ACCA P1 Governance, Risk and Ethics - 2011 - Study text - Emile Woolf Publishing
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Paper P1: Governance, risk and ethics
44 © Emile Woolf Publishing Limited
A board will be ineffective at monitoring the decisions of management if it is
dominated by the chief executive officer (CEO). This is because the CEO is the
head of the executive management team. The board would be especially
ineffective in a monitoring role if the CEO is also the chairman of the board.
Fama and Jensen (1983) argued that an effective board must consist largely of
independent non-executive directors. Independent non-executive directors
have no executive role in the company and are not full-time employees. They are
able to act in the best interests of the shareholders.
Independent non-executive directors should also take the decisions where there
is (or could be) a conflict of interest between executive directors and the best
interests of the company. For example, non-executive directors should be
responsible for the remuneration packages for executive directors and other
senior managers.
Jensen also argued (1993) that the board of directors becomes less effective as it
grows in size. This is because a large board is often slow to react to events and will
often be incapable of taking action quickly when it is needed. The directors on a
large board are also less likely to be critical of each other than directors on small
boards.
These ideas for reducing the agency problem are contained in codes of corporate
governance, and will be considered in more detail in later chapters.
1.6 Accountability of agents
Agents should be accountable to their principal for their decisions and actions.
Accountability means:
Having to report back to the principal and give an account of what has been
achieved.
Having to answer questions from the principal about performance and
achievements.
The principal having power to reward or punish an agent for good or bad
performance.
Greater accountability should reduce the agency problem, because it provides
management with a greater incentive (obtaining rewards or avoiding punishments)
to achieve performance levels that are in the best interests of the shareholders.
However, the costs of accountability (which are monitoring costs) should not be
excessive and should not exceed the value of the benefits that the monitoring
provides.
Accountability and the source of authority in an entity
Accountability also determines where the centre of authority lies within an entity.
Day and Klein (1987) made the following comment about accountability in public
services, but the same principle applies to companies: ‘The ability to call people to
account defines the [centre] of authority in any given society…. But the notion of the
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right to call people to account needs to be complemented by the notion of power in
the ability to call people to account.’
The accountability of management depends on both the right of the shareholders to
call the directors to account, but also on their ability to do so.
1.7 Ethics and agency theory
Agency theory may be summarised as follows.
In many companies there is a separation of ownership from control. Professional
managers are appointed to act as agents for the owners of the company.
Individuals are driven by self-interest.
Conflicts of self-interest arise between shareholders and managers.
Managers, because they are driven by self-interest, cannot be relied on to act in
the best interests of the shareholders. This creates problems in the agency
relationship between shareholders and management.
These agency problems create costs for the shareholders. The aim should be to
minimise these costs, by improving the monitoring of management and/or
providing management with incentives that bring their interests closer to those
of the shareholders.
Concepts of agency theory are now applied in various codes of corporate
governance, in many different countries.
‘In brief, agency theory suggests that the prime role of the board is to ensure that
executive behaviour is aligned with the interests of the shareholder-owners.
Otherwise, self-interested managers will use their superior information to line their
own pockets. This is the justification for the separation of the chairman and CEO
roles, huge senior executive salaries and the over-riding requirement for
[independence of non-executive directors], and much more’ (Simon Caulkin, The
Observer, 27 November 2005).
There is an ethical aspect to agency theory. The theory is based on the view that
individuals cannot be trusted to act in any way that is not in their own best interests.
1.8 Agency conflicts in other types of organisation
Agency relationship – Public sector
Managers are also agents acting for principals in public sector organisations so once
again there is potential for agency conflicts.
The principals in this relationship are the taxpayer and the electorate (often one and
the same) and are likely to be concerned with value for money. There are problems
associated with making an assessment of whether an organisation is indeed
providing value for money:
The principals are a heterogeneous group consisting of a large number of
individuals. The group might not agree what actually constitutes value for
money or even if the service is required at all. The government must make
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political decisions as to how public money should be spent in a way that they
believe is best for the country. Citizens in a democracy then have an opportunity
to vote against a government if they are unsatisfied with its performance in
making these decisions.
Another problem in the governance of public sector organisations is how to
establish strategic objectives and then monitor the success of the public sector
organisation in achieving these.
It is normal in most countries to have a limited audit of public sector organisations
to ensure the integrity and transparency of their financial transactions, but this does
not always extend to an audit of its performance or ‘fitness for purpose’.
Agency relationship - Charities
Managers are also agents acting for principals in charities so once again there is
potential for agency conflicts.
