CHAPTER 1

BASIC CONCEPTS
 Board of Directors is a term used in the United States to collectively describe
a company’s supervisors and managers, consisting of majority shareholders, the
company’s founders, major creditors, and people employed by the company. The
model of American corporate structure is illustrated in figure 1-2. It is a one-tier
system. From among the members of the board of directors, at least two will be
elected to the positions of chief executive officer (CEO) and chief financial officer
(CFO). Often, a third is elected to the position of chief operating officer (COO).
Unlike the American model, the European model follows a two-board system (see
figures 1 and 2), such as is adopted in Indonesia. In this two-tier system, shareholders
appoint a group of managers to operate the company (management) and a group o
management supervisors and advisors, who are referred to as commissioners. This
concept of corporate supervision developed over time as companies and their
ownership expanded.

DEVELOPMENT OF CORPORATIONS

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 Supervision and operation of companies started to get complicated with the
industrial revolution in Europe in the 18th century, and later that century in the United
States, with the introduction of public ownership (Hendriksen 1995, p 18). Prior to
that, most companies were owned and supervised by families. Management and
supervision in a family-owned company lay in the hands of one person: the owner.
This management-owner system was neither complex nor complicated.
Public ownership was introduced for the first time in Europe in the 16th
century, with the establishment of a company called South Sea Limited Inc. This
company was involved in the slave trade, transporting slaves from Africa to be sold in
the slave markets in London. In need of substantial funds, the company began
offering shares to the royal family and to members of parliament. Public companies
meant public ownership, and a market was needed to operate trade in shares. So, the
world’s first stock market, the London Stock Exchange, was born in 1873.
With the export of the industrial revolution from Europe to America came the
first corporation, the Santa Fe railroad company. In need of massive funding, the
company's founders invited the public to own shares in the company by purchasing
stocks, which sparked the idea of setting up the world's second stock exchange. The
New York Stock Exchange began operations in 1892.
Following the introduction of corporations, both in America and in Europe,
supervision and operation of companies became increasingly complex and
complicated. In America, the company’s founders and controlling or majority
shareholders, and the company’s major creditors would decide who would supervise
and decide on the company’s strategic direction. So, the company’s founders,
majority shareholders, major creditors and representatives of minority shareholders
formed a group of company supervisors and controllers, which was called the board
of directors. From among the members of the board of directors, two or three were
elected to hold the positions of chief executive officer (CEO), chief financial officer
(CFO), and, in many cases, chief operating officer (COO). The CEO in turn would

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choose several people as senior managers who would be part of a management team
under the command of the CEO. This is what is referred to as one tier management.
The European, two-tier management model divides corporate power between
two groups of managers. The first is called the board of commissioners, which is
chaired by a president commissioner or chief commissioner; and the second is the
board of management, which is chaired by a managing director. These two boards are
elected by a general meeting of shareholders. The board of commissioners has the job
of supervising and advising, and its members are appointed by the majority and
minority shareholders and management (the two-tier model is shown in figure 1-2).
Figure 1-1 shows the contractual relationship between the principals and
agents. The principals are the company’s owners and founders; the agents are
management. Under these conditions, the principal-agent contract is in fact between
the chief executive officer and the managers and employees, not between the board of
directors and the chief executive officer.
Conflict between agents and principals will lead to opportunistic behaviour at
the expense of the owners. Minority stockholder representation is very limited. To
protect the rights of stockholders requires a person with no direct association with
management and stockholders, an independent director.
Brown and Caylor (2006) analysed the relationship between good corporate
governance and company operating performance. Samples were taken from 1,757
firms. The presence of independent directors, audit committee and nomination
committee in a company were associated with high return on equity and return on
assets. This suggests that independent directors play a part in adding value to the
company. The greater the number of independent directors, the better one would
expect corporate governance to be in terms of protecting stakeholders’ interests.

