THE ROLE OF FINANCIAL ACCOUNTING INFORMATION

IN STRENGTHENING CORPORATE CONTROL MECHANISMS

TO ALLEVIATE CORPORATE CORRUPTION

Arvanitidou Virginia, University of Macedonia, Greece

Konstantinidou Eleni, University of Macedonia, Greece

Papadopoulos Dimitrios, University of Macedonia, Greece

Xanthi Chrysoula, University of Macedonia, Greece

ABSTRACT

Corporate governance, as an antidote to corruption, has been attracting a lot of attention and

debate lately. This study is an attempt to examine the relationship between financial

accounting information, corporate control mechanisms and corruption. We critically examine

the relevant literature that investigates the governance role of financial accounting

information as the direct and indirect use of externally reported financial accounting data in

control mechanisms. Specifically, we focus on the role of accounting data in prevalent control

mechanisms (primarily in executive compensation contracts) and the underlying causes that

led to the shift of contracts towards option awards. Corporate control mechanisms are among

the most effective tools to reduce the incidences of corruption, from its supply side, because

they promote values such as accountability, transparency, fairness and responsibility. These

mechanisms are fundamental for the enhancement of the operation of securities’ markets

which in the dubious environment of the 21st century seek relevant and reliable information

based on transparent financial statements.

1 COMMENTS AND THE PURPOSE OF THE PAPER

Corruption is one of the world’s greatest challenges due to its occurrence in every part

of the world and its detrimental effects on the overall development of countries. The solution

to this multidimensional phenomenon, which is caused by several factors, should include the

enforcement of powerful corporate control mechanisms, since corporate governance can

become a critical catalyst against corruption practices.

The purpose of this paper is to examine the relationship and the interactions between

three important elements: corruption, corporate governance mechanisms and financial

accounting information. We argue that the use of transparent financial accounting

information in corporate control mechanisms enhances the effectiveness of the

governance process which in turn prevents corruption. The remainder of the paper is

organized as follows.

In the first section, we explore the linkage between corporate corruption and corporate

control mechanisms. We present the ‘corporate’ side of corruption and argue that corporate

governance and corporate control mechanisms can act against corruption deterring incidents

of bribery and fraud.

In the second section, we present the role of financial accounting information in

corporate control mechanisms in order to eliminate corruption. Specifically, we review the

direct and indirect uses of accounting information in corporate governance mechanisms, and

extensive reference is made to top executive incentive contracts, which represent the most

known use of accounting information in corporate governance.

In the third section, we investigate the role of financial reporting in achieving

corporate transparency to alleviate corruption. We argue that transparency, integrity, and

quality of financial reporting, for which the entire corporate governance system (board of

directors, audit committee, top management team, internal auditors, external auditors, and

governing bodies) is considered to be responsible, determine the effectiveness of the use of

accounting information in corporate governance mechanisms.

The final section consists of concluding remarks and proposals for further research

regarding the contribution of financial accounting information to corporate governance

mechanisms and, consequently, to anti-corruption measures.

2 CORPORATE CORRUPTION, CORPORATE GOVERNANCE AND

CORPORATE CONTROL MECHANISMS

2.1 INTRODUCTION

Corruption is a serious disease and occurs in every economy, in every corner of the

world. None country is free of corruption. Now, more than ever before, it has become evident

that it is one of the world’s greatest challenges due to its detrimental consequences. Many

things have been said about its effects on the overall development of a country. There is no

doubt that it hampers economic growth by various means such as deterring investment and

raising transaction costs and uncertainty. Although it may be difficult to describe, corruption

is generally not difficult to recognize. Cases of corruption are unveiled increasingly

frequently even though most of them don’t take place in broad daylight.

According to World Bank report (2007), corruption is a 1 trillion-dollar industry

around the world, thus combating corruption becomes one of the most important issues in the

21st century. Since corruption is a multidimensional phenomenon, caused by several factors,

the solution cannot be simple and the fight must be pursued on many fronts. The major

emphasis should be put on prevention, and particularly, as we argue, on the enforcement of

corporate control mechanisms.

2.2 FIRMS: THE SUPPLY SIDE OF CORRUPTION

Many definitions have been given to corruption; most of them are deficient in one

aspect or another. The most popular and simplest definition of corruption, which is used by

the World Bank, is the abuse of public power for private benefit (Tanzi, 1998). One could

deduct from this definition that corruption cannot exist in the private sector but the

responsibility of corporations should not be underestimated. We prefer the definition given by

the Australian Standard on Fraud and Corruption Control (AS8001:2003): corruption is a

dishonest activity in which a director, executive, manager, employee or contractor of an entity

acts contrary to the interests of the entity and abuses his position of trust in order to achieve

some personal gain or advantage for himself or for another person or entity.

