Corporate Governance and Financial Risk Reporting in the UK

TABLE OF CONTENTS (Can be found in the end)

 

CHAPTER ONE: INTRODUCTION

1.1 Motivation and Problem Statement

Today, corporate governance has become integral in the business world especially due to the fact that it is largely related to the performance as well as the growth of business firms. Corporate governance is and continues to play a central role when it comes to the success of a company in the current highly competitive business world. Financial risk reporting in the United Kingdom is viewed as a valuable internal control mechanism and as such is crucially highlighted in the UK Corporate Governance Code. Over the past two decades, the concept and practice of corporate governance has gradually become the central focus for academics, managers as well as policy makers. This can be attributed to the increasing concerns over the rising incidences of corporate fraud as well as fraudulent financial reporting leading to corporate scandals and the collapse of major firms. This significant attention given to corporate governance structures and principles in firms indicates that it has a major influence on both the policies and strategies; hence, the eventual performance of these corporations.

Of particular interest in the United Kingdom’s corporate governance scene is financial reporting and accountability. The Cadbury Committee established in 1991 was largely due to continuing concerns regarding the standards of financial reporting as well as accountability due to an earlier generation of corporate scandals such as the BCCI, Maxwell, and the Polly Peck. Recent economic changes as well as the emergence of high profile financial and economic failures over the past decade have reminded management boards, heads of corporate organizations and regulators of the need for efficient corporate governance and financial risk reporting approaches. In the United Kingdom, these financial and economic troubles have raised the need to understand and fine tune the relationship between corporate governance, risk management and corporate performance, which a number of research studies have sought to investigate . The case of the Equitable Life Assurance Society is a UK based insurance firm, which failed to provide its investors with the proper financial risk reports leading to the loss of millions of pounds of investors money demonstrates the critical importance of risk management and in particular financial risk reporting within the UK corporate environment. There is a need to unearth how corporate governance mechanisms impact financial risk reporting in the UK corporate context. Therefore, the proposed study will investigate and analyze 60 UK firms listed in the London Stock Exchange during the period between 2010 and 2014.

1.2 Research Objectives and Questions

The main objectives for this study will be to explore the impact of corporate governance with regard to financial risk reporting. The following are the sub-objectives of this study;

  • To investigate and analyze the level of Financial Risk Disclosure by UK firms
  • To investigate and analyze the determinants of Risk Disclosure by UK firms

The main research question for this study will be: “What is the relationship between corporate governance and the nature of financial risk reporting among UK firms that are listed in the London Stock Exchange and were operational between 2010 and 2014? The following will be the sub-questions for this study;

  • What is the level of Financial Risk Disclosure?
  • What are the determinants of Risk Disclosure?

1.3 Research Methodology

The study will employ a quantitative research design, where the researcher intends to apply a descriptive research design. The target population for the study includes all UK firms that are listed in the London Stock Exchange and were operational between 2010 and 2014. The sample population will be 60 UK firms listed in the London Stock Exchange between the periods of 2010 to 2014. They will be based according to the number of employees whereby the firms that have more than 250 employees will be categorized as large, firms that have less than 250 employees will be classified as medium and bottom level firms. Therefore, the distribution of the study sample will be as follows;

  • 20 firms will be from the top level
  • 20 firms will be from the middle level
  • 20 firms will be from the bottom level

The primary data source will be data from the London Stock Exchange for the period from 2010, 2011, 2012, 2013 and 2014. The secondary source of data will be the annual reports, financial reports as well as management reports for the period between 2010 and 2014. The study will use the manual content analysis approach to measure the level of Financial Risk Disclosure in annual, financial and management reports through the counting of the number of risk-related sentences. Multiple linear regression analysis will be used to test the relationship between corporate governance mechanism and financial risk disclosure by UK firms.

1.4 Research Contributions and Significance

The proposed study is expected to have the following contributions and significance;

  1. Enhance the understanding pertaining to the level of Financial Risk Disclosure as well as the determinants of Risk Disclosure.
  2. Add to the existing literature on Financial Risk Disclosure particularly with regard to the determinants of Risk Disclosure in the annual reports of UK firms.
  3. Add to the literature regarding the relationship between corporate governance features and practices of Financial Risk Disclosure in developed countries such as the United Kingdom.

1.5 Dissertation Structure

The study will be organized as follows;

Chapter 1: Introduction – This chapter presents an overview of the rationale and            motivation behind the need to undertake the research with regard to the impact of corporate governance mechanisms on the level of Financial Risk Disclosure by UK firms. It presents the research objectives and questions, research methodology as well as the significance and contribution of the study.

Chapter 2: Background – it will give a detailed background on the determinants of Risk Disclosure and the level of Financial Risk Disclosure reporting with a particular focus on the corporate organizations in the United Kingdom.

Chapter 3: Theoretical Literature – it will discuss three essential theories related to corporate governance and seek to put them into the context of this study.

Chapter 4: Empirical Literature and Hypotheses Development – it will review some of the empirical literature related to corporate governance and risk reporting in the United Kingdom. Hypotheses will also be developed.

Chapter 5: Research Design or Data and Research Methodology – it will outline the key research methodology aspects from research design, sample selection, data sources, variables to data analysis.

Chapter 6: Empirical Results and Discussion – it will present the results of the study and discuss them in detail.

Chapter 7: Summary and Conclusion – it will present the conclusions of the along with recommendations.

CHAPTER TWO: BACKGROUND

2.1 Introduction

Corporate governance remains an integral part of any business organization. This chapter explores the background of corporate governance with regard to financial risk reporting by firms in the United Kingdom. The chapter will provide an overview of the origin and historical perspective of corporate governance, the rising recognition of corporate governance, corporate governance in the United Kingdom with a particular focus on key policies and legislations such as the Cadbury Committee, the Company Act of 2006 . In terms of financial risk reporting, this chapter will explore the context of financial risk reporting in the United Kingdom with an overview of major policies such as the Financial Risk Disclosures.

