’s assets for their own ends in the
following manners;
◦ Secretaries may take the supplies

◦ Managers may take extra food or fancy furniture for their offices
◦ Executives can use expensive jets for travelling
◦ Etc;etc
So, executives have the ability to steel from the shareholders. This problem can be
solved by;
1. Incentives (chapter 2)
 Common incentives
 Offering stocks, restricted stocks or stock options (normal
practice in US companies)
2. And monitoring
So, the shareholders and executives interest can be aligned through incentives involving
stock options.
Theoretically, managers work for owners but in reality, firms actually seems to
belong to management. There is a race of win-lose between shareholders and management
but most of the time, management has always having the upper hand.
Different proposals are made by the shareholders but are defeated when it comes in
the annual shareholders meeting. There are normally two types of proposals;
◦ Those relate to governance (e.g. suggesting changes in board structure)
◦ Those relate to social reform (e.g. proposing to stop selling chemicals to
rogue countries) etc; etc.
Without management approval, proposals have little chance of succeeding.
Shareholders have to trust management and must go with their wants which leads to chaos
in the firms.
Example
Carly Fiorina’s Takeover of COMPAQ (2002)
Carly Fiorina (CEO Hewlett-Packard) announce acquisition of Compaq on Sept 4, 2001 for
$25.5Billion. Faced negative reaction by stock market, industry experts and the business
media. Hewlett-Packard stock was down by 18% and Compaq’s stocks by 10% following the
announcement. Two major shareholders i.e. David W. Packard and Walter Hewlett were
against this decision. They placed their pressure on other shareholders but all in vain.
Fiorina went ahead with her plan.
Monitoring
Investing public doesn’t know about the firm’s operational level. Only managers know.
Consequently managers may not act in the shareholder’s best interest which demonstrates
the need for MONITOR. The following diagram will demonstrate different levels of
monitoring of the firm’s various stakeholders;
Stakeholders
Within Company
BoDs
Stockholders
Outside Company
Auditors
Creditors
Analysts
Managers
Investment Banks
Credit Agencies
Employees
Government
SEC
Society IRS
Similarly market force is helpful in monitoring. Stakeholders can also monitor by

participating. Creditors can also check by ensuring that the firm is properly handling its
debt processing. Employees, such as, internal auditors can play a vital role in monitoring.
Society can inject a sense of responsibility at the executive level by acting as a noble
corporate citizenship. Unfortunately, all of these mechanisms can fail at one time or
another.
An Integrated System of Governance

The corporate governance system is integrated and complicated. Every
concern stakeholder is keen to get perks i.e. executives, auditors, boards, banks, analysts
and so on. The following diagram will explain the integrated system of governance and
the stakeholders’ interactions;
Board
• MGT
Investment Banks
Regulators
Consultants
Analysts
Creditors Accountant Auditor

Executive Incentives
Introduction
A corporation’s ownership and control are separated between two parties-stockholders and
officers. A simple problem exists with this separation of ownership and control. Why should
the managers care about the owner? So, to align manager and shareholder interest, most
executives receive stock options as a significant component of their compensations.
Potential Managerial Temptation
Manager’s action can affect the following;

Good manager always think for the stakeholders first-not in common practice. Examples of
self-serving managerial actions include;

◦ Hiring friends
◦ Building empires ( making the firm as much as possible, even
though it may hurt the firm’s per share value)
◦ Having a short-run horizon if the manager is near retirement-
very dangerous.
Company executives are compensated through different ways
The CEO salary is determined through the benchmarking method-

surveying the peers CEO salaries for compensation. CEO salary has drifted upward, getting
nice raises if he/she is quite competent to get the competitive edge. New CEOs normally
make more than current CEOs.
Basic pay depends upon the characteristics of the firm, rather than the characteristics of the
CEO. So, large firm CEO will get more than small firm CEO. Small firm can’t afford large firm
CEO and vice versa. Following are some the world top salaries by the CEOs;
Bonuses
Cash bonuses depend upon the firm’s previous year’s performance.
Based on;

◦ Net Income-Dividend on Preferred Stock
An advantage of awarding bonuses, as opposed to giving large raises, is that bonuses

are one-time rewards for past realised performances, while raises are permanent additions
to salaries for future unrealised performances. Following are some of the
advantages/disadvantages of bonuses;

◦ Costly for company

◦ Taxes from employees
◦ Fairness and Jealousy Issues
◦ Increase is not on the basis of past performance- it’s a routine work of

organization for employees.
 Disadvantages
2. Stock Options
This is most common form of market-oriented incentive pay. It allows the

executives to buy shares of stock at a fixed price, called the exercise or the strike price. The
executives can get benefits from the differences of prices i.e. Market price of the stock
minus strike price. That’s how you can align manager’s goal with shareholder’s goals.
This alignment will, somehow, overcome the problem with the separation
of ownership and control. The most common length of the options contract is 10 years. The
median option-based award realized for CEOs in large firms was $2.7 million in 2004.
2.1 Options and Accounting
Stock option is a cost for company, if there is a difference between strike

price and current stock price. This cost was amortized over the life of the options. But if
there is no difference between the strike price and current stock price, then company need
not to report it as a cost in the income statement.
“This award is treated as capital gain, not as income, which is an advantage to the
CEO because capital gain taxes are lower than regular personal income taxes.”
Main Problem with the Grant Options
Even if the stock options are no appeared on the firm’s income statement, means no cost
for company but a real economic lose. For example;
A firm has 100 million outstanding shares in the market ($1 per share)
If the executives exercise their options and sell their options (e.g. 10 million) in the stock
market, this will increase the numbers of outstanding shares in the market i.e. 100 + 10=
110 million shares. This will directly affect the share price. That is a simple rule of demand
and supply. Supply will directly affect the demand of share. $100 millions are available (by
having 100 million shares @ $1 per share). Now $100 millions are available (by having 110
million shares @ $0.91 per share). So this will be lose for shareholders.
3. Stock Grants
Because of the governance failure in late 1990s and early 2000s, many firms have been
looking for alternative forms of long-term incentive compensation.
a) Restricted Stock-Includes limitation that requires a certain length of

time to pass or a certain goal to be achieved before the stocks can be
sold.
b) Performance Sharing-Company’s stock given to executives only if
certain performance criteria are met. It could be viewed as bonuses
for past performances. It is more valuable for the CEOs.
Does Incentive-Based Compensation Work In General
Now we will examine whether there is a relationship between firm’s performances and
management compensations or not. Following are the two approaches regarding this;
◦ 1. Positive relation between firm’s performance and management

compensation (ex post evidence)
 The evidence show that the answer is pretty much “no” (study
conducted over 2000 CEOs)

million to increase his/her compensation by a mere $1 million.
◦ Positive relationship between management compensation and firm’s

performances (ex ante evidence)
 Perhaps CEOs or managers are risk-averse and their salaries are

already large so why should they take risk.
 But if CEOs or managers are risk-takers where risk sometimes pays off
and sometimes it does not.
 Finally, it’s difficult to relate the firm’s performances with the
management compensations.
Potential “Incentive” Problems with Incentive-based Compensation
Dilution can be disgustingly costly over the long term. Many companies
routinely issue stock options and shares, which can easily dilute shareholders by 10% over a
10-year period. Stock option is only affected by price appreciation. Therefore, the CEO might
forego increasing dividends in favour of using the cash to try to increase the stock price. CEO
is more likely to go for the risky business to increase the stock prices. Stock options lose
some incentive for the CEO if the stock price falls too far below the strike price. Price
manipulation can be used by the CEOs for their benefits.
◦ Xerox management improperly accelerated leasing operations revenue from

1997 to 2000.
◦ The accounting manoeuvring increased revenue by $3 billion and profit by

£1.5 billion over that period.
◦ That’s wasn’t the actual financial position of the company.
◦ This artificial profit helped drive the stock price from $13 at the end of 1996
to more than $60 in 1999.
◦ Xerox CEO Paul Allaire sold stocks and profited by $16 million.
◦ In April 2002, Xerox admitted to the SEC that they improperly recorded the
earnings and agree to pay a $10 million fine.
◦ So, Xerox management earned millions of dollars by doing accounting

manoeuvrings.
◦ So, who are the ultimate losers?
70
60
50
40
30
20
10
0
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Incentive Stock Options are generally not tax deductible for companies.
Incentive Stock Options (ISOs) are often a key component of option plans issued by
companies to employees. If a company and employee follow basic ISO rules, the company
CANNOT claim a corporate income tax deduction at any time for the ultimate value given to
an employee. Economy plays a vital role in controlling the stock prices-CEOs always keep
this in mind.
Normal Perception about how stock market works
Stock market boom is the reflection of the progressive economy. As the

economy improves, companies make more money and their stock value rises in its
accordance. In fact, the only real force that ultimately makes the stock market or any
market rise or fall, over the longer term is simply changes in the quantity of money and the
volume of spending in the economy. Stocks rise when there is inflation of money supply (i.e.
more money in the economy and in the markets). Similarly, stock markets can fall by having
decline in the quantity of money and spending.
Another problem with Executive Stock Options
Aligning managers’ incentives with the stockholders goals constitute a major problem.
Employees will work their best unless the stock prices are higher than the strike prices. But
if the stock prices get down than the strike prices (may be because of poor economic
condition), it’s very hard to re-establish the motivational level of executives. As a result,
we’ll see again the race between the owner and controller and no aligned goals.
Treat it as an expense, should appear in the financial statements. Granted options must now
be deducted from the firms reported income. Following are the three advantages;
◦ Would identify that there is a cost to the firm for issuing options.
◦ It may reduce the amount of options executives receive and thereby reduce
their total compensation.
What happens to these compensation systems if options are expensed? The reduction in
reporting earning may cause the companies to curtail option programs. This could inhibit
the growth of new companies. It could even have an impact on the economy.
Other Compensation
 Free access to an online forum allowing executives to post

questions and share insights and resources on strategic
business issues.
 Explore collaboration and business opportunities with other

senior executives
 Find job candidates or look for the next career move.
 CEO Club members receive free access to quarterly executive

seminars that address strategic management and leadership
issues.
The membership is limited to senior executives including the following

level of managers:
 Board of Directors
 Chief Executive Officer (CEO)
 Chief Operation Officer (COO)
 Chief Finance Officer (CFO)
 Chief Marketing Officer (CMO)

 Chief Information Officer (CIO)
 Chief Technology Officer (CTO)
 Chief People Officer (CPO)
 Vice Presidents (VPs)
 Directors
Retirement (or resignation) compensation
Executives receive millions of dollars as company loans at extremely low

interest rates, sometimes even interest free. E.g. Chairman of FleetBoston, Terrence
Murray, receives a pension of $5.8 million per year.
◦ E.g. In July 2005, Bernie Ebbers, founder and former chief executive of
WorldCom, was sentenced to 25 years in prison for his involvement in
WorldCom’s $11 billion accounting fraud.
International Perspective- CEO Compensation around the world:
Paying the top officer in the company with long-term incentive awards is
most common in the US. Normally, compensation of CEOs around the world split into three
categories
 Variable pay (incentive-type instruments like stock options)
63%, on average, of a US CEO’s pay is variable in nature. Singapore and Canada CEOs have
59% and 52%, on average, the variable pay respectively. In China (except china), 79% of the
CEOs compensation is fixed. India, one of the five countries with less than 50% composition
is fixed pay, pays an extraordinary 38% of total compensation in perquisites.
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Fixed Pay
Perquisites
Variable Pay
Argentina
Australia
Belgium
Brazil
Canada
China-Hong Kong
China-Shanghai
France
Germany
India
Italy
Japan
Mexico
Netherlands
Singapore
South Korea
Spain
Sweden
Switzerland
Taiwan
United Kingdom
United States
Venezuela
Accountants and Auditors
Introduction
Accountant and auditors are an important part of any corporate monitoring system. There
is a slight difference between accountant and auditors.
◦ Accountants
 An accountant is a practitioner of accountancy or accounting, which is

the measurement, disclosure or provision of assurance about financial
information that helps managers, investors, tax authorities and others
make decisions about allocating resources.
◦ Auditors
 An auditor is a professional who is responsible for evaluating some

aspect of a project, business, or individual. The term most commonly
refers to audits in accounting.
◦ Scope:
◦ Data:
◦ Purpose:
· The purpose of accounting is to show performance and financial

position of a business.
· The purpose of auditing is to certify true and fair view of financial

statements.
◦ Time:
· The time period of accounting is usually twelve months (one year). It

takes twelve months (one year) to complete records.
· The time period of auditing is less than one year. It may be completed
within one month or may be more than one month.
◦ Start:
· When the work of bookkeeper ends then the accountant work starts.
· when the work of accountants ends Then the auditor work starts.
◦ Necessity:
· Accounting is necessity of every entity having any size.
◦ Report:
A & A are important part of any corporate monitoring system. Accountants keep tracks of
financial information and auditors make a review and monitor. Information can only be
obtained by auditors. Banks, creditors and other rely on these statements to the firm’s
accurate picture and financial health. Good for the investors to assess the value of the
company.
 Gathering, compiling, reporting, and archiving a firm’s business activities.
 Accounting information helps making decision
◦ or outsiders.
 Managers use these information to measure the progress toward their goals and
highlight any potential problems in advance
◦ E.g. Managers wants to know their product’s sales situation.
 Inventory comprises of work in process, stores and spares etc.
◦ Have the firm enough cash to pay its upcoming debt payments?
◦ Budgets
 An estimation of the revenue and expenses over a specified future

period of time. A budget can be made for a person, family, group of
people, business, government, country, multinational organization or
just about anything else that makes and spends money. It may be
either surplus budget or deficit budget
 Surplus Budget
 Deficit Budget
 A financial situation that occurs when an entity has

more money going out than coming in
 In business, a variance report is prepared to evaluate the operating

efficiency of different aspects of (usually) a manufacturing company.
If the company is paying too much for materials or using too

much materials for a product, that is an unfavourable
variance. If the company is getting materials for less than the
standard cost or is using less than the standard materials for a
product, that would be favorable.

Labor rate variance measures deviation from standard in the
average hourly rate paid to direct labor workers.
Labor efficiency variance attempts to measure the productivity
of direct labor.
3. Variable overhead spending variance & variable overhead

efficiency variance.
 A technique used to determine how different values of an

independent variable will impact a particular dependent variable
under a given set of assumptions. The sensitivity analysis can answer
the following questions:


RESUME SERVICES
15% 10% 200X 10%

Figures
Sales $88,400 $93,600 $104,000 $114,400

Cost of $10,200 $10,800 $ 12,000 $ 13,200
Goods Sold
GROSS $78,200 $82,800 $ 92,000 $101,200

PROFIT
◦ Revenue reports
 Daily
 Monthly
 The assessment of SWOT analysis of potential competitors.
 SWOT stands for Strength, Weakness, Opportunities, ans

Threads.
◦ Investors
◦ Banks
◦ The government
Most companies have a corporate website with a section entitled

"Investor Relations", which should have a wide range of company documentation, including
quarterly and annual reports.
 Difference between financial accounting and managerial accounting
Financial accounting primarily provides information for external users

of accounting data, such as investors and creditors.
On the other hand, management accounting provides information for

internal users of accounting data. Internal users include employees, managers, and
◦ Compliance
 Financial accounting information is an element of transparency and

business ethics, requiring honest and accurate information for
investors, competitors and market analysts to review.
◦ Cost
 Expensive part of doing business, especially for large businesses in

shape of having professionals who earn handsome salaries and
require benefits.
◦ Timing Problems
 Accurate accounting can benefit the business but selecting wrong

accounting type can be just a time wasting activity.
 E.g simple cash methods can’t handle large businesses outstanding

payments and accounts receivable.
◦ Since it is focused on making future decisions with the help of past financial
data, it is forward looking and therefore progressive in nature.
◦ It is meant for internal users like top management and therefore it is not
necessary that it is made by following strict guidelines which is the case with
◦ It is flexible in nature and therefore it can be prepared anytime and they are
not required to be made yearly they can be made monthly or on weekly
basis.
◦ It takes all the data and then present it in such a way that a proper analysis
about the feasibility and profitability of any business decision can be made.
◦ It is dependent on cost accounting and financial accounts and therefore the

accuracy of it is also dependent on how accurate that data is, hence it is one
of the limitations as far as its usability is concerned.
◦ It is affected by the bias of top management and therefore it is likely that

they may tweak it in such a way so as to benefit themselves rather than
shareholders.
◦ Since it does not follow accounting principles, it cannot be compared with

other company’s and hence proper evaluation about the management may
not be possible on the basis of management accountancy.
 A financial statement that measures a company's financial

performance over a specific accounting period. Also known as the
"profit and loss statement" or "statement of revenue and expense.
◦ Balance Sheet
 A financial statement that summarizes a company's assets, liabilities

and shareholders' equity at a specific point in time. These three
balance sheet segments give investors an idea as to what the
company owns and owes, as well as the amount invested by the
shareholders.
 The document provides aggregate data regarding all cash inflows a

company receives from both its ongoing operations and external
investment sources, as well as all cash outflows that pay for business
◦ And analysts (financial) recommendations
 Financial analysts help people decide how to invest their money. They
work for banks, insurance companies, mutual funds, and securities
firms. They often meet with company officials to learn more about
the firms in which they want to invest. After the meetings, the
analysts write reports and give talks about what they found out. Then,
they suggest buying or selling that firm's stock.
That’s how outsiders can easily determine the firm’s value, profit and its
risk. However, SEC is looking for the uniform set of standards for public companies i.e. GAAP
(Generally Accepted Accounting Principles). These statements are prepared by the
accountants of the firms and reviewed by the auditors.
◦ The managers
 Reasons for Differences in Financial Accounting and Managerial Accounting
◦ If Financial Accounting shows favourable financial position as compared to

Managerial Accounting
 1. Company’s management is showing fake financial position of the

company i.e. company doesn’t have enough financial position ( as
managerial accounting shows) but showing the wrong face of the
company to the stakeholders.
 If Managerial Accounting shows favourable financial position as

compared to Financial Accounting
 Company’s management is trying to use the hidden money for their

personal interests
i.e. 1. having more perks for themselves
2. using that money for further business, trying to increase

the share prices ( trying to gain the maximum benefit from the
◦ An accounting-related item is unintentionally misrepresented or is measured

inaccurately.
◦ Accounts receivable is money owed to a business by its clients (customers or

debtors) and shown on its balance sheet as an asset. It is one of a series of
accounting transactions dealing with the billing of a customer for goods
and services that the customer has ordered.
Impact of Error on
Ending Inventory =30000 (Actual) 10000 20000 18000

20000 12000 8000 7000

40000 8000 32000 30000
Beginning Inventory= 20000 10000 10000 8000

15000 4000 11000 10000

25000 17000 8000 6000
 Understated liabilities will automatically show the improves financial

position of the company
 Overstated Assets will show the fake financial position of the

company.

 Who is responsible
◦ Accountants or Managers
 Auditing
◦ The general definition of an audit is an evaluation of a person, organization,

system, process, enterprise, project or product.
◦ Audits are performed to ascertain the validity and reliability of information.
 1. Independent Auditors
 Independent auditors are usually CPA’s (Certified Public

Accountants) who are either individual practitioners or
members of public accounting firms who render professional
auditing services to clients. In general, licensing involves
passing the uniform CPA examination and obtaining practical
experience in auditing.
 Internal auditors are employees of the organization they audit.

This type of auditors is involved in an independent evaluation
of evidence, called internal auditing, within an organization as
a service to the organization. The objective of internal auditing
is to assist the management of organization in the effective
discharge of its responsibilities.
 Government auditors are employed by various local, state, and

federal governmental agencies. Government auditors are
specialists in tax and disclosure regulations.
 Internal Auditor
◦ To oversee the firm’s financial and operating procedures
◦ To check the accuracy of the financial record-keeping

◦ Firms are not required to have internal auditors but many

firms have them to enhance their accounting and internal
control efficiency.
◦ In fact, the people who initially detected financial fraud at

WorldCom were the company’s own internal auditors.
 External Auditor
 External auditors are the accountants from outside the firms
They review;
◦ Assess the system and procedure used by internal auditors
 To conduct external audit, the auditor’s might;
◦ Conduct interviews with the firm’s employees to assess the

quality of the internal audit system.
◦ Meeting with the firm’s customers and clients to assess the

firm’s short-term assets and liabilities.
◦ Conduct their own financial statement analysis such as

comparing ratios from one period to the next.

 largest Audit firms are; (BIG FOUR)
◦ Price Waterhouse Coopers (HO in UK)
◦ Deloitte & Touche (HO in US)
◦ Ernst & Young (Ho in UK)
◦ KPMG (HO in Netherland)
 The Changing role of Accounting – Managing Earnings
Accountants role has been changed for the last two decades i.e.
◦ Instead of simply providing information to insiders and outsiders,

accountants act as a profit- centers.
◦ Accounting departments are asked to increase profits through implication of

accounting methods.
◦ Different methods often lead to different levels of reportable profits.
◦ This process of reporting of profit is called managing earnings.
◦ E.g. 1. Pressure on accountants from managers to meet internal targets.
◦ Managers want accountants to show increase revenue and decrease cost

because it may lead to a raise or a bonus for the CEO and other managers.
 2. Pressure on accountants from Analysts to meet external targets.
◦ Analysts make predictions about firms profitability measured by earning per

share (EPS).
◦ If firm fails to meet these expectations, then the share price will decline.
◦ So, the pressure is on accountants to make any sort of arrangement which

can be “window dressing”.
◦ Window dressing is a set of actions or manipulations with financial or other

information in financial documents (financial statements, reports, etc.) to
make this information look more attractive to its users. Even though window
dressing can occur at any time, it is commonly used at the end of a period
e.g. normally banks managers ask their friends to deposit their money for a
short period of time to have attractive financial position etc; etc.
◦ Other examples of window dressing by companies may include advertising,

selling, and marketing. In these cases, window dressing occurs when positive
characteristics of products or services are a little exaggerated to increase
demand for them while negative characteristics are not mentioned or kept
hidden.
 Another example of variations in accounting method is called smooth income.
 An erratic pace profit generated by business is being divided into

number of years.
◦ Give shareholders a sense reduced risk.
◦ Can easily handle with the analysts predictions.
◦ Good for managers to show consistent revenue on the board

meeting.
◦ Good to deal with the government regulations like taxation.
◦ etc; etc.
 From Manipulation to Fraud
A question often asked is how much can companies manipulate accounting figures
◦ E.g. Selling goods/assets at high price to its own subsidiary, where as the
book value is very low and so on.
◦ Therefore, the firm book large capital gain and profits go up, which is not
actual.
◦ The subsidiary capitalizes the cost of the truck by reporting lower earning in
each of the future years in which the truck cost is depreciated.
◦ Accountants are under pressure from the management side;

 To show maximum profit by any mean
 To show less shortfalls
◦ What about the investors or stock holders?
There is a difference between capital investments and operating expenses

e.g. On June 25, 2002, WorldCom disclosed that roughly $3.8 billion had been improperly
booked as capital investments instead of operating expenses.
 Capital investment may also refer to a firm's acquisition of capital

assets or fixed assets such as manufacturing plants and machinery
 A category of expenditure that a business incurs as a result of

performing its normal business operations.
There is a clear line between legal accounting manoeuvring and accounting fraud.
Accountants and auditors are responsible for this fraudulent act but one should not ignore
 Auditors as Consultants
Business consulting firms typically advice firms on tactical issues, such as

how to enter a new market and strategic issues, such as acquiring or spinning off other
firms.
◦ For example, McKinsey & Company
o Advises more than half of the Fortune 500 firms
o 7,700 consultants in 84 locations worldwide and generated $3.4 billion

revenue
o Representing more than 40 percent market share of the consulting business.
◦ One potential problem for a firm’s shareholders occur when a consulting firm
conducts auditing services for the company.
◦ The income for conducting an audit is far lower than the fees earned for consulting.
◦ It is intended to separate auditors and consultants, prohibit accounting firms from

providing both auditing and consulting activities to the same company.
◦ The conflict of interest of consultants and auditors are the main reason.
◦ Compared to accounting systems used internationally, the system in the US is

quite rigorous to protect shareholders rights.
◦ In the recent study of 31 countries, the US was found the best legal
environment to discourage earnings manipulations and smoothing.
◦ Australia, Ireland, Canada, and the UK also have good investor protection and
enforcement histories.
The Board of Directors
Introduction
A board of directors is a body of elected or appointed members who
jointly oversee the activities of a company or organization. The body sometimes has a
different name, such as board of trustees, board of governors, board of managers, or
executive board. It is often simply referred to as "the board."
 Who elects the BODs for a corporation?
◦ In a publicly quoted company this is usually done at the public Annual General
Meeting of shareholders or by ballot.
◦ In privately owned corporations it is, of course, done behind closed doors.
 Composition
It is common for a board to include a combination of directors (outsiders & insiders);
◦ major shareholders,
◦ members from the management team (e.g. the CEO),
◦ as well as executives from other companies.
 Types of Board of Directors (BoDs)
BoDs can be of two types;
◦ 1. One tier or Unitary Board
 Delegates day-to-day business to the CEO, management team, or

executive committee.
 Composed of both executive (CEO, CFO) and non-executive

(Independent) members.
 This structure is most often found in countries with common law

traditions, such as United Kingdom, US etc.
◦ Two-tier or dual board
 Divided into two separate bodies i.e. management board and

supervisory board.
 The supervisory board overseas the management board which handle

day-to-day operations.
 This structure is common in countries with civil law traditions, primary
in Germany, but also in some companies in France and in many
Eastern European countries.
 Board of Directors Functions
◦ To hire, evaluate and perhaps even fire top management, with the position of
CEO being the most important to consider.
◦ To vote on major operating proposals (e.g. Large capital expenditures &

acquisition)
◦ To vote on major financial decisions (e.g. Issuance of stocks and bonds, dividend
payments and stock repurchases)
o What is “share repurchase”?
◦ A program by which a company buys back its own shares from the
marketplace, reducing the number of outstanding shares.
◦ Because a share repurchase reduces the number of shares

outstanding (i.e. supply), it increases earnings per share and tends to
elevate the market value of the remaining shares.
◦ When a company does repurchase shares, it will usually say

something along the lines of, "We find no better investment than our
own company."
◦ To offer expert advice to management

◦ To make sure the firm’s activities and financial conditions are accurately reported
to its shareholders.
◦ Other includes
◦ To represent the interest of the shareholders
◦ To provide an important corporate governance function
◦ Most important internal monitor.
 Hiring a Board of Directors: 8 tips
1. Do you really need one?
 Find out areas where you need any help or input such as finance,
management, or other areas.
 Consider the importance of independent directors.
2. what sort of board is best?
◦ Small businesses may require just advisory board for feedback but for
large businesses a company need a greater clout.
◦ Board members are required to accept fiduciary responsibility even to

outvote on key decision.
3. Whom do you choose?

◦ Ensure diverse set of skills, expertise, and feedback.
4. Avoid mirror images.
◦ An effective board is comprised of people of diverse

backgrounds and viewpoints that can differ from yours.
◦ Good board consist of people who don’t think like you and are
not afraid about standing up to anyone with their ideas.
◦ You need strong-willed people with a great deal of experience.
5. How will the board function?
◦ You need to address the mechanics of its activities.
◦ Figure out the key areas of your business that need a board’s
involvement.
◦ Meetings, discussions and advises should be practical.
◦ Create the accountability environment between the executives

and the board of directors.
◦ The worst thing is to let your board meet and talk, but nothing
actually happens.
6. How often will the board meet?
◦ Schedule your company’s meetings because its your company

and you can best address the timings, even quarterly, monthly
or weekly if that’s your business requirement.
◦ Meeting should not just for the sake of gatherings but must
have some agenda that can provoke hit issues with warrant
attention.
7. How long should they serve?
◦ Experts suggest that terms for board members only runs from
one to three years.
◦ This can help you to say goodbye to those who are not
interested.
◦ Additionally, stagger terms so that you don’t have too many

board members leaving in the same year.
8. How much do you pay board members?
◦ Again, size, frequency, and other variable dictate how much

you should pay your board of directors.
◦ Rule of thumb: the more you pay them, the more you can
expect them to be loyal to the company and result oriented
and vice versa.
 Overview of the Board
 The Board Legal Duties
◦ No federal law explicitly dictates that public corporation must have a

BODs.
◦ State laws vary form one state to the others.

◦ Fortunately every state requires that a corporation having a BODs.
◦ Directors are supposed to enhance the firm’s profitability and share value.
◦ Directors also have a duty of loyalty and fair dealing.
◦ They must put the interest of shareholders before the their own individual
interest.
◦ Must perform the duty of care, means being informed and making rational
decision.
◦ Must perform the duty of Supervision to establish the rules of ethics by

holding regularly meetings to review the firm’s performance, operations and
management.
◦ Business ethics are Employment Practices, Human Rights,

Environment Regulations, Corruption, Moral Obligation of MNCs.
◦ They must ensure that the accurate financial reporting and objective auditing
are taking place.
 Board Committees
Some board include;
◦ An executive committee
 Group of directors appointed to act on behalf of, and within

the powers granted to them by, the board of directors. Typically it
consists of a chairperson, vice-chairperson, secretary, and treasurer.
Or
 Senior-level management committee empowered to make and

implement major organizational decisions.
An executive committee often acts as an overseer of organizational
activities and has the authority to request justification of certain
matters as well as to plan activities.
◦ A finance committee
 The main duty of the Finance Committee is to maintain a continuing

review of the financial affairs of the Institute. Using this information,
it is the committee’s duty to make appropriate recommendations to
the Board or the Executive Committee regarding financial matters.
◦ A community relations committee
 The Community Relations Committee (CRC) facilitates dialogues and

activities between different stakeholders.
The most common board sub committees are;
◦ Audit Committee
◦ Compensation Committee
◦ Nomination Committee
“A great deal of important board work occurs at the subcommittee level

and subsequently goes to the full board for approval.”
 Audit Committee
◦ an audit committee is an operating committee of the BOD charged with

oversight of financial reporting and disclosure.
◦ Committee members are drawn from members of the company's board of

directors, with a Chairperson selected from among the committee members.
◦ A qualifying audit committee is required for a U.S. publicly-traded company

to be listed on a stock exchange.
◦ To qualify, the committee must be composed of independent outside

directors with at least one qualifying as a financial expert.
◦ Responsibilities of an Audit Committee
◦ Overseeing the financial reporting and disclosure process
◦ Monitoring choice of accounting policies and principles.
◦ Overseeing hiring, performance and independence of the external auditors.
◦ Oversight of regulatory compliance, ethics, and whistleblower hotlines.
◦ Monitoring the internal control process.
◦ Overseeing the performance of the internal audit function.
◦ Discussing risk management policies and practices with management.

 Compensation Committee
◦ The main Oversight of regulatory compliance, ethics, and whistleblower

hotlines.
◦ purpose of the Compensation Committee is;
◦ To assist the BODs in discharging its responsibility to the shareholders with

respect to the company’s compensation programmes
◦ To review the annual compensation discussion and analysis in the annual

report.
◦ Appointment and Removal
◦ The members of the Compensation Committee shall be designated by

the Board.
◦ Any member of the Compensation Committee may be removed from

the committee with or without cause
 Nomination Committee
◦ The Board of Directors shall appoint a Nominating Committee of at least two

members, consisting entirely of "independent" directors of the Board
◦ Each member shall serve on the committee at the pleasure of the Board of
Directors and may be removed by the Board at any time with or without
cause.
◦ Purpose of Nominating Committee
◦ (i) to identify individuals qualified to become Board members,
◦ (ii) to recommend to the Board director candidates for each annual meeting
of stockholders or as necessary to fill vacancies and newly created
directorships and
◦ (iii) to perform a leadership role in shaping the Company's corporate

governance policies, including developing and recommending to the Board a
set of corporate governance principles.
◦ Duties and Responsibilities: Some of the duties and responsibilities are ;
◦ Recommend criteria for Board membership.
◦ Identify and recruit candidates for the Board.
◦ Conduct the appropriate and necessary inquiries into the backgrounds and
qualifications of possible candidates for Board membership.
◦ Recommend to the Board candidates to fill new or vacant positions on the

Board.
◦ Recommend to the Board candidates for the election of directors at each

annual meeting of stockholders.
◦ Oversee the Company's corporate governance matters and policies, including

the development of a set of corporate governance principles, and periodically
review such principles and recommend changes to the Board as necessary.
◦ Oversee the evaluation and assessment of the Board and Board committees.
◦ Evaluate annually the performance of the Nominating Committee.
◦ Perform such other duties and responsibilities as are consistent with the
purpose of the Nominating or as may be assigned from time to time by the
Board of Directors.
 Good for Goose, good for Gander
◦ One form of board may be/may not be good for others.
◦ Small board may be/may not be good for others firms and vice versa.
◦ Can good board lead to better firm performance?
◦ No positive correlation between the board quality and firm

performances.
◦ Normally board are reactive, not proactive
◦ Sometimes inside directors are good for board (e.g. infant or new
firms or when the firm has to make any huge financial/investment
decision) and some times outside directors (e.g. when audit as well as
compensation matters are required)
◦ Some potential problems with today's board
◦ Outside Directors relationship with the top management (e.g. CEO)
◦ Outside directors full motivation is still a question mark for firm’s

board.
◦ Inexperienced as well as busy outside directors are fruitless for the

board
 More Attention on Directors
◦ Prior to the mid-1980s, the public paid little heed to directors.
◦ Now the situation has changed.
◦ Increased pressure on BODs has resulted in better corporate governance.
◦ The increased takeover market and the new regulatory environment push the
directors to do their jobs.
 What is a “GOOD” Board?
◦ Experienced members
◦ Technical firms must have technical experts and vice versa.
◦ Its entirely the firms decision.
◦ A board with members having different background can also be beneficial for the
firms.
 Independent Boards
There must be a high fraction of non-insiders (directors) for a good board
◦ E.g. One of the board primary responsibilities is to evaluate, compensate and

possibly fire the CEO. What if the board consists of the following people;
 A friend of a CEO
 A relative of a CEO
 A business collaborator of a CEO

 It’s very difficult to find people who are entirely and unambiguously
independent of the firm’s management.
 Because they all know each other.
 Either friends or relatives
 Small Board
◦ A board with fewer members might be a better board.
◦ Too many cooks spoil the broth.
◦ Most of the researchers are thinking in the same way i.e. Small boards are more
effective than large boards.
◦ In small boards, every individual with think extra responsibility on his/her

shoulder and vice versa.
◦ With larger boards, it’s very difficult to reach consensus and to get anything
meaningful done.
 Good for a Goose, Good for a Gander?
◦ What is good for a firm must be/must not be good for others.
◦ Young growth-oriented firms would be looking for more insiders, might be the
best people to serve the board.
◦ Larger and more diversified firms may need more directors, keeping in mind the
scope of its operations.
◦ So who will take the decision?
◦ The managers- he may be in the best position to pick a good board but his self-
interest may get in the way.
◦ The firm’s outside shareholders – they can vote on the board members and
having no power in appointing directors directly, unless they could make the
majority.
 Can Good Boards Lead to Better Firms Performance?
◦ It is not clear that there is a positive correlation between board quality and firm
performance.
◦ Boards may be effectively reactive and may not be effectively proactive (value
creator).
◦ It depends either insider or outsider.
◦ E.g. Committee that determine CEO compensation and are responsible for the
firm’s audit may best be served by outsider
◦ But committee that make firm financing and long-term investment decisions may
be served best by insider.
 Potential Problems With Today’s Board.
◦ One of the main functions of the board is to evaluate top management,

especially the CEO. However, for many firms, the board’s chairman is also the
firm’s CEO.
◦ Most of the outsiders have some personal tie to the CEO.
◦ The directors (commonly the outsiders) do not have a significant vested interest
in the firm, holding little or no stock.
◦ Are directors capable of providing the time and expertise required to fully
understand the major operating and financial decision of the firm? Most
directors have their own highly demanding full-time jobs. So how to cope with?
◦ Some directors simply don’t have the expertise to be a board member.
◦ Some boards are simply large and difficult to actively involve them.
◦ Some directors might not be truly independent, they might be too busy.
Investment Banks and Securities Analysts
Introduction
An investment bank is a financial institution that assists

corporations and governments to raise capital by underwriting and acting as
the agent in the issuance of securities.
 Investment banks also assist companies involved in mergers

and acquisitions.
 Unlike commercial banks and retail banks, investment

banks do not take deposits.
In recent years, however, the lines between the two types of

structures have blurred, especially as commercial banks have offered more
investment banking services.
 Examples of Investment Banks in Pakistan
◦ Invest Bank Ltd
◦ Islamic Investment Bank
◦ IGI Investment bank
◦ First Credit and Investment Bank (Joint venture of NBP and

WAPDA)
These are some of leading Pakistani investment banks providing financial

management and advisory services.
 Investment bankers
◦ investigate,
◦ analyze,
◦ research,
◦ underwrite and
◦ distribute
 Security
◦ A security is a negotiable instrument representing financial value

and signifies an ownership interest in something tangible.
◦ That may be freely bought, sold and transferred.
 Investment banks should;
◦ Sell “good” securities i.e. They should not be selling securities of a

poorly run firm
 Analysts should;
◦ Recommend “good” securities i.e. They should not be

recommending stocks that they think will go down in value.
Investment banks offers variety of services but their most

notable business is selling newly-created securities. When a private firm wants
to become a public firm, it requires an investment bank for two reasons;
◦ To design and
◦ To sell the new stocks for the investing public to purchase.
An existing firm can also take the services of Investment banks

for additional capital growth. Investment bank is an intermediary to sell
securities on behalf of firms.
Jobs of the analysts are;
◦ To evaluate securities and make recommendations in buying and

selling of securities
◦ To make earning forecasts for the firms as well as the investors.