Charities often raise money by securing donations form the public. This means that
donors are key principals. An important governance issue is whether donations are
used for the intended purpose and not wasted, misdirected or embezzled?
Ways to reduce the agency problem include
A requirement for the charity to be run by a board of directors overseen by a
committee of trustees (sometimes called governors). In this case, the board
manages the charity and the trustees act as a control on the board to ensure that
the board is delivering value to the donors and are acting towards the stated and
agreed benevolent aims.
Open and complete financial disclosure
Requirement for audits both financial and of effectiveness in achieving the
charitable purpose
1.9 Agency realationships – An overview
Publiclisted
companies Publicsector
Charitiesand
voluntary
organisations
Purpose
Maximisationof
shareholderwealth
Implementationof
governmentpolicy
Achievementof
benevolentpurpose
Agents
Directors Managersand
sometimeselected
representatives.
Directorsand
managers
Principals
Shareholders Taxpayersand
voters(ina
democracy)
Donorsandother
supporters
Serviceusers
Typical governance
arrangements
Boardofdirectors
monitoredbynon‐
executivedirectors
Non‐executive
chairman.
Complexstructures
whichtrytoachieve
thebestwayto
deliverservices.
Executiveboard
accountableto
independent
trustees.
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Transaction cost economics theory
Costs of the firm: production costs and transaction costs
Assumptions in transaction cost economics
The variables in transaction cost economics
Comparison of transaction cost economics with agency theory
2 Transaction cost economics theory
Agency theory explains the relationship between the owners of a company and its
management as the resolution of a conflict of interests. Shareholders delegate the
task of running the company to their managers, but need to ensure that agency costs
are minimised.
Transaction cost economics provides a different basis for explaining the relationship
between the owners of a company and its management. Although it is an economic
theory, it also attempts to explain companies not just as ‘economic units’, but as an
organisation consisting of people with differing views and objectives. You need to
know a little about transaction cost economics, in order to contrast it with agency
theory.
The theory of transaction cost economics (TCE) is most closely associated with the
work of Oliver Williamson, who based his ideas on the earlier work of Coase.
Williamson began writing on TCE in the 1970s.
2.1 Costs of the firm: production costs and transaction costs
The operations of a business entity can be performed either through market
transactions or by doing the work in-house. For example, a business entity could
obtain its raw materials from an external supplier, or it could make the materials
itself. Similarly, an entity could hire self-employed contractors to do work, or it
could hire full-time employees. An entity might sell its finished goods to a retail
organisation, or it might sell directly to the end-consumer.
Logically, a firm’s decision about whether to arrange transactions in the open
market or whether to do the work ‘in-house’ (itself) depends on which is cheaper.
When a firm does work ‘in-house’, it needs a management structure and a hierarchy
of authority. Senior management are at the top of this hierarchy. According to the
theory of transaction cost economics, the structure of a firm and the relationship
between the owners of a firm and its management depends on the extent to which
transactions are performed internally.
Total costs are defined as the sum of production costs and transaction costs.
Production costs are the costs that would be incurred in an ideal economic
market, to make and sell goods of the firm. In an ideal economic market,
production costs are minimised.
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Transaction costs are additional costs incurred whenever the ‘perfect’ situation is
not achieved. For example, if a company might buy goods from a supplier who
is not the cheapest available, because it was not aware of the existence of the
cheapest supplier. A company might sell goods on credit to a customer, not
knowing that the trade receivable will become a bad debt.
Transaction costs are sometimes higher when a transaction is arranged in the
market, and they are sometimes higher when the transaction is done ‘in-house’.
Carrying out activities in-house rather than arranging contracts externally is
referred to as vertical integration.
Total costs are minimised when transaction costs are minimised. This should
determine the optimal size of the firm and the size of the management hierarchy in
the firm. The way in which a company is organised, and the extent to which it is
vertically integrated, also affect the control the company has over its transactions.
The way in which transaction costs are minimised depends on a number of
variables. These are described later.
As a general rule, it is in the interests of a company’s management to carry out
transactions internally, and not in the external market. Performing transactions
internally:
removes the risks and uncertainties about the future prices of products and
about product quality
removes all the risks and costs of dealing with external suppliers.
2.2 Assumptions in transaction cost economics (TCE)
Traditional economic theory is based on the assumptions that all behaviour is
rational and that profit maximisation is the rational objective of all businesses.
Transaction cost economics changes these assumptions, by trying to allow for
human behaviour, and the fact that individuals do not always act rationally.