2.2 The Origin and Historical Perspective of Corporate Governance

The origins of corporate governance can be dated back as far as the 17th Century in the East Indies and where a form of governance structure was designed known as the Court of Directors, which is similar to the present day Board of Governors. According to Shleifer and Vishny point out that the definition of corporate governance ‘‘as the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment’’. Corporate governance ‘‘as the system of laws, rules, and factors that control operations at a company’’ .The development and evolution of corporate governance over the past four decades can be attributed to the emergence of crisis situations both in the financial as well as business circles, eventually highlighting Financial Risk Disclosure issues within corporate organizations. The collapse of major multinational corporations such Enron, WorldCom, Lehman Brothers in 2001, 2002 and 2008 respectively are some of the few examples of a failure in corporate governance. The emergence of Financial and Economic Crisis such as the Asian Financial Crisis in 1997 and the Global Financial Crisis in 2007/2008 has been attributed to failures in corporate governance and in particular the area of risk management and reporting . A look at the recent Global Financial Crisis (2007/2008), some of the ripple effects include; the loss of employment opportunities whereby people the ability to meet basic needs, a gradual halt of the global and national economies, lack of credit for small business, and eventually the collapse of businesses whereby shareholders lose their invested money . Therefore, good governance in corporate organizations is seen as of great value when it comes to improving the accountability, risk management as well as the value of both the shareholder and the stakeholder .

2.3 The Growth in Recognition of Corporate Governance

The increasing sense that corporate governance is important is largely related to the fact that new and more challenging risks continue to emerge over the years. The risk management aspect of corporate governance can be seen in how Corporate Governance at the national and regional levels have emerged, evolved and proliferated over the decades. In 2012 an estimated 212 Corporate Codes of Governance as well as other Corporate Governance Guidelines were present globally addressing varying national and regional corporate governance issues . For instance, in the United States there is the Sarbanes Oxley (SOX) legislation whose enactment was subsequently followed by the formation of the Securities and Exchange Commission (SEC) . The case of corporate governance in the United States is seen as unique because it is shareholder oriented and has drawn immense criticism as result of the major corporate scandals that have emerged over the years. Other examples of corporate governance frameworks by different countries include; the Canadian Dey Report, the Olivencia Report established in Spain, France’s Vienot Report, South Africa’s King’s Report, New Zealand’s Principles and Guidelines on Corporate Governance as well as Germany’s Cromme Code.

2.4 Corporate Governance in the United Kingdom

In the United Kingdom, corporate governance has been under immense scrutiny since the 1930s and one of the first concerted efforts towards establishing a sustainable and proper corporate governance framework is referred to as the Cadbury Committee put together in 1991 and chaired by Sir Adrian Cadbury (Mallin, 2009). In addition, it is essential to understand that UK corporate policy and legislative frameworks try as much as possible to evolve with the changing corporate world both within the UK and globally such as the case of the UK Corporate Governance Code, which offers the best example of an evolving policy and regulatory framework over the years.

2.4.1 The Cadbury Code of 1992

In 1996, the Cadbury Code of 1992 was augmented by the recommendations made by the Greenbury Committee with regard to the remuneration of directors. The Cadbury committee was constituted due to the continuing concerns over the standards of accountability and financial reporting brought about by the previous events of corporate scandals such as the BCCI, Maxwell, Coloroll and Polly Peck just to mention a few . The concerns centered on the rampant use of creative accounting, the fact that there was a lack of Accounting Standards as well as the presence of weak auditors. At the time the practice of corporate behaviour in the United Kingdom was viewed by many as a threat to the long held system or approach of self-regulation; hence, the Cadbury Committee was designed towards the culture and system of corporate behavior. The report of the Cadbury Committee was published in 1992 and much of the codes of corporate governance have been useful not just to the UK situation but also globally.

2.4.2 UK Governance Code

The UK Governance Code stipulates the required standards of good practice with regard to the leadership of a corporate board, financial effectiveness and accountability towards the shareholders. The Collapse of Enron in the United Kingdom in 2001 was largely related to the failure to observe corporate governance and financial risk reporting standards.

The main principles of the code include effectiveness, leadership, accountability, relations with the shareholders and remuneration. Under the principle of accountability, the code stipulates that the board of a corporation is required to provide balanced, fair as well as understandable assessment of the prospects and the position of the company In essence, the code stipulates that a corporate board has the responsibility of determining the extent and nature of the principal risks that the corporation is willing to take with the aim of reaching the strategic objectives of the company.

A corporate board under the UK governance code is needed to maintain a sound financial risk management system, which also has an efficient and transparent internal control system. Basically, the governance code seeks to put some major obligations on a company’s board when it comes to the corporation’s activities of engaging in risk financial activities Therefore, a board is needed to set up a formal and transparent system that provides for proper financial risk disclosure, management of risks as well as the presence of internal controls designed for maintaining a good relationship with the auditors of the corporation.

2.4.3 Other UK Governance Codes

In essence, Governance Codes have over the years have become very relevant as well as gained the center stage when it comes to the formulation of business and policy strategies Corporations and also nations have made consistent efforts to enhance their corporate governance related practices. This has largely been driven by partly the negatives effects that have been experienced as a result of numerous corporate governance scandals but also the need to appear attractive to potential investors. Although governance codes tend to refer to the structure and behavior of corporate board of directors, the study area on governance codes has become much broader largely due to the fact that corporate directors are known to be at core of a company as well as inevitably tend to interact with other actors both on the outside and the inside of the firm. Therefore, in the case of the governance codes in the United Kingdom, they appear not just provide recommendations on how the structure of the corporate board ought to be but also provide direction with regard to the relationship that board of directors ought to have to have with the executives of the company.

In 1998, the first Combined Code was published through a review made by the Hampel Committee. Other committees followed with their reports such as the Turnbull committee which published a report on risk management and internal control dubbed the Turnbull Report of 1999, the Myners Report in 2001 on the promotion of active shareholders, Higgs Report of 2003 on the duties of non-executive directors, and the Smith Report of 2003 on Audit Committees

2.4.4The UK’s Company Act of 2006

Today, one of the primary sources of Company Law in the United Kingdom is known as the Companies Act 2006, which is considered to be the major overhaul of Corporate Law in Britain (Slaheddine, 2015). The provisions of the Company Act 2006 can be regarded as relevant to this study as they took effect on April 6th 2008 (the study period is between 2010 to 2014) (Ball, 2006). In particular, the Company Act 2006 requires UK firms to file their accounts within 6 to 7 months for publicly listed companies. The lower limit for the public firms is a clear indication of the immense responsibility these firms have towards their shareholders and stakeholders; hence, the need to be transparent as well as accountable. In addition, UK companies that are quoted on the Main Market are legally required to disclose or report their annual accounts and reports to the London Stock Exchange by use of the website) within a period of 4 months in order to avoid any market regulatory related penalties . This legal requirement in the Company Act 2006, essentially stipulates the urgency as well as importance of corporate risk disclosure especially when it comes to publicly listed companies in the UK.