 Both investment banks and analysts;
◦ Evaluate the firms position
◦ Bring investment opportunities
◦ Possess better information for the investors
◦ In better position to monitor firms
◦ To identify problems for shareholders.
 Investment Banking Activities
◦ To help companies issue new debt and equities securities.
◦ Banks advises the company on the optimal security (stocks, bonds etc) for
the amount of capital being raised, keeping in mind the company’s situation.
◦ The bank charges the company for this service.
 Methods of Issuing Stocks and Bonds
1. Underwriting
the bank will guarantee that the company will receive a specific amount of
capital, if not then bank will compensate and buy the shares.
2. Best Efforts
the bank will not guarantee that the company will receive a specific
amount of capital but do maximum efforts.
The fee charge is much lower for the best-efforts methods than for underwriting. The
process of selling securities to public investors first involves;
◦ Registering securities with SEC and
◦ Documents
 Preliminary prospectus containing information about the security

issue and
 The company
 Financial condition
 Business activities
 Management experience
 How the fund raised will be used.
The prospectus and the banker’s “road show” relay information about the
company to investors. The “road show” is the marketing campaign done by bankers
to generate interest and to market the issue. To sell to individual investors,
investment banks use their brokerage operations.
The crucial importance of investment banks arises when the firm is new.
Investments banks experience greater risk when underwriting an IPO. An initial
public offering (IPO), referred to simply as an "offering" or "flotation", is when a
company (called the issuer) issues common stock or shares to the public for the first
time.
 Criticism of Investment Banks
1. IPO Problems
◦ The business models of many firms would not be more effectively as large
national firms. Or the small business owners may not be capable of running a
large business.
◦ Only a small fraction of firms succeeded.
2. Structured Deals
◦ In bankruptcy, the equity of the firms is taken from the stockholders, who gain
nothing, and given to some of the creditors.
◦ Therefore, investors are not likely to buy additional shares from financially
troubled firms.
◦ Structured deal using SPEs i.e. making debts as company’s revenue.
 Securities Analysts
◦ Analysts fall into two categories
◦ Buy side (Institutional Investors)
◦ Sell side (Investment Banks)

◦ Institutional Investors
◦ Institutional investors are organizations which pool large sums of money

and invest those sums in securities, real property and other investment
assets.
◦ Institutional investors, such as mutual funds and pension funds hires buy-
side analysts to help to decide which stocks the fund should buy.
◦ The recommendations of these analysts are not public and can be seen
only by the institutional investors.
◦ Similarly, investment banks also hire sell-side analysts to generate enough

interest in a security that their firm will generate trading commission or
underwriting business.
◦ Our focus will be on sell-side analysts.
◦ Sell-side analysts look at the firm’s;
◦ Operating and financial conditions

◦ Immediate and long-term future prospects
◦ Effectiveness of its management team
◦ And the general outlook of the industry in which the firm
belongs.
◦ They usually try to predict the quarterly earnings per share

(EPS).
◦ Analysts make trading recommendations to investors.
o Buy or hold or sell
◦ Analyst’s recommendations are timely.
 Quality of Analysts’ Recommendation
◦ Analysts are slightly conservative with regard to predicting earnings.
◦ These conservative predictions are for two reasons;
◦ To meet or beat earnings expectations
o They need information
◦ If the analysts have full access to the firms, such as personal meetings with the
CEO, then their task become easier.
◦ CEO will not be 100% cooperative with analysts.
◦ Analysts’ conservation is what the management also wants and the CEO will be
happy.
◦ The company will either make or beat the estimate and it will be considered a
good company.
◦ “under promise, over delivery” is the name of this game.
◦ The ability of analysts to predict earnings accurately may suffer in the future.
 Potential Conflicts of Interest
1. Analysts and the Firm they analyse
◦ conflict of interest with the management.
o Try to get more and more information
◦ Friendships with the manager can’t bring the desired goals
2. Analysts Working at Investment Banks
◦ Analysts can work for an independent research firm, for a brokerage firms, or for
the brokerage operations of an investment bank.
◦ These analysts charge huge fee for their services.
◦ Will these analysts feel free to make public honest assessments if it would
jeopardize those banking fees?
◦ What if the analysts came out with the statement that his colleagues at the bank
had under writing earlier?
◦ However, analysts that work at investment banks may feel the need to
compromise their integrity for the good of their employer.
◦ Analysts must be “Independent” rather than working as a salesperson or

promoters for the investment bank.
◦ He/she must be the objective analyzers of financial performances.

Shareholders and Shareholder Activism
Introduction
During scandals, share holders are considered as helpless and innocent victims. Investors
are divided into two categories
◦ Individuals investors ( such as you, Bill Gates)
◦ Institutional Investors ( pension funds, insurance companies, and mutual

funds)
Institutional investors invest on behalf of many small investors.

Shareholders (both individual and institutions) lose money when corporate scandals occur.
So they are more concern about their firms for more protection.
Home owners take safety precautions to protect their home and rely on
the local police. Similarly, investors rely on SEC to protect their investments. Police can’t
guarantee to protect all homes. Similarly, this is just true with shareholders’ stock.
 Why individuals don’t pay attention
◦ Because most individuals don’t own enough stock to be able influence its
management.
◦ Most of the shareholders consider it worthless and time wasting.
◦ But they have to bear the cost individually, when loses occur
Institutional investors are more effective than individual investors to influence the
company’s management.
 Survey of Consumer Finances
◦ More trend of individuals are toward to own stocks through a fund rather
than own stocks directly.
◦ In 2001, 69.9% of US households invested through mutual funds compared to

21.3% that owned stocks directly
 Benefits of Mutual Funds
◦ 1. The advantage of professional investment management
o Mutual funds provide full-time, high quality professional management

services by pooling the resources of many hundreds of investors.
o The fund manager’s goals and interests are tied to your success because
their pay check is based on how well the fund performs rather than on
sales commissions.
◦ The fund manager has instant access to real market information and is able to
make trades on very large and therefore cost effective securities packages.
◦ 2. Diversification.
o A major advantage of mutual funds is that they invest in a wide range of

options from stocks to bonds to money market securities.
◦ 3. Low Cost, High Quality Investing
o An average investor could not create a well balanced portfolio holding a

meagre 50 stocks. It would be too expensive.
o A mutual fund lets you buy into a diversified portfolio for as little as $50.
in some circumstances.
o Typically you can get started in a well managed fund for under $1000.
◦ 4. Convenience and Flexibility.
o Mutual Fund managers study the market, analyze the securities, make all
the decisions on what to buy and sell, clip the coupons, collect all the
interest payments and make sure dividends on the fund's securities are
received, recorded and disbursed.
o They protect the interest of the shareholder (you)
◦ 5. Mutual Fund Investments are Liquid and Easy to Withdraw
o Mutual Funds can be traded in (redeemed) at anytime so cash is available

in an emergency.
o The money will be in your hand in about three business days.
 Costs of Mutual Funds
◦ Some critics of the industry say that mutual fund companies get away with
the fees they charge only because the average investor does not understand
what he/she is paying for.
◦ Fees can be broken down into two categories
1. Ongoing yearly fees to keep you invested in the fund.
2. Transaction fees paid when you buy or sell shares in a fund.
 What is shareholders activism?
When shareholders express their opinions to try to affect or to influence a

firm they are being active shareholders.
An activist shareholder uses an equity stake in a corporation to put public

pressure on its management.
 The goals of activist shareholders range from;
◦ financial (increase of shareholder value through changes in corporate policy,

financing structure, cost cutting, etc.)
◦ to non-financial (disinvestment from particular countries, adoption of

environmentally friendly policies, etc)
 Activism by three kinds of Shareholders
1. Activism by Individual Shareholders
◦ An individual investor with only a modest number of shares is able to attend

shareholders meetings, submit proposals to be voted by at those meetings
and vote at those meetings.
◦ Lewis Gilbert is generally credited with being the first individual shareholder
activist.
◦ In 1932, as the owner of 10 shares of New York Consolidated Gas Company,
he attended the annual meeting but was not allowed to ask question.
◦ Then Gilbert and his brother pushed to reform and in 1942, the SEC created a
rule to allow shareholders to submit proposals that they could be put to a
vote.
◦ Today, anyone owing more than $2000 or 1% of a firm’ stock on a continues

basis for at least one year is able to submit a proposal to be considered and
voted on at a shareholders’ meeting.
◦ But, most of the proposals do not approve, especially those that go against
management desires.
 Monitoring by Large Shareholders
Is it good to have large shareholder?
◦ “Yes” for shareholders
◦ “No” for managers.
Some managers are the firm’s largest shareholders (a good news for a firm – can be
a good monitor of a firm) e.g. Bill Gates owns over 10% of Microsoft Corp.
 Consider two firms
◦ One having 1 or 2 large shareholders who own 10% of the firm
◦ Other having no single large shareholder
◦ But large shareholders are required to monitor the firm at the initial stages,
not when the firm matures.
 Institutional Shareholders: An Overview
◦ They can put greater influence.
◦ Proposals sponsored by institutional shareholders have much greater chance

of success than ones sponsored by individuals
◦ The main reason is their increasing ownership stake i.e. institutional investors
are, actually, large shareholders.
◦ Individual investor has the right to push institutions to be more active
shareholders.
◦ Individual investors can influence the firms they own, mainly through direct
communication with management and other shareholders, by identifying
poor corporate performers and through pushing for reforms.
◦ Examples;
◦ During July 2002, the chairmen of 1754 major US firms all received a
letter from the Teachers Insurance and Annuity Association College
Retirement Equities Fund (TIAA-CREF), the country’s largest pension
fund, asking them to account for stock options as an expense.
◦ They constantly monitor firms and make numerous recommendations

for reform.
◦ Coalition of pension funds can place some massive influence e.g.

Council of Institutional Investors (US).
 Does Institutional Shareholder Activism Work?
◦ Increased activism can’t be directly linked to firm performance.
◦ There are many evidences which are in favour of this statement and few are
not.
◦ Activism has its own set of shortcomings, which we discuss next
 Potential Roadblocks to Effective Shareholder Activism:
◦ The short-term view of these investors limits their desire to be activists.
◦ If the equity fund does not like the future prospects of the firm, they simply
sell the stock instead of working to change the firm.
◦ They have many other options to invest.
◦ Corporate executives don’t hire those advisors who are aggressive and can
interfere in management activities.
◦ Therefore, they wouldn’t hire pension fund advisors who are activists.
◦ Private funds usually just go along with the firm’s management.

◦ Mutual funds will not bite the hand that feed them.
◦ More ownership of stocks by mutual funds may lead to face heavy regulatory
and tax burdens.
◦ Most of the time law restrict the pension funds to become stronger
shareholder of any firm and more influential owners.
◦ Experts are of the opinion that legal restrictions are for the corporation
benefits.
◦ At the same time these investors face tremendous SEC paperwork if they do
wish to accumulate a significant stake in a firm.
◦ Extreme and unfavourable tax ramification in the process.
◦ Only a few law actually encourage or make it easier for institutions to be

effective owners.
◦ The public firms in the US and in the UK have the most dispersed ownership
structure in the world.
◦ For an individual investor, it costs a lot of money to own even one percent of
these large, publicly traded firms.
◦ Institutional investors might have enough capital to be significant owners but

they have regulatory restrictions preventing them from owning a significant
fraction of any one firm.
◦ In many other countries, we can see greater ownership concentration.
◦ The two most common types of large shareholders are family-owners and
state-owners.
◦ These large shareholders, especially family-owners, actively participate in

management and can enjoy some private benefits at the expense of their
other smaller shareholders.
Creditors and Credit Rating Agencies
 Introduction
◦ Who really cares about the firm?
 Stock holders
 Lenders (Creditors)
◦ We will discuss about the lenders attitude toward corporate governance.
◦ There are basically two types of lenders
 Commercial banks
 Individual investors (bondholders)
 1. Commercial banks as lender
◦ Almost all banks have commercial lending departments that loan money to
companies to purchase equipment and inventory to start or expand their
businesses.
◦ One of the main revenue sources for banks is the interest made on loans they
lend.
◦ Firm’s financial position is taken into account before issuing loans.
 Individual Investors as lenders (bondholders)
◦ Individual investors can become creditors of a firm by purchasing that firms

bonds.
 Creditors can trade their claims just as stockholders
◦ Bond holders can also sell their bonds to other investors (and banks can also
sell their loans too but primarily to other institutions).
◦ If firms suffer from poor corporate governance, then the value of their bonds
might decline just like the value of stocks.
◦ If a firm collapses from poor corporate governances then lenders may get
back only pennies on the amount of their loan.
◦ While a bank may find it worthwhile to monitor the firm that they lend to
(because millions, even billions could be at stake), individual bondholders
may not have the resources to do so.
◦ Debt, in and of itself, could be a governance mechanism.
 Credit Rating agencies (CRA)- Government/Private (all bonds need to be rated to

attract the investors/creditors)
◦ CRA assesses the credit worthiness of an individual, corporation, or even a

country.
◦ Analysts rate stocks and CRA rate bonds for bond investors (Creditors).
◦ Credit ratings are calculated from the financial history and current assets and
liabilities.
◦ CRA tells a lender or investors the probability of the subject being able to pay
back a loan.
◦ A poor credit rating indicates a high risk of defaulting on a loan, and thus
leads to high interest rates.
◦ Basically, CRA analyse the element of risk involved with the bonds by having
some grades which determine the level of risk associated with.
 Analysis of the situation where a firm has different credit ratings by different CRAs.
◦ CRAs Perspective
◦ Moody rating for a firm=AAA
◦ PACRA rating for a firm=AA
◦ Private rating for a firm=A

◦ Private as well as PACRA must have to evaluate their expertise
for credit rating purposes because Moody CRA is having
international image and a firm is always single financial
position which means having same credit rating if evaluated by
different CRAs.
 How did Rating Agencies Start?
◦ Moody, John. Manual of Railroad Securities, 1909. Provided operating

statistics for 200 railroads and their securities.
◦ 1916—Standard Co. began grading bonds.
◦ 1920s—Poor and Fitch began bond rating.
◦ 1941—Poor’s and Standard merged.
◦ Customers were investors who wanted unbiased, arms-length financial analysis.
◦ CRA help investors understand the riskiness of a bond issued by issuing some
grades.
◦ A high quality rating for a company means that they can offer a bond at a low
interest rate, having low risk and still easily sell them.
◦ A lower quality rating would require offering the bonds at a high interest rate,
having high risk and cost firms millions in interest payment.
◦ So, we can conclude it in this way;
Credit rating = Risk related to credit
High Credit rate= low interest rate i.e. low risk
Low Credit rate= High interest rate i.e. high risk
◦ So, the bond having high interest rate may be awarded as low credit rate by the
CRA.
◦ And, the bond having low interest rate may be awarded high credit rate by the
CRA.
◦ E.g. one lac (100000) worth of bond having 10% interest rate will give the lender
10000 rupees i.e. 100000 x 10/100= 10000
◦ Similarly, one lac (100000) worth of bond having 5% interest rate will give the
lender 5000 rupees i.e. 100000 x 5/100= 5000
◦ So, from the above examples we can conclude that there is a high risk involved in
the first example having 10 interest rate with the bond and will get low credit
rating from the CRAs and vice versa.
 Another view of Credit Rating
New company= low interest on bonds= High credit rate
New company= high interest on bonds=Low credit rate
Mature company=high interest = High credit rate
Mature company= Low interest = Best Credit rate
 The Big 3
The Big Three credit rating agencies are Standard and Poor’s, Moody’s
Investors Service, and Fitch Rating. Moody's and Standard & Poor's each control about 40
percent of the market. Third-ranked Fitch Ratings, which has about a 14 percent market
share, sometimes is used as an alternative to one of the other majors.
In Pakistan, we have PACRA (Pakistan Credit rating Agency) and many

other private credit rating agencies.
 The Ratings
◦ To assess the credit worthiness of companies, the credit agencies employ

financial analysts who examine the firm’s financial positions, business plan,
and strategies.
◦ This means that the analysts carefully review public financial statements by
the companies.
◦ To assist in their investigations, the SEC has granted the agencies an

exemption from disclosure rules so that companies can reveal non-public or
sensitive information to the agencies in confidence.
◦ Companies have no obligation to reveal special information but they often

do so to convince the agencies that their debt issues (bonds) should be rated
highly.
◦ Credit analysts can often question CEOs and other top executives directly
when conducting reviews because of the importance of credit ratings.
Ratings Moody’s Standard & Poors Example bond Yield,%
Best Qty Aaa AAA 6.4
High Qty Aa AA 6.9
Upper Medium Grade A A 7.1
Medium Grade Baa BBB 7.8
Non-Investment Grade Ba BB 9.9
Highly Speculative B B 10.5
Defaulted or close to it Caa to C CCC to C 20 to 90
 Explanation
◦ Consider two companies that want to borrow $1 billion by issuing bonds. The
rating company rates the first company in the “high quality” category. This
firm will have to pay 6.9% (or 69 million) in interest every year.
◦ The second firm is rated “non-investment grade” and would have to pay $99
million annually.
◦ These amount differ substantially riskier companies pay higher interest.
◦ If a company becomes stronger financially stronger over time, then the bond
rating will also improve.
◦ When a firm begins to struggle financially, credit agencies downgrade the

ratings on its securities i.e. from AAA to AA or even A.
 Criticisms
1. consulting businesses (Conflict of interest)
 being both consultants and credit raters creates a conflicts of

interests similar to the one that occurred when auditing firms were
also consultants for a company.
2. First Amendment Right to CRA
 According to this right, companies can’t sui any CRA and makes credit
agencies nearly invincible.
3. Mistakes while “Rating”
 CRA play vital role while rating different firms. Giving wrong credit
rate (high as well as low) can put the company as well as investors in
chaos.
4. CRA as Watchman (independent monitor)
 CRA are not blameless in the corporate scandals. Indeed, their special
relationship with companies allow them to obtain private information
and can detect fraud and warn investors.
5. Relationship with management
 One of the biggest criticisms on CRA i.e. having relationship with the
management. So how the investors would rely on credit ratings.
6. Blackmailing for new businesses
 New businesses normally required moral as well as financial support

to sustain. So CRA can blackmail them to get good credit ratings for
their businesses to sustain.
 International Perspective (Japan Main Bank System during 1980s)
◦ In most countries, bank debt is the primary form of corporate borrowing and
even the primary source of new financing due to lack of a sophisticated
public debt market.
◦ Although Japan is a developed market but still rely heavily on bank debt,
having long-term relationships with banks, usually with each firm having a
“main bank”.
◦ These main banks usually own equity and place its own personnel into
important management positions (including directorships) of the borrowing
firms.
◦ Positive aspects of “main bank”
◦ Active monitor of the Japanese firms.
◦ Firms don’t care about the cash reserves as they have “main banks”.
◦ “man bank” was always there to help in any financial crisis.
◦ Negative aspect of “main bank” (Japanese market crash in 1990)
◦ Too much influence on management.
◦ Pressurising firm for profit stabilization rather than profit

maximization in order to protect their claims as the firm’s largest
creditors.
◦ But if the banks faced financial difficulties, might led their client firms
in financial troubles
Corporate Governance and Other Stakeholders
Introduction
It is fallacious to argue anymore that the immediate concern of

a Company is to be exclusively directed towards the shareholders, while other
stakeholders are only of a nonessential importance to it.
 1.Corporate Governance and Employees
Employees are also one of the stakeholders of the organisation;

by increasing their participation in the organisation, one could ensure
corporate governance. The interest of employees can be protected through;
 Trade union
Trade Unions could represent the collective interests of the

employees and fight for what is rightly due to them from the
organization.
 Co-Determination
It is a situation where there is employee representation on the

board of directors of the organization.
 Profit-Sharing
Most profit-sharing plans are broad-based i.e. all or most

employees were included in the scheme of profit sharing rather
than just executives only.
The objective of such profit sharing is to encourage employee

involvement in the organization and improve their motivation and
distribution of wealth among all the factors of production.
 Equity Sharing
Under equity-sharing, the employee is given an option to buy

the shares, identify themselves with, and thus become the owners
of the organization.
 Team production Solution
Team production solution is a situation where the boards of

directors must balance competing interests of the various
stakeholders and then arrive at decisions that are in the best
interest of the organization.
There are some guidelines that could be used here while

deciding on employee representation in the organization.
1. Voluntary Participation:
There should be voluntary participation on the
part of the employees and they should not be forced
to do anything out of compulsion.
2. Extend Benefits to all Employees:
The benefits should be extended to all
employees, factory workers, clerical staff and the
executives of the organization indiscriminately.
3. Clarity and Transparency :
The process by which the allocation of shares is
done should be clear and transparent, and not too
complicated.
4. Predefined Formula :
There should be a predetermined formula to
work out the number of shares that could be offered,
and it should not be left to the discretion of any
party.
5. Regularity :
There should be some regularity when such
offers are made, they cannot be made as and when
the organisation feels like making such offers.
6. Avoiding Unreasonable Risk for Employees :
The organisation should take into
consideration the interests of the employees when
they make any decisions, and they should see to it
that there is no undue risk taken.
7. Clear Distinction :
There should be a clear distinction between the
participation schemes that are offered to the
employees and the regular wages and the benefits
that are offered by the organisation.
8. Compatibility with Worker Mobility :
The participation schemes offered should be
compatible with the worker mobility. The worker
should not be penalised by accepting the schemes
offered to him.
 2.Customers and Corporate Governance
Dow Chemicals vision statement says: "To be successful, we

have to provide a balance to the needs of all four of these groups
(customers, employees, shareholders and society). If we maximize the
return to any one or two of these stakeholder groups at the expense of
the others, we won't survive very long."
The North American Advocacy Group, dealing with customer

information needs, stresses the need for corporate to disclose actions
brought by customers and regulatory authorities regarding products,
services and market practices.
A customer who is also a stakeholder of a company contributes

towards the success of the enterprise as much as he is affected by the
actions of the company.
 3.Corporate Governance and Institutional Investors
Types of Institutional Investors
◦ The development oriented financial institutions
◦ The second category covers all the insurance companies such as the
Life Insurance Corporation and their subsidiaries.
◦ The third category includes all the banks.
◦ Finally, in the last category, all mutual funds (MFs), are included.
Factors influencing Investment Decisions
◦ Financial results and solvency
◦ Financial statements and annual reports
◦ Investor communications
◦ Composition and quality of the Board
◦ Corporate governance practices
◦ Corporate image
◦ Share price
 The McKinsey Survey on Corporate Governance
McKinsey conducted this survey in Malaysia, Mexico, South

Korea, India, Taiwan and Turkey, to determine the correlation between
good corporate governance and the market valuation of the company.
The Survey found that good corporate governance increases

market valuation by:
◦ Increasing financial performance
◦ Transparency of dealings, thereby reducing the risk that

boards will serve their own self-interests.
◦ Increasing investor confidence

 4.Corporate Governance and Creditors
◦ Without dependable debt collection, no amount of supervision or

competition can make banks run efficiently.
◦ External financing for private firms comes essentially from two sources: debt
and equity.
Creditors Monitoring and Control
 Adequate Information
◦ The first requirement is information. Lenders need information on the

creditworthiness of potential borrowers, and depositors and bank
supervisors need information on bank portfolios.
◦ The existence of appropriate market-based incentives for creditors, in the

form of higher margin of profit, high interest charges
 Debt Collection
◦ The third requirement for creditor monitoring and control in a market

economy is an appropriate legal framework and effective procedures for debt
collection.
◦ Around the world, legal protection of diffuse debt holders seems insufficient
to protect the rights of investors and limit managerial discretion.
 5. Corporate Governance and the Community
◦ That is the role of governance. Corporate governance is the mechanism by

which the values, principles, management policies and procedures of a
corporation are made manifest in the real world.
◦ The fundamental basis of corporate governance and responsibility is the
value system of the corporation:
 Practical steps to Corporate Social Responsibility
The International Chamber of Commerce recommends these nine steps to

attain Corporate Social Responsibility:
1. Confirm CEO/Board commitment that priority to responsible business

conduct comes first
2. State company purpose and agree on company values
3. Identify key stakeholders
4. Define business principles and policies
5. Establish implementation procedures and management systems
6. Benchmark against selected external codes and standards
7. Set up internal monitoring
8. Use language that everyone can understand
9. Set pragmatic and realistic objectives.
Corporations exist because they, in a sustainable fashion, enable people

to constructively practice their craft and create jobs, economic value, and wealth for the
society and the enterprise especially free societies.
6.Corporate Governance and The Government
Political economy forces that produce the laws, enforcement

mechanisms, bankruptcy processes, and the ability of powerful managers to influence
legislation will profoundly shape corporate governance.
Some argue that governments will tend to use regulations instead of the
threat of legal sanctions when the legal system does not effectively discourage managers
from taking socially costly actions.
Thus the government in every country exercises a certain amount of

control over operations of the organization and the government could use this to push the
organization towards the path of good corporate governance.
Corporate Takeovers: A Governance Mechanism
 Definition
◦ A corporate action where an acquiring company makes a bid for an acquiree.
◦ Assumption of control of another (usually smaller) firm through purchase of

51 percent or more of its voting shares or stock.
◦ Normally, takeover is also termed as “acquisitions”
 What are “mergers” and “acquisitions”?
◦ Mergers:
 Combination of two firms into one
◦ Acquisition:
 One business buy another
 Importance of discussing M & A in Corporate Governance
◦ Firing the target firm’s top corrupt and incompetent managers
◦ These types of takeovers are often referred to as “hostile takeovers”.
◦ Such hostile takeovers are sometimes known as “disciplinary takeovers”

because they represent one process in which “bad” managers and/or “bad”
operating procedures can be eliminated once their firms are taken over.
 General Process; Acquisitions
◦ 1. Initial contacts between management teams.
◦ 2. Tender offer by acquirer to target company stockholders.
◦ 3. Stockholders required to vote approval.
◦ 4. Acquirer purchases majority or complete interest.

 General Process; Merger
◦ 2. Negotiations as to new name, management team.
◦ 3. Stock exchange details negotiated.
◦ 4. Merger proposal goes to stockholders for vote.
◦ 5. If stockholders approve, deal consummated when stock changes hands.
So, Mergers and Acquisitions (M & A) are significant and dramatic events. Through M & A,
companies can monitor as well as solve the governance issues. Stockholders has got this
biggest tool to deal with the governance problems in the company.
 Examples of M & A
◦ American Online acquire Time Warners in 2001.
◦ Pfizer bought Warner-Lambert in the 2000.
◦ Exxon and Mobile merged in 1999.
◦ SBC Communication merged with Ameritech in 1999.
◦ Vodafone’s (UK) acquisition of AirTouch (US) and less than 1 year, Vodafone
AirTouch acquired Mannesmann (Germany)
 Characteristics of M & A
There are many characteristics associated with M & A. These are;
◦ The Type
 The merger type could be between firms in the same industry

(Horizontal merger) or different industries (Vertical merger)
◦ The Valuation of the firm involved:
 Participants negotiate over what is a “fair” price when a firm is trying

to acquire another firm.
 Investors in a company that are aiming to take over another one must
determine whether the purchase will be beneficial to them. In order
to do so, they must ask themselves how much the company being
acquired is really worth.
◦ Naturally, both sides of an M & A deal will have different ideas about the
worth of a target company: its seller will tend to value the company at as
high of a price as possible, while the buyer will try to get the lowest price that
he can.
◦ There are, however, many legitimate ways to value companies. The most
common method is to look at comparable companies in an industry
◦ The payment:
 Payments can be made in the following manners
◦ Cash
◦ The form of payment generally preferred by the

shareholders of the acquiree is cash. It is particularly
appreciated by shareholders
◦ Newly created stocks
◦ In a stock-for-stock exchange, the shareholders of the

selling entity swap their shares for the shares of the
acquirer
◦ The New Corporate Structure
 Who will be in charged?
 Which managers or business lines will be retained?
(Comparing acquirer and acquiree firm’s situation both in M & A)
◦ The Legal Issues:
 Government agencies try to determine if a merger or acquisition

significantly reduces competition, in which case it may be deemed
illegal, and therefore challenged, by the federal government.
 So, M & A encourages monopoly and discourages competition.

