THE ROLE OF FINANCIAL ACCOUNTING INFORMATION IN STRENGTHENING CORPORATE CONTROL MECHANISMS TO ALLEVIATE CORPORATE CORRUPTION

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.

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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.

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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.

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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

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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,

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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).

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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

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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.

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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

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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
Managers
Financial Accounting Information
Governance Process




indirect use direct use

(managerial incentive contracts)



Stock


prices





Corporate control mechanisms


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).

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