2.5 Risk Disclosure in the United Kingdom

Risk disclosure alone does not amount to being accountable and transparent from the perspective of effective corporate governance mechanisms. The issue of disclosing risk reports that are easily and properly understood across international have been focused on as investing expands with globalization. The International Financial Reporting Standards (IFRS) offers corporate organizations a global language that is common for performing business affairs and reporting them; hence, the accounts of a firm can be easily understood as well as compared across international boundaries. In the United Kingdom, there is the Generally Accepted Accounting Practice (UK GAAP), which is the agency under the UK Company Law in charge of the regulation that establishes how firm accounts are required to be prepared.

Indicates that accounting systems within a particular country or region are largely influenced by varying factors or dimensions such as the cultural dimension. This explains the differences between the accounting systems used in the Western developed countries and those that are in the East such as Asia. Culture plays a critical role when it comes to explaining as well as explaining the behaviour within a specific social system. The cultural dimension can be used to explain the differences between how countries undertake their financial risk disclosure. For instance, in the case of the United Kingdom, the concept or idea of providing a fair and true view of the corporation’s financial results and position is heavily dependent on the accountant’s perception of him or herself as an independent professional. This is seen even in the case of disclosure of financial risk information where the accounts tend to go beyond what is even required by the law. The situation in the United Kingdom is different from the traditional approach found in Germany and France whereby the role of the professional accountant is largely concerned focused on the implementation of relatively prescriptive as well as legal requirements.

2.5.1 The United Kingdom and Financial Reporting Standards

There is the Financial Reporting Standards which are the standards that have been issued by the Accounting Standards Board in collaboration with the Financial Reporting Council. As of January 2015, New UK GAAP took effect as revised by the Financial Reporting Council. In essence, the Financial Reporting Standards are designed to offer a clear and consistent framework for reporting financial accounts of UK firms as required by the International Financial Reporting Standards (IFRS). The International Financial Reporting Standards has the IFRS 7 and 9, where the IFRS 7 is known as the financial instrument disclosure requiring the disclosure of financial instruments that are significant to a firm, the extent as well as risks emanating from the particular instrument. The IFRS 9 is a replacement of the IAS 39 and took effect on January 1st 2013. It entails measuring as well as classifying of financial instruments i a much simpler manner particularly when it comes to hedge accounting in the case of both macro and general levels.

The goal of the IFRS is to essentially put a requirement on corporate entities to present risk disclosures within their financial statements, which enables the relevant audience to efficiently evaluate or assess;

  • The significance or capability of the financial instruments with regard to the corporation’s financial performance and position
  • The extent and nature of financial risks that emerge from the financial instruments used by corporation as well as how the corporation effectively manages such financial risks

In essence, the principles in the IFRS 7 tends to complement the principles for measuring, recognising, as well as presenting of financial assets or liabilities as found in the IAS 32 Financial Instruments. When it comes to the IFRS 9 it is largely viewed as a replacement of most of the standards present in the IAS 39. This involves the amended or amended guidance for the measurement and classification of financial assets through the introduction of a fair value through various comprehensive income categories for specific debt instruments. The IFRS 9 involves a new impairment model that results in the earlier recognition of losses. However, there were no changes that were introduced with regard to the classification as well as the measurement of corporate financial liabilities. There is a recognition of the changes when it comes to own credit risk when it comes to other comprehensive incomes for corporate liabilities that have been designated at a much fair value through loss or profit. Therefore, the changes that are found in the IFRS 9 have a higher probability of having a greater impact on the corporate entities, which have greater financial assets as well as financial institutions. For the IAS 32, the main objective is to set up the principles of presenting different financial instruments as equity or liabilities as well as for offsetting the financial liabilities and assets. This is applicable to the classification of different financial instruments, from the issuer, financial liabilities, equity instruments, into financial assets as well as the classification of the related interest, dividends, and gains, losses whereby the financial assets and liabilities ought to be offset.

2.6 Summary

This chapter provides a detailed glimpse of the origin, historical as well as evolution of corporate governance from a global perspective narrowed down to the context of the United Kingdom. In addition, the chapter provides a background understanding of financial risk reporting and how it plays a crucial role in the performance of firms in the business world. It highlights some of the major strides made with regard to corporate governance policies and legislations in United Kingdom, most of which have centered on the importance of financial risk reporting by UK firms. These include the report by the Cadbury Committee, the UK Governance Code and the Company Act of 2006.

CHAPTER THREE: THEORETICAL LITERATURE

3.1 Introduction

This chapter explores the theoretical literature related to the focus of this study, which is the impact of corporate governance mechanisms on financial risk reporting by firms based in the United Kingdom. Globally, the concept and practice of corporate governance has dominated much of the debate by academic scholars, policy makers or regulators, investors, corporate executives and practitioners for the past three decades. Today, the term corporate governance is referred to or viewed as a system through corporate organizations are both directed; it is the process by which firms activities are managed and controlled in order to maximize their performance. Corporate governance has without a doubt evolved over the years as new changes and challenges within the corporate environment; hence, the scope of corporate governance has somewhat become a contested area. This means that different interpretations of what exactly corporate governance are supposed to be as are put forward by different commentators . Therefore, this chapter will look at three key theories related to corporate governance and financial risk reporting; agency theory, stakeholder and shareholder theory.

3.2 Agency Theory

This theory provides an explanation regarding the relationship between agents and principals within a business entity. It is largely concerned with seeking solutions to problems that exists or about to emerge in the relationships within a firm; between the principals who are the shareholders and the agents of the principals who are the management heads or board of the firm. The figure below simply illustrates how the agency theory operates within a business entity or a firm.

Figure 1: The Agency Theory

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From the corporate governance perspective, the agency theory is supposed to help the company executives to better understand interests of the shareholders; hence, working in a manner that seeks to safeguard their interests. Financial risk reporting can be one way towards safeguarding the interests of the shareholders by the company executives.

