Alhassanain(p) Network for Heritage and Islamic Thought

ISLAMIC WORLDVIEW AND EFFECTIVE CORPORTE GOVERNANCE

AHMAD BAKHTIAR

MOHD. NAZLI

MSc Accounting Sem 2, 2003-4

WWW.ALHASSANAIN.ORG/ENLGIH

Table of Contents

INTRODUCTION 4

2.0 CORPORATE GOVERNANCE - AN OVERVIEW 6

2.1 What is Corporate Governance?6

2.2 Why Corporate Governance is important?7

2.2.1 Financial reporting and auditing 7

2.2.2 Directors’ remuneration 9

2.2.3 Decision making-power9

2.2.4. Risk management10

2.2.5 Information and communication 10

3.0 ISLAMIC WORLDVIEW 11

3.1 Tawheed (Unity of God)13

3.2 The Core Concepts14

3.2.1 Man 14

3.2.2 Universe16

3.2.3 Religion 17

3.3 Important Values18

3.3.1 Siddiq (Truthfulness)18

3.3.3 ‘Adalah (Justice)19

3.3.4 Ukhuwwah (Brotherhood)20

3.3.5 Mujahadah (Determination)21

3.4 Insan Muttaqun (Pious Individual)21

4.0 DEVELOPMENT OF A MODEL OF EFFECTIVE CORPORATE GOVERNANCE23

4.1 Components of the Islamic Corporate Governance23

4.1.1 Shari’ah Supervisory Board (SSB)23

4.1.2 Board of Directors (BOD)26

4.1.3 Management27

4.1.4 Internal Audit (IA) and Internal Shari’ah Audit (ISA)28

4.2 Internal Forces29

4.2.1 Internal Control and Procedures29

4.2.2 Shuratic Decision Making 30

4.2.3 Shari’ah-Infused Value Individuals31

a. Education 31

b. Love for knowledge33

c. Tazkirah (Reminder)33

4.2.4 Human Resource Development34

4.3 External Forces35

4.3.1 Stakeholders35

a. Employees36

b. General public36

c. Lenders/Creditors37

4.3.2 Legal Requirement37

a. External Control38

b. Accounting standard 38

c. Acts39

4.3.3 The Institution of Hisba39

4.4 Shari’ah Law 40

4.5 Worldview - The Most Outer Layer41

5.0 CONCLUSION 42

REFERENCES 43

Notes48

INTRODUCTION

Corporate governance has become the corporate buzzword since the last two decades (Chapra and Ahmed, 2002). Not until the recent corporate scandals involving gigantic corporations such as Enron, WorldCom, Global Crossing and so forth, the response of corporate entities as well as amongst the public themselves towards the significance of corporate governance are very disappointing. Nevertheless, increasing number of collapses have made public especially investors more aware of the importance to demand high level of corporate governance practices from business entities which they have entrusted their money in them.

The bankruptcy of Enron Corp. has evolved into a scandal of enormous proportions involving allegations of fraud, corruption and unethical practices such as financial manipulation and questionable accounting practices on the part of Enron’s corporate executives, members of its board of directors, external auditors and high government officials in the USA (Baker, 2002 and Chatzkel, 2003). The weaknesses in US Generally Accepted Accounting Principles (GAAP) and Financial Accounting Standard Board (FASB) gave enough room to the Enron’s management to get an advantage from it by inflating income. Enron had “legally” hide substantial amount of its cost and liabilities into its “special purpose entity (SPE)”. The company that uses this practice explicitly has an intention to confuse the public and investors. This is done with the help of its close “business partner”, Arthur Andersen that collapse together with Enron. The conflicts between Enron and its auditors are too obvious because the ties between these two gigantic companies went even deeper when Arthur Andersen was not just appointed as an external auditor but also as an internal auditor in the mid-1990s. The auditors had been in conflict to act independently and at this situation auditors have always been in the uncomfortable position of having to judge the financial integrity of the companies that pay them. Arthur Andersen had begun to be a business partner of Enron instead of the auditor that governed by professional ethic.