 Brief Overview of M & A
M & A can occur for a variety of reasons
◦ Strategic Reason
 To reduce cost
 To get new business
◦ Synergistic Reason
 Interaction or cooperation of two or more organizations to produce a

combined effect greater than the sum of their separate effects.
◦ Diversification
 Diversification is a technique that reduces risk by allocating

investments among various financial instruments, industries and
other categories.
 It aims to maximize return by investing in different areas.
 Most investment professionals agree that, although it does not

guarantee against loss, diversification is the most important
component of reaching long-range financial goals while minimizing
risk
 Are Corporate Takeovers Good for Shareholders?
◦ Takeovers may be viewed as positive as well as negative in the stock market.
◦ Acquirer firm may want to use the infrastructure of the acquiree firm to have
some ease in the business and wants to have an increase in the share price.
◦ Similarly, acquiree firm would be thinking and happy by getting acquired by a

large firm and, definitely, would be looking for higher and stable share price.
◦ But all these predictions can be viewed in a negative way in the stock market
and can badly affect the share price.
 The Target Firm
◦ Most of the time the “target” firm will enjoy a share price increase when its
acquisition is announces to the public.
◦ Because, the investors may believe that now they are in better hands now.
◦ Acquirer firm will also be happy, expecting some return from the “acquiree”
firm.
 Is it appropriate to acquire;
◦ Successful firm
 Require huge sum
 “Net” return for the acquirer firm may not be appropriate
◦ Unsuccessful firm
 Require, comparatively, less money to acquire
 “Net” return may be appropriate for acquirer firm
◦ But acquisition always brings increase in share price because now the firm will work
hard to get the stock market expectations.
◦ By firing bad managers
◦ By giving some premium to the shareholders
 To make happy the existing shareholders
 To attract new investors.
◦ Otherwise, the firm will go in chaos.
◦ What if the management (acquiree firm) didn’t accept the takeover bid?
◦ Then the acquirer may try to take their takeover bid directly to the target
firm’s large shareholders.
◦ If they can enough shares, then they can effectively take control of the target
firm and, thus, the target firm management.
◦ And this is what they called “Hostile Takeover”.
◦ “Hostile” takeover is in the eye of the beholder (i.e. Target firm management)
because;
◦ Many initial hostile acquisitions are eventually approved by the target firm
◦ Also some firm, fearing a hostile takeover, may try to work out a “friendly”
deal which heavy perks for the management as well as premium for the
target firm shareholders etc.
◦ In both of these cases, the firms involved may publicly state that their
merger/acquisition was a friendly one.
 Takeover Defences
◦ Takeover defences include all actions by managers to resist having their firms
acquired.
◦ We can place takeover defences into two categories:
 Firm Level
 Pre-emptive Defences
 Reactionary Defences
 State Level
 Firm-Level Pre-Emptive Takeover Defences
◦ 1. Poison Pill
 The term poison pill represent any strategy that makes a target firm
less attractive immediately after it is taken over. Most poison pills are
simply favourable rights given to its shareholders.
 a. i.e. target firm shareholders the right to buy the acquirer’s

stocks at a deep discount if its firm is acquired.
 Of course these rights make those firms much less attractive

to takeover from the acquirer’s standpoint.
 b. Other type of poison pills could involve a firm’s debt
becoming immediately due once it is taken over or an
immediate deep-discount selling of fixed assets once it is taken
over.
 So these are some of the strategies through which a target

firm can prevent its firm to be acquired.
◦ 2. Golden Parachute
 A golden parachute is an automatic payment made to managers if

their firms get taken over.
 Because the acquirer ultimately bears the costs of these parachutes,

their existence make those firms less attractive.
 Golden parachute can also be viewed as one type of poison pill.
◦ 3. Super Majority Rules
 Where 2/3 or even 90 percent of the shareholders have to approve a

hand-over in control.
◦ 4. Staggered Boards
 A staggered board consists of a board of directors whose members

are grouped into classes; for example, Class 1, Class 2, Class 3, etc.
Each class represents a certain percentage of the total number of
board positions. For example, a class is commonly comprised on one-
third of the total board members. During each election term only one
class is open to elections, thereby staggering the board directorship.
 Firm-Level Reactionary Takeover Defences
◦ 1. Greenmail
 To prevent hostile takeover, the target firm force the shareholder to

purchase stocks from the major shareholders at premium.
◦ 2. Convincing
 It’s a sort of defence by the management to convince the

shareholders that the bid price is very low.
 State-Level Anti-takeover Laws
◦ 1. Freeze-out Laws
 It stipulate a length of time that a bidder that gains control has to wait
to merge the target with its own assets.
◦ 2. Fair Price laws
 Fair price laws make sure that shareholders who sell their shares
during a later stage of an acquisition get the same price as any other
shareholder that sold their shares to the acquirer earlier.
◦ 3. Poison Pill Endorsement Laws
 This law protect the firm’s right to adopt poison pills.
◦ 4. A Control Share Acquisition Law
 A control share acquisition law requires shareholders approval before

a bidder can vote his shares.
◦ 5. A Constituency Statute
 A constitute statute allows managers to include non-shareholders’

(such as employees and creditors) interests in defending against
takeovers
 Assessment of Takeover Defences
◦ Are takeover defences bad for the governance system?
 Takeover defences at least contributed to the end of disciplinary

takeovers.
 If takeover defences prevent disciplinary takeovers then their

existence cause us to be left with one less governance mechanism.
 In this sense, takeover defences are bad for the governance system.
 Adopting takeover defences can badly affect the target firm share
price.
 But this is not to say that we staunchly advocate eliminating anti-

takeover mechanisms.
 We should continue to evaluate the pros and cons of anti-takeover
defences in the light of re-evaluation of corporate governance that is
taking place today.
 Some anti-takeover devices appear only to benefit managers.
 On the other hand, many firms with takeover defences do eventually

agree to be acquired. When they do the acquisition price tend to be
much higher than the original offer.
 Therefore, fighting against the merger for a while may cause the bid
price to increase, thereby increasing wealth to the target firm’s
shareholders.
Role of Media in ensuring Corporate Governance
Introduction
The media can play a role in corporate governance by affecting
reputation in at least three ways.
First, media attention can drive politicians to introduce corporate law

reforms or enforce corporate laws in the belief that inaction would hurt their future
political careers or shame them in the eyes of public opinion, both at home and abroad.
Second, media attention could affect reputations through the standard

channel that most economic models emphasize. Managers' wages in the future depend on
shareholders' and future employers' beliefs about whether the managers will attend to
their interests in those situations where they cannot be monitored. This concern about a
monetary penalty can lead mangers not to take advantage of opportunities for self-
dealing.
Third, media attention affects not only managers' and board members'
reputations in the eyes of shareholders and future employers, but media attention affects
their reputation in the eyes of society at large.
Thus the media does play a role in shaping the public image of corporate
managers and directors, and they also pressure them to behave according to societal
norms.
 Importance of Media
At times, the power of the media is so much that a change takes place
even in the absence of any legal requirement to act.
 Harms of Using Advertisement as a Media Tool
Advertising can betray its role by misrepresentation and withholding

relevant facts. Sometimes, the function of media can be subverted by advertisers'
pressure upon publications or programmes. More often, though, advertising is used
not simply to inform but to persuade and motivate — to convince people to act in
certain ways: buy certain products or services, patronize certain institutions, and the
like.
 Media and Corporate Governance
First, previous research has mostly focused on the legal and contractual
aspects of corporate governance. Research suggests that this focus should be
broadened, and that the policy debate should undergo a similar shift in focus.
Second, the press pressures managers to act not just in shareholders'

interest, but in a publicly acceptable way. This finding brings the role of societal norms to
the forefront of the corporate governance debate.
 Corporate Governance and the Press
Shareholders Activists and Press
Activists such as Robert Monks and Nell Minnow have found the press useful in their
fights with management in the United States.
 Institutional Investors
While institutional investors have many legal mechanisms to encourage

change in corporate policies, the presence of an active press increases their influence. It
provides a relatively cheap way to impose penalties on companies and to coordinate the
response of other investors in availing themselves of potential legal protection.
 Business School Governance and Business Today Rankings:
In 1988, the magazine Business Week started to publish a ranking of the top
U.S. business schools. Despite its arguable criteria (most students experience no
more than one business school, yet their responses are used to rank them), this
ranking gained a lot of attention, and soon assumed the role of a standard in the
industry.
 Selective Coverage and Media Credibility
◦ A critical issue we have ignored is the credibility of the information the media
communicates to the public, which is, of course, extremely important.
◦ Even in Korea and Russia the Financial Times is more credible than local
newspapers.
◦ Similarly the Business Week ranking of business schools had a much greater
impact than the U.S.
◦ The issue of credibility is particularly weak because it opens up the question
of newspapers' incentives to conduct further investigations to establish the
validity of the information reported to them and their incentives to report
the information they receive accurately.
◦ Threats to increase (or withhold) future advertising revenues in exchange for
stories that reflect well (badly) on company management and directors are
one example of side deals. Of course, such side deals might hurt the
reputation of a newspaper in the long run and hence its credibility.
◦ If, as is likely, it is more difficult for an individual newspaper to build a
reputation of integrity in a market where all the other newspapers are
colluding.
◦ One equilibrium is where newspapers have credibility and thus avoid side
deals for fear of losing it.
◦ Another is where newspapers do not have credibility and happily accept
bribes not to publish damaging information or to publish false damaging
information.
◦ Similarly, an independent newspaper whose survival rests solely on its own
success is less likely to collude with established business interests.
◦ By contrast, a newspaper owned by a business group is naturally less likely to
publish bad news about the group itself.
 Ethics in Advertisement
◦ A number of humanities and social science scholars view advertising as

intrusive and environmental and its effects as inescapable and profound.
◦ These are strong indictments which imply that advertising is a powerful force.
 Defenders of advertising argue that it has a beneficial effect on several basic areas
 Information :
 Values and Life-Styles :
 Creative experience :
 The following are some of the adverse effects of advertising :
1. Deception :
For example, a soft drink may be described as an orange drink, though it is

artificially flavored.
2.Fear appeals :
The intent of the fear appeals is to create anxiety in the minds of the
consumer and provoke him/her to make use of a particular product to alleviate the
fear in him/her.
3.Advertising to children :
Most of the advertisements such as those for chocolates, are directed at

children. Children between ages of two and eleven spend at least three hours a day
watching television. Secondly, pre-school children cannot differentiate between
commercials and programmes.
Most of these advertisements are deceptive as they omit significant

information such as the complexity and safety of operating toys.
Defenders of advertising to children offer the following positive effects:
1. Advertising gives product information to the child that assists him

or her in making decisions.
2. Children are developing skills though advertising and will be more

independent and make better selections among products targeted towards
them.
3. Advertising is an influence on the process of socialization – it is a

means whereby children learn the value system and norms of the society
they are entering.
4. Materialism
Materialism is defined as a tendency to give undue importance to material

interests and objects. It leads to a sort of Mammon - worship. Consequently, there
is a corresponding lessening of importance to non-material interests such as love,
freedom, and intellectual pursuits.
5. Advertising Alcoholic Beverages
There is a national concern with the problem of alcoholism. Children see

these ads for beer, wine and other drinks long before they are old enough to drink.
6. Competitive Advertising :
Competitive advertising is a form of advertising in which two or more brands

of the same product are compared and the comparison is made in terms of one or
more specific product. It can lead to consumer confusion and is ethically
questionable.
7. Increasing Costs :
The ultimate burden of the cost is passed on to the consumer.
8. Absence of Full Disclosure :
For example, most of the advertisements catering to cooking oil do not

disclose the harmful effects such as increasing in obesity of an individual by using the
product.
9. Use of Celebrities:
Most of the advertisements use celebrities from the world of cinema or

sports. These celebrities would not have used the product.
10. Fantasy and Reality :
Nowadays, most of the advertisements make use of fantasies. For example,

the advertisement of a popular soft-drink shows a boy going in search of the drink in
question and later on lifts a bottle from a moving truck.
New Governance Rules-Sarbanes Oxley Act 2002
 Introduction
◦ In July of 2002, the US passed the Sarbanes-Oxley Act, other wise known as
the Public Company Accounting Reforms and Investor Protection Act of 2002.
◦ SOX is without question the most dramatic federal law pertaining to

corporate governance since the initial securities laws of the 1930s.
◦ It provide an overview of the new NYSE and NASDAQ corporate governance

rules imposed on their listed firms.
◦ A brief history documented how market conditions lead to both the

strengthening and the relaxing of securities regulations in the US is
presented.
◦ Finally, the discussion concludes by illustrating that the trend for increasing
corporate governance standards was a global trend.
 SARBANES-OXLEY ACT OF 2002
◦ Signed by US President George W.Bush on July 30, 2002.
 To regulate auditors
 Created laws pertaining to corporate responsibilities
 And increased punishments for corporate white-collar crime
 Public Company Accounting Oversight Board
The Act established a non-profit corporations called the Public Company Accounting
Oversight Board to oversee the audit of public companies in order to improve the accuracy
of audit reports. Following are the duties
1. registration
2. standard auditing
3. inspection of firms
4. investigations and sanctions
5. improve auditing services

6. compliance with the rule of Board
7. oversee the board budget
 Auditors Independence
◦ Prohibit accounting firms from providing both auditing as well as consulting

activities to the same firm;
◦ Gives the audit committee of the company’s board of directors more

authority over auditing activities;
◦ Forces the lead audit partners in an audit team to change at least after five
years.
◦ Disallows auditing by an accounting firm if any of the top executives of the

public company were employed by the accounting firm within the past year;
and
◦ Requires a study to be conducted that investigates the potential outcomes of

mandatory rotation of accounting firms conducting audits.
 Corporate Responsibilities
◦ SOX also attempt to increase the monitoring ability and responsibilities of

board of directors and improve their credibility. Specifically, the Act does the
following
◦ Making audit committee of the board of directors both more independent

from management and more responsible for the hiring and oversight of
auditing services and the accounting complaint process;
◦ Forces CEO and CFO to certify the appropriateness of the financial statement
filed with the SEC;
◦ Makes it unlawful to mislead, coerce or fraudulently influence an accountant

engaged in auditing activities;
◦ Forces executives of the firm to forfeit any profit from bonus or stock sales
resulting in earnings that needed to be restated as a result of misconduct;
and
◦ Prohibits executives from making stock transactions during the time in which
the employee pension plan blacks out employee stock transactions.
 Enhanced Financial Disclosure
The new law tries to make executives actions more transparent to shareholders.
Specifically, the Act does the following
◦ Require the disclosure of “off balance sheet transactions” and its corrections
◦ Decreases the time an executives has to report company stocks trades to the
SEC to two days;
◦ Prohibit the lending of money by public companies to executives, except for

the use of home loans;
◦ Requires increased internal financial controls and review by the board of

directors.
◦ Encourages a code of ethics for senior officers of the company and report
changes and exemptions to the SEC; and
◦ Requires a financial expert on the board of director’s audit committee.
 Analysts Conflicts of Interests
◦ Analysts should be separated from the investment banking and their conflict
of interest should be disclosed
 SEC Resources and Authority
◦ SEC budget expanded greatly after the passage of SOX, to regulate tens of
thousands of public companies.
 Corporate and Criminal Fraud, Accountability and Penalties
◦ Different sentences and penalties were introduced, ranges from millions of

fine and/or many years of imprisonment.
 Will The Act Be Beneficial?
◦ SOX addresses different problems i.e. problems with auditing, BODs,

Executive behaviour, the SEC and Analysts.
◦ Legal scholars are of the view that the Act is either misplaced or repetitive to
existing laws
◦ These laws didn’t protect ENRON from governance failure.
◦ These laws are burdensome and expensive
◦ Cost related with compliance of the Act don’t guarantee the firms value, so
what is the benefit of adopting it.
◦ The success of the Act is still debatable and it’ll take few years to succeed.
 Other Regulatory Changes
◦ In 2002, in light of the growing number of accounting scandals, the SEC

Chairman called on the NYSE and the NASDAQ Stock Market to take a fresh
look at their corporate governance listing standards.
◦ Because the debated SOX rules are similar to the Act’s laws.
 The New York Stock Exchange
 The NYSE can impose rules on NYSE-listed firms only, which means
that its rules do not affect
 non-listed firms,
 nor can it impose rules on other members of business

community, such as auditors and financial analysts.
 We focus here on those rules that were adopted by the NYSE but not
adopted by the Act.
 Most of the new NYSE corporate governance rules have to do with

the structure, function, and incentives of the BODs
 The NYSE mandates that companies have a majority of independent

directors
 A director is not independent if he (or immediate family);
 Has worked for the company
 Or its auditor within the past five years
 The NYSE also requires specific functions of the board e.g.
 Nominating committee members must be independent.
 This is also true of the compensation committee.
 Otherwise, the executives would have undue influence on their own

compensation.
 The Audit committee must also be independent.
 Lastly, the NYSE will require the shareholders approve all executives
equity based compensation plan.
 That is, there will be a shareholder vote on whether the CEO gets a
certain number of the stock options or restricted stock shares.
 This rule creates more transparency because each shareholder will

receive a proxy statement detailing the compensation proposal.
 NASDAQ Stock Market
◦ The firms listing on the NASDAQ stock market tend to be smaller, on average,
than those listing on the NYSE.
◦ Therefore, NASDAQ adopted rules in the same spirit as those adopted by the
NYSE but with differences intended to fit better with its listing firms.
◦ E.g. smaller firms often have a smaller number of board members. The SOX
and the NYSE rules empower independent directors and give them much
responsibilities.
◦ However, the implementation may overwhelm a small number of

independent directors serving on a small firm board.
◦ Consider a board with only seven directors. Only four independent board
members are needed to create a board with an independent director
majority.
◦ However, having only four independent directors makes it difficult to have
independent committee for executive compensation, nomination, auditing,
etc.
◦ So instead of having a rule that an independent compensation committee

must approve the executive compensation, they provide an alternative that
the independent directors can approve the compensation directly (without
being all members of a compensation committee)
◦ While the NYSE requires that shareholders approve all executive equity based
compensation plans.
◦ Only international firms listing on NASDAQ can apply for a waiver from
corporate governance rules that would be contrary to the firm’s home
country law or business practice.
◦ In those cases where a waiver is appropriate, it must be disclosed in annual

SEC filings.
◦ It is common for the US government to respond with new and tighter

securities regulations during or after market downturns and/or scandalous
periods.
◦ The SOX is one example but journey will go on.

Monopoly, Competition and Corporate Governance
Introduction
A monopoly is said to exist where at least one person or a company controls one-
third of a local or national market. The attitude of the public in many countries towards
complete and partial monopolies has for many years been one of distinct opposition.
Abuses of monopoly are
(i) high prices and restricted output ;
(ii) wrong allocation of resources;
(iii) abuse of investors by monopolists painting alluring pictures of high profits and
perpetual exploitation of the market;
(iv) preventing inventions
(v) increasing the instability of the economic system;
(vi) corruption and bribery and
(vii) concentration of economic power in the hands of a few.
It is for these reasons that monopoly has been regarded as a social evil and various
measures have been designed in free enterprise economies to control and regulate it or in
some cases to eliminate it altogether.
Societies that value corporate democracies and better governance practices have
enacted anti-monopoly laws that have attempted to (a) prevent monopoly firms from
coming into existence, (b) get them dissolved if they exist already or spelt into a number of
competing firms; and (c) prevent monopoly firms from indulging in unfair trade practices
such as price discrimination and cut-throat competition.
A competitive firm in a free market economy is preferred to a monopoly for a variety

of reasons; (i) the consumer stands to gain under it because of low prices available due to
intense competition; (ii) firms avoid wastages and duplication of efforts as they have to be
competitive; (iii) firms tend to be efficient in a system of the survival of the fittest; iv) they
maximize the gains by deploying resources in the best possible way in the context of
consumer’s tastes and preferences. Competition is thus considered to be the best market
situation and its closest to corporate governance practices.
The Concept, Logic and Benefits of Competition
Some of the benefits expected from competitive markets are:
 Growth of entrepreneurial culture leading to an increase in the number of producers

and sellers in the market.
 Increase in investment and capital formation leading to an increase in supply

capabilities.
 A strong incentive for developing cost-cutting technologies through sustained

research and development efforts.
 Reduction in wastage and improvement in efficiency and productivity.
 Greater customer focus and orientation.
 Increased possibility for entering and tapping foreign markets.
 Conducive environment for growth of international trade and investment.
 Better resource and capacity utilization.
 Wider range of availability of goods and services and wider range of choices for
consumers.
On account of these perceived benefits, governments in free enterprise countries

take steps to generate and promote competition. This, however, requires a suitable
economic system and the constitutional framework as well as an appropriate
macroeconomic policy set-up.
Regulation of Competition
While it is important and necessary to promote competition among firms to enable

consumers gain maximum advantage from a free market economy, an unregulated
competition is bad and may even lead to unmitigated disaster and destruction of the
nation’s wealth.
The regulation and protection of competition usually requires a competition policy

backed by an appropriate legislation. There are three basic areas of such competition policy:
 Control of dominance firms by regulation.
 Control of mergers to prevent the possibility of emergence of monopolies; and
 Control of anti-competitive acts like full line forcing and predatory pricing.
Corporate Governance under Limited Competition
The influence of competition on the practice of corporate governance can be gauged

properly if we look at the risks associated with markets where competition is restricted.
Regulatory barriers and firm-level practices have tended to limit the scope of
competition in takeovers, disinvestments and privatization, both in industrial and
developing countries.
In more advanced markets, it was found that as regulatory barriers were imposed on
corporate control transactions, managerial efforts and board supervision became weak.
Firms try to postpone addressing business problems. Corporate performance generally
declines with adverse consequences for shareholders.
Constraints To Competition in Developing Countries
Among developing countries, restricted competition in the market for goods and
services is a more prevalent situation. There are diverse constraints, ranging from anti-
competitive practices by firms to government policy restrictions on ownership and entry.
Frequently, entry barriers are disguised as regulation purportedly designed to serve

the "public interest." In fact, these policies usually give the preferred producers and service
providers profits in excess of competitive returns. Such profits, however, come from
distorted prices, which is truly a hidden tax on consumers.
The resulting burden is borne by the society as a whole. India’s was a classic example
wherein the government adopted between 1951 and 1991 a highly restricted policy in the
name of import substitution and protection of home industry, which resulted in gross
inefficiency, high prices, shoddy goods and an overheated economy. In such a system,
corruption and black money abounded and corporate governance was unheard of.
Banks’ Role in Restraining Emergence of Securities Markets
Banks, which play a predominant role in financial inter-mediation in developing

countries, maintain cozy relationships with established and often well-connected
businesses.
In some countries, commercial firms also own and control major domestic banks,
creating business conglomerates with "in-house" sources of easy financing for themselves.
This was the case in India before twenty of these banks were nationalised in the 1960’s and
thereafter.
More generally, preferred access to bank credit significantly reduces the need of
incumbent firms to rely on securities markets where external financiers often demand
transparency and accountability of corporate insiders.
Lack of Competition Promotes Ownership Concentration
Lack of competition accentuates ownership concentration. They may choose to

remain a private firm or may go public, but without giving up control either by retaining a
controlling stake or by issuing non-voting shares.
Research findings show that a higher share of the leading firms remain private in less
competitive markets.
Benefits of Competition to Stakeholders
Competition improves;
the conduct of managers, as they understand that in such markets only the fittest
can survive.
This, in turn, improves quality of products and reduces prices for consumers, and
maintains or increases market share, and return on shareholders' investment.
In a much freer market, they enjoy a wide variety of products and services to choose
from, competitive prices, technically updated products and other consumer friendly policies
such as easy and installment credit and longer warranties.
These benefits of competition can be analyzed from two aspects:
(i) competition in the product market, and
(ii) competition in the capital market.
1. Competition in Product Market
Increased competition can increase shareholder and consumer welfare. Competition

provides strong incentives for performance. It aids in defending and expanding market
share. It also helps in the provision of accurate information to measure performance, that is,
it increases transparency in all operations. Competition to win market share drives greater
efficiency and innovation. It passes on lower prices to consumers and eliminates monopoly
rents.
Benchmark performance measures are available through reference to competitors unlike
in monopoly. It encourages a customer-driven market rather than product-driven market. In
a competitive market, the consumer determines the quality and quantity of the products, as
reflected in the price mechanism. Competition in product markets is generally associated
with allocative and productive efficiency. Competition encourages the supply of goods and
services at lowest costs and at prices.
2. Competition in a Capital Market
While the benefits of competition to consumers in the product market can be

directly linked and may reflect corporate governance practices, it may not be so direct in the
case of capital market.
Often, competition may undermine the development of long-term relation between

companies and financial institutions. For example, the willingness of banks to provide rescue
to firms in financial distress, hinge on the expectation that these investments will yield long-
term returns.
Where there is competition in financial markets and firms are in financial distress,
the provision of rescue funding by banks may be discouraged.
On the other hand, limitations on competition in financial markets may result in

monopoly exploitation of borrowing firms. Thus, a firm that remains competitive will be able
to get the required funds through the capital market.
Economic Power and Political Influence
Firms have a definite organizational and financial advantage in influencing the

legislative and regulatory agenda.
In advanced countries, powerful commercial interests may not always prevail. But, in
most developing countries, competing opinions are more limited.
In this context, interest groups are more likely to succeed in furthering their own
agendas. It is often alleged that the street-smart companies that wield enormous political
influence grow much faster than those which preferred to be independent.
They could not grow much, though they were in the industry for generations.
Incumbent firms often use their political influence to entrench the position of management
and corporate insiders.
Competition and Political Governance
Political governance includes the regulatory environment and process. It involves

policy making in the public interest.
Monopolization, or lack of competition generally, can affect political governance and

indirectly affect corporate governance.
Effects of Monopoly on Political Governance
 In such a state of affairs,
• The political and economic control may be too concentrated. Democracy and
competition get undermined.
• There is reduced political accountability and transparency. There is increased

corruption.
• Shareholder interest may be confused or compromised by multiple and conflicting

objectives.
Examples abound where due to deliberate state policy and with little objective
regulation, politically influential family-owned companies emerge as winners thwarting even
the limited competition.
Managements are not interested in putting in place any corporate governance

practices. Their focus is distorted away from commercial objectives towards political
influence.
Political favours weaken management and accountability. There is a lack of

transparency, so there is reduced incentive to invest and increased risk in equity markets.
Encouraging Good Governance
Competition in product markets and market for corporate control encourage good
governance. The effects of external auditors can be very important in enforcing good
governance, particularly where there are complexities and other issues that make
shareholder monitoring difficult. Takeover codes should be not be "captured", but should
maintain a consumer and shareholder focus.
Competition is only part of the solution
Competition is not the only solution to the myriad of problems that exist in such
economies. There is a need to regulate certain fiduciary relationships. Steps should be taken
to prevent exploitation and/or abuse of information. There should be situations of
asymmetric information between buyer and seller.
Enforcement of Good Governance
There can be private enforcement through the market mechanism or through

voluntary or self-regulation through trade associations if the losers are sufficiently well -
informed, concentrated and expert.
Public enforcement is called for if private efforts do not work or if the matter is
criminal. The positive effects of competition can also reduce the burden of enforcement.
Regardless of competition, it is important to have sound rules and regulation.
Enforcement is vital, complementary to competitive mechanisms, and often may be

required to put in place corporate governance practices
Challenges to Good Enforcement
The credible threat of detection, whether from private or public investigation

or monitoring, requires resources. Meaningful sanctions applied in a timely period with
correct burden of proof, depend on legal system and legislative and judicial approaches to
white-collar crime.
This is a big challenge in the area of international cooperation as globalization

continues.
Competition Agencies and Competition Policies
Competition policy seeks to prevent anti-competitive practices and business

developments or policy reforms which may facilitate these practices.
It aims to stop unfair business tactics and abuse of market power or political office to
gain excess profits. With a clear set of competition rules, the government is in a better
position to resist the lobbying of interest groups for preferential treatment.
Experience also shows that it's useful to maintain economic efficiency as the
principal policy objective. Encumbering competition policy with other goals, such as
employment, regional development and social pluralism, tends to compromise the
beneficial result.
To be effective, the enforcement agencies should have adequate independence,

resources and the necessary powers to review, investigate and initiate prosecution of anti-
competitive practices. In addition to enforcement, an important role of competition
agencies is to review and spell out the implications of public policies and regulatory
practices on competition and efficiency.
WHAT IS A GOOD COMPETITION POLICY?
A good and effective competition policy with the objective of restraining the
emergence of monopolies and bringing in a competitive market that would ensure benefits
to the consumers and overall economic efficiency, and at the same time taking cognizance
of the specific needs of a developing country like India, should have the following
characteristics:
It should be capable of controlling the misuse of the market power of dominant

firms. It should have a clear perception of dominance and should develop unambiguous
criteria for determining the abuse of dominance.
It should be able to identify the anti-competitive effects of mergers and acquisitions

and provide a prescription to deal with such effects.
It should check barriers to entry subject to the provisions of industrial policy.
It should be capable of monitoring and preventing anti-competitive agreements

between business organisations.
It should be able to identify restrictive and unfair trade practices and provide a
prevention mechanism.
It must ensure that competition leads to better productivity and efficiency and wider
choice to the consumer.
The policy should apply to all the major segments of the economy including
agriculture, agribusiness, manufacturing, infrastructure, utilities and services.
It must provide suitable defenses and protection measures to the marginal or

weaker enterprises in the small-scale sector, which have national importance.
The policy must accommodate international factors and influences in the national
interest.
The policy should be able to create a level playing field for various categories of
enterprises and must target an optimum degree of competition; which is in the best interest
of the economy from the point of view of growth, equity and social justice.
Competition boosts Corporate Governance
In a competitive environment, firms generally cannot expect to earn excess profits.

An industry that generates above-average profits tends to attract new competitors, which
bring forth additional supply and drives down profitability. Where natural barriers to entry
are high, excess profits may persist and interim regulation may be needed to protect
consumers. Over time, however, technological advances and entrepreneurial innovations
tend to chip away the natural barriers, unless they are prevented by regulations. To
withstand competition, firms need to rely on operational efficiency.
Where competition is intense and global in scope, more firms realise that
corporate governance makes good business sense. Investors seek out firms that run the
business efficiently, treat shareholders equitably and comply with high standards of
disclosure, even when they are not mandatory.
By applying good governance, a firm can earn a good reputation and efficient access
to finance, which in turn enhances their ability to compete. In effect, good governance
becomes an instrument of competitive strategies.

voluntary or self-regulation through trade associations. Public enforcement is called for if
private efforts do not work or if the matter is criminal. The positive effects of competition
can also reduce the burden of enforcement. Regardless of competition, it is important to
have sound rules and regulation.


white-collar crime.

continues.

developments or policy reforms which may facilitate these practices. It aims to stop unfair
business tactics and abuse of market power or political office to gain excess profits. With a
clear set of competition rules, the government is in a better position to resist the lobbying of
interest groups for preferential treatment.
principal policy objective. Encumber competition policy with other goals, such as
beneficial result.

A good and effective competition policy with the objective of restraining the emergence of
monopolies and bringing in a competitive market that would ensure benefits to the
consumers and overall economic efficiency, and at the same time taking cognizance of the
specific needs of a developing country like India, should have the following characteristics:
It should be capable of controlling the misuse of the market power of dominant firms. It
should have a clear perception of dominance and should develop unambiguous criteria for
determining the abuse of dominance.
It should be able to identify the anti-competitive effects of mergers and acquisitions and
provide a prescription to deal with such effects.
It should be capable of monitoring and preventing anti-competitive agreements between

business organisations.
It should be able to identify restrictive and unfair trade practices and provide a prevention
mechanism.
It must ensure that competition leads to better productivity and efficiency and wider choice
to the consumer.
The policy should apply to all the major segments of the economy including agriculture,
agribusiness, manufacturing, infrastructure, utilities and services.
It must provide suitable defenses and protection measures to the marginal or weaker
enterprises in the small-scale sector, which have national importance.
The policy must accommodate international factors and influences in the national interest.
The policy should be able to create a level playing field for various categories of enterprises
and must target an optimum degree of competition; which is in the best interest of the
economy from the point of view of growth, equity and social justice.

Where competition is intense and global in scope, more firms realise that corporate
governance makes good business sense. Investors seek out firms that run the business
efficiently, treat shareholders equitably and comply with high standards of disclosure, even
when they are not mandatory. By applying good governance, a firm can earn a good
reputation and efficient access to finance, which in turn enhances their ability to compete.
In effect, good governance becomes an instrument of competitive strategies.
Corporate Governance in Developing and Transition Economies
Introduction
Steps were mooted (debated) to root out the misdemeanors of the ill-behaved
corporations. It was easy to incorporate the required transformational changes in the
corporate sphere of advanced countries where the systems and procedures and regulatory
bodies to combat and arrest the declining standards were in place, albeit in an immature
degree, it was difficult in the case of developing and transition economies where everything
had to be built from the scratch.
Earlier, the common perspective of Corporate Governance was to respect the

individual system of each country. But in the context of globalization with its attendant
enhanced transnational movement of goods and services and for borderless capital
markets, a set of global standards for corporate governance is being attempted in recent
times.
In such a scenario, it is imperative that developing and transition economies should

try to put in place required systems and institutions with a view to benefiting from the
world-wide application of the principles and percepts of best corporate governance
practices.
Problems Faced by Developing and Transition Economies
Many developing, emerging and transition economies lack, or are now in the
process, of developing the most basic market institutions.
Internal owners dominate in many companies, while the external owners do not
have enough voting power to control the companies and thereby to ensure for themselves
appropriate returns.
The capital markets are just developing and do not facilitate the inflow of new
capital as intended. Further, market transactions are often based on the abuse of inside
information.
The need for corporate governance in developing, emerging and transition

economies extends far beyond resolving problems stemming from the separation of
ownership and control, which is the core and substance behind the need for corporate
governance.
Developing and emerging economies are constantly confronted with issues such as
the lack of property rights, the abuse of minority shareholders, contract violations, asset
stripping and self-dealing.
To make matters worse, these acts often go unpunished since many developing,
emerging and transition economies lack the necessary political and economic institutions to
enable democracy and markets to function.
In the context of developing, emerging and transition economies, instituting

corporate governance entails establishing democratic, market-based institutions as well as
sound guidelines for how companies are run internally.
The judiciary is so lethargic and bureaucratic that it takes more than a couple of
decades to bring the scamsters to book..
Regulatory bodies are not alert, government appointees in Boards are lax, due to
partisan politics and corruption in government, the bureaucracy hardly play their roles in
effectively stemming the damages caused by corporate misgovernance.
Summary of Problems Facing These Economies are :
◦ Lower economic growth.

