Perspective Chapter: Governing Corporations in Appearance but Not in Fact – A Possible Unintended Consequence of the Corporate Governance Movement

Abstract

Corporate failures trigger corporate regulations. The corporation is a fiction that is theorized as a nexus of contracts. Mechanisms for monitoring corporations, namely the external audit function and corporate governance, have been promoted and propagated. Whether corporations are governable is a question. An argument made in the accounting literature is that the audit function has been successful because of the ability of external auditors to appear independent when they might not be. The board of directors of such corporations may appear governing executive managers while they are in fact not or cannot. With the ideology of “profit over people,” multinational companies run the world with CEOs who are the most powerful individuals in the corporate model. Without corporate financers’ active involvement, corporations are unleashed. Corporate financers need to be aware of their power and be able to hold executive management accountable to make their corporations good citizens of the globe. Corporate monitoring mechanisms do not make up for their absence in the corporate model, which makes the view that corporations are founded to maximize the value of absentees naïve. A long history of corporate failures has proven its fallacy.

1. Introduction

Corporate failures trigger corporate regulations. The scandal of the Kreuger Corporation in the 1930s that the US capital market experienced during the Great Recession, though contributed to the US financial reporting [1], has not stopped corporate failures and scandals. By providing information about the corporation before the public offering, the Securities Act issued in 1933 safeguarded the US capital market from applying Ivar Kreuger’s strategy. The Security Act of 1934 mandates the continuation of disclosing corporate financial data annually; establishing an agency to oversight corporate reporting and watchdog corporations in the US.

The Sarbanes–Oxley Act (SOX) in 2002 was issued as a quick governmental response to the scandals of Arthur Andersen’s clients, namely Enron and WorldCom. Governments worldwide, for example, Saudi Arabia, issued a bulletin to govern corporations in 2006 after the Saudi capital markets experienced a downfall in 2006. The bulletin is updated in 2009, 2015, 2017, 2018, and 2023. Patching the bulletin shall continue because governing corporations is not constructed on a sound theory of the firm nor does corporate governance stand as a sound theory. In fact, neither has the corporate model been fully comprehended nor has the corporate accounting function been completely understood. The concern is that the best that can be achieved is a corporation that appears governed while in fact is not. This outcome is not new to the corporate model. To maintain the corporate model, the external auditor appears independent [2] because being independent in fact is no longer professionally required nor can he be independent.

Following the issuance of corporate regulations that took place at the beginning of the current millennium, a wave of corporate governance has spread almost worldwide. Recently corporate governance has been propagated as a mechanism that is capable of monitoring corporations. Corporate governance become in some of the world as a profession to a wide range of individuals. Corporate governance models have been proposed to assist in monitoring executive management of corporations.

This chapter is for the public to shed light on the complex nature of corporations and the impossibility of governing them. Multinational corporations that rule the world [3] are not subject to initiatives of being governed. The conjecture is that corporate governance can be in place in appearance but in fact. Such a proposition calls to hypothesize that a certain type of individual fits to become the board of directors. Probably individuals who are serious about governing corporations may not be able to fill seats on the board of directors of some corporations. The corporate model has not been fully understood nor adequately theorized [4].

The remainder of the chapter is organized as follows. The following section highlights our understanding of the corporation. Section 3 brings to attention the challenge that the corporate model represents. Section 4 is about the lasting issue that resulted from the separation between management and ownership. Section 5 addresses the possibility that with the absence of corporate financers corporate governance can be achieved only in appearance. Section 6 concludes that corporations are on unleash unless their financers become aware and actively involved. If they cannot, then the corporate model is needed for an appropriate, probably realistic, theorization and the role of corporate accounting should be expanded.

2. What is corporation?

The firm, as the literature reveals - see, for example, the law literature - is a fiction, [5] that does not have a physical existence. Its existence is juridical or legal [6]. The argument in the law profession (e.g. [7, 8, 9, 10, 11, 12, 13, 14, 15]), in economics [16, 17] about what the corporation has not yet been settled to date. Such divergent views were extended to the accounting literature as well [4, 14, 18, 19].

Viewing the corporation as a “nexus of contracts” prevails and seems to dominate other views in the economic and law literature. The promoters of the contemporary stream of accounting research seem to adopt such a concept as well [20, 21, 22, 23, 24, 25, 26, 27, 28]¹. The variety of arrays of relationships that encompass the corporation form an enterprise where each party has a stake in it. Greenwood [74], however, argued that stakeholder participation in running a corporation possibly would overlap with the moral behavior of stakeholders; nevertheless, it may “run counter to moral” conduct.

