Risk Management and Corporate Governance

Abol Jalilvand, Tassos Malliaris, Abol Jalilvand, Tassos Malliaris

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781136644900
• Edition: 1
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

The asymmetry of responsibilities between management and corporate governance both for day-to-day operations and the board's monthly or quarterly review and evaluation remains an unresolved challenge. Expertise in the area of risk management is a fundamental requirement for effective corporate governance, if not by all, certainly by some board members. This means that along with board committees such as "compensation", "audit", "strategy" and several others, "risk management" committees must be established to monitor the likelihood of certain events that may cause the collapse of the firm.

Risk Management and Corporate Governance allows academics and practitioners to assess the state of international research in risk management and corporate governance. The chapters overlay the areas of risk management and corporate governance on both financial and operating decisions of a firm while treating legal and political environments as externalities to decisions undertaken.

Part I

The Performance Effects
of Risk Management and
Corporate Governance

Recent studies have documented that efforts in managing the firm's overall risk do create shareholders' value by mitigating and managing financial and operating imperfections and enhancing its opportunities (see, for example, Rene Stultz (2008) and Smithson & Simkins, (2005)). In fact, the recent global financial crisis has clearly demonstrated that certain banks that took risk management seriously and diversified appropriately, such as J.P. Morgan, performed much better than others who did not such as Citi Corp. Although both the approach to risk management and the tools utilized continue to evolve, it appears reasonable to argue that a focus on managing the firm's overall risk, also known as Enterprise-Wide Risk Management (ERM), has taken off and created a new paradigm which is devoid from fragmentation where every major department managed its risks following a silo approach. Furthermore, the new paradigm also moves away from selectivity and ad hoc approaches to risk management where risk was managed when division managers judged it necessary. Also, risks were narrowly defined to include insurable risks and risks from interest rate and currency exposures. The new paradigm emphasizes an integrated, enterprise-wide coordinated and continuous process that addresses all possible financial, business and strategic risks and opportunities.

Firms employ various mechanisms of corporate governance and risk management to bolster their shareholders' assurance of fair returns on their investments. Without such mechanisms, only the cash flow and assets of businesses could finance their operations and investments, making adequate economic performance unlikely. Even when implemented, risk management and corporate governance mechanisms cannot guarantee optimized economic performance, for firms' choices regarding risk and governance affect the performance of the individuals who are charged with their oversight. The five chapters that constitute Part I examine the performance effects of risk management and corporate governance from several perspectives that illustrate how systemic decisions and individual behavior are determinates of firm performance.

Chapter 1 explores how enterprise risk management practices can affect firm performance with regard to regulatory compliance. In “The Role of Enterprise Risk Management in Determining Audit Fees: Complement or Substitute,” Kurt Desender and Esteban Lafuente use a sample of pharmaceutical firms to explore how their adoption of enterprise risk management practices influences their external audit fees. Is the hiring of a Chief Risk Officer enough for these firms to keep audit fees low? Or, must they rely more heavily on risk management throughout the enterprise to keep down audit fees? These are two of the key questions addressed in the authors' research. The authors hope that similar studies of other industries will occur.

Recent corporate governance research shows that board independence is linked to improvements in decision making, such as structuring efficient executive compensation arrangements. Adding to the literature are authors Yu Flora Kuang and Bo Qin. In Chapter 2, “Performance Based Equity Grants and Corporate Governance Choices,” the authors examine the relationship between a board's degree of independence and its use of performance targets for equity compensation. Their findings provide valuable insight into matters of incentivizing managers to promote shareholder value, monitoring agency problems, and attracting and retaining talent.

