Unit Three: Accountants and Auditors

Learning Objectives:

(1) Explain the importance of accounting and auditing to good governance.

(2) Explain the different types of accounting and auditors

(3) Analyze auditors as consultants.

Introduction

Accountants and auditors play an indispensable role in the good governance of any business.
Accountants prepare the financial statements used by managers and investors and other stakeholders
to form decisions and auditors check it to prevent fraud or any type of misrepresentation by
management. Truthful financial statements show the real condition of the company in which most
decisions have to be based on. 

Types of Accounting

“Management accounting is the development of information for insiders such as company managers.
Managers use this information to measure the progress toward their goals and highlight any potential
problems in advance. Financial accounting provides information for outsiders. Income statement,
balance sheet and statement of cash flows and other pieces of important information are used by
outsiders to determine the firm’s value, profits and its risks. These statements are prepared by the
accountants of the firm and reviewed by independent accountants from an auditing firm,” (Kim,
Nofsinger and Mohr, 2016). The use of the aforementioned types of accounting is key to an effective
control system that may lead to good corporate governance. 

Types of Auditors

The management of a company may have different motivations to ask its accountant to make
misrepresentations in the preparation of financial statements hence the need for an audit conducted
by internal and external auditors. An internal auditor is an employee of the company who objectively
inspects its financial statements, inventory and risks to spot errors and problems. On the other hand
an external auditor is a board certified accountant from an independent accounting firm who
performs a review of a company’s financial statements and internal controls to ensure accuracy and
prevent fraud. 

Auditors as Consultants
“Accounting firms have aggressively expanded into the consulting business as the income from
consulting exceeds the income from auditing. The problem for shareholders, however, is that there is
a potential conflict of interest when auditors provide consulting services, and this can reduce the
monitoring role of auditors,” (Ibid). To further improve audit quality given to companies the Code of
Corporate Governance provides: “The company should establish standards for the appropriate
selection of an external auditor, and exercise effective oversight of the same to strengthen the
external auditor’s independence and enhance audit quality. The company should disclose the nature
of non-audit services performed by its external auditor in the Annual Report to deal with the potential
conflict of interest. The Audit Committee should be alert for any potential conflict of interest
situations, given the guidelines or policies on non-audit services, which could be viewed as impairing
the external auditor’s objectivity.”

Example

“Enron Corporation was a US energy, commodities, and services company based out of Houston,
Texas. In one of the most controversial accounting scandals in the past decade, it was discovered in
2001 that the company had been using accounting loopholes to hide billions of dollars of bad debt,
while simultaneously inflating the company’s earnings. The scandal resulted in shareholders losing
over $74 billion as Enron’s share price collapsed from around $90 to under $1 within a year. An SEC
investigation revealed that the company’s CEO, Jeff Skillings, and former CEO, Ken Lay, had kept
billions of dollars in debt off the company’s balance sheet. In addition, they had pressured the
company’s auditing firm, Arthur Andersen, to ignore the issue. The two were convicted, largely based
on the testimony of former Enron employee, Sherron Watkins,”
(https://corporatefinanceinstitute.com/resources/knowledge/other/top-accounting-scandals/ ).

Summary

Accountants and auditors play an indispensable role in the good governance of any business. The
types of accounting relevant to corporate governance are management and financial accounting.
Accountants prepare the financial statements whereas the internal and external auditors review it to
ensure truthfulness. The external auditor may also take up the role of consultant for a company and
his objectivity may be compromised hence the need for the audit committee of the board to be alert
for potential conflict of interests.

Unit Four: Executive Compensation

Learning Objectives:

(1) Explain the relevance of executive compensation to good governance.

(2) Identify and explain the components of executive compensation.

Introduction
Executives in a corporation are the president and vice-presidents who are the heads of different
departments or divisions. They play a very important role in the operations of the business and its
success. Companies have to pay competitive salaries and benefits to attract and retain competent and
motivated executives. The Code of Corporate Governance also states: “The Board should align the
remuneration of key officers and board members with the long-term interests of the company. In
doing so, it should formulate and adopt a policy specifying the relationship between remuneration
and performance.”

Components of Executive Compensation

Just like any other employee, executives have to be paid a base salary which refers to the
remuneration that is given on a bi-monthly or monthly basis but is usually stated as an annual salary.
The base salary of executives depends on the factors such as size of the company and type of
industry. It is also common for executives to get a bonus which refers to monetary rewards given for
good performance of the employee and the company. Perks and benefits are also standard for
executive compensation packages which may involve a personal secretary, well-furnished office,
company car and driver, housing, membership in executive associations/clubs, and other allowances.
To further motivate executives to perform better companies provide stock-options, which refers to
the choice to acquire company shares at a fixed price. When the company is profitable its stock price
may go up and the executive who owns stocks may get capital gains.

Principal-Agent Problem and Executive Perks

Despite the high salaries and bonuses given to company executives some are still tempted to misuse
their perks and benefits like excessive spending on air travel, personal security, personal shopping and
other expensive activities unrelated to company activities. The issue of the huge disparity between
the pay of rank and file employees and company executives is further exacerbated by the abuse of
company perks of executives which hurts shareholder value. 