In the broadest sense, the term corporate governance refers to the policies, processes, policies, customs as well as regulations which help in directing, controlling and administering a corporation. Corporate governance codes tend to specify the rights and responsibilities of the different stakeholders in a company. It articulates the relationship between the corporate organization and the immediate stakeholders, who are basically the employers and the shareholders .

Moreover, corporate governance is seen as articulating the relationship that exists between the company and the society; hence, the concept of corporate governance is regarded as a core area of economic sociology. This is because the sociological study of corporate governance is largely concerned with the relationships that exist within the company but not just between the agents and the principals, it also focuses on the relationship between all of the stakeholders as well as in the mediation processes with the objective of attaining an effective organization

However, there have been studies which have sought to disapprove the effectiveness of the agency theory with regard to corporate governance, risk management and corporate performance. Over the last 25 years, a new school of thought has emerged, which is driven by the belief that the operations of a company do impact even the external environment; hence, there is a need for it to not just be accountable to its shareholders but also to the wider audience of stakeholders . According to this school of thought, the agency theory has and continues to be the cause of the failure experienced in corporate governance. This theory is viewed as promoting an economic view of accountability where the board of a company tend to only be accountable to the owners or shareholders by making sure their economic interests have been addressed sufficiently. The Agency theory provides that the company’s management make and implement decisions on behalf of the shareholders or owners . Therefore, this leads to a situation where value that has been created by the organisation can only pertinent as the value that accrues to the company shareholders.

3.3 Stakeholder Theory

This theory is related to organizational management as well as business ethics, which look at addressing the values and morals involved in managing the affairs of the corporate organization. Unlike the agency theory, the stakeholder theory puts emphasis on the fact that external stakeholders that deemed to be impacted by the affairs of the company do have a right to be consulted in specific issues. From a corporate governance perspective, the stakeholder theory the management of a company should views the general public, suppliers and surrounding community as indirect beneficiaries or victims of their actions or decisions. The 2007/2008 Global Financial Crisis demonstrated the failure to adhere to the stakeholder theory by corporate executives.

It is essential to point to the fact that shareholders of a firm need to be considered as an important stakeholder groups in the similar manner for the suppliers, the customer, members of the local community and employees. Therefore, a business organization owes special duties to its investors as well as different responsibilities and obligations to various groups of stakeholder. There is often a misconception among the supporters of the stakeholder theory that the stakeholder groups are made up of only employees, suppliers, customers and communities but not the shareholders. This is a very important aspect especially when it comes to corporate risk disclosures as investors need to be made aware of the risks being taken using their hard earned financial investment into the company. Therefore, the firm as well as the management has special obligations to make sure that the shareholders will receive what can be termed as a fair return for their investment; into the firm. Nonetheless, the stakeholder theory places emphasis on the fact that the firm and the management do also have special obligations to ensure that the interests of other stakeholder groups are addressed both above and beyond the requirement of the law.

One of the key challenges of the stakeholder theory revolves what can be termed as unified concept of stakeholders. One of the main questions asked is, to whom should the firm well perform? In essence, the firm is placed in a very tight dilemma with regard to whose interests it can meet in order to be regarded as performing legal obligations under corporate governance. This is because most of the stakeholder theorists have underestimated the influence of the shareholders with regard to advancing their interest. There is a need for stakeholder theorists to understand that when the needs of the shareholders are sufficiently, it is much easier to advance the interests of the other stakeholder groups. The Enron scandal offers a good example of how the stakeholder theory can be undermined when the interests of the shareholders are not meet by the management of the firm . The board of directors of Enron conspired against the interest of the shareholders, thereby losing their confidence and the eventual collapse of the company. Corporate risk disclosure plays a crucial role in advancing the stakeholder theory as it offers vital information to existing investors or shareholders as well as potential future investors who can be found in the other stakeholder groups.

3.4 Shareholder Theory

Proponents of the stakeholders theory view the shareholders theory as the main cause of the numerous financial and economies woes experienced as a result of poor corporate governance . The shareholder theory basically states that shareholders invest capital into a company and the management of that company must use it in a manner that grows their shareholders capital investment. This theory stipulates that the main objective of the corporate organization is to maximize the return on investments for the shareholders. The shareholder theory is viewed as the dominant theory in most capitalistic economies such as that of the United States of America. Unlike the stakeholder theory which looks at serving the broader interests of varying stakeholder groups, the shareholder theory focuses on the shareholder or investor who has put his or her money in the company .From a corporate governance perspective, the shareholder theory appears to be effective in advancing best corporate practices such as in the case of financial risk disclosures.

Business operations need to be managed in a manner that seeks to maximize the financial returns of the investors. This includes ensuring that all the risks are within manageable proportions. Further supports this idea by noting that advancing and maximizing the value of the shareholders is perhaps the best approach towards addressing the interests of the wider society. By following the shareholder theory, the management of a firm is under the obligation to ensure they have efficiently maximized revenue, minimized cost as well as reduced risks.

The 2007/2008 Global Financial Crisis led to the collapse of small, medium as well as large business organizations due to the failure to follow the corporate governance codes put in place. As a result, thousands if not millions of people all over the world lost their jobs and others lost their source of income from indirect employment. The economic view of the shareholder theory offers an alternative channel to attaining some of the interests demanded by the stakeholder theory.

Previous research studies have argued that jointly considering a number of theories related to corporate governance and risk disclosure can be of great importance when it comes to explaining a specific phenomenon as well as providing additional insights towards understanding the practices of corporate governance and corporate risk disclosure. Using multiple theories tends to strengthen the explanations or rationale behind corporate governance mechanism and corporate risk disclosure practices as opposed to the case of using a single theory, which may not provide a full explanation of these practices (Zhao, Hwang & Low, 2015).

3.5 Institutional and Legitimacy Theories: Their Commensurability

The other two theories are institutional theory and legitimacy theory. In order to properly analyze these two theories in the context of corporate governance mechanism and financial risk disclosure, the study shall explore the concept of consumer ability. The institutional and legitimacy theory are regarded as system oriented theories since they share the same ontological perspective. Business organizations tend to be influenced by the society where they operate and the society is similarly influenced by the operations of the business organizations. This presents a form of interdependence, which is aimed at reducing any form of uncertainty as well as the growth and survival of the business organization. The reason as to why these two theories have a shared ontological perspective is that they both tend to view the structures or reality in a manner that is continually reproduced, created as well as oriented through the interactions among the social organizations. This leads to a situation where these interactions become a constituent of their regional meaning, with the authority to establish and enact the social meanings. In essence, the institutional and legitimacy theories neither view that reality as being purely given nor refuse the existence of social structures.