We must start with the simple recognition that there are two sides of corruption, those

who demand acts of corruption and those who are willing for a price to perform those acts

(Tanzi, 1998). This is the demand and supply side of corruption. Both sides conspire to

corrupt practices, each for its own motives. Firms pay bribes primarily for three reasons: to

counterbalance poor quality or high pricing, to create a market for redundant goods, or to stay

in competition (Moody- Stuart, 1997).

The empirical literature over the years has focused primarily on the demand side and

this led to lack of balance in anticorruption efforts. However, policy-makers have started

considering that maybe it would be a better strategy to reform the supply side, reducing bribe

offers.

2.3 CORPORATE GOVERNANCE: AN ANTIDOTE TO CORRUPTION

The Global Compact Leaders Summit, on 24th June 2004, included a 10th principle

against corruption: “Businesses should work against corruption, in all its forms, including

extortion and bribery”, sending a universal signal that the private sector must, as well, commit

to the anti-corruption effort. Corruption cannot be reduced substantially without modifying

the way firms operate.

First of all, the notion that corruption makes bad business is not yet integrated into the

culture of corporations. The dilemma is that corruption offers to companies short-term

advantages. In the longer-term, however, the winners are those who protect their reputation

and their shareholders. Thus, on the one hand, the investors need an assurance that their

investment will not be channeled into unproductive activities, and on the other hand

businessmen seek ways to attract investors, fulfil their expectations, with a view to make

profits, or for others, maximize the value of the firm. To achieve this, more and more

corporations have embarked on corporate governance reforms. Lack of, or weak governance

systems provide a good environment for corruption to thrive (Mensah, Aboagye, Addo, &

Buatsi, 2003).

Corporate governance is a term that can no longer be ignored by businesses of any

size, public or private. Actually, a stimulant that has prompt companies to focus on anti-

corruption measures was the rapid development of corporate governance. By its definition,

corporate governance “specifies the distribution of rights and responsibilities among different

participants in the corporation, such as the board, managers, shareholders and other

stakeholders, and spells out the rules and procedures for making decisions on corporate

affairs”(OECD, 1999). Just like the good governance of the state, corporate governance sets

out mechanisms to ensure the transparency and accountability of firms. As James

Wolfensohn, ex President of the World Bank, once said: “the governance of the corporation

is as important in the world economy as the government of countries”.

Corporate governance deals not only with the internal government of a company such

as the relation between the board of directors and management but also with its relation to its

suppliers, to its consumers, to its business partners, and to the government. Promoting basic

principles of good governance is crucial in supporting the development of a strong private

sector. Integrity and accountability are the values that guide the relationship between owners,

managers, employees, and other stakeholders. A good corporate governance system entails

also efficient shareholder controls and management responsibility (Shkolnikov, 2001). It

creates a strong institutional environment where all business transactions are transparent,

property rights are protected, and corruption is under control.

At this point, it is interesting to cite what N. Vittal, a former central Vigilance

Commissioner stated at his address in ASCI Conference on 'Governance in Banking and

Finance' at Mumbai on 14.06.99 about the interaction between corporate governance and

corruption: “Where does corruption come in corporate governance? Corruption as we know is

basically an aberration. Corruption is basically dishonesty. When we talk about corruption in

corporate governance, we are referring to the corrupt practices, which go to harm the interests

of shareholders and stakeholders. The management of enterprises, which comes in the way of

corporate governance, becomes relevant in this context. Perhaps we can simplify the whole

concept of corruption in corporate governance by saying that if we are able to make an

enterprise work in a transparent and honest manner, to that extent, automatically there will be

less corruption. If there is less corruption, automatically there will be good corporate

governance.”

Corporate governance can become a critical catalyst to break the vicious cycle of

bribery and corruption. Yet, there is lack of empirical studies on the linkage between

corporate governance and corruption. Wu (2005) has shown that corporate governance is an

important factor that determines the level of corruption and that the implementation of the

principles of good corporate governance can improve firms’ operating performance and can

impose constraints, exposing the corrupt officials to higher risks of being caught.

The relationship between corporate governance and corruption is bidirectional. Poor

corporate governance breeds corruption but also corruption worsens corporate governance,

because firm managers and corrupt government officials connive at the deterrence of auditing

and accounting standards so as to cover up bribery and managerial corruption. Du (2008)

showed that a lower degree of corruption is associated with stronger corporate control

mechanisms such as the legal protection of investor rights and corporate information

disclosure standards. Corporate governance sets up mechanisms which combat corruption

above legal basis; in terms of business ethics. The illegal flow of capital from the private

sector to the pockets of government is definitely restrained.