Figure 1-1. A Contracting Schematic of The Modern Corporation (one tier system)

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 Common stockholders
Public shareholders
Institutional Investors
Large Block Holders
Other Corporations

BOARD OF DIRECTORS

CEO
Creditors:
Financial Institution
Bond Holders
Managers
and
Employees
Government:
• Local
• State
Suppliers Customers • National
• Foreign

Source: Fred R.Kaen, p. 18

CIVIC REPUBLICANISM

Civic republican is a concept that is closely associated with property

ownership and the owners’ social responsibility as members of society. So, owners of
wealth in general will move into politics to protect their property from the
opportunistic tendencies of others, because, it is argued, humans are inherently
opportunistic. Based on this assumption, expansion of ownership to the general

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public will create political protection for owners of wealth. And that means wider
ownership of wealth is one way of making humans less opportunistic.
Wider ownership of wealth will result in collective ownership, which in turn
will grow commitment to public welfare and a harmonious relationship with the
environment.
The civic republican also believes that wider ownership of wealth is the way
to achieve liberty and equality. Liberty in the sense of freedom from tyranny and
oligarchy, and the ability to determine one’s own fate in general and economic self-
reliance in particular, to avoid being dependent on a group of rule makers or those
with power. Under these conditions, the price of labour, and of other factors of
production, would be determined by market forces and not by an aristocracy or a
clique of investors. The market, here, is the media that sets optimum prices, freeing
individuals from dependency and oppression. In other words, the market is the media
that creates love of life, the freedom to choose one’s own values without having to
depend on others, and that, ultimately, creates welfare.

Figure 1-2 Typical Indonesian Contracting Schematic

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 Stockholders Meeting

Board of
Commissioners

Executive Directors:

• President Director
• Operating Directors

Managers Creditors
And Government
Employees Others

Suppliers Customers

Source: Mas’ud Machfoedz

The market will determine a price that balances supply and demand for
economic resources. The market will also increase efficiency through arms length
transactions, a process of price determination that disregards social status and class.
The market will allow people to make transactions freely and responsibly, and in this
way all market players will hold equal positions and enjoy the same freedoms. This in

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turn will create democracy, freedom, and social responsibility through market
mechanisms.
To create these ideal market conditions, ownership of wealth must be spread
wide, not concentrated in certain individuals or stakeholders. In addition, the market
itself must be efficient and free from manipulation by market players. If these
conditions are met, the market will be what is known as a perfect market; otherwise
there will be market failure, with monopolies doing the selling, oligopolies setting
prices, and monopsonies doing the buying, which would be harmful to civil freedoms
and liberties.

LIBERALISM
Another concept of business is liberalism. Unlike the civil republican, the
liberal does not believe that human nature can be changed by distributing wealth to
the public through property markets. Humans, they argue, are basically opportunistic
and self-seeking when it comes to property ownership, and because of this they
cannot be motivated to become socially responsible citizens. Liberalism focuses on
the creation of institutional-procedural structures, and management systems, to create
conditions that prevent concentration of economic and political power in the few. In
other words, liberalism does not seek to eliminate human’s opportunistic tendencies.
They seek only to control that human trait. This means that markets need to be
created to facilitate economic transactions because barter is no longer efficient, and
that property is used to create economic welfare and generate economic growth. For
liberals, economic growth is the goal, not changing human nature.
The key aspect of liberalism is how growth can be maintained through
efficient markets by controlling the opportunistic and self-seeking nature of humans.

AGENCY THEORY

Jensen and Meckling (1976) offered an explanation of the principal-agent

relationship. The principal is represented as stockholders and the agent is represented

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as management. The two parties, principal and agent, in normative and empirical
terms, share several characteristics: moral hazard, bounded rationality, and risk averse
or opportunistic. They are self seeking at the expense of others: shareholders want the
value of their shares to rise, thus increasing their wealth, by asking management to
maximise earnings per share (EPS), because EPS has a positive correlation with share
price (Machfoed and Sugiri 2002; Ou and Penman 1990). With the target of
maximizing EPS, management will implement earnings management (Machfoedz and
Fajrih 2005) to ensure high bottom line earnings and attractive incentives for
management.
These conditions pose problems for the agent. The principal, who wants share
price to rise continually, will pressure management to focus their efforts on
maximizing profits. Managers will retain their positions or receive attractive bonuses
or benefits, and so continue to try to maximise profits by seeking fit accounting
methods. Stockholders do not necessarily realise that adopting earnings management
can endanger the company’s sustainability, as in the case of Enron. This is what is
referred to as bounded rationality. Another problem concerning agency is information
asymmetry. The management operating a company has far more information than do
stockholders or other stakeholders. This will mean that stockholders do not receive
adequate information and adverse selection will be made as a result.