The enterprise theory views the firm as a reporting accounting entity to a variety of stakeholders [75, 76, 77]. The enterprise theory in accounting institutes corporate reporting that serves all stakeholders’ interests [78].

The “nexus of contracts” view necessitates monitoring the corporate reporting function that promotes the external audit function. Recently, major corporate scandals have called for activating corporate governance mechanisms suggested decades ago. Corporate governance goes back to 1932 [79]². These two mechanisms are challenges associated with the c corporate model.

3. The corporation: a model for conducting business representing a challenge

Since its emergence, the corporation has represented an accounting challenge. Early accounting pioneers recognized the challenge. Littleton [80].

“Moderns have produced these business corporation with its far-flung ownership and its limited liability to place upon accounting burdens of which the ancients did not dream. For example, objections to dividends out of capital are of recent origin, and because of these objections much added importance is now attached to properly determined periodic profits. These are sources for much of modern theory.

Business is now regarded as a continuous process rather than a group of disjointed transactions. This is expressed by our development of the terms "earnings" and "income" in contrast with "profits".”

Measuring corporate performance is probably one of the most puzzling tasks that accounting confronted to date. Previts and Merino [81] articulate, “[a]ccountants responded creatively and effectively to…[the separation of ownership and control] challenge…accounting theorists had developed a historic cost allocation model that effectively silenced questions about the relevance of accounting profit and reaffirmed the primarily of ownership rights.” However, the inherently random techniques associated with cost allocation are a drawback that impairs the wished-for results of allocation techniques and brings troublesome disputes [82, 83, 84]³. Former SEC Chief Accountant Walter Schuetze said: “Allocation is used for managing earnings to smooth the hills and valleys of change.”

Defining income and profit is one of longest debating unsettled concepts in accounting [80, 86, 87, 88, 89, 90, 91, 92, 93, 94, 95, 96, 97, 98, 99, 100, 101, 102, 103, 104, 105, 106, 107, 108].

In addition, the divergent interests of the parties who make up the corporation differ and occasionally conflict. Innovations have been proposed to align controverting interests. For example, generous corporate executives’ compensation plans have not been an effective means for encouraging corporate executives to serve the interests of corporate financers, mainly shareholders.

External auditing as a corporate monitoring mechanism has not been an effective device in the corporate model [2, 63, 90, 93, 109, 110, 111, 112, 113, 114, 115, 116, 117, 118, 119, 120, 121, 122, 123, 124, 125, 126, 127, 128, 129, 130, 131, 132, 133, 134, 135, 136]. Due to the challenges in acquiring contact with real-life information, inquiry virtually into auditor-client relationships is conjectural or ancillary ([137], as cited in ([138], p. 13) and Dye 1991, as cited in ([138], p. 13). Theoretically, the corporate model permits collaboration between any two parties that might not be in the best interest of other parties [123]. Professional corporate managers may behave improperly against the interests of investors and shareholders [139]. Auditors are incentivized to collaborate with executive managers to form a partnership that might not be in the best interest of shareholders [140]. Interviewed executive managers and auditors reported that the auditor might be powerless to defend third parties from management fraud [141].

The corporate scandals, to be exact Enron and WorldCom, that occurred at the beginning of the current millennium called for governmental actions to restore confidence in the corporate model. Arthur Anderson, who once symbolized the culture of values in the auditing market, audited the two failed corporations. The failure of external audits fuelled the aggressiveness of the US government. A republican government signed SOX in 2002. Similarly, governments worldwide, for example, Saudi Arabia, issued a bulletin in 2006 governing corporations in their lands after capital markets experienced a downfall in Ref. [142] and keep updating it [143, 144, 145, 146, 147] to articulate and state corporate responsibilities toward the public.

Conventionally unlike the democratic type of government, republicans are promoters of market solutions that are constructed on not interfering with market mechanisms. The market shock, however, was beyond any plan for containing. The market shock required a response with a magnificent scale. Corporate governance, which is so long inactive component of the corporate model, was reactivated with a full scale.

The roles of the board of directors and audit committees have been emphasized. Members of such boards and committees ought to actively participate in the governing activities of their corporations. However, the existence of corporate governance does not guarantee governing executive management in a way that assures alignment with their interest and parties financing the corporation. The ability of the audit committee is doubted [148]. KPMG (2004 as cited in ([149], p. 242)) reported, “Even though Sarbanes-Oxley significantly increased the role of the audit committee, client management remains most influential with regard to issues such as auditor retention and compensation.” Empirical exploration shows that the board of directors is not an effective mechanism for governing executives in Saudi Arabia [150].