Corporate governance is an effective tool to restrict the participation of the private

sector in corruption. Corporate governance shapes transparent and responsible companies,

where the costs of corrupt behaviour are higher (Shkolnikov, 2005). The system that

corporate governance establishes makes it harder for bribery to conceal because decision-

making is not made by one person and behind closed doors, managers act in the interest of the

company, board members exercise good judgment and investors receive quality information

in time (Sullivan D.J., Shkolnikov A., 2004). Undoubtedly, corporate governance is an

antidote to corruption in companies.

2.4 CORPORATE CONTROL MECHANISMS AS A TOOL FOR COMBATING

CORPORATE CORRUPTION

The separation of ownership and control in organizations created problems regarding

the stewardship of enterprises. The principal-agent problem or agency problem in the modern

corporation and mainly the fact that managers have often different motives from the owners

explains up to a point why firms get involved in corrupt practices undertaking great risks1.

The difficulties to monitor managers and the information asymmetry between principal and

agents add up to the problem. In order to control management, corporate control mechanisms,

either internal (organisationally based) or external (market-based), are required (Walsh &

Seward, 1990). The board of directors, corporate ownership structure, incentive contracts,

internal labour market, the turnover of management and the performance-based compensation

(in the form of cash or non-cash payments such as shares or share options) are some examples

of internal control mechanisms that are used in order to safeguard the interests of shareholders

and stakeholders. On the other side, the market, competition in the product market, outside

1 For example, undertaking a public project by bribing public officials may increase the compensations for the manager, but the firms may be held criminally liable for the bribery involvement for the years to come and the shareholders are forced to bear such a risk (Wu, 2005).

shareholder and debtholder monitoring, media pressure, debt covenants, government

regulations (e.g. legal protection of investors’ rights) managerial labor market and takeovers,

are some of the external control mechanisms that assist internal ones to an effective corporate

control.

A strong board of directors that puts in priority the interests of shareholders can

prevent the firm from offering bribes to public officials. Directors and managers are those

who determine the corporate culture. Yet, they often sign shady contracts, ignoring the

negative implications. Management decisions should be based on an ethical framework. This

framework should ensure that, first of all, the board of directors monitors effectively

corporate managers and executives2. Managers, directors and members of the board of

directors that mind good governance will strive to provide reliable and precise information to

the stakeholders and to the public. Directors will act with integrity and will be transparent in

their disclosures about their personal shareholdings and business interests.

The board is effective only if it is sufficiently independent from management and this

usually requires an adequate number of independent directors, transparent board structure and

rigid criterions for the selections of board of directors. An independent and competent

corporate board that truly represents the interest of shareholders can help to prevent the

opportunistic behaviours of the managers and is not willing to give in to corrupt officials (Wu,

2005).

Adding to the problems of board independence is the performance-related awards that

board members and managers are given in order to maximize shareholder’s wealth. Most cash

bonus plans as well as most stock option plans or stock award plans are based on accounting

results. The question is what kind of incentives managerial contracts create. When there are

setbacks in the firm’s performance, management tries to find ways to conceal them or

postpone breaking the news to the public, or even to the board, waiting for things to improve.

The dilemmas are even greater when it comes to option awards because stock options lose

their value in these situations. In these cases, transparency and full disclosure in financial

reporting are often sacrificed.

In order to conceal or delay the bad news, managers try to manipulate financial

reports. And when they are unable to mask their managerial failures themselves, they use the

creative talents of a financial consultant. The latter can match financial statements up to what

manager wish. Accountants should contribute as well to efforts to reduce corruption. Because

2 From the Conference of CIPE “Building Competitive Advantage in Nations: Increasing Transparency, Combating Corruption and Improving Corporate Governance” , Budapest, March 26-28/2002

of their strategic positions within an enterprise they have access to financial information

(Harding, 1999). As professionals, they are obliged to protect the public interest following

professional and personal ethics.

Auditors, besides accountants, are also an important mechanism to prevent fraudulent

reporting. Especially internal auditors have a broad understanding of business operations

because they are present year-round (Balkaran, 2002). They are the eyes and ears of

management and from that position they can play a significant role in the organization's

anticorruption efforts. They establish control mechanisms that prevent and detect the flaws in

the organization. Equally, external auditors can discourage managers and accountants from

falsifying financial statements and at the same time, checking on the internal control system,

can contribute to the enhancement of the firm’s regulations.

Top management has the ultimate responsibility for preventing and fighting corruption

because it establishes the financial reporting environment. Businessmen might condemn

corruption on moral grounds but when it comes to business, values have to be put aside. In the

name of profit, they justify their corrupt behavior (Adwan, 2003). Large bribery cases often

involve top management. Certainly, it is practically impossible for management to uncover all

errors and irregularities. On the other hand, internal control alone is not sufficient, neither is

the external auditor. Furthermore, what the board can do is limited because it is not engaged

on a full-time basis and relies on the internal and external auditor for the necessary

information. Consequently, corporate boards, managers, auditors and accountants should all

work together to create a financial reporting process of unparalleled integrity. And by

introducing proper systems of corporate governance they can significantly reduce the

opportunities for malpractice.