A more recent case involves Parmalat, an Italian dairy-products group. Parmalat used its subsidiaries to hide the declining in its finance. It has been said that Parmalat was simply created “artificial” assets to offset as much as $16.2 billion in liabilities and falsified account over a 15 year period and using complex financial transaction to shore up its balance sheet, forcing it into bankruptcy on December 2003 (Edmondson, 2004). Such case was really giving some blows to the international accounting industry.

Meanwhile, Malaysia, the most developing country in the area of South-East Asia also has its very own classical example. Its Malaysian Airlines System (MAS) was the victim in that case. Even though it was managed by the Muslim, it can prevent the company from involving in fraudulent activities. The independence of its auditors, Arthur Andersen was really questionable as it has failed to issue unqualified report for the financial accounts ended 2000 and 2001 although there are indications that the company was having problem with the going concern problem. MAS was under the mountain of debts especially after 1997 due to its high operation costs and related transaction with the company that owned by the directors at that time. As a consequence, MAS’s share prices had dropped significantly. Nevertheless, the government of Malaysia had become the savior of the century by buying back the stake from Naluri Sdn. Bhd at RM8 which was double of current market price. In this case, not only MAS has the problem with its corporate governance, but also the government of Malaysia.

All the above are examples of the failure in the corporate governance. Such failures might result from the failure in the current codes on the corporate governance which is obviously not based on the revelation. At the same, the major player in the system, man should also be blamed due to their greediness. Therefore, in order to resolve this issue one might suggest us to go back to the religious teaching which is in this case, Islam. This paper is trying to describe the contribution of Islamic worldview, which is based on the belief in this universe and the hereafter, to effective corporate governance.

The next section is arranged as follows. Section 2 will deal with the literature review on the corporate governance, covering the definition and its importance. Section 3 focuses on the Islamic worldview and how it can contribute to theinsan muttaqun (pious individual). Section 4 will be our proposed model for the effective corporate governance. It will among things discuss the issues pertaining to the major components of corporate governance as well as its internal and external forces. The last section will be our conclusion.

2.0 CORPORATE GOVERNANCE - AN OVERVIEW

2.1 What is Corporate Governance?

Corporate governance is a broad theory concerned with the alignment of management and shareholder interest (Grant, 2003). Governance refers to the way in which something is governed and to the function of governing. According to Cadbury Report (1992);

“Corporate governance is the system by which companies are directed and controlled” (p. 4).

A system of corporate governance is needed to ensure that the businesses are running properly (Tricker, 1984)[1] for the realization of the organizational goals (Hemraj, 2002; Bohen, 1995 as quoted in Taylor, 1984). Company needs to be based on guidelines and constraints in achieving its objective such as to maximize wealth of it shareholders and with regard to other group that have interest in company. Guidelines and constraints including behaving in an ethical way and in compliance it laws and regulation. Here, the concept of accountability sets in (Bacchus, 2003 as quoted in Tricker, 1984).

Normally, responsibility and accountability are heaped onto director’s shoulder. Directors are responsible to increase the value of share by enhancing the company performance and in the same time are accountable with the decision that they have made. However, corporate governance is not as simple as what we thought. It is not just referring to the regulation and constraint that need to be complied by company but also concern with how powers are equitably shared and exercised by different group. Such powers need to be carefully used in the favor of various stakeholders and not merely based on the interests and wills of the power holders. Powers is delegated by investors to company’s directors, so that they have a control over the company. Hence, the control mechanisms are emphasizing the enhancement of stakeholders’ interest especially to the shareholders who have direct control on the company (Koh, 2001).

Various authors have given different sets of definition regarding corporate governance. Nevertheless, we can conclude here that the essence of the corporate governance is the relationship between management of the company which included the directors, investors, and other interest stakeholders. Good corporate governance can be established if all of these groups can communicate effectively (Grant, 2003) and to achieve this, the conflict of interests need to be reduced among the groups. The major concern of corporate governance is the conflict of interest between the board of directors and other stakeholders groups, especially shareholders and employees. Normally, directors take decisions that are in their personal best interests, and regardless of the interests of other stakeholders. Therefore good corporate governance at least can secure the interest of other stakeholders and directors be more accountable to decision that their take.

Combined Code of Corporate Governance on July 2003 has released Code of Best Practices which is focus on companies’ environment and institutional shareholders. An issue that has been given attentions is directors, remuneration, accountability and audit and relation with shareholders (Combined Code of Corporate Governance, 2003).