Figure 1-3 Agency Theory

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 AG E NC Y THE O R Y

•MORALE HAZARD
EVERY EFFORT TO REDUCE
•BOUNDED RATIONALITY THE INFORMATION ASSIMETRY
•RISK AVERSE WILL INCREASE AGENCY COSTS

INFORMATION
ASSIMETRY

ADVERSE
SELECTION

In the one-tier system adopted by America, the game of information

asymmetry can be played by majority shareholders along with management, because
they are members of a group of corporate decision makers. If this happens, those that
suffer most are the minority shareholders, because they could make adverse
investment decisions and suffer investment losses as a result. So, a system of good
corporate governance is needed, such as increasing the number of outside directors or
independent commissioners. Information asymmetry is even worse in two-tier
systems, such as in Indonesia, where shareholders are outside management (though in
many cases majority shareholders sit on the board of commissioners). So, to ensure
good corporate governance, a company must have independent commissioners.

THE COMPLEXITY OF RELATIONS IN A MODERN CORPORATION

Today we are all connected.

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Today is a time of shifting paradigm, in which corporations consist of relations
between management and owners, such as stockholders, but encompass wider
relations too. Extended enterprise includes relations between investors, customers,
suppliers, competitors, regulators and networks (stakeholders’ paradigm). From the
corporate governance perspective, understanding these relations is vital.
Good corporate governance begins by paying heed to the interests of the
company’s owners. Investor confidence is essential for the company to get the capital
it needs for corporate development. An understanding of the company’s consumers is
needed to make market strategies that will add value to the company for its
consumers. In the same vein, an understanding of suppliers is an integral part of
creating value for the company. Failure in selection of the company’s suppliers, for
example, could cause delays in the production process. Corporate governance is a
mechanism that understands and accommodates the interests of these stakeholders.
As an example, not having good relations with stakeholders may result in
substantial losses, or even ruin a company. Newmont, Freeport and Lapindo are
examples of companies that have failed to accommodate the interests of stakeholders.
Newmont ignored the environmental problems caused by its poor waste management,
and as a result received several claims, including from NGOs concerned with health
issues. Investor confidence in the company decreased because it was thought not to
have taken into account stakeholders’ interests. This suggests that today companies
have to be concerned not only with maximising profits for its investors, but must also
accommodate the interests of other stakeholders that have relations with the
company, including the public, consumers and other stakeholders.

SUMMARY

Concepts of good corporate governance must take into consideration the

relationships between the organs of the company and its structure, whether two tier or
one tier. There are two models of business management, the United States adopts a
one-tier system, and the countries of Europe, a two-tier system. The one-tier system

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is a concept inspired by liberalism; the two-tier system by civic republicanism. The
civic republican believes that everyone who holds wealth has a pubic responsibility,
and for this reason ownership of corporations is shared with the public. This one-tier
system is concept inspired by liberalism. Liberalism says that responsibility for
ownership of wealth is not to the public, but to increasing welfare, so managers of
corporations must be able to enhance welfare. Indonesia adopts a two-tier system. As
a consequence of the country’s long experience of operating state enterprises during
Dutch colonial times, its statutes and social regulations tend towards Dutch law. In
some companies, such as PT Sampoerna, PT Gudang Garam and PT Polytron, where
the owner is also the company’s majority stockholders and founder, the positions of
company president and chief executive officer are found. Though this may seem
similar to the one-board system adopted in the United States, Indonesian corporate
law and regulations do not allow this. Under these circumstances, independent
directors are required to keep the opportunistic tendencies of the owners in check, and
to avoid moral hazard and information asymmetry in management. Independent
directors are a media for achieving good corporate governance. Today, corporations
focus not only on stockholders, but on stakeholders, too. Corporate governance is a
mechanism that understands and accommodates the interests of these various
stakeholders. Accommodating the interests of stakeholders will increase the value of
the firm.

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 CHAPTER 2
COMMISSIONERS’ DUTIES

For many people, especially medium and small size business, a company
directorship is simply a status symbol. Often it is up to the accountant to
ensure that clients understand the complexities and magnitude of
directors’ responsibility.