Example

“Apple CEO Tim Cook made $125 million in the company’s 2019 fiscal year, less than the year before
due in part to a lower bonus. Cook got a $3 million salary, a $7.7 million bonus and $884,466 in perks
and other compensation in the latest period. The executive also had $113.5 million worth of Apple
stock vest. Apple spent $457,083 on Cook’s security in 2019, another $315,311 on personal air travel
expenses,”(https://fortune.com/2020/01/03/apple-ceo-tim-cook-compensation). 

Summary
Companies have to pay competitive salaries and benefits to attract and retain competent and
motivated executives. The usual components of executive compensation are base salary, bonuses,
perks and benefits and stock options. The issue of the huge disparity between the pay of rank and file
employees and company executives is further exacerbated by the abuse of company perks of
executives which hurts shareholder value. 

Review Questions

(1) Why should companies offer attractive compensation to executives?

(2) What is the composition of executive compensation?

(3) How could principal-agent problem occur in executive compensation?

Investment Banks and Securities Analysts

Learning Outcomes: 

(1) Explain the relevance of investment banks and securities analysts to good corporate governance.

(2) Explain the different investment banking approaches.

(3) Explain the different types of securities analysts.

Introduction

Private corporations which intend to pool funds from the general public need to be listed in the
Philippine Stock Exchange (PSE) and undergo an Initial Public Offering (IPO). An investment bank is
needed by a corporation to have its IPO. After this the stocks of the corporation will be traded in the
secondary market and possibly be recommended by securities analysts to its clients and
organizations. A corporation will only be taken on by an investment bank, accepted by the PSE and
recommended by securities analysts if it has a proven track record of profitability.

Investment Banking

“The basic investment banking service is to help companies issue new debt and equity securities. The
investment banks charge the company a fee for this service. There are two methods that banks can
use to issue stock and bonds: underwriting and using best efforts. When underwriting an issue, the
bank will guarantee that the company will receive a specific amount of capital. If the investment bank
did not want to assume the risk on a security it could use the best-efforts method. The bank does its
best to sell as much of the new security as possible for the company but does not guarantee that the
company will get its desired amount of capital,” (Kim, Nofsinger and Mohr, 2016).
 Securities Analysts

Securities analysts can be categorized into buy-side and sell-side. Buy-side analysts are those who are
employed by institutional investors like insurance companies to make recommendations as to which
securities to invest in. Sell-side analysts are those who work as stockbrokers and recommend to their
clients and to the public which securities are good investments. “Based on their evaluations, analysts
will make earnings predictions. These predictions are useful to investors who rely on these estimates
to determine the health of the companies in which they may or may not own stock. Perhaps more
important, the analyst also makes trading recommendations to investors,” (Kim, Nofsinger and Mohr,
2016).

Example

“Facebook has priced its initial public offering at $38 per share, making it the third-largest IPO in U.S.
history. At that price, the IPO would value the social networking giant at $104.2 billion and make the
offering worth $16.08 billion, behind only Visa and power company Enel by size of the offering.
Bankers on the deal include Morgan Stanley, J.P. Morgan, Goldman Sachs, BofA Merril Lynch,
Barclays, Allen & Co, Citigroup, Credit Suisse and Deutsche Bank,”
(https://www.forbes.com/sites/tomiogeron/2012/05/17/facebook-prices-ipo-at-38-per-
share/#48e281f2728a).

Summary

An investment bank is needed by a corporation to have its IPO. After this the stocks of the corporation
will be traded in the secondary market and possibly be recommended by securities analysts to its
clients and organizations. There are two methods that banks can use to issue stock and bonds:
underwriting and using best efforts. Securities analysts can be categorized into buy-side and sell-side.

Review Questions

(1) What is the role of investment banks and securities analysts in promoting good corporate
governance?

(2) What are the different investment banking methods?

(3) What are the different types of securities analysts?

.
It refers to the person who prepares the company's financial statements - Accountant
It refers to the person who reviews the company's financial statements:- Auditor

It shows the assets, liabilities and capital of the company: balance sheet

It shows the financial performance of the company:Income statement

It refers to the type of accounting that is used to make business decisions in the company: -
managerial management

The following are executives in a corporation except: - Chairman

The compensation of executives must be: - competitive

The base salary of executives is paid: - Monthly

Executive bonus is given for: - Performance

The following are examples of executive benefits except: - social insurance

Executives who own stocks can profit from their companies success through: - Capital Gains

In a stock option an executive may buy the stock of his company at a: - Fixed price

With stock option an executive is motivated to make the company: - Profitable

Extravagant executive spending hurts: - Shareholder Value

Executive compensation is set by the company's: - Board

Private corporations which intend to pool funds from the general public need to be listed in the:
--------Philippine Stock Exchange

A private corporation which intend to be taken on by an investment bank must show a track record
of:
- Profitability

In this method an investment bank guarantees to raise capital for a corporation: - Underwriting

It refers to the process wherein a private corporation sells its stock to the public for the first time:
- Initial Public Offering

A stockbroker make _________ as to which securities to invest in. - recommendations