2.2 Why Corporate Governance is important?

A large company has a large number of stakeholders and has to balance the demand and the need of each and every one of them. Although some stakeholders have a power to influence or decide the action of the company, others who do not have much power need to rely on the information disclosed by company’s management which the main source is financial report. This is to ensure that the actions taken by the company are in their interest. Therefore, there are always conflicts between the stakeholder groups.A major concern of corporate governance is to reduce the conflict between directors of the company and other stakeholders especially shareholders and employees as directors normally tend to take decision based on their interest. Furthermore, directors can assess more information therefore in a position to control or manipulate the information that is released to the stakeholders.

“In the absence of the protections that good governance supplies, asymmetries of information and difficulties of monitoring mean that capital providers who lack control over the corporation will find it risky and costly to protect themselves from the opportunistic behaviour of managers and controlling shareholders” (p. 11)[2] .

Relationship between board of directors and shareholders is at the center of many problems that arise in corporate governance. Hence, the challenge of good corporate governance is to find a way in which the interest of shareholders, directors and other interest group can all be sufficiently satisfied. Good corporate governance will ensure the company survival for a long time. Directors should somehow or rather be more accountable and responsible to ensure this. They should not think of themselves at the expense of others. Enron is a good example where the directors were rewarded with bonus for almost $400 million for achieving the target of stock price although they know the company financial was not in a good position. According to Vinten (1998,p. 423),“companies with chief executives who over pay themselves perform badly in terms of profit and share price; attributes the blame to weak governance and to a lack of alignment between individuals’ and shareholders’ interest”.

In order to avoid a conflict of interest that may harm the interest of shareholders and other stakeholders, five issues need to be given high concern which are financial reporting and auditing, director remuneration, decision-making powers, risk taking and a lack of communication between the directors and shareholders.

2.2.1 Financial reporting and auditing

Financial reporting and auditing is one of the main factors in ensuring a good corporate governance. Directors may “make-up” their financial report just to portray better performance of the company. This problem exists because of weaknesses of accounting standards which allow company to do fraud in legal manner. Shenanigans scandal was obvious in Enron and Parmalat. Enron was the biggest accounting scandal ever happened in US whereas Parmalat representing Europe biggest accounting scandal. Enron had used FASB weaknesses to record its debt and asset for new investment in “special purpose entity” that was allowed to be established. Enron had misstated its earning for more than $1 billion from year 1997 to 2000. Parmalat was the latest issue and had recorded the largest accounting calamity in the world and history when it involves the losses for more than 13 billion. According to Baker (2002);

“The sanctioning of off-balance sheet financing vehicles and SPE’s by the FASB and SEC provided the opportunity for Enron to mislead its creditors and investors. Without the tacit involvement of the FAS and the SEC, the Enron scandal could not have occurred” (p. 463).

Accounting body should tightening its accounting standard in order to avoid the manipulation of accounting numbers although the problems of window dressing are unlikely ever to disappear. Furthermore, the company needs to be forced to produce transparent accounting report and concise descriptions of their accounting policies as well as how it will affect earning and revenue. Indeed, investors have a right to be informed all the relevant information that will affect the future performance as they are the capital provider. Therefore, it is suggested that the company’s annual report must disclose information beyond financial performance. Non-financial information sometime can explain better about the company’s performance and is vital to interpret the quantitative data (Vinten, 2003). Perhaps this may reduce information asymmetry between board of directors and shareholders. In addition, good corporate governance demands good quality of financial reporting which is to be transparent and show the real financial position (Rutteman, 2001).

Increasing in a number of gigantic companies (Enron, WorldCom, Parmalat, Tyco International and Global Crossing) involving in allegations of financial fraud and lack of responsible corporate governance has increased attention on corporate governance in general and the audit committee (internal and external) in particular (Hemraj, 2002, Rezaee et al., 2003 and Weir and Laing, 2001). Audit committee needs to be more transparent in carrying out their auditing job. Scrutiny inspection should be conducted rather than based on sampling because the major weaknesses of sampling process are auditor may over-look fraud sample. According to Vinten (2003), “all the ramifications of audit independence need to be assessed andreported on as does the detail of how the external audit has been carried out and the conclusion drawn” (p. 452). In fact, in the current situation in almost countries in the world, audit firm is allowed to do consulting work to the same clients they were auditing which will lead to the conflict of interest (Chatzkel, 2003). Audit firms have involved beyond its traditional areas and their responsibility to produce true and fair view becomes blurred. In this case, the auditor tend to be influenced by client company and they might be persuaded to agree with a controversial method of accounting for particular transactions to show better company’s performance like what Enron had done. The tight regulation needs to be enforced to the audit firm not to do the task that will create a conflict and can affect their independence.