Whether corporations are governable is a question. The issue for society and stakeholders is when a corporation can appear as a governed entity while in fact, it is not. This issue is not new to accounting. The concept of auditor in appearance has been divided into two sub-concepts: independent in appearance and independent in fact [109], an indicator of the impossibility of maintaining independence in truth. Independence is a state of mind. “[O]nly the auditor himself or herself knows for sure whether…[independence in fact] has been compromised” [151].

4. The separation between management and ownership: the lasting issue in corporate economy

The separation between management and ownership [152] brought into existence a challenge facing accounting of how to report to external parties about corporate internal affairs that affect the financial position of the reporting entity [2, 4, 32, 33, 34, 81, 87, 140, 153, 154, 155].

Given the fact that the corporation is the result of cooperative contracted parties each of which is serving his/her interest, the conflicting interests among such parties permit theorizing the corporations as an agency issue. Jensen and Meckling [156] observed “…agency costs arise in any situation involving cooperative effort… by two or more….” Fogarty et al. [157] deemed Jensen and Meckling [156] a “rediscovery.” The agency issue is not new to accounting. Agency as a model for theorizing the corporation was rediscover but not invented to assist in mitigating risk that the corporate model for conducting business brings to stakeholders of the incorporated enterprise. [158, 159]. Agency relationship in Italy was an important concept because it forced accountability; the concept was later important to the development of corporations [159]. With risky equity particularly with respect to the action of agents, such risks were offset by the deep personal loyalties of covenants deriving from kinship bonds” ([158], p. 52).

Agency theory is a dogma [160] that has dominated accounting research worldwide (e.g. [29, 33, 54, 71, 161, 162, 163, 164, 165, 166, 167, 168, 169, 170, 171, 172, 173]) to the extent it has dictated the accounting publishing market in the US to become an immutable theoretical foundation in top-tier accounting outlets [30, 174, 175].

The agency model that is used for theorizing corporations is incomplete. The principal in the agency relationship is actually absent [2, 154, 155, 176]. Stockholders tend to invest in corporations through intermediaries [177]. When individual investors incorporate shares, they tend to hold them for short periods that can last seconds [178]. Individual investors do not appear as investors who make decisions regarding their investments [177, 179, 180]. Institutional investors are the main corporate investors.

Modeling the corporation as an agency requires encompassing the agency between shareholders and mutual funds that manage the investment of shareholders [181]. The agency model is then two-tier: the first tier is between executive management and mutual funds managers while the second is between mutual fund managers and shareholders [181].

In comparison to other parties in the corporate model, the chief executive officer (CEO) is the most powerful individual. Defiant investors are weak in comparison to the executive management of their corporation [180, 182]. Empowering shareholders is yet another myth [183] which is the myth of shareholder maximization value myth [184, 185, 186, 187, 188, 189, 190, 191, 192, 193, 194, 195, 196, 197]⁴. Mutual funds directors who are supposed to be the agents of shareholders in the contractual relationship between executive management and shareholders do not participate in governing corporations [180].

The audit function, as a conventional mechanism for safeguarding the shareholders’ interest, as well as corporate governance, the current mechanism of newly enacted regulations reactivated, might not be as effective as hoped [109, 140, 187]. Executive management prefers a close relationship with their auditors [2, 109, 199]. Empirical confirmation reveals the client’s first choice for a relational tactic with their auditors ([200], p. 4). External auditors cannot always resist the demands of the executive management whose financial statements they are auditing [109]. Executive management has numerous prospects to conspire in hiding transactions from the auditor ([201], p. 121). Executive management employs financial accounting standards in ways best serve their interest [23]. Bost [118] contended “…auditing firms too often lost their independence and become overly accommodating to their clients in deferring to questionable accounting stratagems.” In some circumstances, external auditors find it optimal to cooperate with the executive management [140]. Chung & Kallapur [202] conjectured that auditors’ motivations to compromise their independence are associated with client status.

Strengthening auditor independence has not been successful in a corporate setting [109, 140, 201]. The Securities and Exchange Commission (SEC) keeps providing details for circumstances where auditor independence might be breached (e.g. [201]) an indicator of the impossibility of performing corporate auditing with total impartiality [114, 115, 116, 129, 140]. Because of lacking independence, auditors are perceived as synonymous with ‘CEO,’ and ‘CEO’ does not stand for anything good ([203], p. 30), is identified with the client “in the public eye” ([204], p. 34), and create “long-term cooperative partnerships with their clients”⁵ (Max Bazerman). The same can arguably happen to the corporate governance mechanism in a corporate setting [111].