In today's globalized economy companies with weak corporate governance systems

are likely to suffer serious consequences; examples of those are financial scandals. The core

elements of good governance may have been said in one way or another by many, but

transferring these concepts from words into reality has proven to be a very difficult task to

accomplish. The perceived low level of confidence both in financial reporting and in the

ability of auditors to provide safeguards to shareholders and the lack of effective board

accountability prove the above (Darrough, 2004). It still remains largely on a voluntary basis

whether companies would institute good corporate governance mechanisms, and it is difficult

to change corporate habits.

We should mention that the role of financial accounting information in corporate

control mechanisms is not limited in the compensation contracts. DeAngelo (1988), for

example, documents the importance of the use of accounting information in proxy fights.

The existence of additional corporate control mechanisms in the availability of

governance is of substantial importance. It is vital, during the examination of corporate

control mechanisms, to have in mind that corporations usually use a range of governance

mechanisms. Thus, the interactions between them should be seriously considered (Bushman

& Smith, 2003). An elucidation of the importance of that consideration is thoroughly given by

Bertrand and Mullainathan (1998).

We should also consider the potential existence of “complex interactions between

incentive contracts written on objective performance measures and features of organizational

design such as promotion ladders, allocation of decision rights, task allocation, divisional

interdependencies, and subjective performance evaluation” (Bushman and Smith-2003). A

relative study is that of Baker, Gibbs & Holmstrom (1994a, b) who shed light to such

complex relations.

3 THE ROLE OF FINANCIAL ACCOUNTING INFORMATION IN

CORPORATE CONTROL MECHANISMS

3.1 GENERAL COMMENTS

Financial accounting information can be defined as ‘the product of corporate

accounting and external reporting systems that measure and publicly disclose audited,

quantitative data concerning the financial position and performance of publicly held firms’

(Bushman & Smith, 2001). Thus, financial accounting is the fundamental source of

independently certified information about the performance of executives. Indeed, financial

accounting systems provide valuable information to corporate control mechanisms that help

to alleviate the agency problem which results from the separation of managers and financiers.

The use of accounting information in corporate governance mechanisms can be

explicit (direct) or implicit (indirect). Financial accounting information is explicitly used in

managerial incentive contracts or debt contracts (direct use), but also contributes to the

information contained in stock prices (indirect use). Furthermore, financial accounting

information is both an output of the governance process, since it is produced by managers,

and also an input since it is used in corporate control mechanisms (Sloan, 2001). This is

shown explicitly on Figure 1 below. As a result, additional governance mechanisms are

required in order to ensure the quality, integrity, transparency, and reliability of the

accounting information supplied by managers, such as adequate internal control systems,

independent board members, vigilant audit committees and independent external auditors

(Rezaee, 2005).

A brief discussion of the direct and indirect uses of financial accounting in corporate

governance is presented in the following subsections.

output input indirect use direct use (managerial incentive contracts)

Figure 1: Financial Accounting information as an input and output of the governance process

3.2 GOVERNANCE MECHANISMS AND FINANCIAL ACCOUNTING

INFORMATION

The accounting information system is still regarded as the main source of effective

and low-cost governance information. Indeed, the cost for shareholders and directors to gather

and process data from the accounting information system is in many cases low, relative to

alternative performance measures. Nevertheless, when it’s difficult for accounting

information system to provide substantial information about governance, corporations appeal

to more costly governance mechanisms in order to compensate for the inadequacies

(Bushman & Smith, 2001; Bushman & Smith, 2003).

Managers Governance Process

Stock prices

Financial Accounting Information

Corporate control mechanisms

Ittner, Larcker, and Rajan (1997), examine the factors that affect the choice between

non-financial performance measures (e.g. productivity or market share) and financial

performance measures (e.g. earnings or return on investment), focusing in annual bonuses.

They indicate that the use of non-financial performance measures is greater in firms that

follow an “innovation-oriented prospector strategy” than in firms that follow a “cost leader

strategy”.

Bushman, Chen, Engel, and Smith (2000) taking into account a range of governance

systems such as board composition, ownership concentration, stockholdings of inside and

outside directors and the structure of executive compensation, argue that if current accounting

numbers do a relatively poor job of capturing the effects of the firm's current activities and

outcomes on shareholder value, then the accounting numbers are less effective in the

governance regulation.