Mark J.Warner (Executive Excellence, September 8, 1997)

In this module, the term ‘board’ is used to mean ‘board of commissioners’.

This term in fact comes from the country where the system originates, the United
States. Board refers to those appointed by a general meeting of shareholders whose
main task is to represent the company’s shareholders by undertaking specific duties
described in this chapter.

The main duty of board is to supervise and advise the company’s executives.
But in a broader sense, boards’ duties go beyond supervising and advising executives
to include several other important duties. Patrick (2001) identifies six main duties of
boards:

1.ANTICIPATION:

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 Boards must be able, using certain tools, to anticipate what will happen to a
company in the future. To do this, potential problems must analysed. Boards must
build appropriate corporate visions and missions, and be visionary. That done, boards
must actively participate in developing the company’s programmes.

Figure 2-1 Flowchart of Board of Directors’ and Board of Commissioners’ Duties

Board’s VISION, MISSION

Responsibility and STRATEGY
and Direction

PROGRAMMING

BUDGETTING

Supervising and
advising

VALUE COMPANY

Source: Mas’ud Machfoedz

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The processes involved in the operation and execution of a company’s vision and
mission in a management control system (Anthony and Govindarajan, 2005) are
illustrated in figure 2-1. At the highest level, the company must develop a vision and
mission. Strategies to execute the vision and mission must then be outlined. The
responsibility of boards is to determine the direction of the company and participate
directly in formulating strategies. At this stage, boards (not necessarily boards of
commissioners) will determine the direction of the company in the context of
achieving the company’s goals, which bottom line will be increasing the value of the
firm. In companies that sell shares to the public, the value of the firm is determined
by market capitalisation per share, that is, share price times number of shares issued.
Vision, mission and strategy can be well formulated if boards have the vision and
experience to anticipate what will happen to the company in the future.
For boards to be able to anticipate what will happen in the future, they need to
able to manage risk.
Many boards fall short when it comes to anticipating what might happen in
the future, leaving them powerless to deal with crises in the firm. This is where an
ideal composition of board members is an advantage. In particular, independent
members of boards should be selected for their competence in their field. To help
anticipate what might happen in the future, a board may be assisted by a risk
management committee, or form a team of experts that can perform analysis of the
industry in which the firm operates.
Empowering the directors of firms to focus on the bigger picture of what
management should be doing is another factor associated with the duty of
anticipation. Firms adopting a one-tier system are better able to supervise corporate
strategy than those employing a two-tier system. In the one-tier system, the positions
of chief executive officer and chief finance officers, and sometimes chief operations
officers, are held by members of the board. This dual function makes execution of
mission and strategy easier. In the two-tier system, because the board of

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commissioners cannot be directly involved in the operation of the company, board
members are not such an inspiration in the company’s vision, mission and strategy.
An example is the role of the board of directors in the collapse of Enron,
declared by the United States Senate’s Permanent Suborindatee on Investigation and
based on an in-depth review that found evidence of the board’s failure to monitor.
The board occasionally “chose to ignore” problems, and also allowed Enron to
engage in “risky” practices. This was a problem of corporate governance. The
problem originated from the company’s “progressive” organisational strategy, known
as “redesign corporation”. In a redesigned corporation, projects are implemented
bottom up, not top down. In some firms, executive monitoring means analysing risk
management reports. Power Report concludes that the Enron board was and should be
found guilty because it failed to request information and failed to review and analyse
information not given to board members. This indicates a failure on the part of the
Enron board to anticipate future events.

2.ADVOCACY:

Advocacy refers to individual support given by board members to

stakeholders. Board members can communicate with stakeholders, shareholders and
the public in several ways. Board members can shape perceptions of the company,
public education and knowledge, and understanding of the company’s business. In
this way, board provide not only emotional and intellectual support, but also financial
management and investment policy support.
One way in which board members can influence perceptions of the company
is through disclosure policy on corporate social responsibility (CSR). Today, CSR is
a major trend. CSR is legally required action taken by the company in the interests of
the workforce, environment, and society. CSR can increase the value of the firm.
Rubin and Barnea (2006) analysed the relationship between CSR expenditure and the
value of the firm. When CSR expenditure is low, a positive contribution to the value
of the firm will be made by increasing the productivity of the workforce or avoiding