3.6 Legitimacy Theory and Institutional Theory

The legitimacy theory revolves on whether the organization’s value system is usually congruent with the society’s value system as well as whether the organization’s objective is to address the social expectations. However, the legitimacy theory fails to specify on how such a congruency can be attained or how such actions can be properly formulated. Legitimacy theory has been used to provide the explanation for the rationale behind voluntary environmental disclosure by corporations. Even though legitimacy theory tends to provide a basis for proper understanding of specific managerial actions like environmental disclosures, it is currently being applied to different scenarios. One of the main challenges of the legitimacy theory is that the term is widely applied but tends to be loosely defined. Even though this is not a problem in itself for the legitimacy theory since the similar situation can be equally used in other.

Institutional theory tends to be similar to the legitimacy theory but usually concentrates on the link between the organizations and the environment, particularly when it comes to the survival as well as stability of organizations. Although legitimacy theory fails to express specifically how to address the social expectations and attain social support, on the part of the institutional theory, it puts strong emphasizes that corporate organizations can usually involve institutionalized rules and norms with the aim of gaining stability and promoting its survival. Therefore, conforming to such institutional patterns that have been established forms the pathway to legitimacy and receiving support as well as attracting resources.

3.7 Summary

In summary, the above three theories possess both weaknesses as well as strengths, which play a crucial role towards the understanding of corporate governance mechanisms and financial risk reporting. In addition, the theories also help in highlighting the varying positions that are held by different groups of people in the society with regard corporate governance mechanisms and financial risk reporting. There are those that have for long been of the opinion that the scope of corporate governance is to mainly maximize the interests of the company’s shareholders or their invested wealth. On the other hand, there are those that are of the opinion that corporate governance has evolved over the years to include aspects such as corporate social responsibility, corporate accountability, protecting the interests of both shareholders and stakeholders as well as the management of risks related to the company activities . There are three key theories which are regarded important in relation to the conceptualization, understanding and scope of corporate governance mechanism and how it impacts the aspect of financial risk reporting. The following chapter explores the empirical literature of different researchers regarding the impact of corporate board mechanisms when it comes to the financial risk reporting as well as the development of hypotheses.

CHAPTER FOUR: EMPIRICAL LITERATURE AND HYPOTHESES DEVELOPMENT

4.1 Introduction

This chapter will explore previous empirical literature from a global perspective and narrow it to the context of the United Kingdom. The focus of this chapter will be guided by the overall objective and purpose of this study, which is to investigate the impact of corporate governance mechanism on financial risk reporting. The researcher will focus on key aspects such as governance and performance of a corporate organization and risk disclosure practise. When it comes to the development of the hypotheses, the research will explore these research constructs or variables; Corporate Ownership Structure, Corporate Board Leadership Structure (Dual Board Leadership Structure) as well as Diverseness of the Corporate Board with a view of further illuminating the impact of corporate governance and financial risk reporting.

4.2 Governance and Performance of a Corporate Organization

Numerous studies have been conducted on the relationship between governance and performance of a corporate organization in the past. However, the subject matter of governance can be said to be dynamic or evolving as new governance issues emerge, there is always a need to update the corporate governance standards. A case in point is the Global Financial Crisis, which emerged a decade ago and London being considered to be a major international financial hub and the Global Financial Crisis led to new concerns over the effectiveness of corporate governance and financial risk reporting or management standards not just for the financial services firms but also for firms in other industries or sectors.

Murthy (2006) defines good corporate governance as “a corporate set up designed to maximize the value of the shareholders legally, ethically and on a sustainable basis, while ensuring equity and transparency to every stakeholder: the company’s customers, employees, investors, vendor-partners, the government of the land and the community”. Moreover, Cohen, Krishnamoorthy and notes that the most important function of corporate governance is in making sure that corporate organizations undergo a high level of financial risk reporting process. Financial risk reporting has in away become an important aspect of the company’s public image and brand (Rotberg, 2014). However, there are both internal as well as external factors that play a role when it comes to the extent to which a corporate organization can perform quality level of financial risk reporting. These include the ownership structure, the leadership structure of the corporate board as well as the diverse nature of the corporate board (Daelen & Elst, 2010).

4.3 Risk Disclosure Practices

The broad definition of risk “The sentences were coded as risk disclosures if the reader is reasonably informed (i.e., based on reading) of any opportunity or prospect, or of any hazard, danger, threat or exposure, that has already impacted upon the company or may impact upon the company in the future or of the management of any such opportunity, prospect, hazard, harm, threat or exposure” Linsley & Shrives ( 2006, cited in Ntim, Lindop and Thomas, 2013,p.370). Most of the previous studies appear to examine risk disclosure practices by focusing largely on risk information especially the disclosure of what is seen as market-based risk with regard to financial instruments. This has been seen as a common trend in the case of countries such as the United Kingdom, the United States, Germany as well as Canada.

Two groups have been identified in relation to the research methods they use when it comes to studying risk disclosure; the first group, focuses on a firm’s annual report whereby it sees it as the source of analyzing content related to disclosure; the second group focuses on the management discussion as well as analysis. A firm’s annual reports are viewed as the main source of risk disclosure information, which is prepared by the directors in a bid to meet the legal mandatory requirements as well as act within the firm’s accountability function.

In essence, financial risk reporting or any other form of financial reporting is supposed to link a firm’s management such as the Chief Executive Officers and the Board of Directors to shareholders as well as stakeholders. Financial reporting as a tool is often viewed as a bridge designed to communicate or connect the firm with what can be termed as the external parties. How effective such a communication is can be used as a measurement in determining the outcome or performance of the firm. It is worth noting that a firm’s financial information is regarded as the first and initial source of both true and independent communication about the performance as well as effectiveness of the firm’s management team.