The internal audit and audit committee also need to play significant role to ensure company internal systems are working properly. The major accounting scandals have raised concern regarding the lack of vigilant oversight function of audit committee. Therefore, an effective audit committee reporting can improve corporate governance and accountability to regain the public confidence in financial report (Rezaee et al., 2003). Audit committee should oversee corporate governance, financial report, internal control, internal audit function and external audit service to reduce the risk of company malfeasance. Hence, to effective fulfill its oversight function, the audit committee should be independent, competent, financially literate, adequately resourced and properly compensated (Rezaee et al., 2003). Audit committee need to build a close working relationship with other participants of corporate governance to achieve it objective.

2.2.2 Directors’ remuneration

Independent committee should be formed to determine directors’ remuneration. This is important to avoid directors reward themselves although company not doing well. At least, remuneration committee can monitor and review the remuneration that should be rewarded to the directors. Reward should depend largely on the performance of the company. It is not fair to give high remuneration to the directors when the company is not performing well as the burden will be heaped to the shareholders by reducing their dividend. Therefore, corporate governance will be the monitoring mechanisms to ensure the shareholders’ interest are being promoted (Weir and Laing, 2001). Cadbury Report has delegated the responsibility to the independent directors to monitor the actions of the CEO and other executive directors and to ensure they pursue shareholder interests. However, it is quiet difficult for independent directors to monitors an action of the executive directors as they do not involve directly with company management. Indeed, most of them are appointed in part-time basis. Therefore, they will highly depend on information provided by the executive directors.

2.2.3 Decision making-power

There is a huge debate on to what extent the board of directors exercise their power in the interest of the shareholders and other stakeholders in the company and whether directors’ power should be restricted. Corporate governance should effectively monitor the board of directors and this only can be done if the company has proper structure of board of directors. Board of directors structure itself can be a checking system to ensure directors decision is in line with the company objective. Perhaps, to balance the power within directors, the post of CEO and chairman of the company should be separated (Weir and Lang, 2001). CEO is the most powerful person in the company, therefore, the person in this position is easily making a decision on its own interest.Nevertheless, by having independent chairman, the CEO activities will be examined and any malfeasance can be detected at an earlier stage. Daily and Dalton (1994) as quoted by Weir and Lang (2001) stated that duality is more common to find in failed company than in non-failed company. These two posts ultimately need to be segregated as it carries different responsibility. CEO is responsibility to the company daily operation and implements corporate strategy, whereas, chairman is responsible to ensure the board of director works effectively. Hence, the role of chairman also involves monitoring and evaluating the performance of executive directors, including the CEO. Combining these two positions onto one person may have negative consequence to the company as the board of directors will lack of monitoring.

2.2.4. Risk management

Board of directors tends to take a decision to increase profits without giving high attention to the risk faced. Some of the companies are not aware with the changing in risk over the time or when they invested in new project. The obvious example was Enron when it keeps investing in new project without realizes it not giving much return as they expected. At the end, they need to bear a huge amount of losses. Therefore, if there is good corporate governance practiced, the board will be more aware of the risks and shareholder will be more confident on the action of board directors.

2.2.5 Information and communication

The other issue why company needs to have corporate governance is the lack of communication and information release to the shareholder and stakeholders. The information release normally is based on directors’ discretion and the normal information vehicle used by company is annual report. However, the information disclosed is very minimum and just to meet the minimum requirement of regulation. This will increase the information asymmetry gap between management of company and shareholders. Corporate governance set a guide line to enforce the company to disclose beyond the financial position and director’s report. Investors have a right to be presented, in a clear and unambiguous way, all the factors that might affects company future performance.