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costs and fines associated with reputation and pollution. But at the same time, each
increase in CSR expenditure will reduce the welfare of stockholders. If corporate
decisions are made to maximise the value of the firm, the level of CSR expenditure is
a significant decision for boards to make. Insider managers (corporate managers,
directors, blockholders) may want to increase CSR expenditure to level higher than
that which would maximise the value of the firm if there are personal gains to be
made from doing so. For example, if a certain level of CSR enhances their reputation
as individuals who care about the environment, society and workers. While high CSR
expenditure may be advantageous to the firm’s insiders (affiliated shareholders), non-
affiliated shareholders may not approve of high CSR expenditure if it reduces the
value of the firm. Thus, CSR can be a cause of conflict between shareholders. This
conflict can be seen from two normative perspectives. On the one hand, there is
evidence for choosing CSR expenditure higher than that which would maximise the
value of the firm. This has a negative connotation because it reduces shareholder
value. On the other hand, high CSR expenditure promotes a social agenda, which is
perceived as positive. Most would interpret the problem as action by managers
seeking to profit from share prices, and would be very surprised that CSR conflict has
implications for the balance between corporate goals and social goals. From the social
welfare perspective, whether this conflict will increase welfare depends on whether
the company stands to benefit from making a contribution to social welfare.
(what did the lapindo board do?). How did Lapindo’s CSR contribute to social
welfare? Was Lapindo transparent in its communication of the condition of the
company to stakeholders?

3.AUTONOMY:

Engaging boards in formulating and implementing corporate strategy is a

sensitive issue. Although boards also direct CEOs in formulating the corporate
structure and strategy, it is understandable if there is problem concerning the
“ownership” of strategies that are in the hands of CEOs and their management teams.

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To increase effectiveness, an organisation not only needs clear, unambiguous
strategy, but also the confidence that top management has the authority and capacity
to implement it. By their very nature, boards do not have the leadership needed to
manage products and markets, because the majority of their members do not have
specific experience and knowledge of industry, and more importantly, do not have the
capacity to translate corporate vision and strategy into concrete operations. Thus,
boards cannot make decisions alone, but need the help of competent CEOs.
To implement the company’s vision, mission and strategy, the board must
work with the CEO to run the company drawing on their individual expertise and
creating synergy. Although boards have the legal right to monitor and evaluate the
performance of CEOs, they must give CEOs the freedom to do their work properly.
Given this autonomy, CEOs feels they are trusted to manage the firm properly, and
will try not to abuse that trust. But without the autonomy and freedom to do their
jobs, CEOs will feel useless and increasingly frustrated. At the very least, it will
generate negative feeling.

4.ACCOUNTABILITY:

Autonomy must be balanced by accountability. Boards must ensure that while

giving autonomy to executives, in return they require accountability from the
executives. Given fiduciary, executives must be monitored to ensure that they are
able to maintain public trust, advance the company, and carry out and execute the
company's mission. To monitor the accountability of the executives, boards can form
several committees, such as an audit committee, risk monitoring committee, and a
remuneration and nomination committee. It should be noted that formation of these
committees can create tension in relations with the executives, and here the role of
boards is to alleviate such tension.
Independence will reduce agency cost by making boards responsible to
shareholders for the company's performance. Independence ensure that they evaluate