◦ Dominant public sector – the general perception is that corporate governance is
meant for the private sector and the public sector does not fall within its purview.
◦ Lack of effectiveness of privatisation.
◦ Lack of awareness among shareholders.
◦ Greater government influence, and less autonomy to enterprises.
◦ Internal owners dominate more than a company’s external owners. Given their
discretionary powers, company managers use the company resources to their own
advantage. Investors, therefore, cannot get their returns from cash flow of the
company from the projects.
◦ External owners do not have enough voting power.
◦ Concentration of ownership in the hands of few individuals and family-owned
corporations.
◦ Lack of strong legal protection for investors in developing countries that leads to
concentration of ownership which is used as a means to overcome the power of the
management. This, leads to misappropriation of minority interests.
◦ Capital markets are underdeveloped and do not facilitate the inflow of new capital.
◦ Market transactions are often based on abuse of internal information.
◦ Redrawing property rights and contract laws are slow in coming.
◦ Lack of well regulated banking sector.
◦ Exit mechanisms, bankruptcy and foreclosure norms are absent.
◦ Sound securities markets do not exist.
◦ Competitive markets have not developed.
◦ Corruption and mismanagement.
◦ Non-uniform guidelines: the government – formulated guidelines to ensure better
governance are not uniformly applied to all companies.
Corporate Governance Models
The countries with developed economies apply two different systems of corporate
governance: the group-based system and the market-based one or, as they are often
referred to, the insider and outsider systems.
1. Insider System
In concentrated ownership structures, ownership and/or control is concentrated in

the hands of a small number of individuals, families, managers, directors, holding
companies, banks and/or other non-financial corporations.
Insiders exercise control over companies in several ways; own the majority of the
company shares and voting rights; own some shares, but enjoy the majority of the voting
rights.
Companies that are controlled by insiders enjoy certain advantages. Insiders have
the power and the incentive to monitor management closely thereby minimising the
potential for mismanagement and fraud.
Insiders tend to keep their investment in a firm for long periods of time. As a result,
insiders tend to support decisions that will enhance a firm's long-term performance as
opposed to decisions designed to maximise short-term gains.
However, insider systems predispose a company to certain corporate governance

failures. One is that dominant owners and/or vote holders can bully or collude with
management to expropriate the firm’s assets at the expense of minority shareholders. This
is a significant risk when minority shareholders do not enjoy legal rights.
Insiders who exercise their power irresponsibly waste resources and drain company
productivity levels; they also foster investor reluctance and illiquid capital markets. Shallow
capital markets, in turn, deprive companies of capital and prevent investors from
diversifying their risks.
2. Outsider System
Dispersed ownership is the other type of ownership structure. In this scenario, a

large number of owners hold a small number of company shares. Small shareholders have
little incentive to closely monitor a company's activities and tend not to be involved in
management decisions or policies.
Hence, they are called outsiders, and dispersed ownership structures are referred to
as outsider systems.
Common Law countries such as the UK and the US tend to have dispersed ownership
structures. The outsider system or Anglo-American, market-based model is characterised by
the ideology of corporate individualism and private ownership, a well-developed and liquid
capital market, with a large number of shareholders, and a small concentration of investors.
The corporate control is realised through the market and outside investors.
In contrast to insider systems, owners in outsider systems rely on independent board

members to monitor managerial behaviour and keep it in check.
As a result, outsider systems are considered more accountable and less corrupt and
they tend to foster liquid capital markets. Dispersed ownership structures have certain
weaknesses. Dispersed owners tend to be interested in short-term profit maximisation.
They tend to approve policies and strategies that will yield short-term gains, but that may
not necessarily promote long-term company performance.
At times, this can lead to conflicts between directors and owners, and to frequent
ownership changes because shareholders may divest in the hopes of reaping higher profits
elsewhere, both of which weaken company stability. Small-scale investors have less financial
incentive to vigilantly monitor boardroom decisions and to hold directors accountable.
Directors who support unsound decisions may remain on the board when it is in the
company's interest that they be removed.
Developing a Corporate Governance Framework
There are three different ways that owners maintain control over the work of management:
1) the owners directly influence the corporate strategy and selection of the top
management team;
2) the owners delegate their rights to the board, but ensure that
compensation and other incentives are aligned with share price maximization; and
3) the owners rely on the market mechanisms of corporate control..
In other words, the corporate governance mechanisms can be both internal and
external.
MODERN CORPORATIONS ARE DISCIPLINED BY INTERNAL AND EXTERNAL FACTORS

INTERNAL EXTERNAL
Private Regulatory
Shareholders Stakeholders Standards

(for example,
accounting and
auditing)
Board of Directors Reputed agents Laws and regulations

* Accountants Financial sector
Reports Appoints * Lawyers
to * Credit rating * Debt
and * Investment bankers
* Financial media * Equity
monitors * Investment advisors
* Research
* Corporate governance Financial sector
Management analysts
* Competitive factor
and product markets
Operates * Corporate control
Core functions
It can be observed from the illustration of the framework that there are internal and
external forces that interface and interact with each other and have an impact on the
behaviour and activities of corporations.
The Institutional Framework for Effective Corporate Governance
(1) Property Rights
It is essential that property rights, laws and regulations establish simple and
straightforward standards to specify clearly who owns what and how these rights can be
combined or exchanged for recording required information in a timely and cost-efficient
manner into an integrated, publicly accessible data base.
(2) Contract Law
Very few business transactions will occur without legislation and regulations that
legally guarantee and enforce the sanctity of contracts.
(3) A Well-regulated Banking Sector
The banking sector provides the necessary capital and liquidity for corporate
transactions and growth. Good governance within the banking system is especially
important in developing countries where banks provide most of the finance.
(4) Exit Mechanisms: Bankruptcy and Foreclosure
Not all corporate endeavours succeed legislation that establishes orderly and
equitable clearing and exit mechanisms are essential so that investments can be liquidated
and reallocated into productive undertakings before they are squandered completely.
(5) Sound Securities Markets
Efficient securities markets discipline insiders by sending price signals rapidly and
allowing investors to liquidate their investment quickly and inexpensively.
(6) Competitive Markets
The existence of competitive markets is an important external control on companies

forcing them to be efficient and productive lest they lose market share or go under. To this
end, governments can:
◦ Remove barriers to entry

◦ Enact competition and anti-trust laws
◦ Eliminate protectionist barriers including the protection of monopolies
◦ Eliminate preferential treatment schemes such as subsidies, quotas, tax
exemptions etc.
◦ Establish fair trade priorities
◦ Remove restrictions on foreign direct investment and foreign exchange
◦ Reduce the cost of setting-up and running a formal business.
(7) Transparent and Fair Privatisation Procedures
Having transparent, straightforward and fair rules and procedures stipulating how
and when enterprises can be privatised is, therefore, essential.
(8) Transparent and Fair Taxation Regimes
Taxation systems should be reformed so that they are fair, simple and
straightforward. In this regard, multi-step, complex procedures on fiscal reporting, that
allow officials to exercise considerable discretion and therefore engage in corruption, should
be eliminated.
(9) An Independent, Well-functioning Judicial System
One of the most important institutions of a democratic, market-based economy is an

independent, well-functioning judicial system that enforces laws consistently, efficiently and
fairly, thereby maintaining the rule of law.
(10) Anti-Corruption Strategies
The State should implement effective anti-corruption measures by specifying and

streamlining legal and regulatory codes and clarifying laws on conflict of interest.
(11) Reform Government Agencies
Government agencies that are excessively bureaucratic and inefficient need to be

reformed.
(12) Strengthen Administrative and Enforcement Capacity of Government Agencies
Governments should strengthen and maintain their agencies' administrative and

enforcement capacity by cultivating a staff of well-qualified civil servants, hiring and
promoting staff based on verifiable professional standards, offering civil servants vocational
training based on the latest technology, paying adequate salaries to attract well-qualified
professionals and to deter bribe-taking, and offering tenure based on performance.
(13) Establish Routine Mechanisms of Participation
To ensure that the new framework creates a level playing field, citizens need to
have ample opportunity to participate in grafting it.
(14) An Investigative and Well Informed Media
The role of the Fourth Estate (Press) in ensuring corporate democracy cannot be
overstressed, and can be considered as important as its role in ensuring that political
democracy functions as well as it is intended to be. Many a scam in the corporate world
would not have come to limelight but for the bold and upright investigation of journalists.
(15) Strengthening Reputed Agents
Reputed agents are individuals and/or groups that reduce the information gap
between insiders and outsiders by seeking and providing information to outsiders about the
performance of insiders and enterprises and by setting high professional standards and then
applying peer pressure and, at times, sanctions to uphold them. Reputed Agents can also
“refer to private sector agents, self-regulating bodies, the media and civic society that
reduce information asymmetry, improve the monitoring of firms, and shed light on
opportunistic behaviour”. Examples include:
◦ Self-regulation bodies such as accounting and auditing professionals

◦ Media
◦ Investment bankers and corporate governance analysts,
◦ Lawyers
◦ Academicians, economists and corporate analysts
◦ Credit rating agencies
◦ Consumer activists
◦ Environmentalists
◦ Activist investors and shareholders such as institutional investors and venture
capitalists
◦ Non-Government Organisations (NGOs)
Sound Stakeholder Relationships are Good for Business
A common misconception is that achieving profits and looking after

stakeholders' interests are diametrically opposite goals. Operating fairly, responsibly,
transparently and accountably towards both shareholders and other stakeholders does
more than improve a company's reputation and attract investment; it gives the corporation
a competitive advantage.
A company's treatment of other stakeholders such as suppliers is just as

important to the company's long-term performance. A firm that breaks a contract with a
supplier or pays unfair prices not only hurts the supplier, but damages its own reputation as
a reliable and honest business partner.
Corporate Governance Challenges in Developing, Emerging and Transition Economies
Establishing any one of institutions enumerated above is a necessary and challenging

undertaking without which democratic markets and corporate governance can not take
root.
Some of the general challenges confronting developing, emerging and transition

economies include:
◦ Establishing a rule-based (as opposed to a relationship-based) system of

governance;
◦ Combating vested interests;
◦ Establishing property rights systems that clearly and easily identify true
owners even if the state is the owner;
◦ De-politicising decision-making and establishing firewalls between the
government and management in corporatised companies where the state is a
dominant or majority shareholder;
◦ Protecting and enforcing minority shareholders' rights;
◦ Educating and enlightening investors of their rights and duties
◦ Encouraging good corporate governance practices and creating benchmarks
through co-operation with trade associations.
◦ Promoting good governance within family-owned and concentrated
ownership structures; and
◦ Cultivating technical and professional know-how.
Successful Strategies - one size does not fit all
Many international organizations are funding corporate governance initiatives that

aim to put in place developed country models of corporate governance.
Critics complain that these Western-based organizations try to transplant systems

and procedures that are workable in the West, but are unsuitable in the developing
economies that have different cultures, work ethics, employer-employee relations and so
on.
Current Corporate Governance Settings in Transition Economies
Unstable macroeconomic conditions create a situation of great uncertainty and

shorten the time horizon in business. Under unpredictable economic circumstances,
managers see their positions as temporary and uncertain which leads to maximizing their
own profit instead of maximizing the company profit.
In transition economies, the most important firms, such as public sector companies
that contribute more to the nation's gross national product, employment, income, and
capital use than private sector firms, are controlled by the state.
The missing element in the context of corporate governance development in

transition economies is the lack of institutions associated with successful market economies.
The transition economies cannot afford the luxury of searching for new third way
between socialism and capitalism. Instead, they have to find a way to accept the existing
institutional portfolio and to make it work in the specific cultural, historical and economic
environment. Each region is in a different stage of establishing a democratic, market-based
economy and a corporate governance system.
Manual of Corporate Governance-
Securities and Exchange of Pakistan

(Note: Please see the attached manual for detailed study)
Corporate Citizenship
 Introduction
◦ Previous chapters discuss corporate governance from the perspective of

agency theory
◦ However, many believes that companies should have a greater

responsibilities to society.
◦ Proponents argue that companies have unique opportunities to improve

society.
◦ The stakeholder view of the firm describes the firm as having many different
groups with legitimate interests in the firm’s activities.
◦ Corporate governance is then defined as the mechanism that ensures

corporations take responsibility for directing their activities in a manner fair
to all stakeholders.
◦ Strategic management concepts argue that this is based on creating positive

relationships with stakeholders.
◦ Through creating these positive relationships, firms can create sustainable

economic growth.
◦ Many countries have operated under the idea that large corporations have
greater responsibilities in a society than just maximizing shareholders wealth.
◦ Now, many firms believed they had social obligations to be good citizens.
◦ However, do firms have a sense of social responsibility?
◦ Some agreed and some don’t.
 Stakeholders of the firm
◦ Stakeholders are identified as people or groups with legitimate interests in

various aspects of the company’s activities.
 Stakeholders are defined by their interest in the corporation
 Not whether the corporation has any interest in them.
◦ So, companies have varying responsibilities to each of their stakeholders.

 Some relationships may be valuable than others.
 These relationships between managers and stakeholders are based on

a moral or ethical foundation.
 Primary stakeholders
 Stockholders
 Employees
 Creditors
 Suppliers
 Customers
 Secondary stakeholders
 Environment
 Competitors
 Society
 Community
 Governments
 These grouping can be based on;
 Resource-view
 Industry structure
 Social or political affiliations
 Institutional, economic and ethical interests.
◦ There is no consensus on how these stakeholders should be categorised but

all the stakeholder views illustrate a much different perspective than agency
theory.
◦ Many companies now have an organizational unit tasked with

communicating with stakeholders.
◦ These units may have camouflaged names like “corporate communication
department” or “public affairs department”.
◦ Other use more direct names like “sustainability group” or “corporate social
responsibility committee”
 Legal Foundation
◦ Consider a land-owner. Building a home require a building permit.
◦ The government agency that grants the permit must first approve the
building plans i.e. the building must meet adequate safety appearance
criteria.
◦ Although, citizens are not the owner of the land but they are the
stakeholders of this land. They have some rights.
◦ Uses and misuses of stakeholders interference
 E.g. personal business vs. government/private departments
 Corporate Social Responsibilities
◦ Proponents are of the view that companies have a social obligation to

operate in ethically, socially and environmentally responsible ways.
◦ This active approach is referred to as corporate social responsibility (CSR) or

corporate citizenship.
◦ What is a company’s responsibility to society? Archie Carroll has offered a

four-part taxonomy of CSR.
◦ Level 1. Economic- firm first social responsibility is to survive by producing

goods and services at a profit for the sake of the economy. (also students
example)
◦ Level 2. Legal- society expects firms to operate their business within the legal
framework.
◦ Level 3. Ethical- these responsibilities are those over and above the ones
codified in laws and are in line with societal norms and customs.
◦ Level 4. Philanthropy- Charitable giving to human causes on a large scale.
Philanthropy must be more than just a charitable donation.
◦ E.g. Billionaire Microsoft mogul Bill Gates, along with his wife,
Melinda, established the Bill and Melinda Gates Foundation to
support global development and global health programs.
◦ Another example is the Ford Foundation, established by the son of

Ford Motor Company founder Henry Ford. The foundation focuses on
strengthening democracy, improving economic opportunity and
advancing education.
 Drivers of citizenship trends inlude;
◦ Globalization
◦ Governments involvements
◦ Pressure from other social organizations
◦ Related popular movements like environment etc
◦ Education
◦ Global capital market pressure
So many firms have mentioned in their code of conducts or ethics about CSR in
terms of environmental consciousness and solid issues like employees health and
education.
E.g. “we love safe and clean environment”
“we believe in friendly relations with our employees”
 Benefits of CSR to firms
◦ Long-term thinking
◦ Customer engagement
◦ Employee engagement
◦ Brand differentiation
◦ Cost saving (cost-benefit analyses)
◦ Innovation
 Governance and Stakeholder Theory
◦ The accounting measure can’t measure the managerial decision on

stakeholder welfare.
◦ So the firm should begin their employees to guess the overall welfare
measurement by clear recruitment and promotion practices.
 Criticism
◦ Considering stakeholder’s theory as Descriptive theory but the problem

remains there i.e. how to measure.
◦ More focus on solid reforms will give you;
 Cost
 Reducing competition and
 Worsening economic performances

Course Review
1. Corporations and Corporate Governance (outlines)
◦ Studying global political system from business point of view
◦ Corporate governance: An integrated and complex system.
2. Executives Incentives (Outlines)
◦ Briefly discussion on principle-agent or agency problem.
 Salary, Bonuses, Stock Options,
◦ There are advantages and disadvantages of bonuses and permanent

increases to salary.
◦ But the question is whether these incentives based compensation really work
or not.
 Positive relation between firm’s performance and management

 Positive relationship between management compensation and firm’s

◦ Problems related with incentive based compensation.
 Cost for a firm, price manipulation by CEO etc.
 Related with the economy

 Treat it as an expense
◦ Cost for a firm
◦ Identify stock options
◦ Contribute to corporate scandals
3. Accountants and Auditors (Outlines)
◦ Accounting for Inside use (management)
◦ Accounting for outside use (Investors, Banks, The Governments, other

stakeholders)
◦ Difference between Financial Accounting and Managerial Accounting.
◦ Accounting records are different for Managers and Public Financial

Statement.
◦ Reasons for differences in Financial Accounting and Managerial Accounting.

◦ Unintentional errors
◦ Problems with receivables
◦ Intentional Errors.
◦ Understated liabilities
◦ Overstated assets.
◦ Who are Responsible
◦ Audit Role
◦ Types of Auditors
◦ World largest 4 Audit Firms
◦ The changing role of accountants-managing earnings i.e. accountants will act

as a profit-centers
◦ Through managing earning methods, accountants can release the pressure of

managers as well as analysts.
◦ Window dressing and smooth earnings are another technique used by

accountants to show the favourable financial condition of the company.
◦ Price manipulation is acceptable to some extend but it should not violate the
law becoming fraudulent acts.
◦ End of the story is that investors as well as stock holders will have to suffer
with all these techniques used by accountants and management.
◦ Single accounting firm should not allowed to conduct audit as well as
consulting activities for a single firm
◦ Main reason is the conflict of interest between auditors and consultants.
4. Board of Directors (Outlines)
◦ A BoDs is a body of elected or appointed members who jointly oversee the

activities of a company.
◦ BoDs are appointment at the public Annual General Meeting of shareholders.
◦ Types of board are depending upon company status as well as the territory
where the company prevails.
◦ Normally, we can see One-Tier board in common law based societies (like US
and UK) and Two-Tier board in civil law based societies (like Germany etc).
◦ BoDs functions involve to hire, evaluate or even fire the top management, to
vote in support or against of major proposals as well as financial decisions.
◦ In short, BoDs main primary function is to safeguard the shareholder’s

interest.
◦ But the most important factor is to think a lot before selecting your board
◦ Overview of the Board
◦ Board legal duties
◦ May not be the federal law requirement but the state wants
BoDs.
◦ Firms profitability and increase in share value
◦ Loyal and fair
◦ Take care of the rule of ethics
◦ Employment practices
◦ Human rights
◦ Environment regulations
◦ Corruptions
◦ Moral obligations
◦ Board Committees
◦ An Executive Committee
◦ A Finance Committee
◦ A Public Relation Committee
◦ Board Sub Committees
◦ Audit Committee
◦ More attention on Directors
◦ What is a “Good Board”?
◦ Having different back ground i.e. technical as well as non technical
◦ Independent board-having fraction of non-insider directors (difficult

to find unambiguously independent directors)
◦ Small board
◦ Good for Goose, good for Gander

performances.
◦ Sometimes inside directors are good for board (e.g. infant or

new firms or when the firm has to make any huge
financial/investment decision) and some times outside
directors (e.g. when audit as well as compensation matters are
required)

board.

board
5. Investment Bank and Securities Analysts
◦ What is Investment Bank?
◦ Examples of Investment banks
◦ What does Investment Bank actually do?
◦ What is “Security”?
◦ Who are analysts in Investment Banks?
◦ Duties and responsibilities of “Analysts”.
◦ Methods of issuing stocks and bonds
 Underwriting method
 Best effort method
◦ What is “IPO”?
◦ Criticisms of Investment Banks
 IPO Problems
 Structured Deals
◦ Two categories of securities analysts
 Buy-side Analysts (Institutional Investors)
 Sell-side Analysts (Investment Bank)
◦ What is “Institutional Investors”
◦ Our focus is toward the sell-side analysts.

◦ Functions of sell-side analysts
◦ Quality of Analysts Recommendations
 Conservative predictions
 Under promise and over delivery is the name of this game
◦ Potential conflicts of interests
 Analysts and the firm they analyse
 Analysts dual responsibility toward its employer (i.e. Investment

Bank), the firm and the investors.
6. Shareholders and shareholder Activism
◦ Shareholders are innocent and helpless victims when scandals occur.
◦ Two categories of investors
 Individual investors
 Institutional investors
◦ Two questions
◦ Institutional investors are more effective and influential than the individual
investors.
◦ Benefits of Mutual Funds
 The advantage of professional investment management.
 Funds managers have real access and information about the market.
 Diversification in the investment.
 Low cost and high quality investing.
 Convenience and flexible.
 Mutual funds investment funds are liquid and easy to withdraw.

◦ Costs of Mutual Funds
 Hidden fee charges
 What is Shareholders activism?
 The goal of activists ranges from financial as well as non-financial

matters.
 Individual shareholders activism
 Monitoring by large shareholders
 Institutional Shareholders: An Overview
 Does Institution Shareholders activism works?
◦ Potential Roadblocks to effective Shareholders activism.
 Limited desire to be activists
 Many other options for investments
 Mgt don’t hire pension fund advisors who are trouble makers for
management
 Private/public funds normally go with management activities.
 Law restricts them to become major of the firm.
 Long paperwork.
 In west, we can see company discourages one investor to become the

significant owner
 In east, we can see greater owners i.e. family owner as well as state
owner.
7. Creditors and Credit Rating Agencies (Outlines)
◦ Introduction
 Who care about the firm 1. stock holders 2. Creditors

◦ Two types of lenders
 Commercial Banks
 Individual (bondholders)
◦ Credit Rating Agencies (CRAs)
◦ Analysis of the situation having different credit ratings by different CRAs
◦ How did CRAs start?
◦ High credit rating vs. Low credit rating
◦ Another view of credit rating
 New company vs. Mature company
◦ The BIG 3
◦ PACRA
◦ The Ratings
◦ Criticisms
 Consulting firms
 First Amendment Right to CRAs
 Mistakes
 CRAs as watchman
 Relationship with management
 blackmailing
 Japan (main bank)
8. Corporate Governance and Other Stakeholders (Outlines)
◦ Corporate Governance and Employees
 Trade unions, Co-Determination (Employee representation), Profit

sharing, Earning sharing, and Team production solution.
◦ Corporate Governance and Customers
◦ Corporate Governance and Institutional Investors
◦ Corporate Governance and Creditors
◦ Corporate Governance and the Community
◦ Corporate Governance and the Government
9.Corporate Takeovers: A Governance Mechanism (Outlines)
◦ Definition
◦ What are mergers and acquisitions?
◦ Importance of discussing M & A in corporate governance.
◦ General process: Acquisition
◦ General process: Merger
◦ Characteristics of M & A
◦ Type (vertical/horizontal)
◦ The valuation of firm involved
◦ The payment (Cash, Newly created stocks)
◦ The new corporate structure
◦ The legal issue
◦ Brief overview of M & A.
◦ Strategic reason (to reduce cost, to get new business)
◦ Synergistic reason (combined effort)
◦ Diversification (reduce the risk by making investment in different

locations)
◦ Are corporate takeover good for shareholders
◦ Acquirer firm’s shareholders perspective
◦ Acquiree firm’s shareholders perspective

◦ The Target Firm
◦ Increase in share price
◦ Is it appropriate to acquire
◦ Successful firm
◦ What if the management (acquiree firm) didn’t accept the takeover bid
◦ “Hostile” takeover is in the eye of the beholder
◦ Acquisition/merger being approved by the target firm.
◦ Target firm may go for “friendly” deal
◦ Perks for the management
◦ Premium for the shareholders
◦ Takeover Defences
◦ 1. Firm Level Pre-emptive defences
◦ Poison Pills
◦ Acquirer firm stocks at a deep discount rate
◦ Target firm’s debt immediately due
◦ Golden Parachute (payment to managers)
◦ Super majority rule (2/3 shareholders approval)
◦ Staggered Board
◦ 1.1 Firm Level Reactionary Takeover Defences
◦ Greenmail (purchasing shares from the major shareholders at a

premium to prevent takeover)
◦ Convincing (by management to convince the shareholders)
◦ 2. State Level Anti-Takeover Laws
◦ Freeze-out Laws
◦ Fair price law (later shareholders get the same price)

◦ Poison pill endorsement laws
◦ A control share acquisition law ( shareholders approval)
◦ A constituency statute (include non-shareholders)
◦ Assessment of takeover Defences
◦ Are takeover defences bad for governance system
◦ Takeover defences are bad for governance system
◦ But the pros and cons of takeover defences should be

evaluated.
◦ But normally these defences are just to increase the company

price
9. Role of Media in Ensuring Corporate Governance (Outlines)
◦ Role of Media in ensuring Corporate Governance
◦ Media can play role in CG by effecting in three ways;
 Pressure on politicians to go for corporate law reforms
 Pressure on managers to take care of the shareholders money
 Pressure on managers to take care of the societal norms
◦ Importance of media
 Can play role even in the absence of legal act
◦ Harms of using advertisement as a media tool.
 Misrepresentation of facts
◦ Media and corporate governance
 Should be broadened rather than just legal and contractual aspects
 Managers focus should be shareholders but also the societal norms
◦ Individual as well as institutional investors can use press to fight with the
management.
◦ Selective coverage and media credibility

 Sometimes foreign newspapers are more credible than the local.
 The issue of credibility can question the investigation made by the

newspaper
 Management side deals can increase the query of credibility.
 A single credible newspaper can’t fight with lots more incredible

newspapers.
◦ Adverse effects of advertising
 Deception
 Fear appeals
◦ Positive effects of advertising
 Guidance to children in making decisions
 Developing skills
 socialization

newspapers.
 Deception
 Fear appeals
 socialization
◦ Materialism
◦ Advertising Alcoholic Beverages
◦ Competitive Advertising
◦ Increasing cost
◦ Absence of full disclosure
◦ Use of celebrities
◦ Fantasy and reality
10. New Governance Rules-Sarbanes Oxley Act 2002 (Outlines)
◦ Introduction
 Also know as Public Company Accounting Reforms and Investor

Protection Act of 2002.
 SOX contain laws pertaining to corporate governance
◦ SOX
 To regulate auditors
 Created laws pertaining to corporate responsibilities
 And increased punishments for corporate white-collar crime
◦ Public Company Accounting Oversight Board
1. registration
◦ Auditors independence
 Accounting firms will not perform both auditing as well as consulting

activities for a single firm.
 Changes after five years in audit team.
 An executive from the accounting firm within the past year will
disqualify the public company to be audited
 Rotation of accounting firms conducting audits.
◦ Corporate Responsibilities
 Making audit committee independent form the management.
 CEO and CFO will be responsible for the financial statement.
 Separate any profit from bonuses or stock sales that needs to be

restated as a result of misconduct.
 No stock transaction during employee pension plan.
◦ Enhanced Financial Disclosure
 All transactions must be disclosed
 Report to SEC within 2 days
 Encourage code of ethics and report everything to SEC
◦ Analysts conflicts of Interests
 Analysts should be separated from the investment banking
◦ SEC Resources and Authority
 SEC budget expanded greatly
◦ Corporate and criminal fraud, accountability and penalties
 Different sentences and penalties were introduces
◦ Will the act be beneficial?
 Most rules are misplaced or repetition
 Can’t guarantee corporate scandals
 Expensive
 Cost for firms and no firm value
 Still debatable
◦ Other Regulatory Changes
 The NYSE
 NYSE can’t effect non-listed firms as well as other business

members like auditors, financial analysts.
 Focus on more independent directors
 In nominating, compensation and audit committees.
 NYSE require shareholders approval all executive equity based

compensation plan
 It brings transparancy.
 NASDAQ
 Small firms can work with small number of independent

directors.
 So independent directors can perform the duties of different

committees as well as executive compensations
The US government is looking to tighter the securities regulations but there is a long way
to go.
11. Monopoly, Competition and Corporate Governance (Outlines)
◦ 1. Introduction
 Monopoly is that one person or company controls 1/3 of the local or

national market
 Abuses of monopolies are
 High prices
 Wrong allocation of resources
 Abuse of investors/markets by giving wrong information.
 Preventing inventions
 Economic instability
 Corruption and bribery
 Economic power in the hands of few
◦ Anti-monopoly laws
 Prevents firms to make monopoly
 Prevent unfair price discrimination

◦ Competitive firm is preferred because
 Low prices
 Avoid wastages for competition
 Efficiency
 Consumers’ tastes and preferences
◦ 2. The concept, logic and benefits of competition
 Entrepreneurial culture leads to more producers and sellers
 Increased supply capabilities
 Cost-cutting through research efforts
 Reduction in wastages, & improvement in efficiency & productivity
 Customer focused
 More access to foreign market
 Favourable environment for trade and investment
 Best sources utilization
 Wide range of available goods and services
◦ Regulation of competition
 Competition must be regulated through some legislation which helps

in;
 Firms dominance
 Prevents monopolies
 Controlling anti-competitive acts like
◦ Full line forcing
◦ Predatory pricing
◦ Corporate governance under limited competition
 Regulatory barriers weaken the managerial efforts and board

supervisions leads to governance issues.
◦ Constraints to competition in developing countries

 Nationalization and “public interest” cause constraints for firms to
work efficiently.
◦ Banks’ role in restraining emergence of securities markets
 Banks credit reduces the need to invest in the securities markets
 Banks can play vital role to analyse the companies value for further
businesses.
◦ Lack of competition promotes ownership concentration
 More competitive markets result in more public firm
 Less competitive markets result in more private firms
◦ 3. Benefits of competition to stakeholders
 Managers
 products
◦ Benefits of competition
 Competition in the product market
 Quality products
 Low prices
 Competition in the capital market
 Relationship of firms and financial institutions
 Economic Power and Political Influence
 Firms can take political influence for their benefits
 Monopolistic market can lead toward the political influence,

would results in bad governance.
 Competition is the only solution.
◦ Enforcement of Good Governance
 First go for private enforcement through market mechanism
 Or self-regulation through trade associations
 Or public enforcement
 Positive competition reduces the burden of enforcement
 Enforcement is vital
◦ Challenges to Good Enforcement
 Resources
 Meaningful sanctions
 A real big challenge
◦ Competition Agencies and Competition Policies
 To prevent anti-competitive practices
 To resist the lobbying of interest groups
 Competition policy should be at the top.
 Adequate resources to investigate anti-competitive practices.
◦ Good competition policy should be there to;
 Prevent monopoly
 Ensure economic efficiency
 Control dominant firms
 Discourage merger and acquisition
 Check barriers for new entrants to market
 prevent anti-competitive agreements
 Apply to all major segments of the economy
 Protect small firms
◦ Competition boosts corporate governance
12. Corporate Governance in Developing and Transition Economies (Outlines)
◦ Introduction
 Corporate governance: advanced vs. developing nations

 Globalization tends the standards of corporate governance from local
to global perspective
 So developing nation should have to work hard.
◦ Problems faced by developing and transition economies
 Still in process of basic market institutions to regulate
 Internal owner vs. external owner
 Inflow of new capital is not facilitated
 Lack of property rights, contract violations and self-dealing are the

core issues, not just the owners and controllers relationship
 Act are there but it is hard to implement.
 Judiciary, bureaucracy and regulatory bodies are not alert to stop

corporate misgovernance.
◦ Summary of problems facing these economies
 Low economic growth
 Public sectors dominance i.e. CG is for private sectors
 Lack of effectiveness of privatization
 Lack of awareness among shareholders
 Govt. influence
 Internal owners are more influential than external owner (no voting
powers)
 More concentration toward family-owned corporations.
 Lack of legal protection for investors
 No inflow of new capital
 Low property rights and contract laws.
 Lack of well regulatory banking sector

 Exit mechanism, bankruptcy and foreclosure (taking possession of
mortgage property) norms are absent.
 No sound securities market
 Lack of competition
 Corruption and mismanagement
 Non-uniform guidelines by the govt. for all companies
◦ Corporate Governance Models
 Insider system
◦ Insider own majority of the company shares
◦ Voting rights
◦ Power to monitor management
◦ Keep their investment for long period in a firm
◦ Support decisions for long period of time
◦ Dominant owners can use the firms’ assets by colluding with

the management, at the expense of minority shareholders.
◦ Irresponsible exercise of power resulting waste resources and

drain company productivity levels.
 Outsider system
◦ Large number of owners hold small number of company

shares
◦ Can’t monitor management
◦ Can’t involve in management decisions
◦ Common law countries (UK, USA) own this system
◦ Independent board members to monitor managerial

behaviour
◦ More accountable and less corrupt
◦ Having dispersed ownership structure with some weaknesses

◦ Looking for short term maximization
◦ Conflicts between directors and owners
13. Corporate Citizenship (Outlines)
◦ Introduction
◦ Stakeholders of the firm
 Primary
 secondary
◦ Legal Foundation
◦ Corporate Social Responsibilities
 Level 1. Economic
 Level 2. Legal
 Level 3. Ethical
 Level 4. Philanthropy
◦ Drivers of citizenship trends inlude;
◦ Globalization
◦ Education
◦ Benefits of CSR to firms
◦ Innovation
◦ Governance and Stakeholders Theory
◦ Criticism
◦ Considering stakeholders theory as Descriptive theory
 Cost
14.Manual of Corporate Governance-SEC Pakistan (Outlines)
◦ I. INTRODUCTION
◦ II. WHAT IS CORPORATE GOVERNANCE?
 (i) The Background
 (ii) Definition of Corporate Governance
 (iii) The Benefits of Corporate Governance
 (iv) The Pakistani Corporation
 (v) The Origins of Corporate Governance in Pakistan
◦ III. THE NEED FOR CORPORATE GOVERNANCE
◦ IV. THE STAKEHOLDERS
 (i) General
 (ii) Shareholders
 (iii) Directors
 (iv) Employees
 (v) Creditors
◦ V. PROMOTING REFORM AND SHAREHOLDER ACTIVISM
◦ VI. ROLE AND RESPONSIBILITIES OF DIRECTORS AND
◦ MANAGERS
 (i) Directors and Managers Distinguished
 (ii) Appointment and Proceedings of Directors
 (iii) Fiduciary Duties
 (iv) Powers and Responsibilities of Directors
 (v) Liability of Directors
 (vi) Executive and the Non-Executive Directors
 (vii) The CEO
 (viii) The Company Secretary
 (ix) The CFO
 (x) Internal Control System
 (xi) Reporting Requirements
◦ VII. SCRUTINIZING FINANCIAL STATEMENTS - WHAT EVERY DIRECTOR

SHOULD KNOW
 (i) General
 (ii) Liability of Directors
 (iii) Preparation of Financial Statements
 (iv) Tools for Directors' Review
 (v) How to Prevent Misleading and Fraudulent Financial
 Statements
 (vi) External Auditors
 (vii) Role of the Audit Committee

 (viii) Role of Internal Audit
◦ VIII. CONCLUSION
The End
Hand outs
Corporations and Corporate Governance

Introduction
There are two major political systems in the world from the business point of view. These
are:
1. Communism
Communism refers to a political system that stresses the primacy of collective goals over
individual goals. Following are the characteristics of communism;
◦Needs of the society are viewed as a whole than individual freedom.