In his Chapter 3 essay, “A Theoretical Framework for Voluntary Corporate Governance,” Rodrigo Zeidan focuses on voluntary mechanisms for companies to pursue better corporate governance practices. Zeidan argues that a firm's decision to adopt better governance is complex and cannot be explained by market forces alone. Instead, he posits, one must consider the different contexts in which a given firm operates. Zeidan develops a decision framework that, at its foundation, separates market and non-market mechanisms. A corollary argument of the essay holds non-market mechanisms to be most relevant in developing countries. By classifying the mechanisms and developing a theoretical framework for explaining companies' decisions, the author hopes that his research can aid in the design of regulatory policies in capital markets worldwide.

Chapter 4 and Chapter 5 examine managerial behavior. In “Managers' Behavior when Governance is Weak,” Ralf Steinhauser examines whether under slack governance, managers seek to minimize the risks associated with costly and difficult decisions. Steinhauser argues that in such situations, managers might wish to raise their levels of personal happiness through increasing the firm's focus on issues of corporate social responsibility, usually at the expense of profit maximization. Steinhauser uses a unique dataset to test his hypotheses. His findings may prove useful in both reassessing studies of the causes of socially responsible behavior and informing the design of policy and regulation enforcement for corporate governance.

In “Stock Repurchase Programs and Corporate Governance: Ethical Issues and Dilemmas,” Richard McGowan breaks from the current literature that seeks to establish why stock repurchase programs have begun to replace dividend payments as management's preferred method of cash disbursement. McGowan, instead, uses an econometric model to determine whether or not any of the established motivations of managers for implementing repurchase programs correlate to the size of the repurchases. McGowan believes that if such correlations exist, it is necessary to examine the ethical implications for corporate governance. It is boards of governors, after all, who are responsible for the approval of stock repurchase plans. And with many conflicting interests, boards face ethical decision making challenges in approving stock repurchase plans.

REFERENCES

Stultz, Rene M. 2008. “Risk Management Failures: What Are They and When Do They Happen?” Journal of Applied Corporate Finance, 20(4): 39–48.

Smithson, Charles W., & Betty J. Simkins. 2005. “Does Risk Management Add Value? A Survey of the Evidence”, Journal of Applied Corporate Finance 17(3): 8–17.

1 The Role of Enterprise Risk
Management in Determining
Audit Fees

Complement or Substitute

Kurt Desender and Esteban Lafuente

INTRODUCTION

The clear implication for corporate governance from an agency theory perspective is that adequate monitoring or control mechanisms need to be established to protect shareholders from management's conflict of interest (Fama and Jensen 1983). In that sense, external statutory auditors attest that all shareholders are equally treated and that financial statements are in conformity with contractual commitments. Therefore, audit quality may improve the confidence of investors in financial reporting, facilitate the assessment of the objective situation of the firm, and finally increase fund-raising possibilities. The Enron failure, together with other high-profile corporate collapses, has led to a debate concerning the efficiency and the role of corporate governance and external auditors. Companies have suffered astonishing losses as a result of poor decisions leading to excessive risk taking. Massive gaps in both the understanding and communication of a company's risk appetite and exposure have been identified in postmortem reviews. The corporate governance failures culminated in the passage of the Sarbanes-Oxley Act on July 30, 2002, which emphasized the importance of enterprise risk management (ERM) in preventing fraudulent reporting. Section 404 of the Sarbanes-Oxley Act of 2002 required U.S. publicly traded corporations to utilize a control framework in their internal control assessments (e.g., the Committee of Sponsoring Organizations of the Treadway Commission [COSO] Internal Control Framework). In addition, new guidance issued by the Public Company Accounting Oversight Board (PCAOB) in 2007 placed increasing scrutiny on top-down risk assessment and included a specific requirement to perform a fraud risk assessment (PCAOB 2007). In addition, the emerging regulatory capital framework, Basel II, leading the reform of banking supervision, endorsed enterprise risk management as an umbrella notion that can accommodate the techniques required for bank capital adequacy calculation: “integrated firm-wide approaches to risk management should continue to be strongly encouraged by the regulatory and supervisory community” (BIS 2003, 11-12). In response to these requirements, companies and financial institutions are embracing ERM to manage risks across the entity. Rating agencies, such as Standard and Poor's and Moody's, are examining how managers are controlling and tracking the risks facing their enterprises (Samanta, Azarchs, and Martinez 2005; Standard and Poor's 2005). These rating agencies have publicly reported their explicit focus on ERM activities in the financial services, insurance, and energy industries.