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management decisions objectively. The accountability function includes passive
monitoring. For independent boards, to reduce agency cost, they must actively grow a
culture of responding to shareholders' interests. Though independent boards cannot
and need not make the best decisions about a company's problems, this allows
managers to ensure the basic integrity of management actions.
In recent times, there has been more and more focus on corporate
accountability, largely as a consequence of economic crises, accounting and
remuneration scandals, and suspicion surrounding firms' social and environmental
implications, and as a result, there is growing transparency regarding corporate
practices. This growing demand for transparency comes from two different angles,
which appear to overlap. On the one hand, accountability is required in the context of
corporate governance, and began by covering matters related to staffing and ethics.
On the other hand, separate from the traditional corporate governance framework, are
sustainability reports. Generally focusing solely on environmental issues, the scope of
these reports has begun to expand to include ethical and social issues, such as
problems related to society and company employees, which the corporate structure
must address, and to financial aspects.
Sustainability reporting is broadly defined to include environmental,
social/ethical, and financial aspects (or triple bottom line “people, plant, profit”
reporting). The number of constituents and potential readers of sustainability reports
has expanded to include internal and external stakeholders, including shareholders.
Sometimes referred to as CSR reporting, sustainability reporting is perceived as
fulfilling the company's CSR role, a concept seen as fulfilling a company’s economic,
legal, ethical and philanthropic responsibilities to stakeholders and the public in
general. On this basis, the implication is that accountability in the sustainability
reporting and corporate governance frameworks tends to converge. What is
interesting is that the sustainability reporting framework raises questions about the
nature of accountability and the concept of transparency. Whether accountability
should be part of the annual report or a separate sustainability report needs to be

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made. Although an integrated report—an annual financial report including social and
ethical information, otherwise referred to as “sustainable stakeholder accounting”—
has been recommended, it should be noted that attention must be given to ensuring
proper integration. Sustainability measures in the annual report in some cases are kept
separate, though incorporated into the corporate governance section related to
sustainability. When corporate governance and sustainability are properly integrated
and reported together, this provides an opportunity to adopt integrated accounting.
Also important is determining the level and detail of information provided, because
while parts of this information are provided voluntarily, other parts are required,
particularly information about risk and management control (including social, ethical
and environmental aspects), reputation and trademarks, and the ethical dimensions of
remuneration and auditing.
Sustainability reporting is a way for companies to meet the wants of a variety
of stakeholders. If it is integrated with corporate governance, the relationship between
the company and shareholders and between the company and society, will be
covered. How to give stakeholders (including shareholders) the information they
want, and at the same time accommodate the different interests (which can lead to
conflict)? The auditor verifying the report can act as liaison in identifying the areas
that need more attention.

5. ADVICE:

Boards have legal authority when it comes to decision making in a firm. This
means that boards must review and approve operations fundamentals, finances,
strategy, and other corporate plans. To reduce moral hazard, boards must participate
actively in decision making. In their role as advisor, boards must adopt a variety of
approaches. Boards use the expertise of their members to direct management, in
keeping with the direction of company strategy. When board members have full-time
jobs in other companies, they rely on the company’s CEO to provide the necessary

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information to evaluate, for example, whether the company should enter a new line of
business. The more information provided and the better managers synthesise the
information, the better advice will be given by the boards. When a board acts in its
advisory role, it is better for shareholders if the board’s preferences correspond to
those of the company’s managers. This means that other constituents than
shareholders will not reduce the value of shareholdings by allowing the board’s
preferences to override those of management.
Board members are people who have expertise, experience and skills in a
variety of fields. With their expertise and experience, a board should be able to give
advice to management about operating the company efficiently and effectively.
Boards should comprise people of various backgrounds, notably finance,
accountancy, the industry in which the company operates, and politics.

6.ASSISTANCE:

A more important duty of boards than giving advice is giving assistance.

There are interesting lessons to be learned from the game of football about the
importance of assistance. The aim of football is the same as that of business: to beat
the competition by scoring goals. In a World Cup match, the Brazilian eleven was
losing right up to the closing minutes. At this critical time, Ronaldinho, the ace
Brazilian striker took the ball into left field and carefully passed the ball to Ronaldo,
who was standing unmarked on the right of the English goal. Ronaldo took the pass
from Ronaldinho and kicked the ball into the net with ease – GOAL! The
commentator said, “Ronaldinho was assisting Ronaldo to create a spectacular goal”.
In other words, with the assistance of Ronaldinho, Ronaldo was able to score and win
the match for Brazil. Assistance for company executive is crucial, because executives
have to realise company strategy and the need the direction or assistance of the board
to really achieve what the board wants.

