Question

Corporate governance reforms and best practices require the establishment of key gatekeepers to deal with perceived agency problem of asymmetric information between management and investors and improve the quality of public financial information while discouraging earning management practice. 

Required: 

a) Explain the primary intent of corporate governance reforms.  

b) Citing appropriate examples discuss the role of FIVE corporate gate keepers. 

c) Define earning management and explain key incentives for its practice. 

Answer 1

a) The primary intent of corporate governance is to ensure that interest of minority shareholders and general public is protected from fraudulent reporting by the management. Ultimately it ensures that general public shareholders are not misled by the earnings reported and do not lose their wealth and trust in the firm.

b) Five corporate gatekeepers are:-

1) Finance and account team - They keep the book of accounts and ensure adequate precautions are taken in revenue recognition.

2) Internal audit and the audit committee- Responsible for checking robustness of internal controls.

3) External auditors- Verify the correctness and prudence of reported financial statements.

4) Board of the company- Ultimately responsible for steering the firm in correct direction and have fiduciary responsibility towards shareholders.

5) Shareholders who have access to information on the daily operations of the firm

3) Earning management is to overstate earnings and net income in order to increase revenue and profits than would be normally possible.

This happens because managerial compensation and bonuses are linked to quarterly and annual targets and hence some of the sales of next quarter are recorded in the current quarter itself to report better numbers. Similarly some expenses are deferred to ensure that profitability is higher.