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Auditing corporate governance - the next big thing for rating agencies? Back  
Antoinette Flynn and Michael Smyth examine how corporate governance practices cannot only be improved, but also be shown to be improved, and ask whether a time will come when corporate governance audit ratings are as common as debt ratings.
Recent evidence suggests that capital markets around the globe are beginning to operate in concert and this global convergence is taking place, without overtly harmonising accounting standards. This convergence is also recognised in corporate governance guidelines, or codes, which have appeared in countries across the world, ‘gaining considerable momentum in the late 1990s’.

Consequently, a crisis in USA markets creates potential failures in international capital markets. Legislators around the world have correctly interpreted recent corporate governance misadventures in this light. So much so that, suggestions of regularising regional and global corporate governance systems have been offered as the panacea to restore confidence in capital markets. Research indicates that there is a significant correlation between effective corporate governance and strong financial performance.

According to the University of Michigan Business School, firms with strong corporate governance also exhibit profitable investment opportunities and increased reliance on external financing.

Similarly, McKinsey & Co state that most investors will pay a premium for companies with high governance standards. Sarbanes-Oxley (Sarbox) requirements place a legal, mandatory requirement on US companies (non-US companies listed in the US) to conform to a standardised compliance framework by 2005. Is it na?ve to presume that following the application of this framework, legislators may next turn their attention to imposing a mandatory audit of such processes?

But more immediately, how can corporate governance practices be realistically improved and more importantly, be shown to be improved? The general approach is a combination of legislative and non-legislative measures that concentrate efforts on reducing legal and regulatory barriers to competition. The majority of the proposed improvements, centre on the role of non-executive directors (NEDs), within the board of directors. Some of these suggestions include:

• The appointment of a lead director among the NED,
• Compelling the chairman to be a NED,
• A restriction on the number of other boards and committees on which directors can serve,
• Enlarging the gatekeeper duty of company directors to dilute the power of the CEO,
• And the compulsory training of NEDs in business schools.

Another focus of improving corporate governance practices globally is the audit committee. Audit committees have been a standard feature of the corporate governance system in the UK since Cadbury 1992 (and in the USA since 1978) and are a widely adopted practice. The supposition is that audit committees are generally effective corporate governance tools, fortified by independent NEDs. However, the presence of NEDs is a black-box phenomenon. Evidence suggests that they do seem to improve the quality of financial information yet; the specific mechanics of that enhancement remains a mystery.

All of the above suggestions have merit to some degree. What they lack is defensible and measurable consequences of implementation. The key to corporate governance efficacy is the unambiguous and immediate appraisal of the protection and creation of corporate wealth. This information enables shareholders/stakeholders to distinguish between the nuances of various corporate governance observances. The answer lies not with further legislation but rather it lies in an existing market solution, the corporate governance audit.

The corporate governance audit
As early as 1998, CalPERS (California Public Employees’ Retirement System) in a move to enhance corporate governance standards required companies to undergo a corporate governance audit. Corporations were encouraged to hire independent consultants to evaluate corporate governance functions and report to shareholders. Others have suggested that corporations voluntarily commission corporate governance audits as a means of anticipating and managing shareholder activism, as another function of investor relations.

Despite the obvious benefits of disclosing good corporate governance ratings, the historical demand from corporations and institutional investors for corporate governance audits was weak. However, in view of the corporate governance confidence crisis facing corporations today, demand is rising. The authors propose that proactive governance practices should be recognised as governance excellence that copper fastens corporate wealth and thus add corporate value. This recognition can be achieved through an independent corporate governance audit incorporating a published rating scale. Currently, a variety of consultancy firms offer this service, for example, Standard & Poor’s, GovernanceMetrics International and Moody’s. These scores/ratings are based on quantitative and qualitative corporate governance analysis.

Standard and Poor’s Corporate Governance Score (1 to 10) is a composite of four scores on (1) ownership structure and influence, (2) financial stakeholder rights and relations, (3) financial transparency and information disclosure and (4) board structure and process. Corporations around the world participate in this exercise. Fannie Mae, a low-cost provider of financing for mortgages in the US, rated 9.0 on the scale, confirming its consistently strong corporate governance position. In Japan, ORIX Corporation, an integrated financial services group scored 7.9, demonstrating a persistent weakness in its board structure and process. KT&G, a Korean manufacturer of tobacco products, scored 7.1 signifying improved corporate governance practices, although scoring low in financial transparency and information disclosure. European firms are now beginning to recognise the need to be publicly accountable for their corporate governance practices. In April 2003, Friends Provident scored 8.4 on this scale, generally indicating strong corporate governance practices, with some weaknesses.

In the future, will we witness a time when corporate governance audit ratings are as common as debt ratings and are published in the Financial Times? Will corporate governance auditing standards ever be mandatory? That remains to be seen. One fact is certain. External monitoring in and of itself reduces corporate governance malfeasance and institutional ownership pressure improves earnings quality. In this world of converging international capital markets, is it ‘irrational exuberance’ to assume that one consultancy service appears to have a promising future?

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