◦State-owned enterprises are managed to benefit society as a whole, rather
than individual capitalists
◦ Examples are:
 Cuba
 Vietnam
2. Capitalism
Capitalism is an economic system based on the private ownership of capital goods and
the means of production, with the creation of goods and services for profit. Following are
the characteristics of capitalism;
 Goal of the Business
In corporate world, the main goal of the business/corporation is to profit maximization and
this can be achieved through two ways;
◦ 1. Increasing sales in the existing market

◦ 2. Creating new markets for the existing products.
Enhancing business requires capital which brings risk. So, the ability to access capital and
control risk is important in the success or failure of a firm.
Before we discuss the relationship of capital, control and risk, let’s first discuss different
forms of business ownerships.
a. Sole Proprietorship- a business own by a single person
Following are the characteristics of sole proprietorship
1. Easy to start
2. More than 70% of all US business
3. But limited lifespan
4. Die with the owner’s death or retirement
5. Limited ability to obtain capital
6. Owner bears unlimited personal liabilities for the firm
7. Less trustworthy
b. Partnership – similar to sole proprietorship but there is more than one owner.
Following are the characteristics of partnerships

1. The ability to pool capital
2. But may not be as important as combining service- oriented
expertise and skill, especially for larger partnerships, for
example;
i. Accounting firms
ii. Law firms
iii. Investment banks
iv. And advertising firms
c. Corporation – the corporation is its own legal entity, as if it were a person.
Following are the characteristics of corporations

1. The owner of the corporation enjoys limited financial liabilities
2. This is very hard in the case of sole proprietorships and
partnerships. For example;
i. Bill Gates of Microsoft
ii. Tim Cook of Apple
iii. Larry Ellison of Oracle
Fewer than 20% of all US businesses are corporation but are generating approximately 90%
of the country’s business revenue. The most important advantage of corporation business is
access to capital market and can raise money by issuing stocks and bonds to investors. It
doesn’t die when its owner do because corporation is not in single person ownership, it has
many owners. For example
“Between 1977 and 1980, Apple Computers sold a total of 121,000 computers. To
meet the potential demands for millions of computer per year, Apple needed to expand
operations significantly. As a result, in 1980, Apple became the public corporation and sold
$65 million worth of stocks”.
Main disadvantages of corporations are;
◦ Corporate profits are subject to business taxes before any income goes to
share holders in the form of dividends.
◦ Subsequently, shareholders must also pay personal taxes on dividend
income.
◦ This means shareholders are exposed to double taxation.
Running corporation cab be expensive. For example

◦ The cost of hiring accountants
◦ Legal experts
◦ Cost of communicating with all shareholders
◦ Cost of complying with Regulations and so forth.
◦ Perhaps the main disadvantage is of governance problems.
◦ Small stake and lack of true sense of ownership bring RISK and lack of
CONTROL.
What is Corporate Governance?

“Problems that result from the separation of ownership and control
Focusing on
◦ The internal structure and rules of the board of directors;
◦ The creation of independent audit committees;
◦ Rules for disclosure of information to shareholders and creditors
◦ And control of the management
Separation of ownership and management

Shareholders
Board
Management
Employees
Stockholders own the firm and officers (or executives) control the firm. Hundreds of
thousands of investors can’t collectively take decisions. So firms hire managers for that
work. The shareholder’s main focus is toward business performances and return of their
stock, rather than in decision making process. Now the question is why should managers
care about the owners’ money? This creates problem between the management and
share/stock holders because it’s the shareholders money but in the hands of management.
So the management will always be looking for the satisfactory profit for the
stockholders and massive perks for themselves (principal-agent problem or the agency
problem). Managers may be tempted to use the firm’s assets for their own ends in the
following manners;
◦ Secretaries may take the supplies

◦ Managers may take extra food or fancy furniture for their offices
◦ Executives can use expensive jets for travelling
◦ Etc;etc
So, executives have the ability to steel from the shareholders. This problem can be
solved by;
1. Incentives (chapter 2)
 Common incentives
 Offering stocks, restricted stocks or stock options (normal
practice in US companies)
2. And monitoring
So, the shareholders and executives interest can be aligned through incentives involving
stock options.
Theoretically, managers work for owners but in reality, firms actually seems to
belong to management. There is a race of win-lose between shareholders and management
but most of the time, management has always having the upper hand.
Different proposals are made by the shareholders but are defeated when it comes in
the annual shareholders meeting. There are normally two types of proposals;
◦ Those relate to governance (e.g. suggesting changes in board structure)
◦ Those relate to social reform (e.g. proposing to stop selling chemicals to
rogue countries) etc; etc.
Without management approval, proposals have little chance of succeeding.
Shareholders have to trust management and must go with their wants which leads to chaos
in the firms.
Example
Carly Fiorina’s Takeover of COMPAQ (2002)
Carly Fiorina (CEO Hewlett-Packard) announce acquisition of Compaq on Sept 4, 2001 for
$25.5Billion. Faced negative reaction by stock market, industry experts and the business
media. Hewlett-Packard stock was down by 18% and Compaq’s stocks by 10% following the
announcement. Two major shareholders i.e. David W. Packard and Walter Hewlett were
against this decision. They placed their pressure on other shareholders but all in vain.
Fiorina went ahead with her plan.
Monitoring
Investing public doesn’t know about the firm’s operational level. Only managers know.
Consequently managers may not act in the shareholder’s best interest which demonstrates
the need for MONITOR. The following diagram will demonstrate different levels of
monitoring of the firm’s various stakeholders;
Stakeholders
Within Company
BoDs
Stockholders
Outside Company
Auditors
Creditors
Analysts
Managers
Investment Banks
Credit Agencies
Employees
Government
SEC
Society IRS
Similarly market force is helpful in monitoring. Stakeholders can also monitor by

participating. Creditors can also check by ensuring that the firm is properly handling its
debt processing. Employees, such as, internal auditors can play a vital role in monitoring.
Society can inject a sense of responsibility at the executive level by acting as a noble
corporate citizenship. Unfortunately, all of these mechanisms can fail at one time or
another.
An Integrated System of Governance

The corporate governance system is integrated and complicated. Every
concern stakeholder is keen to get perks i.e. executives, auditors, boards, banks, analysts
and so on. The following diagram will explain the integrated system of governance and
the stakeholders’ interactions;
Board
• MGT
Investment Banks
Regulators
Consultants
Analysts
Creditors Accountant Auditor

Executive Incentives
Introduction
A corporation’s ownership and control are separated between two parties-stockholders and
officers. A simple problem exists with this separation of ownership and control. Why should
the managers care about the owner? So, to align manager and shareholder interest, most
executives receive stock options as a significant component of their compensations.
Potential Managerial Temptation
Manager’s action can affect the following;

Good manager always think for the stakeholders first-not in common practice. Examples of
self-serving managerial actions include;

◦ Hiring friends
◦ Building empires ( making the firm as much as possible, even
though it may hurt the firm’s per share value)
◦ Having a short-run horizon if the manager is near retirement-
very dangerous.
Company executives are compensated through different ways
The CEO salary is determined through the benchmarking method-

surveying the peers CEO salaries for compensation. CEO salary has drifted upward, getting
nice raises if he/she is quite competent to get the competitive edge. New CEOs normally
make more than current CEOs.
Basic pay depends upon the characteristics of the firm, rather than the characteristics of the
CEO. So, large firm CEO will get more than small firm CEO. Small firm can’t afford large firm
CEO and vice versa. Following are some the world top salaries by the CEOs;
Bonuses
Cash bonuses depend upon the firm’s previous year’s performance.
Based on;

◦ Net Income-Dividend on Preferred Stock
An advantage of awarding bonuses, as opposed to giving large raises, is that bonuses

are one-time rewards for past realised performances, while raises are permanent additions
to salaries for future unrealised performances. Following are some of the
advantages/disadvantages of bonuses;

◦ Costly for company

◦ Taxes from employees
◦ Fairness and Jealousy Issues
◦ Increase is not on the basis of past performance- it’s a routine work of

organization for employees.
 Disadvantages
2. Stock Options
This is most common form of market-oriented incentive pay. It allows the

executives to buy shares of stock at a fixed price, called the exercise or the strike price. The
executives can get benefits from the differences of prices i.e. Market price of the stock
minus strike price. That’s how you can align manager’s goal with shareholder’s goals.
This alignment will, somehow, overcome the problem with the separation
of ownership and control. The most common length of the options contract is 10 years. The
median option-based award realized for CEOs in large firms was $2.7 million in 2004.
2.1 Options and Accounting
Stock option is a cost for company, if there is a difference between strike

price and current stock price. This cost was amortized over the life of the options. But if
there is no difference between the strike price and current stock price, then company need
not to report it as a cost in the income statement.
“This award is treated as capital gain, not as income, which is an advantage to the
CEO because capital gain taxes are lower than regular personal income taxes.”
Main Problem with the Grant Options
Even if the stock options are no appeared on the firm’s income statement, means no cost
for company but a real economic lose. For example;
A firm has 100 million outstanding shares in the market ($1 per share)
If the executives exercise their options and sell their options (e.g. 10 million) in the stock
market, this will increase the numbers of outstanding shares in the market i.e. 100 + 10=
110 million shares. This will directly affect the share price. That is a simple rule of demand
and supply. Supply will directly affect the demand of share. $100 millions are available (by
having 100 million shares @ $1 per share). Now $100 millions are available (by having 110
million shares @ $0.91 per share). So this will be lose for shareholders.
3. Stock Grants
Because of the governance failure in late 1990s and early 2000s, many firms have been
looking for alternative forms of long-term incentive compensation.
a) Restricted Stock-Includes limitation that requires a certain length of

time to pass or a certain goal to be achieved before the stocks can be
sold.
b) Performance Sharing-Company’s stock given to executives only if
certain performance criteria are met. It could be viewed as bonuses
for past performances. It is more valuable for the CEOs.
Does Incentive-Based Compensation Work In General
Now we will examine whether there is a relationship between firm’s performances and
management compensations or not. Following are the two approaches regarding this;
◦ 1. Positive relation between firm’s performance and management

 The evidence show that the answer is pretty much “no” (study
conducted over 2000 CEOs)

million to increase his/her compensation by a mere $1 million.
◦ Positive relationship between management compensation and firm’s

 Perhaps CEOs or managers are risk-averse and their salaries are

already large so why should they take risk.
 But if CEOs or managers are risk-takers where risk sometimes pays off
and sometimes it does not.
 Finally, it’s difficult to relate the firm’s performances with the
management compensations.
Potential “Incentive” Problems with Incentive-based Compensation
Dilution can be disgustingly costly over the long term. Many companies
routinely issue stock options and shares, which can easily dilute shareholders by 10% over a
10-year period. Stock option is only affected by price appreciation. Therefore, the CEO might
forego increasing dividends in favour of using the cash to try to increase the stock price. CEO
is more likely to go for the risky business to increase the stock prices. Stock options lose
some incentive for the CEO if the stock price falls too far below the strike price. Price
manipulation can be used by the CEOs for their benefits.
◦ Xerox management improperly accelerated leasing operations revenue from

1997 to 2000.
◦ The accounting manoeuvring increased revenue by $3 billion and profit by

£1.5 billion over that period.
◦ That’s wasn’t the actual financial position of the company.
◦ This artificial profit helped drive the stock price from $13 at the end of 1996
to more than $60 in 1999.
◦ Xerox CEO Paul Allaire sold stocks and profited by $16 million.
◦ In April 2002, Xerox admitted to the SEC that they improperly recorded the
earnings and agree to pay a $10 million fine.
◦ So, Xerox management earned millions of dollars by doing accounting

manoeuvrings.
◦ So, who are the ultimate losers?
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Incentive Stock Options are generally not tax deductible for companies.
Incentive Stock Options (ISOs) are often a key component of option plans issued by
companies to employees. If a company and employee follow basic ISO rules, the company
CANNOT claim a corporate income tax deduction at any time for the ultimate value given to
an employee. Economy plays a vital role in controlling the stock prices-CEOs always keep
this in mind.
Normal Perception about how stock market works
Stock market boom is the reflection of the progressive economy. As the

economy improves, companies make more money and their stock value rises in its
accordance. In fact, the only real force that ultimately makes the stock market or any
market rise or fall, over the longer term is simply changes in the quantity of money and the
volume of spending in the economy. Stocks rise when there is inflation of money supply (i.e.
more money in the economy and in the markets). Similarly, stock markets can fall by having
decline in the quantity of money and spending.
Another problem with Executive Stock Options
Aligning managers’ incentives with the stockholders goals constitute a major problem.
Employees will work their best unless the stock prices are higher than the strike prices. But
if the stock prices get down than the strike prices (may be because of poor economic
condition), it’s very hard to re-establish the motivational level of executives. As a result,
we’ll see again the race between the owner and controller and no aligned goals.
Treat it as an expense, should appear in the financial statements. Granted options must now
be deducted from the firms reported income. Following are the three advantages;
◦ Would identify that there is a cost to the firm for issuing options.
◦ It may reduce the amount of options executives receive and thereby reduce
their total compensation.
What happens to these compensation systems if options are expensed? The reduction in
reporting earning may cause the companies to curtail option programs. This could inhibit
the growth of new companies. It could even have an impact on the economy.
Other Compensation
 Free access to an online forum allowing executives to post

questions and share insights and resources on strategic
business issues.
 Explore collaboration and business opportunities with other

senior executives
 Find job candidates or look for the next career move.
 CEO Club members receive free access to quarterly executive

seminars that address strategic management and leadership
issues.
The membership is limited to senior executives including the following

level of managers:
 Board of Directors
 Chief Executive Officer (CEO)
 Chief Operation Officer (COO)
 Chief Finance Officer (CFO)
 Chief Marketing Officer (CMO)

 Chief Information Officer (CIO)
 Chief Technology Officer (CTO)
 Chief People Officer (CPO)
 Vice Presidents (VPs)
 Directors
Retirement (or resignation) compensation
Executives receive millions of dollars as company loans at extremely low

interest rates, sometimes even interest free. E.g. Chairman of FleetBoston, Terrence
Murray, receives a pension of $5.8 million per year.
◦ E.g. In July 2005, Bernie Ebbers, founder and former chief executive of
WorldCom, was sentenced to 25 years in prison for his involvement in
WorldCom’s $11 billion accounting fraud.
International Perspective- CEO Compensation around the world:
Paying the top officer in the company with long-term incentive awards is
most common in the US. Normally, compensation of CEOs around the world split into three
categories
 Variable pay (incentive-type instruments like stock options)
63%, on average, of a US CEO’s pay is variable in nature. Singapore and Canada CEOs have
59% and 52%, on average, the variable pay respectively. In China (except china), 79% of the
CEOs compensation is fixed. India, one of the five countries with less than 50% composition
is fixed pay, pays an extraordinary 38% of total compensation in perquisites.
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Fixed Pay
Perquisites
Variable Pay
Argentina
Australia
Belgium
Brazil
Canada
China-Hong Kong
China-Shanghai
France
Germany
India
Italy
Japan
Mexico
Netherlands
Singapore
South Korea
Spain
Sweden
Switzerland
Taiwan
United Kingdom
United States
Venezuela
Accountants and Auditors
Introduction
Accountant and auditors are an important part of any corporate monitoring system. There
is a slight difference between accountant and auditors.
◦ Accountants
 An accountant is a practitioner of accountancy or accounting, which is

the measurement, disclosure or provision of assurance about financial
information that helps managers, investors, tax authorities and others
make decisions about allocating resources.
◦ Auditors
 An auditor is a professional who is responsible for evaluating some

aspect of a project, business, or individual. The term most commonly
refers to audits in accounting.
◦ Scope:
◦ Data:
◦ Purpose:
· The purpose of accounting is to show performance and financial

position of a business.
· The purpose of auditing is to certify true and fair view of financial

statements.
◦ Time:
· The time period of accounting is usually twelve months (one year). It

takes twelve months (one year) to complete records.
· The time period of auditing is less than one year. It may be completed
within one month or may be more than one month.
◦ Start:
· When the work of bookkeeper ends then the accountant work starts.
· when the work of accountants ends Then the auditor work starts.
◦ Necessity:
· Accounting is necessity of every entity having any size.
◦ Report:
A & A are important part of any corporate monitoring system. Accountants keep tracks of
financial information and auditors make a review and monitor. Information can only be
obtained by auditors. Banks, creditors and other rely on these statements to the firm’s
accurate picture and financial health. Good for the investors to assess the value of the
company.
 Gathering, compiling, reporting, and archiving a firm’s business activities.
 Accounting information helps making decision
◦ or outsiders.
 Managers use these information to measure the progress toward their goals and
highlight any potential problems in advance
◦ E.g. Managers wants to know their product’s sales situation.
 Inventory comprises of work in process, stores and spares etc.
◦ Have the firm enough cash to pay its upcoming debt payments?
◦ Budgets
 An estimation of the revenue and expenses over a specified future

period of time. A budget can be made for a person, family, group of
people, business, government, country, multinational organization or
just about anything else that makes and spends money. It may be
either surplus budget or deficit budget
 Surplus Budget
 Deficit Budget
 A financial situation that occurs when an entity has

more money going out than coming in
 In business, a variance report is prepared to evaluate the operating

efficiency of different aspects of (usually) a manufacturing company.
If the company is paying too much for materials or using too

much materials for a product, that is an unfavourable
variance. If the company is getting materials for less than the
standard cost or is using less than the standard materials for a
product, that would be favorable.

Labor rate variance measures deviation from standard in the
average hourly rate paid to direct labor workers.
Labor efficiency variance attempts to measure the productivity
of direct labor.
3. Variable overhead spending variance & variable overhead

efficiency variance.
 A technique used to determine how different values of an

independent variable will impact a particular dependent variable
under a given set of assumptions. The sensitivity analysis can answer
the following questions:


RESUME SERVICES
15% 10% 200X 10%

Figures
Sales $88,400 $93,600 $104,000 $114,400

Cost of $10,200 $10,800 $ 12,000 $ 13,200
Goods Sold
GROSS $78,200 $82,800 $ 92,000 $101,200

PROFIT
◦ Revenue reports
 Daily
 Monthly
 The assessment of SWOT analysis of potential competitors.
 SWOT stands for Strength, Weakness, Opportunities, ans

Threads.
◦ Investors
◦ Banks
◦ The government
Most companies have a corporate website with a section entitled

"Investor Relations", which should have a wide range of company documentation, including
quarterly and annual reports.
 Difference between financial accounting and managerial accounting
Financial accounting primarily provides information for external users

of accounting data, such as investors and creditors.
On the other hand, management accounting provides information for

internal users of accounting data. Internal users include employees, managers, and
◦ Compliance
 Financial accounting information is an element of transparency and

business ethics, requiring honest and accurate information for
investors, competitors and market analysts to review.
◦ Cost
 Expensive part of doing business, especially for large businesses in

shape of having professionals who earn handsome salaries and
require benefits.
◦ Timing Problems
 Accurate accounting can benefit the business but selecting wrong

accounting type can be just a time wasting activity.
 E.g simple cash methods can’t handle large businesses outstanding

payments and accounts receivable.
◦ Since it is focused on making future decisions with the help of past financial
data, it is forward looking and therefore progressive in nature.
◦ It is meant for internal users like top management and therefore it is not
necessary that it is made by following strict guidelines which is the case with
◦ It is flexible in nature and therefore it can be prepared anytime and they are
not required to be made yearly they can be made monthly or on weekly
basis.
◦ It takes all the data and then present it in such a way that a proper analysis
about the feasibility and profitability of any business decision can be made.
◦ It is dependent on cost accounting and financial accounts and therefore the

accuracy of it is also dependent on how accurate that data is, hence it is one
of the limitations as far as its usability is concerned.
◦ It is affected by the bias of top management and therefore it is likely that

they may tweak it in such a way so as to benefit themselves rather than
shareholders.
◦ Since it does not follow accounting principles, it cannot be compared with

other company’s and hence proper evaluation about the management may
not be possible on the basis of management accountancy.
 A financial statement that measures a company's financial

performance over a specific accounting period. Also known as the
"profit and loss statement" or "statement of revenue and expense.
◦ Balance Sheet
 A financial statement that summarizes a company's assets, liabilities

and shareholders' equity at a specific point in time. These three
balance sheet segments give investors an idea as to what the
company owns and owes, as well as the amount invested by the
shareholders.
 The document provides aggregate data regarding all cash inflows a

company receives from both its ongoing operations and external
investment sources, as well as all cash outflows that pay for business
◦ And analysts (financial) recommendations
 Financial analysts help people decide how to invest their money. They
work for banks, insurance companies, mutual funds, and securities
firms. They often meet with company officials to learn more about
the firms in which they want to invest. After the meetings, the
analysts write reports and give talks about what they found out. Then,
they suggest buying or selling that firm's stock.
That’s how outsiders can easily determine the firm’s value, profit and its
risk. However, SEC is looking for the uniform set of standards for public companies i.e. GAAP
(Generally Accepted Accounting Principles). These statements are prepared by the
accountants of the firms and reviewed by the auditors.
◦ The managers
 Reasons for Differences in Financial Accounting and Managerial Accounting
◦ If Financial Accounting shows favourable financial position as compared to

Managerial Accounting
 1. Company’s management is showing fake financial position of the

company i.e. company doesn’t have enough financial position ( as
managerial accounting shows) but showing the wrong face of the
company to the stakeholders.
 If Managerial Accounting shows favourable financial position as

compared to Financial Accounting
 Company’s management is trying to use the hidden money for their

personal interests
i.e. 1. having more perks for themselves
2. using that money for further business, trying to increase

the share prices ( trying to gain the maximum benefit from the
◦ An accounting-related item is unintentionally misrepresented or is measured

inaccurately.
◦ Accounts receivable is money owed to a business by its clients (customers or

debtors) and shown on its balance sheet as an asset. It is one of a series of
accounting transactions dealing with the billing of a customer for goods
and services that the customer has ordered.
Impact of Error on
Ending Inventory =30000 (Actual) 10000 20000 18000

20000 12000 8000 7000

40000 8000 32000 30000
Beginning Inventory= 20000 10000 10000 8000

15000 4000 11000 10000

25000 17000 8000 6000
 Understated liabilities will automatically show the improves financial

position of the company
 Overstated Assets will show the fake financial position of the

company.

 Who is responsible
◦ Accountants or Managers
 Auditing
◦ The general definition of an audit is an evaluation of a person, organization,

system, process, enterprise, project or product.
◦ Audits are performed to ascertain the validity and reliability of information.
 1. Independent Auditors
 Independent auditors are usually CPA’s (Certified Public

Accountants) who are either individual practitioners or
members of public accounting firms who render professional
auditing services to clients. In general, licensing involves
passing the uniform CPA examination and obtaining practical
experience in auditing.
 Internal auditors are employees of the organization they audit.

This type of auditors is involved in an independent evaluation
of evidence, called internal auditing, within an organization as
a service to the organization. The objective of internal auditing
is to assist the management of organization in the effective
discharge of its responsibilities.
 Government auditors are employed by various local, state, and

federal governmental agencies. Government auditors are
specialists in tax and disclosure regulations.
 Internal Auditor
◦ To oversee the firm’s financial and operating procedures
◦ To check the accuracy of the financial record-keeping

◦ Firms are not required to have internal auditors but many

firms have them to enhance their accounting and internal
control efficiency.
◦ In fact, the people who initially detected financial fraud at

WorldCom were the company’s own internal auditors.
 External Auditor
 External auditors are the accountants from outside the firms
They review;
◦ Assess the system and procedure used by internal auditors
 To conduct external audit, the auditor’s might;
◦ Conduct interviews with the firm’s employees to assess the

quality of the internal audit system.
◦ Meeting with the firm’s customers and clients to assess the

firm’s short-term assets and liabilities.
◦ Conduct their own financial statement analysis such as

comparing ratios from one period to the next.

 largest Audit firms are; (BIG FOUR)
 The Changing role of Accounting – Managing Earnings
Accountants role has been changed for the last two decades i.e.
◦ Instead of simply providing information to insiders and outsiders,

accountants act as a profit- centers.
◦ Accounting departments are asked to increase profits through implication of

accounting methods.
◦ Different methods often lead to different levels of reportable profits.
◦ This process of reporting of profit is called managing earnings.
◦ E.g. 1. Pressure on accountants from managers to meet internal targets.
◦ Managers want accountants to show increase revenue and decrease cost

because it may lead to a raise or a bonus for the CEO and other managers.
 2. Pressure on accountants from Analysts to meet external targets.
◦ Analysts make predictions about firms profitability measured by earning per

share (EPS).
◦ If firm fails to meet these expectations, then the share price will decline.
◦ So, the pressure is on accountants to make any sort of arrangement which

can be “window dressing”.
◦ Window dressing is a set of actions or manipulations with financial or other

information in financial documents (financial statements, reports, etc.) to
make this information look more attractive to its users. Even though window
dressing can occur at any time, it is commonly used at the end of a period
e.g. normally banks managers ask their friends to deposit their money for a
short period of time to have attractive financial position etc; etc.
◦ Other examples of window dressing by companies may include advertising,

selling, and marketing. In these cases, window dressing occurs when positive
characteristics of products or services are a little exaggerated to increase
demand for them while negative characteristics are not mentioned or kept
hidden.
 Another example of variations in accounting method is called smooth income.
 An erratic pace profit generated by business is being divided into

number of years.
◦ Give shareholders a sense reduced risk.
◦ Can easily handle with the analysts predictions.
◦ Good for managers to show consistent revenue on the board

meeting.
◦ Good to deal with the government regulations like taxation.
◦ etc; etc.
 From Manipulation to Fraud
A question often asked is how much can companies manipulate accounting figures
◦ E.g. Selling goods/assets at high price to its own subsidiary, where as the
book value is very low and so on.
◦ Therefore, the firm book large capital gain and profits go up, which is not
actual.
◦ The subsidiary capitalizes the cost of the truck by reporting lower earning in
each of the future years in which the truck cost is depreciated.
◦ Accountants are under pressure from the management side;

 To show maximum profit by any mean
 To show less shortfalls
◦ What about the investors or stock holders?
There is a difference between capital investments and operating expenses

e.g. On June 25, 2002, WorldCom disclosed that roughly $3.8 billion had been improperly
booked as capital investments instead of operating expenses.
 Capital investment may also refer to a firm's acquisition of capital

assets or fixed assets such as manufacturing plants and machinery
 A category of expenditure that a business incurs as a result of

performing its normal business operations.
There is a clear line between legal accounting manoeuvring and accounting fraud.
Accountants and auditors are responsible for this fraudulent act but one should not ignore
 Auditors as Consultants
Business consulting firms typically advice firms on tactical issues, such as

how to enter a new market and strategic issues, such as acquiring or spinning off other
firms.
◦ For example, McKinsey & Company
o Advises more than half of the Fortune 500 firms
o 7,700 consultants in 84 locations worldwide and generated $3.4 billion

revenue
o Representing more than 40 percent market share of the consulting

business.
◦ One potential problem for a firm’s shareholders occur when a consulting

firm conducts auditing services for the company.
◦ The income for conducting an audit is far lower than the fees earned for
consulting.
◦ It is intended to separate auditors and consultants, prohibit accounting

firms from providing both auditing and consulting activities to the same company.
◦ The conflict of interest of consultants and auditors are the main reason.
◦ Compared to accounting systems used internationally, the system in the

US is quite rigorous to protect shareholders rights.
◦ In the recent study of 31 countries, the US was found the best legal
environment to discourage earnings manipulations and smoothing.
◦ Australia, Ireland, Canada, and the UK also have good investor protection
and enforcement histories.
The Board of Directors
Introduction
A board of directors is a body of elected or appointed members who
jointly oversee the activities of a company or organization. The body sometimes has a
different name, such as board of trustees, board of governors, board of managers, or
executive board. It is often simply referred to as "the board."
 Who elects the BODs for a corporation?
◦ In a publicly quoted company this is usually done at the public Annual General
Meeting of shareholders or by ballot.
◦ In privately owned corporations it is, of course, done behind closed doors.
 Composition
It is common for a board to include a combination of directors (outsiders & insiders);
◦ major shareholders,
◦ members from the management team (e.g. the CEO),
◦ as well as executives from other companies.
 Types of Board of Directors (BoDs)
BoDs can be of two types;
◦ 1. One tier or Unitary Board
 Delegates day-to-day business to the CEO, management team, or

executive committee.
 Composed of both executive (CEO, CFO) and non-executive

(Independent) members.
 This structure is most often found in countries with common law

traditions, such as United Kingdom, US etc.
◦ Two-tier or dual board
 Divided into two separate bodies i.e. management board and

supervisory board.
 The supervisory board overseas the management board which handle
day-to-day operations.
 This structure is common in countries with civil law traditions, primary

in Germany, but also in some companies in France and in many
Eastern European countries.
 Board of Directors Functions
◦ To hire, evaluate and perhaps even fire top management, with the position of
CEO being the most important to consider.
◦ To vote on major operating proposals (e.g. Large capital expenditures &

acquisition)
◦ To vote on major financial decisions (e.g. Issuance of stocks and bonds, dividend
payments and stock repurchases)
o What is “share repurchase”?
◦ A program by which a company buys back its own shares from the
marketplace, reducing the number of outstanding shares.
◦ Because a share repurchase reduces the number of shares

outstanding (i.e. supply), it increases earnings per share and tends to
elevate the market value of the remaining shares.
◦ When a company does repurchase shares, it will usually say
something along the lines of, "We find no better investment than our
own company."
◦ To offer expert advice to management
◦ To make sure the firm’s activities and financial conditions are accurately reported
to its shareholders.
◦ Other includes
◦ To represent the interest of the shareholders
◦ To provide an important corporate governance function
◦ Most important internal monitor.
 Hiring a Board of Directors: 8 tips
1. Do you really need one?
 Find out areas where you need any help or input such as finance,
management, or other areas.
 Consider the importance of independent directors.
2. what sort of board is best?
◦ Small businesses may require just advisory board for feedback but for
large businesses a company need a greater clout.
◦ Board members are required to accept fiduciary responsibility even to

outvote on key decision.
3. Whom do you choose?

◦ Ensure diverse set of skills, expertise, and feedback.
4. Avoid mirror images.
◦ An effective board is comprised of people of diverse

backgrounds and viewpoints that can differ from yours.
◦ Good board consist of people who don’t think like you and are
not afraid about standing up to anyone with their ideas.
◦ You need strong-willed people with a great deal of experience.

5. How will the board function?
◦ You need to address the mechanics of its activities.
◦ Figure out the key areas of your business that need a board’s
involvement.
◦ Meetings, discussions and advises should be practical.
◦ Create the accountability environment between the executives

and the board of directors.
◦ The worst thing is to let your board meet and talk, but nothing
actually happens.
6. How often will the board meet?
◦ Schedule your company’s meetings because its your company

and you can best address the timings, even quarterly, monthly
or weekly if that’s your business requirement.
◦ Meeting should not just for the sake of gatherings but must
have some agenda that can provoke hit issues with warrant
attention.
7. How long should they serve?
◦ Experts suggest that terms for board members only runs from
one to three years.
◦ This can help you to say goodbye to those who are not
interested.
◦ Additionally, stagger terms so that you don’t have too many

board members leaving in the same year.
8. How much do you pay board members?
◦ Again, size, frequency, and other variable dictate how much

you should pay your board of directors.
◦ Rule of thumb: the more you pay them, the more you can
expect them to be loyal to the company and result oriented
and vice versa.
 Overview of the Board
 The Board Legal Duties

◦ No federal law explicitly dictates that public corporation must have a
BODs.
◦ State laws vary form one state to the others.
◦ Fortunately every state requires that a corporation having a BODs.
◦ Directors are supposed to enhance the firm’s profitability and share value.
◦ Directors also have a duty of loyalty and fair dealing.
◦ They must put the interest of shareholders before the their own individual
interest.
◦ Must perform the duty of care, means being informed and making rational
decision.
◦ Must perform the duty of Supervision to establish the rules of ethics by

holding regularly meetings to review the firm’s performance, operations and
management.
◦ Business ethics are Employment Practices, Human Rights,

Environment Regulations, Corruption, Moral Obligation of MNCs.
◦ They must ensure that the accurate financial reporting and objective auditing
are taking place.
 Board Committees
Some board include;
◦ An executive committee
 Group of directors appointed to act on behalf of, and within

the powers granted to them by, the board of directors. Typically it
consists of a chairperson, vice-chairperson, secretary, and treasurer.
Or
 Senior-level management committee empowered to make and

implement major organizational decisions.
An executive committee often acts as an overseer of organizational
activities and has the authority to request justification of certain
matters as well as to plan activities.
◦ A finance committee
 The main duty of the Finance Committee is to maintain a continuing
review of the financial affairs of the Institute. Using this information,
it is the committee’s duty to make appropriate recommendations to
the Board or the Executive Committee regarding financial matters.
◦ A community relations committee
 The Community Relations Committee (CRC) facilitates dialogues and

activities between different stakeholders.
The most common board sub committees are;
◦ Audit Committee
“A great deal of important board work occurs at the subcommittee level

and subsequently goes to the full board for approval.”
 Audit Committee
◦ an audit committee is an operating committee of the BOD charged with

oversight of financial reporting and disclosure.
◦ Committee members are drawn from members of the company's board of

directors, with a Chairperson selected from among the committee members.
◦ A qualifying audit committee is required for a U.S. publicly-traded company

to be listed on a stock exchange.
◦ To qualify, the committee must be composed of independent outside

directors with at least one qualifying as a financial expert.
◦ Responsibilities of an Audit Committee
◦ Overseeing the financial reporting and disclosure process
◦ Monitoring choice of accounting policies and principles.
◦ Overseeing hiring, performance and independence of the external auditors.
◦ Oversight of regulatory compliance, ethics, and whistleblower hotlines.

 Compensation Committee
◦ The main Oversight of regulatory compliance, ethics, and whistleblower

hotlines.
◦ purpose of the Compensation Committee is;
◦ To assist the BODs in discharging its responsibility to the shareholders with

respect to the company’s compensation programmes
◦ To review the annual compensation discussion and analysis in the annual

report.
◦ Appointment and Removal
◦ The members of the Compensation Committee shall be designated by

the Board.
◦ Any member of the Compensation Committee may be removed from

the committee with or without cause
 Nomination Committee
◦ The Board of Directors shall appoint a Nominating Committee of at least two

members, consisting entirely of "independent" directors of the Board
◦ Each member shall serve on the committee at the pleasure of the Board of
Directors and may be removed by the Board at any time with or without
cause.
◦ Purpose of Nominating Committee
◦ (i) to identify individuals qualified to become Board members,

◦ (ii) to recommend to the Board director candidates for each annual meeting
of stockholders or as necessary to fill vacancies and newly created
directorships and
◦ (iii) to perform a leadership role in shaping the Company's corporate

governance policies, including developing and recommending to the Board a
set of corporate governance principles.
◦ Duties and Responsibilities: Some of the duties and responsibilities are ;
◦ Recommend criteria for Board membership.
◦ Identify and recruit candidates for the Board.
◦ Conduct the appropriate and necessary inquiries into the backgrounds and
qualifications of possible candidates for Board membership.
◦ Recommend to the Board candidates to fill new or vacant positions on the

Board.
◦ Recommend to the Board candidates for the election of directors at each

annual meeting of stockholders.
◦ Oversee the Company's corporate governance matters and policies, including

the development of a set of corporate governance principles, and periodically
review such principles and recommend changes to the Board as necessary.
◦ Oversee the evaluation and assessment of the Board and Board committees.
◦ Evaluate annually the performance of the Nominating Committee.
◦ Perform such other duties and responsibilities as are consistent with the
purpose of the Nominating or as may be assigned from time to time by the
Board of Directors.
 Good for Goose, good for Gander

performances.

◦ Sometimes inside directors are good for board (e.g. infant or new
firms or when the firm has to make any huge financial/investment
decision) and some times outside directors (e.g. when audit as well as
compensation matters are required)

board.

board
 More Attention on Directors
◦ Prior to the mid-1980s, the public paid little heed to directors.
◦ Now the situation has changed.
◦ Increased pressure on BODs has resulted in better corporate governance.
◦ The increased takeover market and the new regulatory environment push the
directors to do their jobs.
 What is a “GOOD” Board?
◦ Technical firms must have technical experts and vice versa.
◦ Its entirely the firms decision.
◦ A board with members having different background can also be beneficial for the
firms.
 Independent Boards
There must be a high fraction of non-insiders (directors) for a good board
◦ E.g. One of the board primary responsibilities is to evaluate, compensate and

possibly fire the CEO. What if the board consists of the following people;
 A friend of a CEO
 A relative of a CEO
 A business collaborator of a CEO
 It’s very difficult to find people who are entirely and unambiguously
independent of the firm’s management.
 Because they all know each other.
 Either friends or relatives
 Small Board
◦ A board with fewer members might be a better board.
◦ Too many cooks spoil the broth.
◦ Most of the researchers are thinking in the same way i.e. Small boards are more
effective than large boards.
◦ In small boards, every individual with think extra responsibility on his/her

shoulder and vice versa.
◦ With larger boards, it’s very difficult to reach consensus and to get anything
meaningful done.
 Good for a Goose, Good for a Gander?
◦ What is good for a firm must be/must not be good for others.
◦ Young growth-oriented firms would be looking for more insiders, might be the
best people to serve the board.
◦ Larger and more diversified firms may need more directors, keeping in mind the
scope of its operations.
◦ So who will take the decision?
◦ The managers- he may be in the best position to pick a good board but his self-
interest may get in the way.
◦ The firm’s outside shareholders – they can vote on the board members and
having no power in appointing directors directly, unless they could make the
majority.
 Can Good Boards Lead to Better Firms Performance?
◦ It is not clear that there is a positive correlation between board quality and firm
performance.
◦ Boards may be effectively reactive and may not be effectively proactive (value
creator).
◦ It depends either insider or outsider.
◦ E.g. Committee that determine CEO compensation and are responsible for the
firm’s audit may best be served by outsider
◦ But committee that make firm financing and long-term investment decisions may
be served best by insider.
 Potential Problems With Today’s Board.
◦ One of the main functions of the board is to evaluate top management,

especially the CEO. However, for many firms, the board’s chairman is also the
firm’s CEO.
◦ Most of the outsiders have some personal tie to the CEO.
◦ The directors (commonly the outsiders) do not have a significant vested interest
in the firm, holding little or no stock.
◦ Are directors capable of providing the time and expertise required to fully
understand the major operating and financial decision of the firm? Most
directors have their own highly demanding full-time jobs. So how to cope with?
◦ Some directors simply don’t have the expertise to be a board member.
◦ Some boards are simply large and difficult to actively involve them.
◦ Some directors might not be truly independent, they might be too busy.
Investment Banks and Securities Analysts
Introduction
An investment bank is a financial institution that assists

corporations and governments to raise capital by underwriting and acting as
the agent in the issuance of securities.
 Investment banks also assist companies involved in mergers

and acquisitions.
 Unlike commercial banks and retail banks, investment

banks do not take deposits.
In recent years, however, the lines between the two types of

structures have blurred, especially as commercial banks have offered more
investment banking services.
 Examples of Investment Banks in Pakistan
◦ Invest Bank Ltd
◦ Islamic Investment Bank
◦ IGI Investment bank
◦ First Credit and Investment Bank (Joint venture of NBP and

WAPDA)
These are some of leading Pakistani investment banks providing financial

management and advisory services.
 Investment bankers
◦ investigate,
◦ analyze,
◦ research,
◦ underwrite and
◦ distribute
 Security
◦ A security is a negotiable instrument representing financial value

and signifies an ownership interest in something tangible.
◦ That may be freely bought, sold and transferred.
 Investment banks should;
◦ Sell “good” securities i.e. They should not be selling securities of a

poorly run firm
 Analysts should;
◦ Recommend “good” securities i.e. They should not be

recommending stocks that they think will go down in value.
Investment banks offers variety of services but their most

notable business is selling newly-created securities. When a private firm wants
to become a public firm, it requires an investment bank for two reasons;
◦ To design and
◦ To sell the new stocks for the investing public to purchase.
An existing firm can also take the services of Investment banks

for additional capital growth. Investment bank is an intermediary to sell
securities on behalf of firms.
Jobs of the analysts are;

◦ To evaluate securities and make recommendations in buying and
selling of securities
◦ To make earning forecasts for the firms as well as the investors.
 Both investment banks and analysts;
◦ Evaluate the firms position
◦ Bring investment opportunities
◦ Possess better information for the investors
◦ In better position to monitor firms
◦ To identify problems for shareholders.
 Investment Banking Activities
◦ To help companies issue new debt and equities securities.
◦ Banks advises the company on the optimal security (stocks, bonds etc) for
the amount of capital being raised, keeping in mind the company’s situation.
◦ The bank charges the company for this service.
 Methods of Issuing Stocks and Bonds
1. Underwriting
the bank will guarantee that the company will receive a specific amount of
capital, if not then bank will compensate and buy the shares.
2. Best Efforts
the bank will not guarantee that the company will receive a specific
amount of capital but do maximum efforts.
The fee charge is much lower for the best-efforts methods than for underwriting. The
process of selling securities to public investors first involves;
◦ Registering securities with SEC and
◦ Documents
 Preliminary prospectus containing information about the security

issue and
 The company
 Financial condition
 Business activities
 Management experience
 How the fund raised will be used.
The prospectus and the banker’s “road show” relay information about the
company to investors. The “road show” is the marketing campaign done by bankers
to generate interest and to market the issue. To sell to individual investors,
investment banks use their brokerage operations.
The crucial importance of investment banks arises when the firm is new.
Investments banks experience greater risk when underwriting an IPO. An initial
public offering (IPO), referred to simply as an "offering" or "flotation", is when a
company (called the issuer) issues common stock or shares to the public for the first
time.
 Criticism of Investment Banks
1. IPO Problems
◦ The business models of many firms would not be more effectively as large
national firms. Or the small business owners may not be capable of running a
large business.
◦ Only a small fraction of firms succeeded.
2. Structured Deals
◦ In bankruptcy, the equity of the firms is taken from the stockholders, who gain
nothing, and given to some of the creditors.
◦ Therefore, investors are not likely to buy additional shares from financially
troubled firms.
◦ Structured deal using SPEs i.e. making debts as company’s revenue.
 Securities Analysts
◦ Analysts fall into two categories
◦ Buy side (Institutional Investors)
◦ Sell side (Investment Banks)
◦ Institutional Investors
◦ Institutional investors are organizations which pool large sums of money

and invest those sums in securities, real property and other investment
assets.
◦ Institutional investors, such as mutual funds and pension funds hires buy-
side analysts to help to decide which stocks the fund should buy.
◦ The recommendations of these analysts are not public and can be seen
only by the institutional investors.
◦ Similarly, investment banks also hire sell-side analysts to generate enough

interest in a security that their firm will generate trading commission or
underwriting business.
◦ Our focus will be on sell-side analysts.
◦ Sell-side analysts look at the firm’s;
◦ Operating and financial conditions

◦ Immediate and long-term future prospects
◦ Effectiveness of its management team
◦ And the general outlook of the industry in which the firm
belongs.
◦ They usually try to predict the quarterly earnings per share

(EPS).
◦ Analysts make trading recommendations to investors.
o Buy or hold or sell
◦ Analyst’s recommendations are timely.
 Quality of Analysts’ Recommendation

◦ Analysts are slightly conservative with regard to predicting earnings.
◦ These conservative predictions are for two reasons;
◦ To meet or beat earnings expectations
o They need information
◦ If the analysts have full access to the firms, such as personal meetings
with the CEO, then their task become easier.
◦ CEO will not be 100% cooperative with analysts.
◦ Analysts’ conservation is what the management also wants and the CEO
will be happy.
◦ The company will either make or beat the estimate and it will be
considered a good company.
◦ “under promise, over delivery” is the name of this game.
◦ The ability of analysts to predict earnings accurately may suffer in the

future.
 Potential Conflicts of Interest
1. Analysts and the Firm they analyse
◦ conflict of interest with the management.
o Try to get more and more information
◦ Friendships with the manager can’t bring the desired goals
2. Analysts Working at Investment Banks
◦ Analysts can work for an independent research firm, for a brokerage firms, or for
the brokerage operations of an investment bank.
◦ These analysts charge huge fee for their services.
◦ Will these analysts feel free to make public honest assessments if it would
jeopardize those banking fees?
◦ What if the analysts came out with the statement that his colleagues at the bank
had under writing earlier?
◦ However, analysts that work at investment banks may feel the need to
compromise their integrity for the good of their employer.
◦ Analysts must be “Independent” rather than working as a salesperson or

promoters for the investment bank.
◦ He/she must be the objective analyzers of financial performances.
Shareholders and Shareholder Activism

Introduction
During scandals, share holders are considered as helpless and innocent victims. Investors
are divided into two categories
◦ Individuals investors ( such as you, Bill Gates)
◦ Institutional Investors ( pension funds, insurance companies, and mutual

funds)
Institutional investors invest on behalf of many small investors.

Shareholders (both individual and institutions) lose money when corporate scandals occur.
So they are more concern about their firms for more protection.
Home owners take safety precautions to protect their home and rely on
the local police. Similarly, investors rely on SEC to protect their investments. Police can’t
guarantee to protect all homes. Similarly, this is just true with shareholders’ stock.
 Why individuals don’t pay attention
◦ Because most individuals don’t own enough stock to be able influence its
management.
◦ Most of the shareholders consider it worthless and time wasting.
◦ But they have to bear the cost individually, when loses occur
Institutional investors are more effective than individual investors to influence the
company’s management.
 Survey of Consumer Finances

◦ More trend of individuals are toward to own stocks through a fund rather
than own stocks directly.
◦ In 2001, 69.9% of US households invested through mutual funds compared to

21.3% that owned stocks directly
 Benefits of Mutual Funds
◦ 1. The advantage of professional investment management
o Mutual funds provide full-time, high quality professional management

services by pooling the resources of many hundreds of investors.
o The fund manager’s goals and interests are tied to your success because
their pay check is based on how well the fund performs rather than on
sales commissions.
◦ The fund manager has instant access to real market information and is
able to make trades on very large and therefore cost effective securities
packages.
◦ 2. Diversification.
o A major advantage of mutual funds is that they invest in a wide range of

options from stocks to bonds to money market securities.
◦ 3. Low Cost, High Quality Investing
o An average investor could not create a well balanced portfolio holding a

meagre 50 stocks. It would be too expensive.
o A mutual fund lets you buy into a diversified portfolio for as little as $50.
in some circumstances.
o Typically you can get started in a well managed fund for under $1000.
◦ 4. Convenience and Flexibility.

o Mutual Fund managers study the market, analyze the securities, make all
the decisions on what to buy and sell, clip the coupons, collect all the
interest payments and make sure dividends on the fund's securities are
received, recorded and disbursed.
o They protect the interest of the shareholder (you)
◦ 5. Mutual Fund Investments are Liquid and Easy to Withdraw
o Mutual Funds can be traded in (redeemed) at anytime so cash is available

in an emergency.
o The money will be in your hand in about three business days.
 Costs of Mutual Funds
◦ Some critics of the industry say that mutual fund companies get away
with the fees they charge only because the average investor does not
understand what he/she is paying for.
◦ Fees can be broken down into two categories
1. Ongoing yearly fees to keep you invested in the fund.
2. Transaction fees paid when you buy or sell shares in a fund.
 What is shareholders activism?
When shareholders express their opinions to try to affect or to influence a

firm they are being active shareholders.
An activist shareholder uses an equity stake in a corporation to put public

pressure on its management.
 The goals of activist shareholders range from;
◦ financial (increase of shareholder value through changes in corporate policy,

financing structure, cost cutting, etc.)
◦ to non-financial (disinvestment from particular countries, adoption of
environmentally friendly policies, etc)
 Activism by three kinds of Shareholders
1. Activism by Individual Shareholders
◦ An individual investor with only a modest number of shares is able to attend

shareholders meetings, submit proposals to be voted by at those meetings
and vote at those meetings.
◦ Lewis Gilbert is generally credited with being the first individual shareholder
activist.
◦ In 1932, as the owner of 10 shares of New York Consolidated Gas Company,

he attended the annual meeting but was not allowed to ask question.
◦ Then Gilbert and his brother pushed to reform and in 1942, the SEC created a
rule to allow shareholders to submit proposals that they could be put to a
vote.
◦ Today, anyone owing more than $2000 or 1% of a firm’ stock on a continues

basis for at least one year is able to submit a proposal to be considered and
voted on at a shareholders’ meeting.
◦ But, most of the proposals do not approve, especially those that go against
management desires.
 Monitoring by Large Shareholders
Is it good to have large shareholder?
◦ “Yes” for shareholders
◦ “No” for managers.
Some managers are the firm’s largest shareholders (a good news for a firm – can be
a good monitor of a firm) e.g. Bill Gates owns over 10% of Microsoft Corp.
 Consider two firms
◦ One having 1 or 2 large shareholders who own 10% of the firm
◦ Other having no single large shareholder

◦ But large shareholders are required to monitor the firm at the initial stages,
not when the firm matures.
 Institutional Shareholders: An Overview
◦ They can put greater influence.
◦ Proposals sponsored by institutional shareholders have much greater chance

of success than ones sponsored by individuals
◦ The main reason is their increasing ownership stake i.e. institutional investors
are, actually, large shareholders.
◦ Individual investor has the right to push institutions to be more active

shareholders.
◦ Individual investors can influence the firms they own, mainly through direct
communication with management and other shareholders, by identifying
poor corporate performers and through pushing for reforms.
◦ Examples;
◦ During July 2002, the chairmen of 1754 major US firms all received a
letter from the Teachers Insurance and Annuity Association College
Retirement Equities Fund (TIAA-CREF), the country’s largest pension
fund, asking them to account for stock options as an expense.
◦ They constantly monitor firms and make numerous recommendations

for reform.
◦ Coalition of pension funds can place some massive influence e.g.

Council of Institutional Investors (US).
 Does Institutional Shareholder Activism Work?
◦ Increased activism can’t be directly linked to firm performance.
◦ There are many evidences which are in favour of this statement and few are
not.
◦ Activism has its own set of shortcomings, which we discuss next

 Potential Roadblocks to Effective Shareholder Activism:
◦ The short-term view of these investors limits their desire to be activists.
◦ If the equity fund does not like the future prospects of the firm, they simply
sell the stock instead of working to change the firm.
◦ They have many other options to invest.
◦ Corporate executives don’t hire those advisors who are aggressive and can
interfere in management activities.
◦ Therefore, they wouldn’t hire pension fund advisors who are activists.
◦ Private funds usually just go along with the firm’s management.
◦ Mutual funds will not bite the hand that feed them.
◦ More ownership of stocks by mutual funds may lead to face heavy regulatory
and tax burdens.
◦ Most of the time law restrict the pension funds to become stronger
shareholder of any firm and more influential owners.
◦ Experts are of the opinion that legal restrictions are for the corporation
benefits.
◦ At the same time these investors face tremendous SEC paperwork if they do
wish to accumulate a significant stake in a firm.
◦ Extreme and unfavourable tax ramification in the process.
◦ Only a few law actually encourage or make it easier for institutions to be

effective owners.
◦ The public firms in the US and in the UK have the most dispersed ownership
structure in the world.
◦ For an individual investor, it costs a lot of money to own even one percent of
these large, publicly traded firms.
◦ Institutional investors might have enough capital to be significant owners but

they have regulatory restrictions preventing them from owning a significant
fraction of any one firm.
◦ In many other countries, we can see greater ownership concentration.

◦ The two most common types of large shareholders are family-owners and
state-owners.
◦ These large shareholders, especially family-owners, actively participate in

management and can enjoy some private benefits at the expense of their
other smaller shareholders.
Creditors and Credit Rating Agencies

 Introduction
◦ Who really cares about the firm?
 Stock holders
 Lenders (Creditors)
◦ We will discuss about the lenders attitude toward corporate governance.
◦ There are basically two types of lenders
 Commercial banks
 Individual investors (bondholders)
 1. Commercial banks as lender
◦ Almost all banks have commercial lending departments that loan money to
companies to purchase equipment and inventory to start or expand their
businesses.
◦ One of the main revenue sources for banks is the interest made on loans they
lend.
◦ Firm’s financial position is taken into account before issuing loans.
 Individual Investors as lenders (bondholders)
◦ Individual investors can become creditors of a firm by purchasing that firms

bonds.
 Creditors can trade their claims just as stockholders
◦ Bond holders can also sell their bonds to other investors (and banks can also
sell their loans too but primarily to other institutions).
◦ If firms suffer from poor corporate governance, then the value of their bonds
might decline just like the value of stocks.
◦ If a firm collapses from poor corporate governances then lenders may get
back only pennies on the amount of their loan.
◦ While a bank may find it worthwhile to monitor the firm that they lend to
(because millions, even billions could be at stake), individual bondholders
may not have the resources to do so.
◦ Debt, in and of itself, could be a governance mechanism.
 Credit Rating agencies (CRA)- Government/Private (all bonds need to be rated to

attract the investors/creditors)
◦ CRA assesses the credit worthiness of an individual, corporation, or even a

country.
◦ Analysts rate stocks and CRA rate bonds for bond investors (Creditors).
◦ Credit ratings are calculated from the financial history and current assets and
liabilities.
◦ CRA tells a lender or investors the probability of the subject being able to pay
back a loan.
◦ A poor credit rating indicates a high risk of defaulting on a loan, and thus
leads to high interest rates.
◦ Basically, CRA analyse the element of risk involved with the bonds by having
some grades which determine the level of risk associated with.
 Analysis of the situation where a firm has different credit ratings by

different CRAs.
◦ CRAs Perspective
◦ Moody rating for a firm=AAA
◦ PACRA rating for a firm=AA
◦ Private rating for a firm=A
◦ Private as well as PACRA must have to evaluate their expertise

for credit rating purposes because Moody CRA is having
international image and a firm is always single financial
position which means having same credit rating if evaluated by
different CRAs.
 How did Rating Agencies Start?
◦ Moody, John. Manual of Railroad Securities, 1909. Provided operating

statistics for 200 railroads and their securities.
◦ 1916—Standard Co. began grading bonds.
◦ 1920s—Poor and Fitch began bond rating.
◦ 1941—Poor’s and Standard merged.
◦ Customers were investors who wanted unbiased, arms-length financial analysis.
◦ CRA help investors understand the riskiness of a bond issued by issuing some
grades.
◦ A high quality rating for a company means that they can offer a bond at a low
interest rate, having low risk and still easily sell them.
◦ A lower quality rating would require offering the bonds at a high interest rate,
having high risk and cost firms millions in interest payment.
◦ So, we can conclude it in this way;

Credit rating = Risk related to credit
High Credit rate= low interest rate i.e. low risk
Low Credit rate= High interest rate i.e. high risk
◦ So, the bond having high interest rate may be awarded as low credit rate by the
CRA.
◦ And, the bond having low interest rate may be awarded high credit rate by the
CRA.
◦ E.g. one lac (100000) worth of bond having 10% interest rate will give the lender
10000 rupees i.e. 100000 x 10/100= 10000
◦ Similarly, one lac (100000) worth of bond having 5% interest rate will give the
lender 5000 rupees i.e. 100000 x 5/100= 5000
◦ So, from the above examples we can conclude that there is a high risk involved in
the first example having 10 interest rate with the bond and will get low credit
rating from the CRAs and vice versa.
 Another view of Credit Rating
New company= low interest on bonds= High credit rate
New company= high interest on bonds=Low credit rate
Mature company=high interest = High credit rate
Mature company= Low interest = Best Credit rate
 The Big 3
The Big Three credit rating agencies are Standard and Poor’s, Moody’s
Investors Service, and Fitch Rating. Moody's and Standard & Poor's each control about 40
percent of the market. Third-ranked Fitch Ratings, which has about a 14 percent market
share, sometimes is used as an alternative to one of the other majors.
In Pakistan, we have PACRA (Pakistan Credit rating Agency) and many

other private credit rating agencies.
 The Ratings
◦ To assess the credit worthiness of companies, the credit agencies employ
financial analysts who examine the firm’s financial positions, business plan,
and strategies.
◦ This means that the analysts carefully review public financial statements by
the companies.
◦ To assist in their investigations, the SEC has granted the agencies an

exemption from disclosure rules so that companies can reveal non-public or
sensitive information to the agencies in confidence.
◦ Companies have no obligation to reveal special information but they often

do so to convince the agencies that their debt issues (bonds) should be rated
highly.
◦ Credit analysts can often question CEOs and other top executives directly
when conducting reviews because of the importance of credit ratings.
Ratings Moody’s Standard & Poors Example bond Yield,%
Best Qty Aaa AAA 6.4
High Qty Aa AA 6.9
Upper Medium Grade A A 7.1
Medium Grade Baa BBB 7.8
Non-Investment Grade Ba BB 9.9
Highly Speculative B B 10.5
Defaulted or close to it Caa to C CCC to C 20 to 90
 Explanation
◦ Consider two companies that want to borrow $1 billion by issuing bonds. The
rating company rates the first company in the “high quality” category. This
firm will have to pay 6.9% (or 69 million) in interest every year.
◦ The second firm is rated “non-investment grade” and would have to pay $99
million annually.
◦ These amount differ substantially riskier companies pay higher interest.
◦ If a company becomes stronger financially stronger over time, then the bond
rating will also improve.
◦ When a firm begins to struggle financially, credit agencies downgrade the

ratings on its securities i.e. from AAA to AA or even A.
 Criticisms
1. consulting businesses (Conflict of interest)
 being both consultants and credit raters creates a conflicts of

interests similar to the one that occurred when auditing firms were
also consultants for a company.
2. First Amendment Right to CRA
 According to this right, companies can’t sui any CRA and makes credit
agencies nearly invincible.
3. Mistakes while “Rating”
 CRA play vital role while rating different firms. Giving wrong credit
rate (high as well as low) can put the company as well as investors in
chaos.
4. CRA as Watchman (independent monitor)
 CRA are not blameless in the corporate scandals. Indeed, their special
relationship with companies allow them to obtain private information
and can detect fraud and warn investors.
5. Relationship with management
 One of the biggest criticisms on CRA i.e. having relationship with the
management. So how the investors would rely on credit ratings.
6. Blackmailing for new businesses
 New businesses normally required moral as well as financial support

to sustain. So CRA can blackmail them to get good credit ratings for
their businesses to sustain.
 International Perspective (Japan Main Bank System during 1980s)
◦ In most countries, bank debt is the primary form of corporate borrowing and
even the primary source of new financing due to lack of a sophisticated
public debt market.
◦ Although Japan is a developed market but still rely heavily on bank debt,
having long-term relationships with banks, usually with each firm having a
“main bank”.
◦ These main banks usually own equity and place its own personnel into
important management positions (including directorships) of the borrowing
firms.
◦ Positive aspects of “main bank”
◦ Active monitor of the Japanese firms.
◦ Firms don’t care about the cash reserves as they have “main banks”.
◦ “man bank” was always there to help in any financial crisis.
◦ Negative aspect of “main bank” (Japanese market crash in 1990)
◦ Too much influence on management.
◦ Pressurising firm for profit stabilization rather than profit

maximization in order to protect their claims as the firm’s largest
creditors.
◦ But if the banks faced financial difficulties, might led their client firms
in financial troubles
Corporate Governance and Other Stakeholders

Introduction
It is fallacious to argue anymore that the immediate concern of

a Company is to be exclusively directed towards the shareholders, while other
stakeholders are only of a nonessential importance to it.
 1.Corporate Governance and Employees
Employees are also one of the stakeholders of the organisation;

by increasing their participation in the organisation, one could ensure
corporate governance. The interest of employees can be protected through;
 Trade union
Trade Unions could represent the collective interests of the

employees and fight for what is rightly due to them from the
organization.
 Co-Determination
It is a situation where there is employee representation on the

board of directors of the organization.
 Profit-Sharing
Most profit-sharing plans are broad-based i.e. all or most
employees were included in the scheme of profit sharing rather
than just executives only.
The objective of such profit sharing is to encourage employee

involvement in the organization and improve their motivation and
distribution of wealth among all the factors of production.
 Equity Sharing
Under equity-sharing, the employee is given an option to buy

the shares, identify themselves with, and thus become the owners
of the organization.
 Team production Solution
Team production solution is a situation where the boards of

directors must balance competing interests of the various
stakeholders and then arrive at decisions that are in the best
interest of the organization.
There are some guidelines that could be used here while

deciding on employee representation in the organization.
1. Voluntary Participation:
There should be voluntary participation on the
part of the employees and they should not be forced
to do anything out of compulsion.
2. Extend Benefits to all Employees:
The benefits should be extended to all
employees, factory workers, clerical staff and the
executives of the organization indiscriminately.
3. Clarity and Transparency :
The process by which the allocation of shares is
done should be clear and transparent, and not too
complicated.
4. Predefined Formula :
There should be a predetermined formula to
work out the number of shares that could be offered,
and it should not be left to the discretion of any
party.
5. Regularity :
There should be some regularity when such
offers are made, they cannot be made as and when
the organisation feels like making such offers.
6. Avoiding Unreasonable Risk for Employees :
The organisation should take into
consideration the interests of the employees when
they make any decisions, and they should see to it
that there is no undue risk taken.
7. Clear Distinction :
There should be a clear distinction between the
participation schemes that are offered to the
employees and the regular wages and the benefits
that are offered by the organisation.
8. Compatibility with Worker Mobility :
The participation schemes offered should be
compatible with the worker mobility. The worker
should not be penalised by accepting the schemes
offered to him.
 2.Customers and Corporate Governance
Dow Chemicals vision statement says: "To be successful, we

have to provide a balance to the needs of all four of these groups
(customers, employees, shareholders and society). If we maximize the
return to any one or two of these stakeholder groups at the expense of
the others, we won't survive very long."
The North American Advocacy Group, dealing with customer

information needs, stresses the need for corporate to disclose actions
brought by customers and regulatory authorities regarding products,
services and market practices.
A customer who is also a stakeholder of a company contributes

towards the success of the enterprise as much as he is affected by the
actions of the company.
 3.Corporate Governance and Institutional Investors
Types of Institutional Investors
◦ The development oriented financial institutions
◦ The second category covers all the insurance companies such as the
Life Insurance Corporation and their subsidiaries.
◦ The third category includes all the banks.
◦ Finally, in the last category, all mutual funds (MFs), are included.
Factors influencing Investment Decisions
◦ Financial results and solvency
◦ Financial statements and annual reports
◦ Investor communications
◦ Composition and quality of the Board
◦ Corporate governance practices
◦ Corporate image
◦ Share price
 The McKinsey Survey on Corporate Governance

McKinsey conducted this survey in Malaysia, Mexico, South
Korea, India, Taiwan and Turkey, to determine the correlation between
good corporate governance and the market valuation of the company.
The Survey found that good corporate governance increases

market valuation by:
◦ Increasing financial performance
◦ Transparency of dealings, thereby reducing the risk that

boards will serve their own self-interests.
◦ Increasing investor confidence
 4.Corporate Governance and Creditors
◦ Without dependable debt collection, no amount of supervision or

competition can make banks run efficiently.
◦ External financing for private firms comes essentially from two sources:
debt and equity.
Creditors Monitoring and Control
 Adequate Information
◦ The first requirement is information. Lenders need information on the

creditworthiness of potential borrowers, and depositors and bank
supervisors need information on bank portfolios.
◦ The existence of appropriate market-based incentives for creditors, in the

form of higher margin of profit, high interest charges
 Debt Collection
◦ The third requirement for creditor monitoring and control in a market
economy is an appropriate legal framework and effective procedures for debt
collection.
◦ Around the world, legal protection of diffuse debt holders seems

insufficient to protect the rights of investors and limit managerial discretion.
 5. Corporate Governance and the Community
◦ That is the role of governance. Corporate governance is the mechanism by

which the values, principles, management policies and procedures of a
corporation are made manifest in the real world.
◦ The fundamental basis of corporate governance and responsibility is the
value system of the corporation:
 Practical steps to Corporate Social Responsibility
The International Chamber of Commerce recommends these nine steps to

attain Corporate Social Responsibility:
1. Confirm CEO/Board commitment that priority to responsible business

conduct comes first
2. State company purpose and agree on company values
3. Identify key stakeholders
4. Define business principles and policies
5. Establish implementation procedures and management systems
6. Benchmark against selected external codes and standards
7. Set up internal monitoring
8. Use language that everyone can understand
9. Set pragmatic and realistic objectives.

Corporations exist because they, in a sustainable fashion, enable people
to constructively practice their craft and create jobs, economic value, and wealth for the
society and the enterprise especially free societies.
6.Corporate Governance and The Government
Political economy forces that produce the laws, enforcement

mechanisms, bankruptcy processes, and the ability of powerful managers to influence
legislation will profoundly shape corporate governance.
Some argue that governments will tend to use regulations instead of the
threat of legal sanctions when the legal system does not effectively discourage managers
from taking socially costly actions.
Thus the government in every country exercises a certain amount of

control over operations of the organization and the government could use this to push the
organization towards the path of good corporate governance.
Corporate Takeovers: A Governance Mechanism

 Definition
◦ A corporate action where an acquiring company makes a bid for an acquiree.
◦ Assumption of control of another (usually smaller) firm through purchase of

51 percent or more of its voting shares or stock.
◦ Normally, takeover is also termed as “acquisitions”
 What are “mergers” and “acquisitions”?
◦ Mergers:
 Combination of two firms into one
◦ Acquisition:
 One business buy another
 Importance of discussing M & A in Corporate Governance

◦ Firing the target firm’s top corrupt and incompetent managers
◦ These types of takeovers are often referred to as “hostile takeovers”.
◦ Such hostile takeovers are sometimes known as “disciplinary takeovers”

because they represent one process in which “bad” managers and/or “bad”
operating procedures can be eliminated once their firms are taken over.
 General Process; Acquisitions
◦ 2. Tender offer by acquirer to target company stockholders.
◦ 3. Stockholders required to vote approval.
◦ 4. Acquirer purchases majority or complete interest.
 General Process; Merger
◦ 2. Negotiations as to new name, management team.
◦ 3. Stock exchange details negotiated.
◦ 4. Merger proposal goes to stockholders for vote.
◦ 5. If stockholders approve, deal consummated when stock changes hands.
So, Mergers and Acquisitions (M & A) are significant and dramatic events. Through M & A,
companies can monitor as well as solve the governance issues. Stockholders has got this
biggest tool to deal with the governance problems in the company.
 Examples of M & A
◦ American Online acquire Time Warners in 2001.
◦ Pfizer bought Warner-Lambert in the 2000.

◦ Exxon and Mobile merged in 1999.
◦ SBC Communication merged with Ameritech in 1999.
◦ Vodafone’s (UK) acquisition of AirTouch (US) and less than 1 year, Vodafone
AirTouch acquired Mannesmann (Germany)
 Characteristics of M & A
There are many characteristics associated with M & A. These are;
◦ The Type
 The merger type could be between firms in the same industry

(Horizontal merger) or different industries (Vertical merger)
◦ The Valuation of the firm involved:
 Participants negotiate over what is a “fair” price when a firm is trying

to acquire another firm.
 Investors in a company that are aiming to take over another one must
determine whether the purchase will be beneficial to them. In order
to do so, they must ask themselves how much the company being
acquired is really worth.
◦ Naturally, both sides of an M & A deal will have different ideas about the
worth of a target company: its seller will tend to value the company at as
high of a price as possible, while the buyer will try to get the lowest price that
he can.
◦ There are, however, many legitimate ways to value companies. The most
common method is to look at comparable companies in an industry
◦ The payment:
 Payments can be made in the following manners
◦ Cash
◦ The form of payment generally preferred by the

shareholders of the acquiree is cash. It is particularly
appreciated by shareholders
◦ Newly created stocks

◦ In a stock-for-stock exchange, the shareholders of the
selling entity swap their shares for the shares of the
acquirer
◦ The New Corporate Structure
 Who will be in charged?
 Which managers or business lines will be retained?
(Comparing acquirer and acquiree firm’s situation both in M & A)
◦ The Legal Issues:
 Government agencies try to determine if a merger or acquisition

significantly reduces competition, in which case it may be deemed
illegal, and therefore challenged, by the federal government.
 So, M & A encourages monopoly and discourages competition.
 Brief Overview of M & A
M & A can occur for a variety of reasons
◦ Strategic Reason
 To reduce cost
 To get new business
◦ Synergistic Reason
 Interaction or cooperation of two or more organizations to produce a

combined effect greater than the sum of their separate effects.
◦ Diversification
 Diversification is a technique that reduces risk by allocating

investments among various financial instruments, industries and
other categories.
 It aims to maximize return by investing in different areas.

 Most investment professionals agree that, although it does not
guarantee against loss, diversification is the most important
component of reaching long-range financial goals while minimizing
risk
 Are Corporate Takeovers Good for Shareholders?
◦ Takeovers may be viewed as positive as well as negative in the stock market.
◦ Acquirer firm may want to use the infrastructure of the acquiree firm to have
some ease in the business and wants to have an increase in the share price.
◦ Similarly, acquiree firm would be thinking and happy by getting acquired by a

large firm and, definitely, would be looking for higher and stable share price.
◦ But all these predictions can be viewed in a negative way in the stock market
and can badly affect the share price.
 The Target Firm
◦ Most of the time the “target” firm will enjoy a share price increase when its
acquisition is announces to the public.
◦ Because, the investors may believe that now they are in better hands now.
◦ Acquirer firm will also be happy, expecting some return from the “acquiree”
firm.
 Is it appropriate to acquire;
◦ Successful firm
 Require huge sum
 “Net” return for the acquirer firm may not be appropriate
 Require, comparatively, less money to acquire

 “Net” return may be appropriate for acquirer firm
◦ But acquisition always brings increase in share price because now the firm will work
hard to get the stock market expectations.
◦ By firing bad managers
◦ By giving some premium to the shareholders
 To make happy the existing shareholders
 To attract new investors.
◦ Otherwise, the firm will go in chaos.
◦ What if the management (acquiree firm) didn’t accept the takeover bid?
◦ Then the acquirer may try to take their takeover bid directly to the target
firm’s large shareholders.
◦ If they can enough shares, then they can effectively take control of the target
firm and, thus, the target firm management.
◦ And this is what they called “Hostile Takeover”.
◦ “Hostile” takeover is in the eye of the beholder (i.e. Target firm management)
because;
◦ Many initial hostile acquisitions are eventually approved by the target firm
◦ Also some firm, fearing a hostile takeover, may try to work out a “friendly”
deal which heavy perks for the management as well as premium for the
target firm shareholders etc.
◦ In both of these cases, the firms involved may publicly state that their
merger/acquisition was a friendly one.
 Takeover Defences
◦ Takeover defences include all actions by managers to resist having their firms
acquired.
◦ We can place takeover defences into two categories:

 Firm Level
 Pre-emptive Defences
 Reactionary Defences
 State Level
 Firm-Level Pre-Emptive Takeover Defences
◦ 1. Poison Pill
 The term poison pill represent any strategy that makes a target firm
less attractive immediately after it is taken over. Most poison pills are
simply favourable rights given to its shareholders.
 a. i.e. target firm shareholders the right to buy the acquirer’s

stocks at a deep discount if its firm is acquired.
 Of course these rights make those firms much less attractive

to takeover from the acquirer’s standpoint.
 b. Other type of poison pills could involve a firm’s debt

becoming immediately due once it is taken over or an
immediate deep-discount selling of fixed assets once it is taken
over.
 So these are some of the strategies through which a target

firm can prevent its firm to be acquired.
◦ 2. Golden Parachute
 A golden parachute is an automatic payment made to managers if

their firms get taken over.
 Because the acquirer ultimately bears the costs of these parachutes,

their existence make those firms less attractive.
 Golden parachute can also be viewed as one type of poison pill.
◦ 3. Super Majority Rules
 Where 2/3 or even 90 percent of the shareholders have to approve a

hand-over in control.
◦ 4. Staggered Boards
 A staggered board consists of a board of directors whose members

are grouped into classes; for example, Class 1, Class 2, Class 3, etc.
Each class represents a certain percentage of the total number of
board positions. For example, a class is commonly comprised on one-
third of the total board members. During each election term only one
class is open to elections, thereby staggering the board directorship.
 Firm-Level Reactionary Takeover Defences
◦ 1. Greenmail
 To prevent hostile takeover, the target firm force the shareholder to

purchase stocks from the major shareholders at premium.
◦ 2. Convincing
 It’s a sort of defence by the management to convince the

shareholders that the bid price is very low.
 State-Level Anti-takeover Laws
◦ 1. Freeze-out Laws
 It stipulate a length of time that a bidder that gains control has to wait
to merge the target with its own assets.
◦ 2. Fair Price laws
 Fair price laws make sure that shareholders who sell their shares
during a later stage of an acquisition get the same price as any other
shareholder that sold their shares to the acquirer earlier.
◦ 3. Poison Pill Endorsement Laws
 This law protect the firm’s right to adopt poison pills.
◦ 4. A Control Share Acquisition Law
 A control share acquisition law requires shareholders approval before

a bidder can vote his shares.
◦ 5. A Constituency Statute
 A constitute statute allows managers to include non-shareholders’

(such as employees and creditors) interests in defending against
takeovers
 Assessment of Takeover Defences
◦ Are takeover defences bad for the governance system?
 Takeover defences at least contributed to the end of disciplinary

takeovers.
 If takeover defences prevent disciplinary takeovers then their

existence cause us to be left with one less governance mechanism.
 In this sense, takeover defences are bad for the governance system.
 Adopting takeover defences can badly affect the target firm share
price.
 But this is not to say that we staunchly advocate eliminating anti-

takeover mechanisms.
 We should continue to evaluate the pros and cons of anti-takeover

defences in the light of re-evaluation of corporate governance that is
taking place today.
 Some anti-takeover devices appear only to benefit managers.
 On the other hand, many firms with takeover defences do eventually

agree to be acquired. When they do the acquisition price tend to be
much higher than the original offer.
 Therefore, fighting against the merger for a while may cause the bid
price to increase, thereby increasing wealth to the target firm’s
shareholders.
Role of Media in ensuring Corporate Governance
Introduction
The media can play a role in corporate governance by affecting
reputation in at least three ways.
First, media attention can drive politicians to introduce corporate law

reforms or enforce corporate laws in the belief that inaction would hurt their future
political careers or shame them in the eyes of public opinion, both at home and abroad.
Second, media attention could affect reputations through the standard

channel that most economic models emphasize. Managers' wages in the future depend on
shareholders' and future employers' beliefs about whether the managers will attend to
their interests in those situations where they cannot be monitored. This concern about a
monetary penalty can lead mangers not to take advantage of opportunities for self-
dealing.
Third, media attention affects not only managers' and board members'
reputations in the eyes of shareholders and future employers, but media attention affects
their reputation in the eyes of society at large.
Thus the media does play a role in shaping the public image of corporate
managers and directors, and they also pressure them to behave according to societal
norms.
 Importance of Media
At times, the power of the media is so much that a change takes place
even in the absence of any legal requirement to act.
 Harms of Using Advertisement as a Media Tool
Advertising can betray its role by misrepresentation and withholding

relevant facts. Sometimes, the function of media can be subverted by advertisers'
pressure upon publications or programmes. More often, though, advertising is used
not simply to inform but to persuade and motivate — to convince people to act in
certain ways: buy certain products or services, patronize certain institutions, and the
like.
 Media and Corporate Governance
First, previous research has mostly focused on the legal and contractual
aspects of corporate governance. Research suggests that this focus should be
broadened, and that the policy debate should undergo a similar shift in focus.
Second, the press pressures managers to act not just in shareholders'

interest, but in a publicly acceptable way. This finding brings the role of societal norms to
the forefront of the corporate governance debate.
 Corporate Governance and the Press
Shareholders Activists and Press
Activists such as Robert Monks and Nell Minnow have found the press useful in their
fights with management in the United States.
 Institutional Investors
While institutional investors have many legal mechanisms to encourage

change in corporate policies, the presence of an active press increases their influence. It
provides a relatively cheap way to impose penalties on companies and to coordinate the
response of other investors in availing themselves of potential legal protection.
 Business School Governance and Business Today Rankings:
In 1988, the magazine Business Week started to publish a ranking of the top
U.S. business schools. Despite its arguable criteria (most students experience no
more than one business school, yet their responses are used to rank them), this
ranking gained a lot of attention, and soon assumed the role of a standard in the
industry.
 Selective Coverage and Media Credibility
◦ A critical issue we have ignored is the credibility of the information the media
communicates to the public, which is, of course, extremely important.
◦ Even in Korea and Russia the Financial Times is more credible than local
newspapers.
◦ Similarly the Business Week ranking of business schools had a much greater
impact than the U.S.
◦ The issue of credibility is particularly weak because it opens up the question
of newspapers' incentives to conduct further investigations to establish the
validity of the information reported to them and their incentives to report
the information they receive accurately.
◦ Threats to increase (or withhold) future advertising revenues in exchange for
stories that reflect well (badly) on company management and directors are
one example of side deals. Of course, such side deals might hurt the
reputation of a newspaper in the long run and hence its credibility.
◦ If, as is likely, it is more difficult for an individual newspaper to build a
reputation of integrity in a market where all the other newspapers are
colluding.
◦ One equilibrium is where newspapers have credibility and thus avoid side
deals for fear of losing it.
◦ Another is where newspapers do not have credibility and happily accept
bribes not to publish damaging information or to publish false damaging
information.
◦ Similarly, an independent newspaper whose survival rests solely on its own
success is less likely to collude with established business interests.
◦ By contrast, a newspaper owned by a business group is naturally less likely to
publish bad news about the group itself.
 Ethics in Advertisement
◦ A number of humanities and social science scholars view advertising as

intrusive and environmental and its effects as inescapable and profound.
◦ These are strong indictments which imply that advertising is a powerful force.
 Defenders of advertising argue that it has a beneficial effect on several basic areas
 Information :
 Values and Life-Styles :
 Creative experience :
 The following are some of the adverse effects of advertising :
1. Deception :
For example, a soft drink may be described as an orange drink, though it is

artificially flavored.
2.Fear appeals :
The intent of the fear appeals is to create anxiety in the minds of the
consumer and provoke him/her to make use of a particular product to alleviate the
fear in him/her.
3.Advertising to children :
Most of the advertisements such as those for chocolates, are directed at

children. Children between ages of two and eleven spend at least three hours a day
watching television. Secondly, pre-school children cannot differentiate between
commercials and programmes.
Most of these advertisements are deceptive as they omit significant

information such as the complexity and safety of operating toys.
Defenders of advertising to children offer the following positive effects:
1. Advertising gives product information to the child that assists him

or her in making decisions.
2. Children are developing skills though advertising and will be more

independent and make better selections among products targeted towards
them.
3. Advertising is an influence on the process of socialization – it is a

means whereby children learn the value system and norms of the society
they are entering.
4. Materialism
Materialism is defined as a tendency to give undue importance to material

interests and objects. It leads to a sort of Mammon - worship. Consequently, there
is a corresponding lessening of importance to non-material interests such as love,
freedom, and intellectual pursuits.
5. Advertising Alcoholic Beverages
There is a national concern with the problem of alcoholism. Children see

these ads for beer, wine and other drinks long before they are old enough to drink.
6. Competitive Advertising :
Competitive advertising is a form of advertising in which two or more brands

of the same product are compared and the comparison is made in terms of one or
more specific product. It can lead to consumer confusion and is ethically
questionable.
7. Increasing Costs :
The ultimate burden of the cost is passed on to the consumer.
8. Absence of Full Disclosure :
For example, most of the advertisements catering to cooking oil do not

disclose the harmful effects such as increasing in obesity of an individual by using the
product.
9. Use of Celebrities:
Most of the advertisements use celebrities from the world of cinema or

sports. These celebrities would not have used the product.
10. Fantasy and Reality :
Nowadays, most of the advertisements make use of fantasies. For example,

the advertisement of a popular soft-drink shows a boy going in search of the drink in
question and later on lifts a bottle from a moving truck.
New Governance Rules-Sarbanes Oxley Act 2002

 Introduction
◦ In July of 2002, the US passed the Sarbanes-Oxley Act, other wise known as
the Public Company Accounting Reforms and Investor Protection Act of 2002.
◦ SOX is without question the most dramatic federal law pertaining to

corporate governance since the initial securities laws of the 1930s.
◦ It provide an overview of the new NYSE and NASDAQ corporate governance

rules imposed on their listed firms.
◦ A brief history documented how market conditions lead to both the

strengthening and the relaxing of securities regulations in the US is
presented.
◦ Finally, the discussion concludes by illustrating that the trend for increasing
corporate governance standards was a global trend.
 SARBANES-OXLEY ACT OF 2002
◦ Signed by US President George W.Bush on July 30, 2002.
 To regulate auditors
 Created laws pertaining to corporate responsibilities
 And increased punishments for corporate white-collar crime
 Public Company Accounting Oversight Board
The Act established a non-profit corporations called the Public Company Accounting
Oversight Board to oversee the audit of public companies in order to improve the accuracy
of audit reports. Following are the duties
1. registration
 Auditors Independence
◦ Prohibit accounting firms from providing both auditing as well as consulting

activities to the same firm;
◦ Gives the audit committee of the company’s board of directors more

authority over auditing activities;
◦ Forces the lead audit partners in an audit team to change at least after five
years.
◦ Disallows auditing by an accounting firm if any of the top executives of the
public company were employed by the accounting firm within the past year;
and
◦ Requires a study to be conducted that investigates the potential outcomes of

mandatory rotation of accounting firms conducting audits.
 Corporate Responsibilities
◦ SOX also attempt to increase the monitoring ability and responsibilities of

board of directors and improve their credibility. Specifically, the Act does the
following
◦ Making audit committee of the board of directors both more independent

from management and more responsible for the hiring and oversight of
auditing services and the accounting complaint process;
◦ Forces CEO and CFO to certify the appropriateness of the financial statement
filed with the SEC;
◦ Makes it unlawful to mislead, coerce or fraudulently influence an accountant

engaged in auditing activities;
◦ Forces executives of the firm to forfeit any profit from bonus or stock sales
resulting in earnings that needed to be restated as a result of misconduct;
and
◦ Prohibits executives from making stock transactions during the time in which
the employee pension plan blacks out employee stock transactions.
 Enhanced Financial Disclosure
The new law tries to make executives actions more transparent to shareholders.
Specifically, the Act does the following
◦ Require the disclosure of “off balance sheet transactions” and its corrections
◦ Decreases the time an executives has to report company stocks trades to the
SEC to two days;
◦ Prohibit the lending of money by public companies to executives, except for

the use of home loans;
◦ Requires increased internal financial controls and review by the board of
directors.
◦ Encourages a code of ethics for senior officers of the company and report
changes and exemptions to the SEC; and
◦ Requires a financial expert on the board of director’s audit committee.
 Analysts Conflicts of Interests
◦ Analysts should be separated from the investment banking and their conflict
of interest should be disclosed
 SEC Resources and Authority
◦ SEC budget expanded greatly after the passage of SOX, to regulate tens of
thousands of public companies.
 Corporate and Criminal Fraud, Accountability and Penalties
◦ Different sentences and penalties were introduced, ranges from millions of

fine and/or many years of imprisonment.
 Will The Act Be Beneficial?
◦ SOX addresses different problems i.e. problems with auditing, BODs,

Executive behaviour, the SEC and Analysts.
◦ Legal scholars are of the view that the Act is either misplaced or repetitive to
existing laws
◦ These laws didn’t protect ENRON from governance failure.
◦ These laws are burdensome and expensive
◦ Cost related with compliance of the Act don’t guarantee the firms value, so
what is the benefit of adopting it.
◦ The success of the Act is still debatable and it’ll take few years to succeed.
 Other Regulatory Changes
◦ In 2002, in light of the growing number of accounting scandals, the SEC

Chairman called on the NYSE and the NASDAQ Stock Market to take a fresh
look at their corporate governance listing standards.
◦ Because the debated SOX rules are similar to the Act’s laws.
 The New York Stock Exchange
 The NYSE can impose rules on NYSE-listed firms only, which means
that its rules do not affect
 non-listed firms,
 nor can it impose rules on other members of business

community, such as auditors and financial analysts.
 We focus here on those rules that were adopted by the NYSE but not
adopted by the Act.
 Most of the new NYSE corporate governance rules have to do with

the structure, function, and incentives of the BODs
 The NYSE mandates that companies have a majority of independent

directors
 A director is not independent if he (or immediate family);
 Has worked for the company
 Or its auditor within the past five years
 The NYSE also requires specific functions of the board e.g.
 Nominating committee members must be independent.
 This is also true of the compensation committee.
 Otherwise, the executives would have undue influence on their own

compensation.
 The Audit committee must also be independent.
 Lastly, the NYSE will require the shareholders approve all executives
equity based compensation plan.
 That is, there will be a shareholder vote on whether the CEO gets a
certain number of the stock options or restricted stock shares.
 This rule creates more transparency because each shareholder will

receive a proxy statement detailing the compensation proposal.
 NASDAQ Stock Market
◦ The firms listing on the NASDAQ stock market tend to be smaller, on average,
than those listing on the NYSE.
◦ Therefore, NASDAQ adopted rules in the same spirit as those adopted by the
NYSE but with differences intended to fit better with its listing firms.
◦ E.g. smaller firms often have a smaller number of board members. The SOX
and the NYSE rules empower independent directors and give them much
responsibilities.
◦ However, the implementation may overwhelm a small number of

independent directors serving on a small firm board.
◦ Consider a board with only seven directors. Only four independent board
members are needed to create a board with an independent director
majority.
◦ However, having only four independent directors makes it difficult to have

independent committee for executive compensation, nomination, auditing,
etc.
◦ So instead of having a rule that an independent compensation committee

must approve the executive compensation, they provide an alternative that
the independent directors can approve the compensation directly (without
being all members of a compensation committee)
◦ While the NYSE requires that shareholders approve all executive equity based
compensation plans.
◦ Only international firms listing on NASDAQ can apply for a waiver from
corporate governance rules that would be contrary to the firm’s home
country law or business practice.
◦ In those cases where a waiver is appropriate, it must be disclosed in annual

SEC filings.
◦ It is common for the US government to respond with new and tighter
securities regulations during or after market downturns and/or scandalous
periods.
◦ The SOX is one example but journey will go on.
Monopoly, Competition and Corporate Governance

Introduction
A monopoly is said to exist where at least one person or a company controls one-
third of a local or national market. The attitude of the public in many countries towards
complete and partial monopolies has for many years been one of distinct opposition.
Abuses of monopoly are
(i) high prices and restricted output ;
(ii) wrong allocation of resources;
(iii) abuse of investors by monopolists painting alluring pictures of high profits and
perpetual exploitation of the market;
(iv) preventing inventions

(v) increasing the instability of the economic system;
(vi) corruption and bribery and
(vii) concentration of economic power in the hands of a few.
It is for these reasons that monopoly has been regarded as a social evil and various
measures have been designed in free enterprise economies to control and regulate it or in
some cases to eliminate it altogether.
Societies that value corporate democracies and better governance practices have
enacted anti-monopoly laws that have attempted to (a) prevent monopoly firms from
coming into existence, (b) get them dissolved if they exist already or spelt into a number of
competing firms; and (c) prevent monopoly firms from indulging in unfair trade practices
such as price discrimination and cut-throat competition.
A competitive firm in a free market economy is preferred to a monopoly for a variety

of reasons; (i) the consumer stands to gain under it because of low prices available due to
intense competition; (ii) firms avoid wastages and duplication of efforts as they have to be
competitive; (iii) firms tend to be efficient in a system of the survival of the fittest; iv) they
maximize the gains by deploying resources in the best possible way in the context of
consumer’s tastes and preferences. Competition is thus considered to be the best market
situation and its closest to corporate governance practices.
The Concept, Logic and Benefits of Competition
Some of the benefits expected from competitive markets are:
 Growth of entrepreneurial culture leading to an increase in the number of producers

and sellers in the market.
 Increase in investment and capital formation leading to an increase in supply

capabilities.
 A strong incentive for developing cost-cutting technologies through sustained

research and development efforts.
 Reduction in wastage and improvement in efficiency and productivity.
 Greater customer focus and orientation.
 Increased possibility for entering and tapping foreign markets.
 Conducive environment for growth of international trade and investment.

 Better resource and capacity utilization.
 Wider range of availability of goods and services and wider range of choices for
consumers.
On account of these perceived benefits, governments in free enterprise countries

take steps to generate and promote competition. This, however, requires a suitable
economic system and the constitutional framework as well as an appropriate
macroeconomic policy set-up.
Regulation of Competition
While it is important and necessary to promote competition among firms to enable

consumers gain maximum advantage from a free market economy, an unregulated
competition is bad and may even lead to unmitigated disaster and destruction of the
nation’s wealth.
The regulation and protection of competition usually requires a competition policy

backed by an appropriate legislation. There are three basic areas of such competition policy:
 Control of dominance firms by regulation.
 Control of mergers to prevent the possibility of emergence of monopolies; and
 Control of anti-competitive acts like full line forcing and predatory pricing.
Corporate Governance under Limited Competition
The influence of competition on the practice of corporate governance can be gauged

properly if we look at the risks associated with markets where competition is restricted.
Regulatory barriers and firm-level practices have tended to limit the scope of
competition in takeovers, disinvestments and privatization, both in industrial and
developing countries.
In more advanced markets, it was found that as regulatory barriers were imposed on
corporate control transactions, managerial efforts and board supervision became weak.
Firms try to postpone addressing business problems. Corporate performance generally
declines with adverse consequences for shareholders.
Constraints To Competition in Developing Countries

Among developing countries, restricted competition in the market for goods and
services is a more prevalent situation. There are diverse constraints, ranging from anti-
competitive practices by firms to government policy restrictions on ownership and entry.
Frequently, entry barriers are disguised as regulation purportedly designed to serve

the "public interest." In fact, these policies usually give the preferred producers and service
providers profits in excess of competitive returns. Such profits, however, come from
distorted prices, which is truly a hidden tax on consumers.
The resulting burden is borne by the society as a whole. India’s was a classic example
wherein the government adopted between 1951 and 1991 a highly restricted policy in the
name of import substitution and protection of home industry, which resulted in gross
inefficiency, high prices, shoddy goods and an overheated economy. In such a system,
corruption and black money abounded and corporate governance was unheard of.
Banks’ Role in Restraining Emergence of Securities Markets
Banks, which play a predominant role in financial inter-mediation in developing

countries, maintain cozy relationships with established and often well-connected
businesses.
In some countries, commercial firms also own and control major domestic banks,
creating business conglomerates with "in-house" sources of easy financing for themselves.
This was the case in India before twenty of these banks were nationalised in the 1960’s and
thereafter.
More generally, preferred access to bank credit significantly reduces the need of
incumbent firms to rely on securities markets where external financiers often demand
transparency and accountability of corporate insiders.
Lack of Competition Promotes Ownership Concentration
Lack of competition accentuates ownership concentration. They may choose to

remain a private firm or may go public, but without giving up control either by retaining a
controlling stake or by issuing non-voting shares.
Research findings show that a higher share of the leading firms remain private in less
competitive markets.
Benefits of Competition to Stakeholders

Competition improves;
the conduct of managers, as they understand that in such markets only the fittest
can survive.
This, in turn, improves quality of products and reduces prices for consumers, and
maintains or increases market share, and return on shareholders' investment.
In a much freer market, they enjoy a wide variety of products and services to choose
from, competitive prices, technically updated products and other consumer friendly policies
such as easy and installment credit and longer warranties.
These benefits of competition can be analyzed from two aspects:
(i) competition in the product market, and
(ii) competition in the capital market.
1. Competition in Product Market
Increased competition can increase shareholder and consumer welfare. Competition

provides strong incentives for performance. It aids in defending and expanding market
share. It also helps in the provision of accurate information to measure performance, that is,
it increases transparency in all operations. Competition to win market share drives greater
efficiency and innovation. It passes on lower prices to consumers and eliminates monopoly
rents.
Benchmark performance measures are available through reference to competitors unlike

in monopoly. It encourages a customer-driven market rather than product-driven market. In
a competitive market, the consumer determines the quality and quantity of the products, as
reflected in the price mechanism. Competition in product markets is generally associated
with allocative and productive efficiency. Competition encourages the supply of goods and
services at lowest costs and at prices.
2. Competition in a Capital Market
While the benefits of competition to consumers in the product market can be

directly linked and may reflect corporate governance practices, it may not be so direct in the
case of capital market.
Often, competition may undermine the development of long-term relation between

companies and financial institutions. For example, the willingness of banks to provide rescue
to firms in financial distress, hinge on the expectation that these investments will yield long-
term returns.
Where there is competition in financial markets and firms are in financial distress,
the provision of rescue funding by banks may be discouraged.
On the other hand, limitations on competition in financial markets may result in

monopoly exploitation of borrowing firms. Thus, a firm that remains competitive will be able
to get the required funds through the capital market.
Economic Power and Political Influence
Firms have a definite organizational and financial advantage in influencing the

legislative and regulatory agenda.
In advanced countries, powerful commercial interests may not always prevail. But, in
most developing countries, competing opinions are more limited.
In this context, interest groups are more likely to succeed in furthering their own
agendas. It is often alleged that the street-smart companies that wield enormous political
influence grow much faster than those which preferred to be independent.
They could not grow much, though they were in the industry for generations.
Incumbent firms often use their political influence to entrench the position of management
and corporate insiders.
Competition and Political Governance
Political governance includes the regulatory environment and process. It involves

policy making in the public interest.
Monopolization, or lack of competition generally, can affect political governance and

indirectly affect corporate governance.
Effects of Monopoly on Political Governance
 In such a state of affairs,
• The political and economic control may be too concentrated. Democracy and
competition get undermined.
• There is reduced political accountability and transparency. There is increased
corruption.
• Shareholder interest may be confused or compromised by multiple and conflicting

objectives.
Examples abound where due to deliberate state policy and with little objective
regulation, politically influential family-owned companies emerge as winners thwarting even
the limited competition.
Managements are not interested in putting in place any corporate governance

practices. Their focus is distorted away from commercial objectives towards political
influence.
Political favours weaken management and accountability. There is a lack of

transparency, so there is reduced incentive to invest and increased risk in equity markets.
Encouraging Good Governance
Competition in product markets and market for corporate control encourage good
governance. The effects of external auditors can be very important in enforcing good
governance, particularly where there are complexities and other issues that make
shareholder monitoring difficult. Takeover codes should be not be "captured", but should
maintain a consumer and shareholder focus.
Competition is only part of the solution
Competition is not the only solution to the myriad of problems that exist in such
economies. There is a need to regulate certain fiduciary relationships. Steps should be taken
to prevent exploitation and/or abuse of information. There should be situations of
asymmetric information between buyer and seller.

voluntary or self-regulation through trade associations if the losers are sufficiently well -
informed, concentrated and expert.
Public enforcement is called for if private efforts do not work or if the matter is
criminal. The positive effects of competition can also reduce the burden of enforcement.
Regardless of competition, it is important to have sound rules and regulation.


white-collar crime.

continues.

developments or policy reforms which may facilitate these practices.
It aims to stop unfair business tactics and abuse of market power or political office to
gain excess profits. With a clear set of competition rules, the government is in a better
position to resist the lobbying of interest groups for preferential treatment.
principal policy objective. Encumbering competition policy with other goals, such as
beneficial result.


A good and effective competition policy with the objective of restraining the
emergence of monopolies and bringing in a competitive market that would ensure benefits
to the consumers and overall economic efficiency, and at the same time taking cognizance
of the specific needs of a developing country like India, should have the following
characteristics:
It should be capable of controlling the misuse of the market power of dominant

firms. It should have a clear perception of dominance and should develop unambiguous
criteria for determining the abuse of dominance.
It should be able to identify the anti-competitive effects of mergers and acquisitions

and provide a prescription to deal with such effects.
It should be capable of monitoring and preventing anti-competitive agreements

between business organisations.
It should be able to identify restrictive and unfair trade practices and provide a
prevention mechanism.
It must ensure that competition leads to better productivity and efficiency and wider
choice to the consumer.
The policy should apply to all the major segments of the economy including
agriculture, agribusiness, manufacturing, infrastructure, utilities and services.
It must provide suitable defenses and protection measures to the marginal or

weaker enterprises in the small-scale sector, which have national importance.
The policy must accommodate international factors and influences in the national
interest.
The policy should be able to create a level playing field for various categories of
enterprises and must target an optimum degree of competition; which is in the best interest
of the economy from the point of view of growth, equity and social justice.

Where competition is intense and global in scope, more firms realise that
corporate governance makes good business sense. Investors seek out firms that run the
business efficiently, treat shareholders equitably and comply with high standards of
disclosure, even when they are not mandatory.
By applying good governance, a firm can earn a good reputation and efficient access
to finance, which in turn enhances their ability to compete. In effect, good governance
becomes an instrument of competitive strategies.

voluntary or self-regulation through trade associations. Public enforcement is called for if
private efforts do not work or if the matter is criminal. The positive effects of competition
can also reduce the burden of enforcement. Regardless of competition, it is important to
have sound rules and regulation.


white-collar crime.

continues.

developments or policy reforms which may facilitate these practices. It aims to stop unfair
business tactics and abuse of market power or political office to gain excess profits. With a
clear set of competition rules, the government is in a better position to resist the lobbying of
interest groups for preferential treatment.
principal policy objective. Encumber competition policy with other goals, such as
beneficial result.

A good and effective competition policy with the objective of restraining the emergence of
monopolies and bringing in a competitive market that would ensure benefits to the
consumers and overall economic efficiency, and at the same time taking cognizance of the
specific needs of a developing country like India, should have the following characteristics:
It should be capable of controlling the misuse of the market power of dominant firms. It
should have a clear perception of dominance and should develop unambiguous criteria for
determining the abuse of dominance.
It should be able to identify the anti-competitive effects of mergers and acquisitions and
provide a prescription to deal with such effects.
It should be capable of monitoring and preventing anti-competitive agreements between

business organisations.
It should be able to identify restrictive and unfair trade practices and provide a prevention
mechanism.
It must ensure that competition leads to better productivity and efficiency and wider choice
to the consumer.
The policy should apply to all the major segments of the economy including agriculture,
agribusiness, manufacturing, infrastructure, utilities and services.
It must provide suitable defenses and protection measures to the marginal or weaker
enterprises in the small-scale sector, which have national importance.
The policy must accommodate international factors and influences in the national interest.
The policy should be able to create a level playing field for various categories of enterprises
and must target an optimum degree of competition; which is in the best interest of the
economy from the point of view of growth, equity and social justice.

Where competition is intense and global in scope, more firms realise that corporate
governance makes good business sense. Investors seek out firms that run the business
efficiently, treat shareholders equitably and comply with high standards of disclosure, even
when they are not mandatory. By applying good governance, a firm can earn a good
reputation and efficient access to finance, which in turn enhances their ability to compete.
In effect, good governance becomes an instrument of competitive strategies.
Corporate Governance in Developing and Transition Economies

Introduction
Steps were mooted (debated) to root out the misdemeanors of the ill-behaved
corporations. It was easy to incorporate the required transformational changes in the
corporate sphere of advanced countries where the systems and procedures and regulatory
bodies to combat and arrest the declining standards were in place, albeit in an immature
degree, it was difficult in the case of developing and transition economies where everything
had to be built from the scratch.
Earlier, the common perspective of Corporate Governance was to respect the

individual system of each country. But in the context of globalization with its attendant
enhanced transnational movement of goods and services and for borderless capital
markets, a set of global standards for corporate governance is being attempted in recent
times.
In such a scenario, it is imperative that developing and transition economies should

try to put in place required systems and institutions with a view to benefiting from the
world-wide application of the principles and percepts of best corporate governance
practices.
Problems Faced by Developing and Transition Economies
Many developing, emerging and transition economies lack, or are now in the
process, of developing the most basic market institutions.
Internal owners dominate in many companies, while the external owners do not
have enough voting power to control the companies and thereby to ensure for themselves
appropriate returns.
The capital markets are just developing and do not facilitate the inflow of new
capital as intended. Further, market transactions are often based on the abuse of inside
information.
The need for corporate governance in developing, emerging and transition

economies extends far beyond resolving problems stemming from the separation of
ownership and control, which is the core and substance behind the need for corporate
governance.
Developing and emerging economies are constantly confronted with issues such as
the lack of property rights, the abuse of minority shareholders, contract violations, asset
stripping and self-dealing.
To make matters worse, these acts often go unpunished since many developing,
emerging and transition economies lack the necessary political and economic institutions to
enable democracy and markets to function.
In the context of developing, emerging and transition economies, instituting

corporate governance entails establishing democratic, market-based institutions as well as
sound guidelines for how companies are run internally.
The judiciary is so lethargic and bureaucratic that it takes more than a couple of
decades to bring the scamsters to book..
Regulatory bodies are not alert, government appointees in Boards are lax, due to
partisan politics and corruption in government, the bureaucracy hardly play their roles in
effectively stemming the damages caused by corporate misgovernance.
Summary of Problems Facing These Economies are :
◦ Lower economic growth.