Williamson based his theory on two assumptions about behaviour:
bounded rationality, and
opportunism.
Bounded rationality
It is assumed in TCE that humans act rationally, but only within certain limits of
understanding. This means for example that the managers of a company will in
theory act rationally in seeking to maximise the value of the company for its
shareholders, but their bounded rationality might make them act differently.
Business is very complex and large businesses are much more complex than small
businesses. However, in any business, there is a limit to the amount of information
that individuals can remember, understand and deal with. No one is capable of
assessing all the possible courses of action and no one can anticipate what will
happen in the future. In a competitive market, no one can anticipate with certainty
what competitors will do.
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Playing the game of chess has been used as an example of bounded rationality. The
game is very complex, and there are many different possible moves. The actions of
the opponent in a game of chess cannot be predicted, so it is impossible to predict
what the opponent will do in response to a particular move. The same problem
applies to managing a company. It is impossible to predict with certainty what will
happen, because there are too many factors and too many possibilities to consider.
Williamson was mainly concerned with what happens when individuals reach the
boundaries of their understanding, because a situation is too complex or too
uncertain. He wrote: ‘Bounds on rationality are interesting … only to the extent that
the limits of rationality are reached – which is to say under conditions of uncertainty
and/or complexity.’
When uncertainty is high, or when a situation is very complex, there is a greater
tendency to carry out transactions ‘in-house’ and to have vertical integration.
Opportunism
Williamson also argued that individuals will act in a self-interested way, and ‘with
guile’. In other words, people will not always be honest and truthful about their
intentions. Williamson defined opportunism as: ‘an effort to realise individual gains
through a lack of candour or honesty in transactions.’ An individual might try to
take advantage of an opportunity to gain a benefit at the expense of someone else.
Williamson also argued that it is not possible to predict in advance who might act
with opportunism, or when. However, managers are opportunistic by nature. Given
the opportunity, they will take advantage of available ways of improving their own
benefits and privileges.
In terms of transaction cost economics, a problem with opportunism is that external
parties – such as contractors and suppliers of goods – cannot always be trusted to
act honestly. As a result, there may be a tendency for a firm to carry out transactions
itself, rather than rely on external suppliers. However, there is also a risk that by
taking control of transactions internally, managers will have opportunities to take
decisions and actions that are in their own personal interests.
This self-interest needs to be controlled. When managers act in their own interests,
investors will be discouraged from providing finance to the company. In this
respect, transaction cost theory has similarities with agency theory.
2.3 The variables in transaction cost economics
Williamson argued that there are three factors or variables which determine the
extent to which a firm is ‘integrated vertically’ and does the work itself. These
factors are:
frequency of transactions
uncertainty
asset specificity.
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Frequency of transactions
A firm will never wish to bring ‘in house’ a service or the production of an item that
is very rarely used. Rare transactions will always be arranged in the market with
another individual or entity.
For example, a company will rarely ever want to establish its own department for
management consultancy. This is because the services of management consultants
should be required only rarely, and they can be provided much better by external
specialists. The transaction costs of a market transaction are therefore much lower.
However, when goods are purchased very frequently, or services are used
frequently, there is a much stronger case for vertical integration and bringing the
work ‘in house’ because the transaction costs should be lower.
Uncertainty
As indicated earlier, uncertainty creates problems partly because of bounded
rationality. Uncertainty about transactions will affect a decision about whether the
transactions should be done in house or arranged in the market. As a general rule,
greater uncertainty makes it more likely that the transactions will be done in-house.
For example, suppose that a holiday tour operator wants to arrange a long-term
contract for the supply of ski instructors for customers on its winter skiing holidays.
The tour operator might consider negotiating a long-term contract with a company
that employs and trains ski instructors. However, with such a long term contract
there would inevitably be some uncertainties. How can the tour operator be sure
that the other company will remain in business? What will guarantee that a
sufficient number of ski instructors will always be available? Who will guarantee
the quality of the ski instruction? Who will be responsible in the event of a skiing
accident, caused by an instructor? Depending on circumstances – and the extent of
the uncertainty – the tour operator might decide to hire and train its own ski
instructors, to improve the probability that it can obtain a long-term supply of
enough ski instructors of a suitable quality.
Asset specificity
Asset specificity refers to assets that are only valuable for a specific transaction.
When an asset has only one specific use, transaction costs are likely to be reduced by
vertical integration.