Therefore, from a corporate governance perspective, the relevant nature of financial risk reporting makes it a key aspect when it comes to understanding the influence of the firm’s management. The authenticity of financial risk reporting is largely dependent on the conduct and performance on the people that are actively involved in the firm’s financial reporting ecosystems especially directors, the auditors, and the management. This implies that the integrity of financial risk reporting is largely reliant on corporate governance mechanisms of the firm in question. This is where the Board of Directors are viewed as having the main responsibility of overseeing a company’s financial risk reporting activities and processes The board of directors in collaboration with the firm’s management work towards producing a financial statement, which depicts whether the firm has attained the recommendable profit (Calder, 2008). The auditor is viewed as the independent person that also reviews the corporate risk reports by following the set auditing standards in a diligent and competent manner.

Corporate governance is viewed as a reflection of the process relating to how a firm managed; hence, there is a direct link between the failures of corporate governance mechanism resulting in a failure of financial risk reporting as well. Previous research studies have found there to be a correlation between the weaknesses present in corporate governance mechanisms and the presence of poor financial risk reporting such as low quality of risk reporting, manipulation of earnings manipulation, fraudulent financial statement as well as internal financial controls that are weak

4.4 The development of Research Hypotheses

On the basis of the theoretical and empirical research, three corporate governance mechanisms have been analyzed in the study namely; corporate ownership structure, structure of board leadership and the diverseness of the corporate board

4.4.1 Corporate Ownership Structure

Most studies have come to the conclusion that firms that have a high government ownership tend to actively participate in the disclosure of risks largely due to the fact they need to get support either financial or technical towards meeting the corporate objectives However, in the case of rich and developed countries such as the United Kingdom and the United States, where the corporate market is extensively liberalized, the involvement or ownership of government is limited to a few of firms. There are those who view the cause of this as the fact that government ownership in a corporate organization can hinder the effectiveness of the agency theory, which is to look for solutions towards agency problems between government (influential shareholder) and managers.

Government ownership can impair the effectiveness with which monitoring of internal managerial as well as disclosure practices is done. This shows how the ownership structure of a corporate organization can substantially impact its operations and practices in relation corporate governance mechanism. For instance, in a situation of an excessively dispersed ownership structure, the shareholder has little incentives to monitor the workings of the management team. This tends to be found in large multinational corporations.

In the case of the United Kingdom, majority of the corporate organizations are under the ownership of either private or public ownership. There have been studies that have focused on the link between the performance of a firm and its ownership structure Economic Policy Research. The focus of this study is on the impact of corporate ownership structure as part of corporate governance mechanism on the level of financial risk disclosures in UK firms. Therefore, in connection, the first hypotheses will be;

H1 – There is a statistically significant relationship between the ownership structure of   corporate organization and the effectiveness of corporate financial risk disclosure.

4.4.2 Corporate Board Leadership Structure: Dual Board Leadership Structure

The concept of duality takes place if a firm’s chief executive officer or CEO is also the chairman of the board at the same time As a result, there can be a concentration of decision-making powers due to the aspect of duality role, thereby impairing the governing role of the firm’s board especially when it comes to financial risk disclosure practices or policies

Findings from previous studies on analyzing the connection between duality and risk disclosure appear to be mixed such as the case of some research studies that reported that there was a negative relationship between duality of roles and corporate risk disclosure. Others have found that there is an insignificant relationship between the role duality of a firm’s CEO and the firm’s financial risk disclosure. On the basis of this mixed arguments, the second hypothesis formulated for this study is as follows:

H2 – There is a statistically significant relationship between the board characteristic and the effectiveness of corporate financial risk reporting.

4.4.3 Diverseness of the Corporate Board

The terms diversity refers to the different features present among a group of individuals and which can influence a group’s decision-making process. From the perspective of a corporate board, it would the various features present among the different board members or director and which can impact or affect their decision making especially with regard to financial risk disclosure policies and practices (Shultz, & Amacom, 2001; Dhir, 2015). These features range from the ones that can be directly observed such as ethnicity, age and gender as well as those features that are considered to be less visible; religion, education, and occupation.

A diverse board means that there is also diverseness of views with regard to how best handle issues related to the interest of the firm (Hollow, Akinbami, Michie & Edward Elgar Publishing, 2016). Western nations such as the United Kingdom can be credited to making significant strides when it comes to the inclusion of women in senior management and leadership positions such as the board of directors, which is contrary to the case of less developed countries (Dhir, 2015). Inclusivity is a valuable component of corporate governance because it provides a wider platform for participation and sharing of opinions.

Disclosure is largely viewed as a managerial duty but the presence of a diverse is expected to put sufficient pressure on the management to engage in more disclosure). Therefore, the third hypothesis is as follows;

H3 – There is a statistically significant relationship between the diversity of a corporate board and the effectiveness of corporate financial risk reporting.

4.5 Summary

This chapter presents the empirical literature of the individual variables that are linked to the focus of this study, which is the need to understand the impact of corporate governance mechanism on financial risk reporting. It does so by exploring prior research studies that have covered the same area of corporate governance mechanism and financial risk reporting. The research looks at the varying findings and conclusions made by the prior studies with a view of identifying a research gap that can be addressed in this study. The following chapter provides a discussion of the research methodology, which will include the research design, data sources, study samples, as well as data collection procedures.

 


CHAPTER FIVE: RESEARCH METHODOLOGY

5.1 Introduction

This chapter will provide the research design as well as the methodological approach to be used in this study. It will cover key research areas such as; the sources of data sources, identify the study sample, identify the research variables, identify the data collection and analysis method, as well as highlight the limitations of the study. The researcher intends to employ a quantitative research design. In particular, the researcher intends to apply a descriptive research design. A descriptive study will be appropriate in gathering quantifiable data to be used in making statistical inferences about the impact of corporate governance mechanism on financial risk reporting in the United Kingdom.

5.2 Data Sources and Sample Selection

As mentioned above, the study intends to employ a quantitative research design, where the researcher intends to apply a descriptive research method. The primary data source on the selected sample of UK based corporate organizations will be data from the London Stock Exchange for the period from 2010, 2011, 2012, 2013 and 2014. The secondary source of data will be the annual reports, financial reports as well as management reports of the 60 sampled UK firms listed in the London Stock Exchange for the period between 2010 and 2014.

As of 31st March 2016, the total number of companies listed in the London Stock Exchange was 2324 companies. Because compliance to corporate governance codes and regulations tends to vary with the size of the company, the researcher intends to focus on the different sizes of companies listed in the London Stock Exchange. Therefore, the target population for the study will include all UK firms that are listed in the London Stock Exchange and operational in the period between 2010 and 2014.

The study sample will be 60 UK firms listed in the London Stock Exchange between the periods of 2010 to 2014. The selection of the study sampled will be according to the number of employees working for the firms, whereby firms that have more than 250 employees will be categorized as large, firms that have less than 250 employees will be classified as medium and bottom level firms. Therefore, the distribution of the study sample will be as follows;

  • 20 firms will be from the top level
  • 20 firms will be from the middle level
  • 20 firms will be from the bottom level

A Descriptive study is often the most appropriate research method for gathering information, which can be used in demonstrating relationships as well as describing the world around us as it exists. The rationale behind the researcher’s decision to focus on the period between 2010 and 2014 was to ensure that data influenced or related to the Global Financial Crisis of 2007/2009 was excluded. Therefore, this will provide a neutral environment for the collection of data for the study.

5.3 Variables and Measures

5.3.1 Dependent Variables

Corporate Risk Disclosure Variables

  1. Corporate Financial Risk Reporting Variable (CFRR) – This will involves risks that arise from major changes such as a shift in the interest rates, international capital flows, exchange rates, commodity prices, equity prices, credit, liquidity and capital adequacy or insolvency.

The proposed study intends to employ the content analysis method in measuring the financial risk disclosure variable, which is the dependent variable. The content analysis method will be suitable for measuring this dependent variable because it looks at the amount of extent as opposed to the quality of financial risk disclosure. It has also been adopted in previous studies corporate governance and risk disclosure (Elzahar & Hussainey, 2012; Rajab & Handley-Schachler, 2009 and Oliveira et al., 2013; 2011a).

The study intends to investigate risk disclosure by looking at firms’ annual reports, extensively reviewing, risk disclosure literature, corporate financial reporting standards as well as corporate governance and financial risk disclosure regulatory requirements in the United Kingdom. This will be all in an effort to come up with specific risk disclosure categories as well as financial risk disclosure items. These categories will be used in calculating or measuring the dependent variable of financial risk reporting or disclosure.

5.3.2 Independent Variables

In measuring the following five independent variables, the proposed study intends to employ as similar approach used by Ntim, Lindop and Thomas (2013).

Corporate Ownership Structure Variables

Under ownership structure the study will focus on the following variables;

  1. Institutional Ownership Variable (IOWN) – This will be measured as the percentage of ordinary shares that are held by institutional shareholders.
  2. Block Ownership Variable (BOWN) – This will be measured as the percentage of ordinary shares that are held by the shareholders who have at least 5 percent of the total ordinary shareholdings of the company.

Diverseness of the Board Variables

The study will look at the variable of board diversity (BDIV), which focuses on the gender and ethnic diversity of the board membership in the UK corporate environment as well as how this impacts financial risk reporting by UK firms;

  1. Board Diversity (BDIV) will measured as the percentage of male and female directors to the total number of directors on the firm’s board as well as the percentage of Asians, white, blacks, as well as mixed race to the total number of directors on the firm’s board.

Board Leadership Structure Variables

The study proposes to look at Dual Board Leadership Structure in the UK corporate environment in terms of its impact on financial risk reporting.

  1. Dual Board Leadership Structure (DBLS) will be measured as 1 in the case the positions of a chairperson and CEO in a firm are held by different persons and 0 in the case the positions of a chairperson and CEO in a firm are held by the same person.
  2. Board Size (BSIZE) – this will be measured as the natural log of all the total number of company directors that are on the board of a given company.

5.3.3 Control Variables

The following will be control variables for the study;

  1. A firm that has an established Corporate Governance Committee (CGCO) – this control variable will be measured as either 1, which is where a company has established a corporate governance committee or 0, whereby the company has not established such a committee
  2. A firm that has an established Corporate Social Responsibility Committee (CSRCO) – this control variable will be measured as either 1, which is where a company has established a corporate social responsibility committee or 0, whereby the company has not established such a committee
  3. A firm that has been audited by any of the Big Four Audit Firms (BIG4) – this control variable will be measured as either 1, which is where a company has been audited by any of the big four audit firms such as Deloitte & Touche, PricewaterhouseCoopers, KPMG and Ernst & Young or 0, whereby a company has not been audited by any of the big 4 audit firm
  4. A firm that is listed on a Foreign Stock Market (CLIST) – this control variable will be measured as either 1, which is where a company is listed on a foreign stock market or 0, , whereby a company has not been listed on a foreign stock market
  5. A firm that has a Corporate Risk Disclosure Policy (CRDP) this control variable will be measured as either 1, which is where a company has a risk disclosure policy or 0, , whereby a company does not have a has a risk disclosure policy.

 

Below is a table of the variables that will be used in the study;

Type of variable
Definition
DEPENDENT VARIABLE
CFRR
Corporate Financial Risk Reporting Variable
INDEPENDENT VARIABLES

 

IOWN This will be measured as the percentage of ordinary shares that are held by institutional shareholders.
BOWN This will be measured as the percentage of ordinary shares that are held by the shareholders who have at least 5 percent of the total ordinary shareholdings of the company.
BDIV will measured as the percentage of male and female directors to the total number of directors on the firm’s board as well as the percentage of Asians, white, blacks, as well as mixed race to the total number of directors on the firm’s board
DBLS Will be measured as 1 in the case the positions of a chairperson and CEO in a firm are held by different persons and 0 in the case the positions of a chairperson and CEO in a firm are held by the same person.
BSIZE this will be measured as the natural log of all the total number of company directors that are on the board of a given company.
   
CONTROL VARIABLES CGCO A firm that has an established Corporate Governance Committee
CSRCO A firm that has an established Corporate Social Responsibility Committee
BIG4 A firm that has been audited by any of the Big Four Audit Firms
CLIST A firm that is listed on a Foreign Stock Market
CRDP A firm that has a Corporate Risk Disclosure Policy

 

Table 1: Variables for the Study

5.4 Model Specification

The study will use the manual content analysis approach in order to measure the level of risk reporting or disclosure in annual, financial reports through the counting of the number of risk-related sentences. In addition, the study will adopt regression analysis to investigate the relationship between corporate governance and financial risk disclosure by UK firms. The study will apply one regression equation with one dependent variable as indicated below:

CFRR = β0 + β1*IOWN + β2*BOWN + β3*BDIV + β4*DBLS + β5*BSIZE + β6*CGCO+ β7*CSRCO + β8*BIG4 + β9*CLIST + β10*CRDP + ε

The main goal is to investigate and analyze the impact of corporate ownership, board diversity and board leadership structure on the extent of corporate financial risk reporting by UK firms.

5.5 Limitations

The London Stock Exchange is ranked among the largest and most advanced Stock Exchanges in the world. As a result, it has a huge and growing number of listed corporate organizations. This can be a limitation for the study as the researcher focused on only a small sample population of 60 firms, which can be a drop in the ocean compared to the 2324 firms listed in the London Stock Exchange. This is a limitation because the listed firms tend to be mixed in terms of size and nature of operations; hence, can present a challenge when it comes to the generalization of the research findings.

The nature of this study introduces cost limitations as the researcher is expected to spend a substantial amount of financial resources to gather both the primary and secondary data. Although some of the data can be available online, there can be case of certain data that would require to be manually accessed, making it expensive as well as cumbersome for the researcher. Corporate financial information is considered to be sensitive; hence, the researcher can expect some limitations where some corporate organizations might refuse to corporate in giving out their corporate related data for the study.

5.6 Summary

In summary, the data for the study will be gathered from a study sample of 60 UK firms listed in the London Stock Exchange. The criteria for selecting the study sample will be based on the number of employees, where firms that employ more than 250 employees will be considered as the large firms and those that have less 250 employees will be ranked as middle and small sized firms. The dependent variables for the study will be corporate financial risk reporting and return on assets while the independent variables will be under corporate ownership structure, board diversity and board leadership structure. The study will also have five control variables. The study will use regression analysis model to examine the relationship between corporate governance mechanism and financial risk disclosure by UK firms.

Corporate Governance and financial risk reporting in the UK Data Analysis

REFERENCES

Hollow, M., Akinbami, F., Michie, R. C., & Edward Elgar Publishing. (2016). Complexity and crisis in the financial system: Critical perspectives on the evolution of American and British banking. Cheltenham: Edward Elgar Pub. Ltd.

Calder, A. (2008). Corporate governance: A practical guide to the legal frameworks and international codes of practice. London: Kogan Page.

Daelen, M. ., & Elst, C. . (2010). Risk management and corporate governance: Interconnections in law, accounting and tax. Cheltenham, UK: Edward Elgar.

Zhao, X., Hwang, B.-G., & Low, S. P. (2015). Enterprise risk management in international construction operations.

Organisation for Economic Co-operation and Development. (2011). Board practices: Incentives and governing risks. Paris: OECD.

In Wright, M., In Siegel, D. S., In Keasey, K., & In Filatotchev, I. (2013). The Oxford handbook of corporate governance.

Forbes, W., & Hodgkinson, L. (2014). Corporate governance in the United Kingdom: Past, present and future.

Hawley, J. P., Williams, A. T., Kamath, S. J., & Hawley, J. P. (2011). Corporate governance failures: The role of institutional investors in the global financial crisis. Philadelphia: University of Pennsylvania Press.

Reuvid, J. (2013). Managing business risk: A practical guide to protecting your business. London: Kogan Page.

Lowe, D. J. (2013). Commercial management: Theory and practice. Chichester: Wiley, Blackwell.

Gee, P. (2006). UK GAAP for Business and Practice. Burlington: Elsevier.

Berghe, L. (1999). International Standardisation of Good Corporate Governance: Best Practices for the Board of Directors. Boston, MA: Springer US.

Stationery Office U. k., the. (2009). Banking Supervision and Regulation: 2nd Report of Session 2008-09, Evidence. The Stationery Office/Tso.

Hannigan, B. (2012). Company law.

Solomon, J. (2007). Corporate governance and accountability. Chichester [u.a.: Wiley.

Tricker, R. I. (2015). Corporate governance: Principles, policies, and practices.

Doig, A. (2012). Fraud: The counter fraud practitioner’s handbook. Farnham, Surrey, England: Gower.

PricewaterhouseCoopers LLP. (2011). Manual of accounting: Narrative reporting 2012. Haywards Heath: Bloomsbury Professional.

TABLE OF CONTENTS (Must be at the beginning)

Dissertation Proposal: Corporate Governance and financial risk reporting in the UK

CHAPTER ONE: INTRODUCTION

1.1 Motivation and Problem Statement

1.2 Research Objectives and Questions

1.3 Research Methodology

1.4 Research Contributions and Significance

1.5 Dissertation Structure

CHAPTER TWO: BACKGROUND

2.1 Introduction

2.2 The Origin and Historical Perspective of Corporate Governance

2.3 The Growth in Recognition of Corporate Governance

2.4 Corporate Governance in the United Kingdom

2.4.1 The Cadbury Code of 1992

2.4.2 UK Governance Code

2.4.3 Other UK Governance Codes

2.4.4The UK’s Company Act of 2006

2.5 Risk Disclosure in the United Kingdom

2.5.1 The United Kingdom and Financial Reporting Standards

2.6 Summary

CHAPTER THREE: THEORETICAL LITERATURE

3.1 Introduction

3.2 Agency Theory

3.3 Stakeholder Theory

3.4 Shareholder Theory

3.5 Institutional and Legitimacy Theories: Their Commensurability

3.6 Legitimacy Theory and Institutional Theory

3.7 Summary

CHAPTER FOUR: EMPIRICAL LITERATURE AND HYPOTHESES DEVELOPMENT

4.1 Introduction

4.2 Governance and Performance of a Corporate Organization

4.3 Risk Disclosure Practices

4.4 The development of Research Hypotheses

4.4.1 Corporate Ownership Structure

4.4.2 Corporate Board Leadership Structure: Dual Board Leadership Structure

4.4.3 Diverseness of the Corporate Board

4.5 Summary

CHAPTER FIVE: RESEARCH METHODOLOGY

5.1 Introduction

5.2 Data Sources and Sample Selection

5.3 Variables and Measures

5.3.1 Dependent Variables

5.3.2 Independent Variables

5.3.3 Control Variables

5.4 Model Specification

5.5 Limitations

5.6 Summary

REFERENCES

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