◦ Dominant public sector – the general perception is that corporate governance is
meant for the private sector and the public sector does not fall within its purview.
◦ Lack of effectiveness of privatisation.
◦ Lack of awareness among shareholders.
◦ Greater government influence, and less autonomy to enterprises.
◦ Internal owners dominate more than a company’s external owners. Given their
discretionary powers, company managers use the company resources to their own
advantage. Investors, therefore, cannot get their returns from cash flow of the
company from the projects.
◦ External owners do not have enough voting power.
◦ Concentration of ownership in the hands of few individuals and family-owned
corporations.
◦ Lack of strong legal protection for investors in developing countries that leads to
concentration of ownership which is used as a means to overcome the power of the
management. This, leads to misappropriation of minority interests.
◦ Capital markets are underdeveloped and do not facilitate the inflow of new capital.
◦ Market transactions are often based on abuse of internal information.
◦ Redrawing property rights and contract laws are slow in coming.
◦ Lack of well regulated banking sector.
◦ Exit mechanisms, bankruptcy and foreclosure norms are absent.
◦ Sound securities markets do not exist.
◦ Competitive markets have not developed.
◦ Corruption and mismanagement.
◦ Non-uniform guidelines: the government – formulated guidelines to ensure better
governance are not uniformly applied to all companies.
Corporate Governance Models

The countries with developed economies apply two different systems of corporate
governance: the group-based system and the market-based one or, as they are often
referred to, the insider and outsider systems.
1. Insider System
In concentrated ownership structures, ownership and/or control is concentrated in

the hands of a small number of individuals, families, managers, directors, holding
companies, banks and/or other non-financial corporations.
Insiders exercise control over companies in several ways; own the majority of the
company shares and voting rights; own some shares, but enjoy the majority of the voting
rights.
Companies that are controlled by insiders enjoy certain advantages. Insiders have
the power and the incentive to monitor management closely thereby minimising the
potential for mismanagement and fraud.
Insiders tend to keep their investment in a firm for long periods of time. As a result,
insiders tend to support decisions that will enhance a firm's long-term performance as
opposed to decisions designed to maximise short-term gains.
However, insider systems predispose a company to certain corporate governance

failures. One is that dominant owners and/or vote holders can bully or collude with
management to expropriate the firm’s assets at the expense of minority shareholders. This
is a significant risk when minority shareholders do not enjoy legal rights.
Insiders who exercise their power irresponsibly waste resources and drain company
productivity levels; they also foster investor reluctance and illiquid capital markets. Shallow
capital markets, in turn, deprive companies of capital and prevent investors from
diversifying their risks.
2. Outsider System
Dispersed ownership is the other type of ownership structure. In this scenario, a

large number of owners hold a small number of company shares. Small shareholders have
little incentive to closely monitor a company's activities and tend not to be involved in
management decisions or policies.
Hence, they are called outsiders, and dispersed ownership structures are referred to
as outsider systems.
Common Law countries such as the UK and the US tend to have dispersed ownership
structures. The outsider system or Anglo-American, market-based model is characterised by
the ideology of corporate individualism and private ownership, a well-developed and liquid
capital market, with a large number of shareholders, and a small concentration of investors.
The corporate control is realised through the market and outside investors.
In contrast to insider systems, owners in outsider systems rely on independent board

members to monitor managerial behaviour and keep it in check.
As a result, outsider systems are considered more accountable and less corrupt and
they tend to foster liquid capital markets. Dispersed ownership structures have certain
weaknesses. Dispersed owners tend to be interested in short-term profit maximisation.
They tend to approve policies and strategies that will yield short-term gains, but that may
not necessarily promote long-term company performance.
At times, this can lead to conflicts between directors and owners, and to frequent
ownership changes because shareholders may divest in the hopes of reaping higher profits
elsewhere, both of which weaken company stability. Small-scale investors have less financial
incentive to vigilantly monitor boardroom decisions and to hold directors accountable.
Directors who support unsound decisions may remain on the board when it is in the
company's interest that they be removed.
Developing a Corporate Governance Framework
There are three different ways that owners maintain control over the work of management:
1) the owners directly influence the corporate strategy and selection of the top
management team;
2) the owners delegate their rights to the board, but ensure that
compensation and other incentives are aligned with share price maximization; and
3) the owners rely on the market mechanisms of corporate control..
In other words, the corporate governance mechanisms can be both internal and
external.
INTERNAL EXTERNAL
Private Regulatory
Shareholders Stakeholders Standards

(for example,
accounting and
auditing)
Board of Directors Reputed agents Laws and regulations

* Accountants Financial sector
Reports Appoints * Lawyers
to * Credit rating * Debt
and * Investment bankers
* Financial media * Equity
monitors * Investment advisors
* Research
* Corporate governance Financial sector
Management analysts
* Competitive factor
and product markets
Operates * Corporate control
Core functions
It can be observed from the illustration of the framework that there are internal and
external forces that interface and interact with each other and have an impact on the
behaviour and activities of corporations.
The Institutional Framework for Effective Corporate Governance
(1) Property Rights
It is essential that property rights, laws and regulations establish simple and
straightforward standards to specify clearly who owns what and how these rights can be
combined or exchanged for recording required information in a timely and cost-efficient
manner into an integrated, publicly accessible data base.
(2) Contract Law
Very few business transactions will occur without legislation and regulations that
legally guarantee and enforce the sanctity of contracts.
(3) A Well-regulated Banking Sector

The banking sector provides the necessary capital and liquidity for corporate
transactions and growth. Good governance within the banking system is especially
important in developing countries where banks provide most of the finance.
(4) Exit Mechanisms: Bankruptcy and Foreclosure
Not all corporate endeavours succeed legislation that establishes orderly and
equitable clearing and exit mechanisms are essential so that investments can be liquidated
and reallocated into productive undertakings before they are squandered completely.
(5) Sound Securities Markets
Efficient securities markets discipline insiders by sending price signals rapidly and
allowing investors to liquidate their investment quickly and inexpensively.
(6) Competitive Markets
The existence of competitive markets is an important external control on companies

forcing them to be efficient and productive lest they lose market share or go under. To this
end, governments can:
◦ Remove barriers to entry

◦ Enact competition and anti-trust laws
◦ Eliminate protectionist barriers including the protection of monopolies
◦ Eliminate preferential treatment schemes such as subsidies, quotas, tax
exemptions etc.
◦ Establish fair trade priorities
◦ Remove restrictions on foreign direct investment and foreign exchange
◦ Reduce the cost of setting-up and running a formal business.
(7) Transparent and Fair Privatisation Procedures
Having transparent, straightforward and fair rules and procedures stipulating how
and when enterprises can be privatised is, therefore, essential.
(8) Transparent and Fair Taxation Regimes
Taxation systems should be reformed so that they are fair, simple and
straightforward. In this regard, multi-step, complex procedures on fiscal reporting, that
allow officials to exercise considerable discretion and therefore engage in corruption, should
be eliminated.
(9) An Independent, Well-functioning Judicial System
One of the most important institutions of a democratic, market-based economy is an

independent, well-functioning judicial system that enforces laws consistently, efficiently and
fairly, thereby maintaining the rule of law.
(10) Anti-Corruption Strategies
The State should implement effective anti-corruption measures by specifying and

streamlining legal and regulatory codes and clarifying laws on conflict of interest.
(11) Reform Government Agencies
Government agencies that are excessively bureaucratic and inefficient need to be

reformed.
(12) Strengthen Administrative and Enforcement Capacity of Government Agencies
Governments should strengthen and maintain their agencies' administrative and

enforcement capacity by cultivating a staff of well-qualified civil servants, hiring and
promoting staff based on verifiable professional standards, offering civil servants vocational
training based on the latest technology, paying adequate salaries to attract well-qualified
professionals and to deter bribe-taking, and offering tenure based on performance.
(13) Establish Routine Mechanisms of Participation
To ensure that the new framework creates a level playing field, citizens need to
have ample opportunity to participate in grafting it.
(14) An Investigative and Well Informed Media
The role of the Fourth Estate (Press) in ensuring corporate democracy cannot be
overstressed, and can be considered as important as its role in ensuring that political
democracy functions as well as it is intended to be. Many a scam in the corporate world
would not have come to limelight but for the bold and upright investigation of journalists.
(15) Strengthening Reputed Agents
Reputed agents are individuals and/or groups that reduce the information gap
between insiders and outsiders by seeking and providing information to outsiders about the
performance of insiders and enterprises and by setting high professional standards and then
applying peer pressure and, at times, sanctions to uphold them. Reputed Agents can also
“refer to private sector agents, self-regulating bodies, the media and civic society that
reduce information asymmetry, improve the monitoring of firms, and shed light on
opportunistic behaviour”. Examples include:
◦ Self-regulation bodies such as accounting and auditing professionals

◦ Media
◦ Investment bankers and corporate governance analysts,
◦ Lawyers
◦ Academicians, economists and corporate analysts
◦ Credit rating agencies
◦ Consumer activists
◦ Environmentalists
◦ Activist investors and shareholders such as institutional investors and venture
capitalists
◦ Non-Government Organisations (NGOs)
Sound Stakeholder Relationships are Good for Business
A common misconception is that achieving profits and looking after

stakeholders' interests are diametrically opposite goals. Operating fairly, responsibly,
transparently and accountably towards both shareholders and other stakeholders does
more than improve a company's reputation and attract investment; it gives the corporation
a competitive advantage.
A company's treatment of other stakeholders such as suppliers is just as

important to the company's long-term performance. A firm that breaks a contract with a
supplier or pays unfair prices not only hurts the supplier, but damages its own reputation as
a reliable and honest business partner.
Corporate Governance Challenges in Developing, Emerging and Transition Economies

Establishing any one of institutions enumerated above is a necessary and challenging
undertaking without which democratic markets and corporate governance can not take
root.
Some of the general challenges confronting developing, emerging and transition

economies include:
◦ Establishing a rule-based (as opposed to a relationship-based) system of

governance;
◦ Combating vested interests;
◦ Establishing property rights systems that clearly and easily identify true
owners even if the state is the owner;
◦ De-politicising decision-making and establishing firewalls between the
government and management in corporatised companies where the state is a
dominant or majority shareholder;
◦ Protecting and enforcing minority shareholders' rights;
◦ Educating and enlightening investors of their rights and duties
◦ Encouraging good corporate governance practices and creating benchmarks
through co-operation with trade associations.
◦ Promoting good governance within family-owned and concentrated
ownership structures; and
◦ Cultivating technical and professional know-how.
Successful Strategies - one size does not fit all
Many international organizations are funding corporate governance initiatives that

aim to put in place developed country models of corporate governance.
Critics complain that these Western-based organizations try to transplant systems

and procedures that are workable in the West, but are unsuitable in the developing
economies that have different cultures, work ethics, employer-employee relations and so
on.
Current Corporate Governance Settings in Transition Economies
Unstable macroeconomic conditions create a situation of great uncertainty and

shorten the time horizon in business. Under unpredictable economic circumstances,
managers see their positions as temporary and uncertain which leads to maximizing their
own profit instead of maximizing the company profit.
In transition economies, the most important firms, such as public sector companies
that contribute more to the nation's gross national product, employment, income, and
capital use than private sector firms, are controlled by the state.
The missing element in the context of corporate governance development in

transition economies is the lack of institutions associated with successful market economies.
The transition economies cannot afford the luxury of searching for new third way
between socialism and capitalism. Instead, they have to find a way to accept the existing
institutional portfolio and to make it work in the specific cultural, historical and economic
environment. Each region is in a different stage of establishing a democratic, market-based
economy and a corporate governance system.
Manual of Corporate Governance-
Securities and Exchange of Pakistan

(Note: Please see the attached manual for detailed study)
Corporate Citizenship
 Introduction
◦ Previous chapters discuss corporate governance from the perspective of

agency theory
◦ However, many believes that companies should have a greater

responsibilities to society.
◦ Proponents argue that companies have unique opportunities to improve
society.
◦ The stakeholder view of the firm describes the firm as having many different
groups with legitimate interests in the firm’s activities.
◦ Corporate governance is then defined as the mechanism that ensures

corporations take responsibility for directing their activities in a manner fair
to all stakeholders.
◦ Strategic management concepts argue that this is based on creating positive

relationships with stakeholders.
◦ Through creating these positive relationships, firms can create sustainable

economic growth.
◦ Many countries have operated under the idea that large corporations have
greater responsibilities in a society than just maximizing shareholders wealth.
◦ Now, many firms believed they had social obligations to be good citizens.
◦ However, do firms have a sense of social responsibility?
◦ Some agreed and some don’t.
 Stakeholders of the firm
◦ Stakeholders are identified as people or groups with legitimate interests in

various aspects of the company’s activities.
 Stakeholders are defined by their interest in the corporation
 Not whether the corporation has any interest in them.
◦ So, companies have varying responsibilities to each of their stakeholders.
 Some relationships may be valuable than others.
 These relationships between managers and stakeholders are based on

a moral or ethical foundation.
 Primary stakeholders
 Stockholders
 Employees
 Creditors
 Suppliers
 Customers
 Secondary stakeholders
 Environment
 Competitors
 Society
 Community
 Governments
 These grouping can be based on;
 Resource-view
 Industry structure
 Social or political affiliations
 Institutional, economic and ethical interests.
◦ There is no consensus on how these stakeholders should be categorised but

all the stakeholder views illustrate a much different perspective than agency
theory.
◦ Many companies now have an organizational unit tasked with

communicating with stakeholders.
◦ These units may have camouflaged names like “corporate communication

department” or “public affairs department”.
◦ Other use more direct names like “sustainability group” or “corporate social
responsibility committee”
 Legal Foundation
◦ Consider a land-owner. Building a home require a building permit.

◦ The government agency that grants the permit must first approve the
building plans i.e. the building must meet adequate safety appearance
criteria.
◦ Although, citizens are not the owner of the land but they are the
stakeholders of this land. They have some rights.
◦ Uses and misuses of stakeholders interference
 E.g. personal business vs. government/private departments
 Corporate Social Responsibilities
◦ Proponents are of the view that companies have a social obligation to

operate in ethically, socially and environmentally responsible ways.
◦ This active approach is referred to as corporate social responsibility (CSR) or

corporate citizenship.
◦ What is a company’s responsibility to society? Archie Carroll has offered a

four-part taxonomy of CSR.
◦ Level 1. Economic- firm first social responsibility is to survive by producing

goods and services at a profit for the sake of the economy. (also students
example)
◦ Level 2. Legal- society expects firms to operate their business within the legal
framework.
◦ Level 3. Ethical- these responsibilities are those over and above the ones
codified in laws and are in line with societal norms and customs.
◦ Level 4. Philanthropy- Charitable giving to human causes on a large scale.

Philanthropy must be more than just a charitable donation.
◦ E.g. Billionaire Microsoft mogul Bill Gates, along with his wife,
Melinda, established the Bill and Melinda Gates Foundation to
support global development and global health programs.
◦ Another example is the Ford Foundation, established by the son of

Ford Motor Company founder Henry Ford. The foundation focuses on
strengthening democracy, improving economic opportunity and
advancing education.
 Drivers of citizenship trends inlude;
◦ Globalization
◦ Education
So many firms have mentioned in their code of conducts or ethics about CSR in
terms of environmental consciousness and solid issues like employees health and
education.
E.g. “we love safe and clean environment”
“we believe in friendly relations with our employees”
 Benefits of CSR to firms
◦ Innovation
 Governance and Stakeholder Theory
◦ The accounting measure can’t measure the managerial decision on

stakeholder welfare.
◦ So the firm should begin their employees to guess the overall welfare
measurement by clear recruitment and promotion practices.
 Criticism
◦ Considering stakeholder’s theory as Descriptive theory but the problem

remains there i.e. how to measure.
 Cost
Course Review
1. Corporations and Corporate Governance (outlines)
◦ Studying global political system from business point of view

◦ Corporate governance: An integrated and complex system.
2. Executives Incentives (Outlines)
◦ Briefly discussion on principle-agent or agency problem.
 Salary, Bonuses, Stock Options,
◦ There are advantages and disadvantages of bonuses and permanent

increases to salary.
◦ But the question is whether these incentives based compensation really work
or not.
 Positive relation between firm’s performance and management

 Positive relationship between management compensation and firm’s

◦ Problems related with incentive based compensation.
 Cost for a firm, price manipulation by CEO etc.
 Related with the economy
 Treat it as an expense
◦ Cost for a firm
◦ Identify stock options
◦ Contribute to corporate scandals

3. Accountants and Auditors (Outlines)
◦ Accounting for Inside use (management)
◦ Accounting for outside use (Investors, Banks, The Governments, other

stakeholders)
◦ Difference between Financial Accounting and Managerial Accounting.
◦ Accounting records are different for Managers and Public Financial

Statement.
◦ Reasons for differences in Financial Accounting and Managerial Accounting.
◦ Unintentional errors
◦ Problems with receivables
◦ Intentional Errors.
◦ Understated liabilities
◦ Overstated assets.
◦ Who are Responsible
◦ Audit Role
◦ Types of Auditors
◦ World largest 4 Audit Firms
◦ The changing role of accountants-managing earnings i.e. accountants will act

as a profit-centers
◦ Through managing earning methods, accountants can release the pressure of

managers as well as analysts.
◦ Window dressing and smooth earnings are another technique used by

accountants to show the favourable financial condition of the company.
◦ Price manipulation is acceptable to some extend but it should not violate the
law becoming fraudulent acts.
◦ End of the story is that investors as well as stock holders will have to suffer
with all these techniques used by accountants and management.
◦ Single accounting firm should not allowed to conduct audit as well as

consulting activities for a single firm
◦ Main reason is the conflict of interest between auditors and consultants.
4. Board of Directors (Outlines)
◦ A BoDs is a body of elected or appointed members who jointly oversee the

activities of a company.
◦ BoDs are appointment at the public Annual General Meeting of shareholders.

◦ Types of board are depending upon company status as well as the territory
where the company prevails.
◦ Normally, we can see One-Tier board in common law based societies (like US
and UK) and Two-Tier board in civil law based societies (like Germany etc).
◦ BoDs functions involve to hire, evaluate or even fire the top management, to
vote in support or against of major proposals as well as financial decisions.
◦ In short, BoDs main primary function is to safeguard the shareholder’s

interest.
◦ But the most important factor is to think a lot before selecting your board
◦ Overview of the Board
◦ Board legal duties
◦ May not be the federal law requirement but the state wants
BoDs.
◦ Firms profitability and increase in share value
◦ Loyal and fair
◦ Take care of the rule of ethics
◦ Employment practices
◦ Human rights
◦ Environment regulations
◦ Corruptions
◦ Moral obligations
◦ Board Committees
◦ An Executive Committee
◦ A Finance Committee
◦ A Public Relation Committee
◦ Board Sub Committees
◦ Audit Committee
◦ More attention on Directors
◦ What is a “Good Board”?
◦ Having different back ground i.e. technical as well as non technical
◦ Independent board-having fraction of non-insider directors (difficult

to find unambiguously independent directors)
◦ Small board
◦ Good for Goose, good for Gander

performances.
◦ Sometimes inside directors are good for board (e.g. infant or

new firms or when the firm has to make any huge
financial/investment decision) and some times outside
directors (e.g. when audit as well as compensation matters are
required)

board.

board
5. Investment Bank and Securities Analysts
◦ What is Investment Bank?
◦ Examples of Investment banks
◦ What does Investment Bank actually do?
◦ What is “Security”?
◦ Who are analysts in Investment Banks?
◦ Duties and responsibilities of “Analysts”.
◦ Methods of issuing stocks and bonds
 Underwriting method
 Best effort method
◦ What is “IPO”?
◦ Criticisms of Investment Banks
 IPO Problems
 Structured Deals
◦ Two categories of securities analysts
 Buy-side Analysts (Institutional Investors)
 Sell-side Analysts (Investment Bank)
◦ What is “Institutional Investors”
◦ Our focus is toward the sell-side analysts.
◦ Functions of sell-side analysts
◦ Quality of Analysts Recommendations
 Conservative predictions
 Under promise and over delivery is the name of this game
◦ Potential conflicts of interests
 Analysts and the firm they analyse

 Analysts dual responsibility toward its employer (i.e. Investment
Bank), the firm and the investors.
6. Shareholders and shareholder Activism
◦ Shareholders are innocent and helpless victims when scandals occur.
◦ Two categories of investors
 Individual investors
 Institutional investors
◦ Two questions
◦ Institutional investors are more effective and influential than the individual
investors.
◦ Benefits of Mutual Funds
 The advantage of professional investment management.
 Funds managers have real access and information about the market.
 Diversification in the investment.
 Low cost and high quality investing.
 Convenience and flexible.
 Mutual funds investment funds are liquid and easy to withdraw.
◦ Costs of Mutual Funds
 Hidden fee charges
 What is Shareholders activism?
 The goal of activists ranges from financial as well as non-financial

matters.
 Individual shareholders activism
 Monitoring by large shareholders

 Institutional Shareholders: An Overview
 Does Institution Shareholders activism works?
◦ Potential Roadblocks to effective Shareholders activism.
 Limited desire to be activists
 Many other options for investments
 Mgt don’t hire pension fund advisors who are trouble makers for
management
 Private/public funds normally go with management activities.
 Law restricts them to become major of the firm.
 Long paperwork.
 In west, we can see company discourages one investor to become the

significant owner
 In east, we can see greater owners i.e. family owner as well as state
owner.
7. Creditors and Credit Rating Agencies (Outlines)
◦ Introduction
 Who care about the firm 1. stock holders 2. Creditors
◦ Two types of lenders
 Commercial Banks
 Individual (bondholders)
◦ Credit Rating Agencies (CRAs)
◦ Analysis of the situation having different credit ratings by different CRAs
◦ How did CRAs start?
◦ High credit rating vs. Low credit rating

◦ Another view of credit rating
 New company vs. Mature company
◦ The BIG 3
◦ PACRA
◦ The Ratings
◦ Criticisms
 Consulting firms
 First Amendment Right to CRAs
 Mistakes
 CRAs as watchman
 Relationship with management
 blackmailing
 Japan (main bank)
8. Corporate Governance and Other Stakeholders (Outlines)
◦ Corporate Governance and Employees
 Trade unions, Co-Determination (Employee representation), Profit

sharing, Earning sharing, and Team production solution.
◦ Corporate Governance and Customers
◦ Corporate Governance and Institutional Investors
◦ Corporate Governance and Creditors
◦ Corporate Governance and the Community
◦ Corporate Governance and the Government
9.Corporate Takeovers: A Governance Mechanism (Outlines)

◦ Definition
◦ What are mergers and acquisitions?
◦ Importance of discussing M & A in corporate governance.
◦ General process: Acquisition
◦ General process: Merger
◦ Characteristics of M & A
◦ Type (vertical/horizontal)
◦ The valuation of firm involved
◦ The payment (Cash, Newly created stocks)
◦ The new corporate structure
◦ The legal issue
◦ Brief overview of M & A.
◦ Strategic reason (to reduce cost, to get new business)
◦ Synergistic reason (combined effort)
◦ Diversification (reduce the risk by making investment in different

locations)
◦ Are corporate takeover good for shareholders
◦ Acquirer firm’s shareholders perspective
◦ Acquiree firm’s shareholders perspective
◦ The Target Firm
◦ Increase in share price
◦ Is it appropriate to acquire
◦ Successful firm
◦ What if the management (acquiree firm) didn’t accept the takeover bid
◦ “Hostile” takeover is in the eye of the beholder

◦ Acquisition/merger being approved by the target firm.
◦ Target firm may go for “friendly” deal
◦ Perks for the management
◦ Premium for the shareholders
◦ Takeover Defences
◦ 1. Firm Level Pre-emptive defences
◦ Poison Pills
◦ Acquirer firm stocks at a deep discount rate
◦ Target firm’s debt immediately due
◦ Golden Parachute (payment to managers)
◦ Super majority rule (2/3 shareholders approval)
◦ Staggered Board
◦ 1.1 Firm Level Reactionary Takeover Defences
◦ Greenmail (purchasing shares from the major shareholders at a

premium to prevent takeover)
◦ Convincing (by management to convince the shareholders)
◦ 2. State Level Anti-Takeover Laws
◦ Freeze-out Laws
◦ Fair price law (later shareholders get the same price)
◦ Poison pill endorsement laws
◦ A control share acquisition law ( shareholders approval)
◦ A constituency statute (include non-shareholders)
◦ Assessment of takeover Defences
◦ Are takeover defences bad for governance system
◦ Takeover defences are bad for governance system

◦ But the pros and cons of takeover defences should be
evaluated.
◦ But normally these defences are just to increase the company

price
9. Role of Media in Ensuring Corporate Governance (Outlines)
◦ Role of Media in ensuring Corporate Governance
◦ Media can play role in CG by effecting in three ways;
 Pressure on politicians to go for corporate law reforms
 Pressure on managers to take care of the shareholders money
 Pressure on managers to take care of the societal norms
◦ Importance of media
 Can play role even in the absence of legal act
◦ Harms of using advertisement as a media tool.
 Misrepresentation of facts
◦ Media and corporate governance
 Should be broadened rather than just legal and contractual aspects
 Managers focus should be shareholders but also the societal norms
◦ Individual as well as institutional investors can use press to fight with the
management.
◦ Selective coverage and media credibility
 Sometimes foreign newspapers are more credible than the local.
 The issue of credibility can question the investigation made by the

newspaper

newspapers.

 Deception
 Fear appeals
 socialization

newspapers.
 Deception
 Fear appeals
 socialization
◦ Materialism
◦ Advertising Alcoholic Beverages
◦ Competitive Advertising
◦ Increasing cost
◦ Absence of full disclosure
◦ Use of celebrities
◦ Fantasy and reality
10. New Governance Rules-Sarbanes Oxley Act 2002 (Outlines)
◦ Introduction
 Also know as Public Company Accounting Reforms and Investor
Protection Act of 2002.
 SOX contain laws pertaining to corporate governance
◦ SOX
 To regulate auditors
 Created laws pertaining to corporate responsibilities
 And increased punishments for corporate white-collar crime
◦ Public Company Accounting Oversight Board
1. registration
◦ Auditors independence
 Accounting firms will not perform both auditing as well as consulting

activities for a single firm.
 Changes after five years in audit team.
 An executive from the accounting firm within the past year will
disqualify the public company to be audited
 Rotation of accounting firms conducting audits.
◦ Corporate Responsibilities
 Making audit committee independent form the management.
 CEO and CFO will be responsible for the financial statement.
 Separate any profit from bonuses or stock sales that needs to be

restated as a result of misconduct.
 No stock transaction during employee pension plan.
◦ Enhanced Financial Disclosure
 All transactions must be disclosed
 Report to SEC within 2 days
 Encourage code of ethics and report everything to SEC
◦ Analysts conflicts of Interests
 Analysts should be separated from the investment banking
◦ SEC Resources and Authority
 SEC budget expanded greatly
◦ Corporate and criminal fraud, accountability and penalties
 Different sentences and penalties were introduces
◦ Will the act be beneficial?
 Most rules are misplaced or repetition
 Can’t guarantee corporate scandals
 Expensive
 Cost for firms and no firm value
 Still debatable
◦ Other Regulatory Changes
 The NYSE
 NYSE can’t effect non-listed firms as well as other business

members like auditors, financial analysts.
 Focus on more independent directors
 In nominating, compensation and audit committees.
 NYSE require shareholders approval all executive equity based

compensation plan
 It brings transparancy.
 NASDAQ
 Small firms can work with small number of independent
directors.
 So independent directors can perform the duties of different

committees as well as executive compensations
The US government is looking to tighter the securities regulations but there is a long way
to go.
11. Monopoly, Competition and Corporate Governance (Outlines)
◦ 1. Introduction
 Monopoly is that one person or company controls 1/3 of the local or

national market
 Abuses of monopolies are
 High prices
 Wrong allocation of resources
 Abuse of investors/markets by giving wrong information.
 Preventing inventions
 Economic instability
 Corruption and bribery
 Economic power in the hands of few
◦ Anti-monopoly laws
 Prevents firms to make monopoly
 Prevent unfair price discrimination
◦ Competitive firm is preferred because
 Low prices
 Avoid wastages for competition
 Efficiency
 Consumers’ tastes and preferences

◦ 2. The concept, logic and benefits of competition
 Entrepreneurial culture leads to more producers and sellers
 Increased supply capabilities
 Cost-cutting through research efforts
 Reduction in wastages, & improvement in efficiency & productivity
 Customer focused
 More access to foreign market
 Favourable environment for trade and investment
 Best sources utilization
 Wide range of available goods and services
◦ Regulation of competition
 Competition must be regulated through some legislation which helps

in;
 Firms dominance
 Prevents monopolies
 Controlling anti-competitive acts like
◦ Full line forcing
◦ Predatory pricing
◦ Corporate governance under limited competition
 Regulatory barriers weaken the managerial efforts and board

supervisions leads to governance issues.
◦ Constraints to competition in developing countries
 Nationalization and “public interest” cause constraints for firms to

work efficiently.
◦ Banks’ role in restraining emergence of securities markets
 Banks credit reduces the need to invest in the securities markets

 Banks can play vital role to analyse the companies value for further
businesses.
◦ Lack of competition promotes ownership concentration
 More competitive markets result in more public firm
 Less competitive markets result in more private firms
◦ 3. Benefits of competition to stakeholders
 Managers
 products
◦ Benefits of competition
 Competition in the product market
 Quality products
 Low prices
 Competition in the capital market
 Relationship of firms and financial institutions
 Economic Power and Political Influence
 Firms can take political influence for their benefits
 Monopolistic market can lead toward the political influence,

would results in bad governance.
 Competition is the only solution.
◦ Enforcement of Good Governance
 First go for private enforcement through market mechanism
 Or self-regulation through trade associations
 Or public enforcement
 Positive competition reduces the burden of enforcement
 Enforcement is vital
◦ Challenges to Good Enforcement
 Resources
 Meaningful sanctions
 A real big challenge
◦ Competition Agencies and Competition Policies
 To prevent anti-competitive practices
 To resist the lobbying of interest groups
 Competition policy should be at the top.
 Adequate resources to investigate anti-competitive practices.
◦ Good competition policy should be there to;
 Prevent monopoly
 Ensure economic efficiency
 Control dominant firms
 Discourage merger and acquisition
 Check barriers for new entrants to market
 prevent anti-competitive agreements
 Apply to all major segments of the economy
 Protect small firms
◦ Competition boosts corporate governance
12. Corporate Governance in Developing and Transition Economies (Outlines)
◦ Introduction
 Corporate governance: advanced vs. developing nations
 Globalization tends the standards of corporate governance from local

to global perspective
 So developing nation should have to work hard.
◦ Problems faced by developing and transition economies
 Still in process of basic market institutions to regulate

 Internal owner vs. external owner
 Inflow of new capital is not facilitated
 Lack of property rights, contract violations and self-dealing are the

core issues, not just the owners and controllers relationship
 Act are there but it is hard to implement.
 Judiciary, bureaucracy and regulatory bodies are not alert to stop

corporate misgovernance.
◦ Summary of problems facing these economies
 Low economic growth
 Public sectors dominance i.e. CG is for private sectors
 Lack of effectiveness of privatization
 Lack of awareness among shareholders
 Govt. influence
 Internal owners are more influential than external owner (no voting
powers)
 More concentration toward family-owned corporations.
 Lack of legal protection for investors
 No inflow of new capital
 Low property rights and contract laws.
 Lack of well regulatory banking sector
 Exit mechanism, bankruptcy and foreclosure (taking possession of

mortgage property) norms are absent.
 No sound securities market
 Lack of competition
 Corruption and mismanagement

 Non-uniform guidelines by the govt. for all companies
◦ Corporate Governance Models
 Insider system
◦ Insider own majority of the company shares
◦ Voting rights
◦ Power to monitor management
◦ Keep their investment for long period in a firm
◦ Support decisions for long period of time
◦ Dominant owners can use the firms’ assets by colluding with

the management, at the expense of minority shareholders.
◦ Irresponsible exercise of power resulting waste resources and

drain company productivity levels.
 Outsider system
◦ Large number of owners hold small number of company

shares
◦ Can’t monitor management
◦ Can’t involve in management decisions
◦ Common law countries (UK, USA) own this system
◦ Independent board members to monitor managerial

behaviour
◦ More accountable and less corrupt
◦ Having dispersed ownership structure with some weaknesses
◦ Looking for short term maximization
◦ Conflicts between directors and owners
13. Corporate Citizenship (Outlines)
◦ Introduction
◦ Stakeholders of the firm
 Primary
 secondary
◦ Legal Foundation
◦ Corporate Social Responsibilities
 Level 1. Economic
 Level 2. Legal
 Level 3. Ethical
 Level 4. Philanthropy
◦ Drivers of citizenship trends inlude;
◦ Globalization
◦ Education
◦ Benefits of CSR to firms
◦ Innovation
◦ Governance and Stakeholders Theory
◦ Criticism
◦ Considering stakeholders theory as Descriptive theory
 Cost
14.Manual of Corporate Governance-SEC Pakistan (Outlines)
◦ I. INTRODUCTION
◦ II. WHAT IS CORPORATE GOVERNANCE?
 (i) The Background
 (ii) Definition of Corporate Governance
 (iii) The Benefits of Corporate Governance
 (iv) The Pakistani Corporation
 (v) The Origins of Corporate Governance in Pakistan
◦ III. THE NEED FOR CORPORATE GOVERNANCE
◦ IV. THE STAKEHOLDERS
 (i) General
 (ii) Shareholders
 (iii) Directors
 (iv) Employees
 (v) Creditors
◦ V. PROMOTING REFORM AND SHAREHOLDER ACTIVISM
◦ VI. ROLE AND RESPONSIBILITIES OF DIRECTORS AND
◦ MANAGERS
 (i) Directors and Managers Distinguished
 (ii) Appointment and Proceedings of Directors
 (iii) Fiduciary Duties
 (iv) Powers and Responsibilities of Directors
 (v) Liability of Directors
 (vi) Executive and the Non-Executive Directors
 (vii) The CEO
 (viii) The Company Secretary
 (ix) The CFO
 (x) Internal Control System
 (xi) Reporting Requirements
◦ VII. SCRUTINIZING FINANCIAL STATEMENTS - WHAT EVERY DIRECTOR

SHOULD KNOW
 (i) General
 (ii) Liability of Directors
 (iii) Preparation of Financial Statements
 (iv) Tools for Directors' Review
 (v) How to Prevent Misleading and Fraudulent Financial
 Statements
 (vi) External Auditors
 (vii) Role of the Audit Committee
 (viii) Role of Internal Audit
◦ VIII. CONCLUSION
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By: 1. Kenneth A.

◦ Capitalism is an economic system based on the private

ownership of capital goods and the means of production,

with the creation of goods and services for profit.

 . It doesn’t die when its owner do because corporation is

 . Subsequently, shareholders must also pay personal

 . Stockholders own the firm and officers (or

 . Hundreds of thousands of investors can’t

 .The shareholder’s main focus is toward business

 Satisfactory profit for the stockholders and

 Managers may be tempted to use the firm’s assets

 This problem can be solved by

 Theoretically, managers work for owners but

 There is a race of win-lose between

 There are normally two types of proposals;

 . Shareholders have to trust management and

 . Consequently managers may not act in the

 . Only managers know.

 . Consequently managers may not act in the

◦ The corporate governance system is integrated and

◦ Every concern stakeholder is keen to get the perks

Credito Accounta Auditor

◦ The shareholders and executives interest can be

◦ these incentives can’t guarantee to reduce the level

 Manager’s action can affect the following;

 Good manager always think for the

1. Base Salary and Bonus

 Basic pay depends upon the characteristics of

 So, large firm CEO will get more than small

 Small firm can’t afford large firm CEO and

1 CHESAPEAKE ENERGY CORP Aubrey K. McClendon 2008 100,069,201

2 NABORS INDUSTRIES LTD Eugene M. Isenberg 2008 59,834,630

3 ORACLE CORP Lawrence J. Ellison 2009 56,810,851

4 MERCK & CO Fred Hassan 2009 49,653,063

5 GAMCO INVESTORS INC Mario J. Gabelli 2009 43,576,932

6 CBS CORP Leslie Moonves 2009 43,238,875

7 THERMO FISHER SCIENTIFIC INC Marc N. Casper 2009 34,283,774

 Average bonus payments for CEOs in large

◦ Stock option is a cost for company, if there is a

◦ This cost was amortized over the life of the options.

◦ But if there is no difference between the strike price

 Company’s stock given to executives only if certain

 It could be viewed as bonuses for past performances.

 More valuable for the CEOs because the firm stock

 Stock options lose some incentive for the CEO

 Price manipulation can be used by the CEOs

◦ In April 2002, Xerox admitted to the SEC that they

◦ Obviously, that fine was paid by the firm.

◦ So, Xerox management earned millions of dollars

◦ The stock price fell to less than $10 per share.

◦ So, who are the ultimate loser?

 Economy plays a vital role in controlling the

supply (i.e. more money in the economy and in

 Similarly, stock markets can fall by having decline

in the quantity of money and spending.

 The reduction in reporting earning may cause

 It could even have an impact on the economy.

 Executives receive millions of dollars as

◦ E.g. In July 2005, Bernie Ebbers, founder and former

 Managers are supposed to work for the best interest

 Managers try to take the advantage of their control

 Stocks and options benefits can’t guaranteed to

 Managers are supposed to work for the best