FINM3008 w2

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What is corporate governance? Governance is a decision making process and is a mean to achieve performancePredictable rules, transparency, accountability and participationAllows holder to make informed decisions responsibility for corporate's actions

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ANAO (public)Governance should be extended to society not just members/shareholders. The definition of governance looks at accountability to all stakeholders including public at large

Accountability->emphasis-> through accountability company can target performance'The Collapse of HIH'-> biggest corporate governance caseThree former directors breached directors dutiesMany groups were affected-> policyholders, shareholders, employees, creditors, non-profit organisationsWhat went wrong? Key-> under reserving (insurance companies are required to make provisions for outstanding claim, in this case the provision was not sufficient to meet claims)Acquisition of FAI (another insurance company, this was problematic because acquisition was based on incomplete info)Ineffective management of UK and US operations Huge underwriting loss- they made write off against goodwill, not profitInappropriate accounting and financial reporting (operating profit was overstated due to reporting of recovery being reported as revenue even though contracts weren't entered into until the following period; deferred costs can't be converted into cash-but they did so)Ineffective governance

Corporate Governance Problem We turn to BOD, audit committee, management and external auditors.The provisions of claims is normally estimated based on actuary reports and these weren't made available to the audit committee in the HIH case. Owners provide resources for managers to manage. Shareholders appoint BOD to monitor managers.Agency Relationship and ContractingPositive Accounting Theory-> individuals act in their own self interest, suggesting managers will want to increase their own wealth instead of ownersAgency RelationshipOwners delegate decision making authority to manager. The manager holds info the owner may not know (information asymmetry) Delegation of authority may lead to costs (bond costs, monitoring costs)Contracting Contract purpose to align interest of agents and principalsOwner/manager contracting We align interest by using remuneration provided to manager-> Fixed basis, bonus schemes (accounting-based (profit figures) and market based (relating to shareholders return))Risk remuneration (STI (short term incentive)-looks at performance measures granted in terms of cash and deferred shares for one or two years) (LT (long term incentive)I-equity instruments over four years)Accounting-based bonus scheme: Changing accounting method will affect level of bonus paid to manager and managers may have incentive to do s.Market-based bonus scheme: Can reward managers in terms of market value of firm's securities. The managers may have incentive to maximise cash flow and valuee of the firm. But market price reflect market wide factors which may not be controlled by managers.

Debt Contracting-> relationship between managers and debt holders. Possible conflicts between these two are issuing more dividend (less cash for debt holders), taking on additional level of debt, invest in high risk projects (assuming managers interest aligned with shareholders interest)

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The purpose of the contract is to minimise conflict, this is through using debt covenants (generally in terms of accounting ratios) interest coverage (EBIT/interest expense) e.g. if 3 then company should be in good position to repay interestBanker A's concern is if excessive dividends are paid, it reduces cash flow whig could go to them. Banker B is correct because if you pay dividends, cash is lowered which will impact debt/asset ratioManager may have incentive to manipulate accounting numbers when violating debt constraints so other constraints are requested such as audited financial statements and restriction on accounting methods used

'Take a bath'-> in this period they were never going to achieve target so they do something so they can achieve target next time so they shift accounting figures

Corporate Governance Problems Principal agent model promotes free market approachDemand for accountabilitymanagement and governing bodies are accountable to owners and publicIs there an effective system of accountability? Marketplace, board monitoring (internal), regulation (necessary to achieve better governance)Stakeholders relationship e.g. shareholders, lenders, customers, suppliers and employees-> Trust relationship between the firm and stakeholders provides opportunity for long term benefits and success

Corporate Governance Mechanisms- Regulatory mechanisms- Different aspects; shareholders, creditors protection (their rights), accounting and reporting regulation (AASB, ASIC, regulation on corporate governance practices (in response to recent corporate failure e.g. HIH ASX issued Principle of Good Corporate Governance and Best Practice Recommendations -> framework to enhance corporate structure minimise problems improve performance equip Australian firms to compete globally

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