For example, a professional football club will use a football stadium for its football
matches. The stadium has only one specific use – to host football matches for that
particular football club. In such circumstances, transaction costs should be lower if
the football club owns and operates the stadium itself, rather than hires the stadium
from an independent stadium owner.
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2.4 Comparison of transaction cost economics with agency theory
Transaction cost economics provides a theory to explain how a company develops
into the size and structure that it has, and what might make the size and structure
change. It assumes that management behaviour is determined by a combination of
bounded rationality and opportunism, with the result that managers will act in their
own self interests when the opportunities arise. This self-interested behaviour must
be controlled.
Agency theory uses the conflict of interests between shareholders and managers to
explain the nature of a company and its governance. Managers will often try to
increase the size of their company, even though this is not in the best interests of the
shareholders, because they benefit personally from growth in the size of the
company.
Although they are based on different assumptions, both agency theory and
transaction cost theory support the need for controls over corporate governance
practices.
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Stakeholder theory
Stakeholder approach to corporate governance
Definition of stakeholder theory
Rights for stakeholders
Stakeholder theory and agency theory
Ethics and stakeholder theory
3 Stakeholder theory
3.1 Stakeholder approach to corporate governance
Agency theory is based on the assumption that the main objective of a company
should be to maximise the wealth of shareholders. Management should therefore
act and take decisions in the best interests of the shareholders. Corporate
governance should therefore be concerned with minimising agency costs, by
improving the monitoring of management and by bringing the self-interests of
management more into line with the interests of the company’s shareholders.
The stakeholder view is that the purpose of corporate governance should be to
achieve, as far as possible, the aims of all key stakeholders – employees, investors,
major creditors, customers, major suppliers, the government, local communities and
the general public. A role of the company’s directors is therefore to consider the
interests of all the major stakeholders. However, some stakeholders (for example,
employees) might be more important than others, so that management should give
priority to their interests above the interests of other stakeholder groups.
In the introduction to its principles of corporate governance, the OECD commented
that an aim of government policy (‘public policy’) should be ‘to provide firms with
the incentives and discipline to minimise divergence between private and social
returns and to protect the interest of stakeholders.’
The OECD Principles themselves recognise the role of stakeholders in corporate
governance and state that the corporate governance framework should:
recognise the rights of stakeholders that are recognised in law or through mutual
agreements, and also
encourage active co-operation between corporations and stakeholders in
creating wealth, jobs and the sustainability of financially sound enterprises.
3.2 Definition of stakeholder theory
Stakeholder theory can therefore be explained as follows.
The theory states that a company’s managers should take decisions that take into
consideration the interests of all the stakeholders. This means trying to achieve a
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range of different objectives, not just the aim of maximising the value of the
company for its shareholders. This is because different stakeholders each have their
own (different) expectations from the company, which the company’s management
should attempt to satisfy.
It has been suggested that in stakeholder theory, the company should have an
individual set of values that provide an environment in which the interests of
different stakeholders can co-exist, and stakeholders can co-operate to achieve their
differing objectives.
Stakeholder theory can be seen as a mix of a variety of disciplines which produces a
blend of sociological and organisational ideas. As companies are so large, they have
an impact not just on their own shareholders, but on many more sectors of society.
3.3 Rights for stakeholders
Supporters of stakeholder approach to corporate governance recognise that only the
senior managers and directors of a company, and the shareholders, have any
significant power within the framework of corporate governance.
A stakeholder approach to corporate governance can therefore be implemented only
by:
negotiation and co-operation between management and employees, and
legislation giving rights to stakeholders or protecting stakeholder rights.
3.4 Stakeholder theory and agency theory
Stakeholder theory, that a company has obligations to other stakeholders in
addition to shareholders, is based on different assumptions from agency theory,
which is based on the view that managers should act in the best interests of the
shareholders. However, the two approaches to governance (and ethical theory) are
not necessarily inconsistent.
Companies and their managers can act in the best interests of shareholders and at
the same time attempt to satisfy interests of other stakeholders. For example,
shareholders themselves might not have an objective of wealth maximisation. They
might want to obtain satisfactory returns, but at the same time might want the
companies they invest in to shown suitable concerns for society and the
environment.
In other words, best practice in corporate governance and corporate social
responsibility might be consistent with each other.
3.5 Ethics and stakeholder theory
From an ethical perspective, Donaldson and Preston have suggested that there are
two different reasons that may motivate an organisation to take (or not to take) a
stakeholder approach in its decision-making. They called these two different
approaches or viewpoints: