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Simon School Executive MBA Programs

International Seminar SeriesShanghai, China

Corporate Governancein Hong Kong & Mainland China

Judy TsuiDean, Faculty of Business

Director, Graduate School of BusinessChair Professor of Accounting

The Hong Kong Polytechnic University28 March 2006

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Why Do We Need Corporate Governance? Asian financial crisis Corporate scandals in Hong Kong Widespread concerns on “earnings

manipulation” Lack of corporate transparency and

inadequate financial disclosures Discretion in choice/procedures of

accounting methods – Generally Accepted Accounting Principles

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What is Corporate Governance?

Corporate governance is the system by which companies are directed and controlled.

Mechanisms whereby suppliers of corporate finance can assure themselves of a return on their investment (Shleifer and Vishny, 1997).

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Principles underlying Corporate Governance

Openness

Integrity

Accountability

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Governance: Structure and process for decision-making,

accountability, control and behavior at the top of organizations.(Source: Governance in the Public Sector: A Governing Body Perspective, Study 13, IFAC, Aug 2001)

Governance in Private Sector: Focus on board of directors Shareholders

Governance in Public Sector: Focus on boards Stakeholders

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Lack of Corporate Governance

Background and Economic Incentives – theoretical basis:

Agency theory Incomplete contracting Information asymmetry

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Agency Theory:

Separation of ownership and control Financiers (shareholders / debt holders)

vs. Managers (agents) Majority shareholders expropriating

interests of minority shareholders

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Incomplete contracting

Formal (legal contracts) and informal contracts (admin. policies)

Contract negotiation, enforcement & monitoring are costly

Not possible to write contracts that cover every contingency

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Information asymmetry

Managers possess private information that financiers don’t have

Managers’ efforts are not observable Costly, if not impossible, for managers to

reveal true information to financiers

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Asian Financial Crisis:Corporate Governance

Perspective

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The 1997 Asian market crisis “one of the most devastating economic events”

Stock markets plummeted by an average of 40%

Indonesia and Malaysia more catastrophic than Hong Kong and Taiwan

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Currencies across the region lost more than 50% of their value

Mainly weak performance in the corporate sector

Essentially a crisis of confidence

Political pressures to maintain high rates of economic growth

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Government Involvement Perceived and actual lack of financial

transparency in corporate dealings.

Political Pressures Malaysia, United Engineers (United Malay

National Organization) (UMNO) forced to make an offer for Renong (UMNO – affiliated company) – much higher than the latter’s market valuation (SCMP, October 19, 1997)

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Indonesia – “crony capitalism”

Political connection rather than innate efficiency

International investors

Inadequate financial disclosure and corporate transparency

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“Pressure from multilateral agencies and the global market for more disclosure of financial data is rising. Asian companies that want to tap international capital markets will have to meet more stringent reporting requirements.” (Tripathi, 1998)

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Ways managers can misrepresent financial transactions:

Sales related Timing of invoices

Phoney orders

Expense related Splitting invoices

Recording prepayments as expenses

Management discretion over timing of expense recognition

Engaging in substantive transactions to affect reported earnings

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“Creative accounting” devices

Accounts do not present a truthful picture of the underlying economic fundamentals of the company’s financial health

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Six motivations for earnings management (Dechow, Sloan and Sweeney, 1996):

a) Managers increase accounting earnings to:(i) Increase their bonus and compensation (Healy, 1985)

(ii) Loosen debt covenant violations (Dhaliwal, 1980)

(iii) Encourage investors to buy an interest in the company’s shares as owners, or in bonds as creditors

(iv) Increase the value of shares of shareholders

b) Managers decrease accounting earnings to:(i) Negotiate union contracts (Liberty and Zimmerman,

1986)

(ii) Avoid political or regulatory processes

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How do we control managers? Through corporate governance mechanisms by

which: financiers of a corporation

(shareholders and creditors)

corporate insiders (managers)

control

Corporate Governance Mechanisms Weak corporate governance Incentives for

managers and directors in Asian countries - to make inefficient investment decisions and manipulate earnings

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Corporate governance systems in East Asia are relationship-based

as opposed to the arms-length market-based systems in the U.S.

“Market-based systems require transparency as a guarantee of protection.

… By contrast, relationship-based systems are designed to preserve opacity, which has the effect of protecting the relationship from the threat of competition.” (Rajan and Zingales, 1998)

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Relationship-based systems

Example: Chaebol in South Korea; Keiretsus and banking ties in Japan; politically affiliated companies in Malaysia and Indonesia; family controlled companies in Hong Kong

Need to recognize legal environment and political constraints

Successful corporate governance - combines legal protection of investors with a monitoring role for investors

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Insider shareholding reduces agency costs

Non-Executive Directors on the Board provide monitoring of managers

CEO horizon problem: CEOs in final years in office are expected to make inefficient decision

Debt monitoring

Big-5 auditors – higher quality

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A Real Case of Bad A Real Case of Bad Governance :Governance :

KCRCKCRCKowloon-Canton Kowloon-Canton

Railway CorporationRailway Corporation

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KCRC Saga

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KCRC Saga

Background : Government’s introduction of

separation of roles of oversight and execution to public-sector bodies

A chairman, being non-executive, is appointed by the Government on a part-time basis to oversee the Managing Board

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KCRC SagaProblems :Deep-rooted management troubles,

bureaucratic A clash of styles between a hands-on

chairman and his chief executiveClassic case of an overintrusive chairman

and a resistant chief executiveUnclear division of roles and dutiesPeople are reluctant to accept changes, e.g.

transparency, accountability, etc.

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KCRC SagaResult : Boardroom saga going public Pose threats to public interests Damage corporate image Resignation of chief executive and

dismissal of a senior manager Damage morale

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KCRC SagaLesson : Delineate clearly the respective

duties of chairman and chief executive

Balance of power between chairman and chief executive

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Splitting the Roles in Splitting the Roles in Public-sector Bodies :Public-sector Bodies :

SFCSFCSecurities and Securities and Futures CommissionFutures Commission

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SFC

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SFC In line with good corporate governance

practice, Government proposes to improve SFC’s governance structure by splitting roles of Chairman and Chief Executive

Role of chairman should be clearly separated from that of CEO by focusing on his supervisory functions over senior management

Non-executive chairman will not be involved in day-to-day regulatory work

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Corporate Governance in Public-Sector Bodies Managed by senior officials No governance bodies Lack of transparency and accountability Information inaccessible by public In-the-box operation Lead to scandals and disasters

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Corporate Governance in Public-Sector Bodies To avoid management failures and to

facilitate efficient and effective management of public monies as well as to account for public interest, good corporate governance practice is promoted and introduced to various public-sector bodies in recent years, e.g. Airport Authority, Hospital Authority, KCRC, etc.

PSB (Public Service Broadcasting) is under review for re-vamp

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Setting a Good Example Setting a Good Example ::

CLPCLPChina Light & China Light & PowerPower

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Corporate GovernanceA Shared Commitment

(5-min Corporate Governance Video)

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CLP Maintaining a good, solid and sensible framework of corporate governance has been and remains one of CLP’s top priorities

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CLPEvolution of CLP’s Corporate Governance in 2005 Adoption of the CLP Code on Corporate Governance Establishment of a Social, Environmental & Ethics Committee of Board Addition of two more Independent Non-executive Directors A majority of Human Resources & Remuneration Committee members

are Independent Non-executive Directors Second member of Audit Committee appointed with appropriate

professional qualifications and experience in financial matters Rolled out development programme for Directors Implemented formal letters of appointment of Non-executive Directors

modelled on UK best practice Effected fixed-term appointments for Non-executive Directors Confirmation from Senior Management on compliance with Model

Code and CLP Code for Securities Transactions General Mandate to issue new shares voluntarily reduced from 10% to

5% of the share capital in issue

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CLP

Organization of Board & Sub-committees

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CLPOrganization of Board & Sub-committees CLP follows a formal, considered and

transparent procedure for appointment of new directors

Chairman and CEO are held separately to ensure a clear distinction between Chairman’s responsibility to manage Board and CEO’s responsibility to manage company’s business

Board has appointed a number of Board Committees to oversee particular aspects of company’s affairs

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CLP

Operated in an open and transparent manner

Information such as annual report, corporate governance report, environmental report are widely accessible on website by the stakeholders as well as the general public

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Best Corporate Governance Disclosure Awards CLP has won Diamond award (highest honor) in the

Hang Seng Index Category for 3 consecutive years (2003-2005)

Comments by Judges Report was transparent and informative and a reflection

of good corporate governance practices Demonstrated that company has embedded a good

corporate governance culture in its organizational structure and operational procedures

Inclusion of a separate remuneration report, which sets out clearly group’s emolument policy

Company supplemented its annual report with a comprehensive and easy-to-follow booklet

A separate booklet, entitled Social and Environmental Report was also published

CLP

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CLPSocial ResponsibilityWe have supported social and environmental practices that have added to the quality of people’s lives

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CLPSocial

Responsibility Society

Community Care Youth & Education Arts & Culture

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CLPSocial Responsibility Environment

Energy Resources & Renewable Energy

Generation & Process Efficiency

Air Quality Water Global Climate Change By-Products and Waste

Management in CLP Environment Education

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My 3 Consultancy Reports

Awarded by Financial Services Bureau on behalf of Standing Committee on Company Law Reform of the HKSAR Government.

Forms part of “Corporate Governance Review by The Standing Committee on Company Law Reform, A Consultation Paper on Proposals made in Phase II of the Review”, June 2003

1. International Institutional Investors’ Attitudes towards Corporate Governance Standards in Hong Kong

2. Corporate Governance Regimes in Other Jurisdictions

3. Roles and Functions of Audit, Nomination and Remuneration Committees

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References

“Corporate Governance in Emerging Markets: An Asian Perspective”, a chapter with Tony Shieh, in “International Accounting and Finance Handbook”, Third Edition, Edited by Frederick D. S. Choi, New York University, 2003.

“Top Executive Replacement Decisions and Financial, Accounting Information: Effect of Organizational Structure”, by Charles J. P. Chen, Zengquan Li, Xijia Su, and Judy Tsui, working paper.

“ Non-Audit Services, Auditor Quality and the Value Relevance of Earnings ”, by Ferdinand A. Gul, Judy Tsui and Dan S. Dhaliwal.

“Discretionary-Accruals Models and Audit Qualifications”, Journal of Accounting and Economics, Vol. 30, Issue 3, December 2000, by Eli Bartov, Ferdinand A. Gul and Judy S.L. Tsui.

“Board leadership, outside directors’ expertise and voluntary corporate disclosures ”, by Ferdinand A. Gul and Sidney Leung.

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References“Auditors’ Behaviour in an Audit Conflict Situation: A Research

Note on the Role of Locus of Control and Ethical Reasoning”, Accounting, Organizations and Society, Volume 21, No.1, pp 41-51, 1996, Judy S. L. Tsui and Ferdinand A. Gul.

“Auditors’ Ethical Reasoning: Some Audit Conflict and Cross Cultural Evidence”, International Journal of Accounting, Volume 31, pp 121-133, 1996, by Judy S. L. Tsui.

“A Test of the Free Cash Flow and Debt Monitoring Hypotheses: Evidence from Audit Pricing”, Journal of Accounting & Economics, Volume 24, No.2, pp 219-237, 1998, by Ferdinand A. Gul and Judy S. L. Tsui.

“Shareholding Structures, Related Party Transactions and Corporate Governance in China” by Wei Guo Zhang, The Governance of East Asian Corporations, pp27-44, 2004, Edited by Ferdinand A. Gul and Judy S.L. Tsui

“State Owned Enterprises” Judy Tsui, Charles Chen, Xijia Su & Zhuang Dongcheng

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Corporate Governance In

Mainland China

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Corporate Governance in Mainland ChinaChinese SOE Governance Inappropriate governance system in Chinese SOEs

(State Owned Enterprises) is the major reason for their low efficiency

Take consideration of political, cultural and history factors while improving corporate governance

Objective of improvement is to establish an effective control system and incentive system

Improve transparency of financial statements and audit quality

“Corporate Governance, Government Intervention and Performance of ChineseState Owned Enterprises” Judy Tsui, Charles Chen, Xijia Su & Zhuang Dongcheng

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Corporate Governance in Mainland ChinaProblems : The co-existence of extremely strong and weak controls by

the State make the primary objective of corporate governance, to maximize benefits for the company and the minority shareholders, impossible