A board of directors might not be powerful in comparison to executives as it is propagated [199, 205]. Board of directors do tasks that in nature are extensions of the tasks assigned to executive management [180]. The SOX narrowed directors’ focus on financial reporting risk at the expense of strategy and introduced some variation in the extent and nature of the role performed by the audit committee to decide accounting differences of opinions and to give thought to varying construal of law [206]. If corporate executives’ compensations signify their value, then a marginal role is left for the board of directors [199].

A board of directors as a monitoring corporate mechanism is not newly added to the corporate model. Their role has been recently reemphasized after major corporate failures at the beginning of the current millennium. Without a board of directors’ actual involvement in monitoring corporate executives, the risks and consequences of corporate executives’ decisions are overnighted.

5. Corporate governance in appearance: A possibility

5.1 The prescribed remedy is not curing

Since the corporation is viewed as an agency, the risk of making decisions that may affect the wealth of owning parties who do not participate in managing their enterprises can be arguably controlled through monitoring mechanisms [207]. The Sarbanes–Oxley Act (SOX) was the major piece of legislation since the Great Depression [208]. Brown Jr. [208] described it as dilapidated bills, with very diverse philosophies, that were cobblestoned, amplified, and passed in an outbreak of action. Drawn it up in haste [209] does not make the SOX a perfect remedy.

The SOX was a prompt governmental response to restore confidence in the capital market. Reviews of studies on the impact of the SOX suggest that investors’ confidence was assured [210, 211]. Anandarajan et al. [201] however asserted the claim that while “investors may have been lulled into feeling comfortable about audit firm performance given the clear legal penalties that the audit firms face…This…is an area for future research that has not been thoroughly examined.” While others might still deem the movement toward effective corporate governance revolution and attribute it to the SOX [212, 213, 214], it is best described as a wave.

SOX’s effect in comparison to the cost of its implementation is questionable [215]. Some perceive its costs exceed its benefits [216] while others argue that it is not sufficient for the enhancement of corporate governance [217]. It has not necessarily discouraged actual fraudulent behavior [218].

It is a phenomenon that corporate scandals create a demand for regulating corporations. The Securities Act of 1933 and 1934 followed the great depression. SOX followed the failure of two major Arthur Anderson’s audit clients, namely Enron and WorldCom. A quick governmental response does not cure the capital market from its norms nor does it yield the hoped outcomes.

5.2 The complexity of governing corporations

Listing six myths surrounding corporate governance; Brickley & Zimmerman [219] concluded that understanding the nature of corporate governance is not a one-person task. The issue that Berle and Means [152] raised must be understood for any monitoring mechanism to be workable. While an independent board of directors is a convention, evidence suggests that an independent board of directors is correlated with worse corporate performance [220].

With the ideology of “profit over people” [221], multinational companies run the world [3], affecting strategically their affairs for example the consumption of citizens of a variety of countries [222]. Similarly, societies change because of participating in capital markets. The US has become an equity culture [223] and has grown into an “ownership society” [184] that has instigated a public change in the US. In seeking liberty and equality as an alternative to relying on their government, such public has become investors instead of savers [224].

Accounting and auditing are myths and rhetoric [132, 225, 226, 227, 228]. Accounting reality is constructed [229, 230] but not a reflection of the economic reality underlying the enterprise [231]. Accounting truth has been always a challenge [225, 232, 233, 234, 235]. Recently a discourse has emerged as a result of FASB’s approach of constructing reality [236, 237, 238, 239, 240, 241, 242] which is added to the debate on accounting truth and reality [225, 229, 232, 233, 234, 235, 243, 244, 245, 246, 247, 248, 249, 250, 251, 252, 253]. Professor Sterling’s [256] warnings [257] and others’ warnings of the coming crisis in accounting [258] have been ignored. While playing their number game [259], accountants are unaccountable [260] and auditors are unaudited [261, 262]. In response to a Fortune writer regarding the story that the Wall Street Journal ran in 1994 in a front-page story detailing the many ways that Jack Welch and his team smoothed earnings at General Electric (GE), a GE staff member indicated that the people at GE received calls from other corporations (AIG, Champion International, and Cigna) and commented that “Well, this is what companies do. Why is this a front-page story?” [263]. The current accounting system permits such activities [264].

