Worldwide Accounting Irregularities

When accounting irregularities at the giant companies of Enron and WorldCom were reported in the U.S., many people believed that one of the main reasons for such a debacle might be due to the exorbitant compensations of American chief executive officers. The compensation gap between CEOs and average workers is huge and has been increasing over time. The gap is especially large for American companies. In fact, when German Daimler and American Chrysler merged, one of the greatest cultural differences they had to overcome was the gap between the compensations given to the top executives of the two companies.

One of the sure signs of increased globalization in the 1990s in the area of corporate governance was that many companies all over the world realized that their accounting practices had to be more transparent with more disclosure, their corporate governance had to be improved and their board of directors held more accountable for their business decisions. The three most important business decisions the board routinely makes are to oversee annual auditing, to evaluate CEO performance (for hiring and firing the CEO) and to decide CEO compensation.

Partly because of the enormous, and seemingly efficient, equity market in the U.S., many European countries tried to copy the corporate governance practices in the U.S. The reduction of the number of directors, for instance, had been actively discussed and in fact implemented in Germany and in other countries.

The number of board members in Germany and Japan tended to be large and they are still large in comparison with American counterparts. One main reason for the greater number of board members in those countries can be attributed to the large role of creditors. Many German and Japanese firms have higher leverage ratios with larger debts in relation to equity levels. German and Japanese firms borrow heavily from banks, insurance companies and pension funds. Those creditors very often insist on taking seats on the board to make sure they will have their loans repaid.

On the other hand, American firms tend to generate their capital through the equity market. Hence, board members generally represent shareholders rather than bondholders. At the same time, equity holdings have been diluted over the years.

Corporate governance in the rest of the world was approaching the style in the U.S. until the Enron and WorldCom debacle. The reform movements in the Europe naturally stopped, because one of the major contributors of the debacle was allegedly faulty corporate governance _ or the board of directors.

This trend, in retrospect, is understandable. Stock markets performed extremely well in the 1990s. The U.S. economy grew rapidly. In fact, Japan had its stock market going down and down in the entire decade. European countries suffered from high unemployment rates and slow growth. Since companies were performing well in the U.S., investors paid less attention to their corporate governance. Naturally, the board was lax in its duties.

We cannot find fault with the corporate governance per se, but the boards were apparently complacent. As many dot-com, biotech and high-tech companies collapsed, the earnings at many corporations were equally affected. Diligent accountants, careful business consultants and the watchful eyes of board members were all missing in action.

When the Japanese economy grew very rapidly in the 1970s and 1980s, relative to the United States and many European countries, many Western countries tried to copy the success of Japan and Japanese companies. European countries and even the United States openly argue that industrial policy a la Japan should be adopted. Among others, the Japanese just-in-time inventory system has since been widely adopted in the U.S.

On corporate governance, as I mentioned above, European countries tried to copy the American style corporate governance, with a fewer number of board members but with greater accountability. Accounting principles used in the U.S. were also believed to be better than their own.

If the fraudulent activities of Enron, WorldCom, and other companies did not surface, then such reforms could have been completed by now. Once those accounting irregularities were revealed, however, European countries quickly re-evaluated their plans to assimilate American accounting practices. Apparently, they believed that American accounting system must be deeply flawed or equally antiquated.

After a recent revelation that a Dutch food retailer Royal Ahold had been inflating their earnings massively and a realization that it may not be a unique situation in the Europe, their accounting practices and corporate governance are under renewed investigation.

Ironically, the Enron and WorldCom debacle in the United States may hasten the reform of accounting practices and corporate governance in Europe. It appears that accounting irregularities are problematic everywhere. Under globalization, a common system is desirable, or even required, whether it pertains to accounting practices or to corporate governance. Though there still exists a tremendous home bias in international investment, wherein investors overwhelmingly invest their money in their own countries, the extent of home bias has been declining.

That is, more investors invest their money in other countries as well. When investors invest their money abroad, they will look for similar accounting measures and corporate governances in rating foreign companies.

The market will call for similar (or in the extreme, the same) accounting practices and corporate governance structures. Many believe that although American practices are far from perfect, they have been put to market tests better than those in other countries.

Moreover, American systems are undergoing a big reform. Companies in South Korea should pay a greater attention to the reform in the United States in accounting practices and corporate governance to better attract foreign investors and to be globally competitive.