State’s controlling position has led to the following problems : Corporate governance is characterized by the strong influence of

the State. Government can exercise their control on listed companies to influence the major corporate decisions

Corporate governance may also be weakly controlled by the State It is easy for the largest shareholder of the company to

collaborate with internal management, increasing the possibility and feasibility of exploiting the interests of the minority shareholders

Lack of motivation for restructuring the business in the case of corporate crisis

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Corporate Governance in Mainland ChinaProblems : The shareholders’ general meeting –

shareholders’ rights to propose resolutions are often restricted

Board of directors has a weak awareness of responsibility for the interests of the company and all shareholders

Limited function of board of supervisors Lack of strong external monitoring

mechanism“Shareholding Structures, Related Party Transactions and

Corporate Governance in China”Wei Guo Zhang

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Running in the Running in the Forefront :Forefront :

China Vanke China Vanke Co., Ltd. Co., Ltd.

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A RMB20-billion property developer in Mainland China focusing in fast developing cities in Cheung Kong Region Delta, Pearl River Region Delta and Beijing-Tianjin Region with a net profit of RMB2 billion in 2005

Vision & Mission :“To Create Healthy & Opulent Life”

Vanke puts high value on : Customer relationship & satisfaction Human resources Fairness, openness & transparency Business growth and market leadership

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Corporate Governance Good corporate governance practice Supervisory Board

Chaired byParty Secretary

Board of DirectorsChaired byChairman

Audit Committee Investment Strategy Committee

Remuneration &NominationCommittee

Board includes :- 6 Executive Directors- 4 Non-executive Directors- 1 Secretary

2 Tier Board2 Tier Board

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Social Responsibility Implement “Corporate Citizen”

scheme by funding RMB1 million every year for : improving living condition of the low

income households building harmonious community environmental protection social activities and charity

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Scandal in China

Guangdong Kelon

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Top Executive Replacement Decisions and Financial, Accounting Information: Effect of Organizational Structure”, by Charles J. P. Charles, Zengquan Li, Xijia Su, and Judy Tsui, working paper.

Abstract

This study investigates how delegation of control rights affects the role of financial accounting information in top executive replacement decisions. Deriving from the theory on decentralization of the firm as advanced by Christie et. al., (2003), we hypothesize that delegation of control rights from ultimate controlling shareholders heightens their reliance on financial accounting information. Following Morck et. al., (2000) and Bertrand et. al., (2002), we also hypothesize that tunneling activities increase the externalities of the firm, which, in turn, weakens the usefulness of financial performance measures. Using data from the Chinese stock market, we find evidence consistent with both hypotheses. Our findings extend the literature on the relationship between ownership structure and decision usefulness of financial accounting information.

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The Hong Kong PolyU Asia Pacific Centre for Corporate Governance StudiesObjectives: To provide a forum for collaborative and

interdisciplinary research in the areas of accounting and corporate law including auditing and taxation practice.

To identify key projects that revolve around the issue of corporate governance.

To contribute towards the training of professional accountants with a solid legal background.

To provide opportunities for corporate lawyers to acquire a good understanding of accounting practices.

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Mission Statement

Identify key corporate governance issues and problems in the Chinese Mainland and the Asia Pacific Region and undertake collaborative research designed to provide solutions and prescriptions.

Design state-of-the-art curricula such as Master of Corporate Governance.

Host joint conferences in co-operation with other international institutions and bodies.

Establish links with institutions in the HKSAR, the Chinese Mainland, Australia, United Kingdom, United States, Europe and other Asian countries, with a view to conducting comparative studies in the field of corporate governance.

Inaugurate Journal of Contemporary Accounting and Economics.

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Editorial Board

Chief Editor of “China Accounting and Finance Review”

Co-editor of “Journal of Contemporary Accounting & Economics”

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Effective Corporate Governance Depends on a consideration of unique ownership struct

ure and agency problems To create an optimal balance of:

1.Statutory and regulatory requirements on corporate governance code

2.Private action to promote a culture of compliance and a climate of trust and confidence through oversight

To achieve ethical business behaviour & fairness

CONCLUSION

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Q&A