Moreover, the analysis of several proposed models that Jensen & Meckling [265] analyzed reveals the superiority of the Resourceful, Evaluative, and Maximizing Model (REMM). The REMM suggests that if a person finds an opportunity to benefit, he intends to exploit it and benefit from it, and the same applies to him if he is placed under pressure. Arguably, an individual may respond to it, especially if the return from responding to these pressures is greater than adhering to the position dictated by his work requirements. If there are incentives that compensate for the cost or consequences of responding to these more beneficial pressures, then it is economically optimal to comply with these pressures. Management executives, accountants, external auditors, and the board of directors apply to them what applies to humans [266]. Auditors economically represent their self-interest [267]. Financial statements fraud as a form of corruption is a systematic activity [268] that cannot be in place with the organization to deviations from norms [266] and without personnel carrying out such activities [269].

Two years after enacting SOX, Mitchell [214] concluded:

“One could dare hope for the eventual development of a new investment culture in which stockholders buy and hold for the long-term, investigating their companies and reading financial information and other disclosures before investing. One can hope. Whether the regulations are vigorously enforced, or whether the SEC is lax, whether institutional investors continue to exert short-term pressure on management, and whether the market's recent need for instant gratification continues, remain to be seen.”

Twenty years later, one would argue the corporate economy has experienced its norm where fraud behavior deceived individual investors.

Mimicking theory suggests that an enterprise can mimic another to signal to the market that the former is as good as the latter. A corporation may theoretically employ a corporate governance mechanism to signal that its executive management is governed. The board of directors of such corporations may appear governing executive managers while they are in fact not or cannot. The audit function has been successful arguably because of the ability of external auditors to appear independent while in fact they might not be independent [2].

Government regulations alone are not sufficient to establish financial markets that nurture auditor independence ([270], p. 269) as well as effective and true corporate governance. Humans are complex creations. Without a code of values, they tend to rationalize what best serves their interest. Unless the code of values has control over humans’ actions in the corporation, any proposed remedy does not guarantee a cure. If this is too much to ask, then the corporate model needs to be revisited.

6. Conclusion

The old slogan, ‘fake it until you make it’ fits the continuing efforts in minoring the risk brought as a result of founding enterprises that are led and managed by those who did finance them. Corporations can only appear as they are wished to appear, but unlikely to be in fact as wished.

‘Guard it before you lose it’ is better to become an action plan and put in place for corporate financers. Involvements of all stakeholders might not yield effective and efficient corporate governance [74]. Oppositions to shareholder power are myths [187].

Awareness of corporate financers is what is needed. Without their active involvement, corporations are unleashed. When they become aware and realize that they may not be able to hold executive management accountable to make their corporation a good citizen of the globe, they can react and make decisions. Inordinate shareholder power is correlated with superior corporate performance in all deliberate matters [187].

Once becoming aware, the public’s reaction to corporations is magnificent. The best example of exercising the public power would be the blockage that the public undertakes to join Palestine’s suffering and pain caused by the invading people who are supported by powerful international countries affected international corporations. Starbucks bled because of its stand on oppression and injustice to innocent people in Palestine. The government of South Africa has brought a case against the oppression of people in Plantain in the International Court. None of these have happened in the past decades. Palestine had been in the past the case of Arabs and Muslims. Things changed, as the public became aware of reality with a clear vision and without illusion.

Furthermore, the emerging need for the utility of ethics in accounting due to an unsettled environment in which accounting operates and the changes in science call for normative accounting theorization where ethics underline it philosophically, epistemologically, and methodologically [271]. Operationalizing “the accounting function…to serve information needs within a particular cultural environment and… reflect related social, economic, political, and legal influences” ([272], p. 137) potentially assists corporate accounting in serving the public. Accounting has been responding to societies’ economic needs [4, 32, 33, 34, 75, 111, 112, 140, 153, 154, 273, 274, 275, 276, 277, 278, 279, 280, 281, 282, 283, 284, 285, 286, 287, 288]; Montgomery as cited in Nelson [289]) and shall continue once the corporate model is theorized soundly and realistically. The view that corporations are founded to maximize the value of absentees is naïve. A long history of corporate failure has proven its fallacy.

Future research can explore the types of individuals, who are suitable to serve as members of a corporate governor in appearance. Illiterate individuals whose knowledge in accounting, finance, and business is weak and individuals who are willing to cooperate with the executives probably fit such types of people.

Acknowledgments

I am indebted to Case Western Reserve University for granting me access to the resources through the KSL Alumni Online Library, which made completing this article possible.