In addition to the recommendations about risk management, the regulatory reforms have tried to reinforce the independence of the external auditors. Whereas initial literature has looked at firm characteristics related with ERM implementation, little is known about how ERM influences the external audit fees. The objective of this chapter is to explore how the level of ERM and the presence of a chief risk officer (CRO) influence the audit fee. This chapter contributes mainly to the field of corporate governance by providing new evidence on the relationship between the external audit and ERM. The results show that ERM and the external audit effort are substitutes. Specifically, we find that the mere presence of a CRO does not exert any significant impact on external audit fees. However, a different picture emerges when we take into account the different risk management practices adopted by firms. In this case, those firms that heavily rely on ERM report significantly lower audit fees. This finding is especially relevant as it signals that the presence of an integrated system of internal controls and risk management practices not only creates the conditions for better internal monitoring, but it also facilitates external auditor's work, which implies a reduction in the number of hours required by these external auditors. In what follows, we discuss the prior research and hypothesis development. Afterwards, we focus on the sample description and the research method. Finally, we describe the results and formulate the conclusions and limitations of this research.

PRIOR RESEARCH AND HYPOTHESES DEVELOPMENT

Existing agency theory proposes a series of mechanisms that seek to reconcile the interests of shareholders and managers, including the utilization of internal control mechanisms such as monitoring by nonexecutive directors (Fama and Jensen 1983), monitoring by large shareholders (Shleifer and Vishny 1986), the incentive effects of executive share ownership (Jensen and Meckling 1976), and the implementation of internal controls (Matsumura and Tucker 1992). An additional instrument of shareholder monitoring is the statutory audit whereby independent auditors report annually to shareholders on the appropriateness of the financial statements prepared by management (Watts and Zimmerman 1986).

THE EXTERNAL AUDITOR

An extensive body of literature has emerged examining the level and nature of audit fees in organizations (e.g., Hay, Knechel, and Wong 2006; O'Sullivan 2000; Carcello et al. 2002; Abbott et al. 2003). Research on the drivers of audit fees has traditionally explained the determinants of audit fees from a production-based view. The stream of literature shows that audit fees are influenced by factors related to the size of the organization, complexity, inherent risk, and litigation risk amongst others. More hours will be put into an audit to ensure the accounting numbers presented reflect reality, leading to a higher audit fee when a company is large, complex, and has a high risk of accounting errors. Recently, studies focusing on the relationship between audit fees and corporate governance have introduced a new approach. Following a production-based approach, good corporate governance, such as the existence of independent board members, is expected to improve the control mechanisms and reduce the need for external auditing, leading to lower audit fees. However, Hay and Knechel (2004) highlight the importance of the demand effect, which may lead to the opposite result: independent directors may demand more auditing in order to fulfill their responsibilities, protect their reputations, and discharge their responsibility of due diligence. Specifically, Hay and Knechel (2004) argue that the demand for auditing is a function of the set of risks faced by individual stakeholders in an organization (management, shareholders, creditors, etc.) and the set of control mechanisms available for mitigating those risks. Because individual decisions concerning control processes and procedures may shift both benefits and costs across groups of stakeholders, the net investment in auditing may increase (Knechel and Wi...

Table of contents

• Front Cover
• Risk Management and Corporate Governance
• Routledge Advances in Management and Business Studies
• Title page
• Copyright
• Contents
• List of Figures
• List of Tables
• Preface
• Introduction
• PART I The Performance Effects of Risk Management and Corporate Governance
• PART II Theoretical and Experimental Approaches to Risk Management
• PART III Legal and Regulatory Dimensions of Corporate Governance and Risk Management
• Contributors
• Index