3.3 DIRECT USES OF ACCOUNTING INFORMATION IN CORPORATE

CONTROL MECHANISMS

The largest portion of governance research in accounting concerns the explicit use of

financial accounting information in managerial incentive contracts. The use of accounting-

based performance measures in managerial compensation contracts represents probably the

most obvious governance role of accounting information. However, over the last three

decades accounting profitability measures have become relatively less important in

determining cash compensation of top executives (Bushman & Smith, 2001). In addition, cash

compensation itself appears to have become a less important element of the overall pay-

performance system of managers. For most Chief Executive Officers, stock return appears to

be the dominant component of their incentives (Core et al., 2000).

In contrast to the compensation literature, the direct role of accounting information in

debt contracts has not received much attention from accounting researchers, although it has

developed significantly, particularly in private placements of debt and private lending

agreements (Sloan, 2001). Performance pricing, which involves linking the interest rate that is

charged on debt to accounting-based measures of financial health, is a frequent practice in

financial contracting. However, there has been limited research on this explicit governance

role of financial accounting information.

3.4 INDIRECT USES OF ACCOUNTING INFORMATION IN CORPORATE

CONTROL MECHANISMS

The implicit use of financial accounting information in corporate governance

mechanisms represents perhaps the most valuable role of accounting information. Any capital

markets research focusing on the role of accounting information in the determination of

security prices has potential governance implications, since investors are interested in the

efficiency and liquidity of the capital markets in which their securities are traded (Sloan,

2001).

Overall, financial accounting information is implicitly used in a variety of corporate

governance mechanisms. Accounting information plays a significant role in the enforcement

of investors’ legal rights against management as well as in the enforcement of creditors’ rights

in the event of default and/or bankruptcy (Sloan, 2001). Furthermore, academic research

shows that measures of accounting performance are used as input into the board’s firing

decisions and are also related to takeovers, proxy contests and institutional investor activism.

3.5 THE USE OF FINANCIAL ACCOUNTING NUMBERS IN SPECIFIC

CONTROL MECHANISMS: MANAGERIAL INCENTIVE CONTRACTS

3.5.1 General Comments

As previously mentioned, the use of accounting-based performance measures in

managerial compensation contracts represents probably the most obvious governance role of

accounting information. In this section we will verify the extensive use of financial

accounting numbers in defining managerial contracts as it is documented in the compensation

literature. Although this literature is not yet so developed and our understanding of the

different practices in executive compensation is far from complete, the existing studies boost

our assertion as regards the widespread use of accounting numbers in these contracts.

Rather than offering an exhaustive review of research achievements, we present an

intentionally selective examination of the relevant empirical and theoretical research on

managerial incentive contracts, based on the pioneering work of Bushman who has reviewed

and updated the relevant literature and data.

We can notice that researchers in most cases in the empirical models follow either an

explicit or an implicit contract approach. When we are referring to the explicit contract

approach we mean that the researcher is aware of the actual performance measures used.

Whereas, in the implicit contract approach, the researcher is unaware of the details of the

actual contracts and has no information about the actual performance measures used in the

contracts (Bushman & Smith, 2001).

3.5.2 The Explicit Contract Approach

Much of the empirical research regarding the use of accounting information in

managerial contracts focuses on publicly traded firms in the United States. Bushman’s paper

provides an accurate review of the existing literature. It is worthy also to mention the study of

Ittner, Larcker, and Rajan (1997) which collects data about the performance measures used in

defining the annual bonus plans of up to 300 firms of the U.S. This study documents that the

vast majority of the firms use at least one financial measure in their annual plans. It also

mentions that earnings per share, net income as well as operating income proved to be the

most common financial measures used.

In general, numerous papers document the use of accounting information in incentive

contracts. Another interesting and notable survey is that of Hogan and Lewis (1999) which

substantiates adoption of residual income performance measures by a considerably number of

publicly traded firms. Keating (1997) gives additional evidence on the use of accounting

information in determining compensation contracts by establishing the significant use of

accounting measures rather than the use of stock prices. Additionally, Ittner, Larcker, and

Rajan (1997) find no evidence to support the explicit use of stock price information in annual

bonus plans.

3.5.3 The Implicit Contract Approach

In the studies where the implicit approach is used, unlike the explicit approach case,

the actual performance measures used in the compensation layout are unidentified,

compelling the researcher to surmise the appropriate measures. In these studies the researcher

examines the sensitivity of compensation to performance measures mainly by regressing the

measures of managerial compensation on the measures of performance.

In spite of its prevalence in practice, there are a lot of drawbacks in using this

approach. The methodology in which it is based creates potential for serious errors in

variables problems and for omitted variables. According to Bushman, however, “most

compensation studies in accounting include both accounting-based and stock price-based

performance measures in incentive coefficient estimations, and thus partially deal with the

omitted variables problem”.

There is no wonder that this method still has a lot of drawbacks, however the fact that

the results from the regressions show a positive relation between performance measures and

managerial compensations adds a leg to stand on the use of these measures in the

determination of incentive compensation of top executives.

3.5.4 The Evolution in Managerial Incentive Contracts

It is a fact that accounting numbers were not always of prevalent use for the

determination of managers’ compensation. Bushman, Engel, Milliron & Smith (1998),

document the shifting from accounting earnings and the use of other information in

determining managers’ compensations, over the 1971-95 period. All the more so, recent

studies indicate that the sensitivity of compensation to shareholder wealth creation is ruled by

changes in the value of stock and stock option holdings, and that trend seems blooming

(Bushman & Smith, 2003).

The explanation of this phenomenon requires that it would be appropriate to delve into

the observed environmental changes. For instance, in the ‘80s a lot of pressure groups

composed of investors and stakeholders compelled corporations to select such board

structures that assist to a better evaluation of managers’ performance and conduce to their

more effective inspection. Changes may have also occurred in the nature of the corporation

itself. However, this recent shifting from direct accounting-based incentive plans towards

equity-based plans does not mean automatically that accounting information has become less

important for the governance of firms, since there are many issues to be considered (Bushman

& Smith, 2003). First of all, the existence of an efficient financial accounting system is vital

for the existence of a healthy stock market. Moreover, stock price incorporates potential

limitations as a measure of current managerial performance since it reflects future

anticipations. In general, stock price is not an adequate information source, while a complex

set of performance measures, including detailed accounting and other performance data, is

necessary for accurate performance assessments.

4 THE ROLE OF FINANCIAL REPORTING IN ACHIEVING

CORPORATE TRANSPARENCY TO ALLEVIATE CORRUPTION

4.1 GENERAL COMMENTS

Fundamentally, corporate disclosure and transparency are vital for a strong corporate

governance framework. Transparency, which is a desirable characteristic of financial

reporting, can be defined as “the extent to which financial reports reveal an entity’s

underlying economics in a way that is readily understandable by those using the financial

reports” (Barth & Schipper, 2008). The need for accurate, reliable, timely and accessible

financial and non-financial business information is imperative in order to maintain corporate

accountability.

In this section, we present the interaction of financial reporting with corporate

governance and the role of financial reporting in achieving corporate transparency to alleviate

corruption and incidents of fraud.

4.2 THE INTERACTION OF FINANCIAL REPORTING WITH CORPORATE

GOVERNANCE

Corporate governance during the last century has gradually come into the spotlight

and became a matter of great interest and debate (Parker, 2005a). The effusion of corporate

frauds and failures enhanced that interest while contemporaneously brought company

directors, accounting regulations, auditors, and in general the accounting profession into sharp

focuses (Parker, 2007).

Santosh Shetty (2005) has stated about corporate governance: “Corporate governance

is the framework within which companies are directed and controlled. It basically shows the

tone at the top — how management wants to control the affairs of the company. Corporate

governance is therefore concerned with issues such as the effectiveness and efficiency of

operations, the reliability of the financial reporting (disclosure norms and practices),

compliance with laws and regulations and safeguarding of assets”.

This brings up the need to examine the role of financial reporting in the more general

concern of corporate governance and also the extent to which financial reporting serves the

needs of corporate governance for the benefit of a wide range of stakeholders and for the

benefit of society in general.

The existing literature contains different assumptions for an interaction between

corporate governance systems and financial reporting systems. More specifically there are

arguments that an “effective system of corporate governance requires an effective financial

reporting system, and that an effective financial reporting system requires a well-ordered

system of financial accounting” (Baker & Wallagey, 2000).

Financial reporting has gradually become a highly complex activity that is of

considerable interest to many persons throughout modern industrial society, while in past it

was a relatively simple practice, primarily of interest to small groups of industrialists and

financiers. The development of financial reporting within individual countries differs due to

the influences of the history of each country (Baker & Wallagey, 2000). For instance, the

British view has traditionally been that the main purpose of financial reporting is to provide

information for investors, while the continental European view has been that financial reports

can be used for several purposes or more specifically for corporate governance purposes

(Ordelheide, 1993; Kuhner, 1997).

Financial reports play an important role in the economic life not only by affecting the

decisions of investors but also by contributing to the allocation of capital. The improvements

in technology may mark the route of financial reporting in the future. Thus, financial

reporting systems may probably evolve into electronic information systems providing

financial and other forms of information concerning corporations widely available via the

internet. However, there are arguments that even if it is technologically feasible for financial

reports to be changed from their present form, there will still be a need for financial reporting

in its traditional form as an essential component of effective corporate governance (Baker &

Wallagey, 2000).

Corporate governance is currently leading in a range of fields of research such as

information systems or finance, with many professors indicating the existence of significant

and wide-ranging relationship between financial external reporting and corporate governance.

Thus, the literature referring to the connection between financial reporting and corporate

governance is still showing a deficit. There a lot of unanswered questions that researchers are

challenged to deal with. For example, it is important to specify what types of information can

and should be produced for corporate governance purposes or what kind of information

should be provided in order to satisfy the requirements of society for responsible corporate

governance (Parker, 2007).

4.3 TRANSPARENT CORPORATE DISCLOSURE AS A PILLAR OF GOOD

CORPORATE GOVERNANCE TO COMBAT CORRUPTION

The 21st Century must be the century of corporate integrity. A wave of corporate

scandals in recent years has eroded public investor confidence and the need for improved

financial reporting and for higher levels of transparency in the development of the world’s

financial markets has become urgent. More and more countries have focused on corporate

governance reforms to strengthen the protection of the interests of investors with transparency

being a necessary ingredient of good corporate governance.

Corporate transparency is defined as “the accessibility of information to stakeholders

of institutions, regarding matters that affect their interests” 3. Nevertheless, it is far more than

the obligation to disclose basic financial information; transparency is a corporate value,

reflecting the corporate culture. It has been a long time since corporations were first required

to provide full and fair disclosure, informing investors about the condition of the corporation

so as to make their investment decisions. Unfortunately, nowadays it is more prevalent for

firms to distort their actual financial position through obscure and complicated language,

burying the important data in footnotes4. The result is falsified financial reports, giving

investors misleading impressions about the financial status of the corporation.

The prime responsibility rests with management to establish a corporate environment

that promotes the use of high-quality accounting standards in financial statements. The board

of directors, executives, the audit committee, and the outside auditor are also to blame for

fraudulent financial reporting, besides managers. The Sarbanes-Oxley act has first changed

substantially the roles and responsibilities of corporate managers, directors, and both external

and internal auditors. We all understood the important role of auditors after Enron collapse

and WorldCom Inc.’s bankruptcy. Following these, the public has come to believe that

corporate executives are more interested in “lining their own golden parachutes” than in

looking out for the interests of their stakeholders (Schumer, 2003).

Transparency can help to reduce the level of corruption by increasing the probability

of uncovering bribery acts. Supply side anti-corruption strategies aim at the lack of effective

board accountability and at the low level of confidence both in financial reporting and

auditors. As globalization of markets continues, companies address to an increasing number

3 Tapscott and Ticoll, (2003) “The naked corporation: how the age of transparency will revolutionize business”, p.22 4 Gitlow, “Corruption in Corporate America: Who is responsible? Who will protect the investors?”, pp. 60-61

of investors and the importance of proper financial accounting information grows with no

geographical constraints.

Accurate recording, classification and reporting of transactions in financial statements,

full compliance with disclosure standards and annual external audit lead to quality

information and a strong external reporting system. Corporate managers who are engaged in

bribery practices often face a more difficult task of hiding the bribe payments from the

shareholders when the accounting practices are of high standard. When the rules are applied,

the internal control and monitoring system within the firms functions properly. As a result, the

information asymmetry between the principals and the agents is reduced. This implies more

efficient supervision of agents.

Apart from transparency, values of corporate governance, such as accountability and

fairness, prevent both the bribe takers and bribe payers from getting involved in corrupt

practices (Wu, 2005). When ethics and regulations actually function, there is lower demand of

bribes because public officials have the fear of being caught. Illegal payments and services

cannot be concealed with sound accounting standards and financial reporting, even for

companies that have access to different markets (Sullivan D.J., Shkolnikov A., 2004).

Transparent corporate disclosure is one of the most important elements of good

corporate governance. Due to the globalisation of the market economy and the conflicting

stakeholder interests, companies are required to provide relevant and reliable information on

their activities, strategies and plans. However, the level of transparency through disclosure

that is acceptable to both the corporation and the increasing number of stakeholders remains a

difficult balance, as markets seek a compromise between the high cost of collecting,

analyzing and using information and the need to inform the various stakeholders and serve the

public good (Gehlmann, 2003). In general, better corporate disclosure enhances the quality

and level of monitoring of the firm by shareholders, and strengthens corporate governance.

However, providing disclosures can cause negative competitor reaction, especially in

industries where information is highly sensitive, and can also lead to greater shareholder

litigation (Narayanaswamy, 2005).

According to Bushman et al. (2004), transparency of corporate reporting depends

principally on financial accounting disclosures, governance disclosures, timeliness and

credibility of disclosures, and accounting policies. All the above elements determine the

transparency of corporate financial reporting and, consequently, the effectiveness of the use of

accounting information in corporate governance mechanisms.

4.4 TRANSPARENT CORPORATE FINANCIAL REPORTING TO COMBAT

FINANCIAL STATEMENT FRAUD

Financial statement fraud, which has cost market participants including investors,

creditors, pensioners, and employees more than $500 billion during the past several years, has

recently received considerable attention from regulators, accountants, business bodies,

academicians and the general community (Rezaee, 2005). Accounting scandals of high profile

companies (e.g. Enron, WorldCom, Global Crossing) have questioned the effectiveness of

corporate governance mechanisms, the quality of financial reports, and the credibility of audit

functions.

According to Rezaee (2005), financial statement fraud is “a deliberate attempt by

corporations to deceive or mislead users of published financial statements, especially

investors and creditors, by preparing and disseminating materially misstated financial

statements”. Misstated financial statements may involve overstatement of revenues or assets,

understatement of expenses, omission of liabilities, mischaracterization of, or failure to

disclose, transactions or other information material to a fair presentation of the reported

results of operations, and/ or materially misleading disclosures (Dooley, 2002).

Among the most common motivations for companies to commit financial statement

fraud are the constant pressure to meet earnings projections, the competition for capital and

the perverse compensation arrangements (Fahnestock & Yost, 2004). Imhoff (2003) argues

that within the U.S. financial reporting environment, managers have increasingly been

offered, mainly through cash bonus and stock option plans based on accounting results,

incentives to manage earnings and to delay or conceal bad news. Therefore, while the

financial reporting process provides investors and creditors with information about the entity's

performance, it also impacts the current and future wealth position of its managers. For this

reason, the use of accounting performance measures in management compensation contracts

has been the most thoroughly researched corporate governance issue (Parker, 2007).

However, the external financial reporting - corporate governance relationship is not limited to

financial compensation and results alone, since governance accountabilities are also affected

by corporate social and environmental impacts (Parker, 2007).

The reporting environment of a publicly held firm includes a monitoring network

comprised of those who follow the firm in the role of owner/investor, an intermediary such as

an analyst or an investment banker, and those who have actual oversight responsibility such

as the external auditor (Latham & Jacobs, 2000). A presentation of the financial reporting

system is given in Figure 2 below. Traditionally, the role of external auditors has been

perceived as the most important factor in detecting and preventing financial statement fraud.

In recent years, however, the entire corporate governance system (board of directors, audit

committee, top management team, internal auditors, external auditors, and governing bodies)

is responsible for ensuring the integrity, transparency, and quality of financial statements.

The Company

Figure 2: The financial reporting system

5 CONCLUDING REMARKS AND PROPOSALS FOR FURTHER

RESEARCH

Financial accounting systems provide valuable information to corporate control

mechanisms that help to alleviate the agency problem which results from the separation of

management and investors. The use of accounting-based performance measures in managerial

compensation contracts represents probably the most obvious governance role of accounting

information. Furthermore, financial accounting information is both an output of the

governance process, since it is produced by managers, and also an input since it is used in

corporate control mechanisms.

One of the most important elements of good corporate governance is transparent

corporate disclosure. Companies are required to provide relevant and reliable information on

� Board of

directors

� Managers

� Internal control

system

� Accountants

Corporate

financial

reporting

Audit committee

External Auditor

Shareholders Creditors Potential Investors

Institutional & Legal Framework

(SEC, GAAP)

their activities, strategies and plans. In general, better corporate disclosure enhances the

quality and level of monitoring of the firm by shareholders and strengthens corporate

governance.

Corporate governance sets out mechanisms to ensure the transparency and

accountability of firms. More and more countries have focused on corporate governance

reforms to strengthen the protection of the interests of investors with transparency being a

necessary ingredient of good corporate governance, because it can increase the probability of

uncovering bribery acts. The system that corporate governance establishes makes it harder for

bribery to conceal because decision-making is not made by one person and behind closed

doors. Since corruption is a multidimensional phenomenon, the solution cannot be simple and

the fight must be pursued on many fronts with the enforcement of corporate control

mechanisms being the key.

In summary, we propose that future research should concentrate in investigating more

thoroughly the contribution of financial accounting information to corporate governance

mechanisms and consequently to anti-corruption measures. First of all, there has been limited

attention to the direct governance role of financial information in debt contracts. Moreover,

researchers should explore the use of financial information in other control mechanisms,

beyond managerial incentive contracts, for example in the board of directors. A cross-country

analysis would be rather enlightening. We also think that it would be interesting to exploit the

interactions among different corporate control mechanisms and how they are affected by the

limitations posed by accounting information. Last but not least, it is important to start moving

beyond thinking accounting numbers only as the result of the firm’s performance and focus

on its potential use in governance mechanisms.

The authors are the copyright holders of this paper. No quotation or citation is allowed, unless

previous written authorization is obtained from the authors.

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