Summary

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 In practice, the duties of boards vary widely from one country to another,
depending on the organisational structure adopted (one tier or two tier). Following is
a summary of boards’ duties in several countries:
First, boards must ensure that good corporate governance is implemented.
Second, they monitor the performance of management and of the company.
Boards have responsibilities related to control of management performance,
evaluation, and remuneration, management development, and personnel policy.
Boards should pay attention not only to current performance but to long-term
performance, too. Indicators used to evaluate management performance must be
fair and relevant, so that management is motivated to execute its functions
properly because its performance is fairly evaluated. Third, boards should pay
attention to financial reporting, the integrity of internal and external control
systems, management information systems and risk management. Boards should
understand corporate risk and monitor the balance between risk and return, ensure
that effective risk management systems are running properly. Appointment of
external accountants is another duty entrusted to boards as a way of exercising
control over the company’s financial reporting. Fourth is the board’s duties
related to corporate strategy. Boards should provide missions, strategic direction
and long-term goals. Without long-term goals, a company will lost its direction.
Boards must also evaluate implementation of strategy. Fifth is the board’s duties
related to allocation of financial resources. It is a duty of boards to monitor the
adequacy and allocation of financial resources and to approve business plans and
budgets. Finally, there is the communication role of boards. Along with
management, boards are responsible for the continuity of communication between
the company and the outside world, such as the press, consumers and
shareholders. Last but not least, boards play a pivotal role in crisis and conflict
situations.

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 CHAPTER 3
BOARDS’ RESPONSIBILITIES

‘Too much emphasis on monitoring tends to create a rift between non-executive

and executive directors, whereas the more traditional job of forming strategy
requires close collaboration. In both activities, though, independent directors
face the same problem: they depend largely on the chief executive and the
company’s management for information.’ The Economist (February 10, 2001 p
68) describing a survey by PWC of British boards.

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 A characteristic of public companies in Indonesia is the separation of owners
and managers. This makes it difficult for owners to directly monitor all actions taken
by managers. The main problem is information asymmetry, or the difference in
information provided management as an internal organ of the company, and that held
by owners. Managers, as full-time company employees, have a great deal more
information about the company than the owners do. Management can behave
opportunistically, in their own interests, by not giving reliable information to owners,
for example about an accounting profit based bonus contract. Management could
manipulate profit figures, among others by changing accounting methods or
manipulating receivables loss reserves, guarantee costs and other discretionary
expenditure. Profits are manipulated to achieve the targets required to receive a
bonus. Profit manipulation will diminish the reliability of accounting information,
and less than reliable information will result in adverse selection by information
users. What is needed to prevent this is an independent party, in this case the board of
commissioners. Boards are responsible for building build appropriate corporate
visions and missions, and ensuring the company is visionary. This done, the
commissioners must actively participate in developing company programmes and
ensuring that the company’s programmes are run properly (figure 2.1). In short, the
responsibility of the board of commissioners includes: accountability, information
transparency and shareholder voice function.

1. ACCOUNTABILITY

Corporate governance theory states that the function of the board of

commissioners is to identify mechanisms and reduce agency cost. Management has
information superiority that allows managers to distort information. In game theory,
the players in a game try to work out the strategy of each of the other players.
Likewise investors, having anticipated opportunistic behaviour by management, will
ask managers to use the services of an auditor to conduct a special purpose audit, for
example to improve information transparency. Employing the services of an auditor

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will incur a cost that will be deducted from company profits, thus reducing
shareholders’ dividends. The board of commissioners is responsible for developing
mechanisms to prevent management domination by reviewing corporate decisions
and reducing management misbehaviour to protect the interests of shareholders.

Boards of commissioners can reduce agency cost because they are

accountable to shareholders for improving company performance. Boards of
commissioners perform accountability by monitoring. A wide spread of shareholders
means that they are unable monitor and get close to managers to detect management
negligence, so delegation of monitoring is crucial.

Accountability is not only about passive monitoring. Boards of commissioners

must actively respond to shareholders interests. Although commissioners do not
always act as policy makers in a company, their closeness with managers should
guarantee integrity of management actions. In other words, boards of commissioners
are not only accountable after the fact, but are also involved in decision making. In
this way, boards of commissioners can assure investors, and regulation and law
makers that the company is being run in the interests of the company.

2. INFORMATION TRANSPARENCY

Boards of commissioners are responsible for improving the transparency of

information produced by management. The main problem with agency is information
asymmetry: investors need information to make investment decisions, but
management tends to provide information that is less than accurate, for example by
manipulating profits. As an example, a company makes profits of 500 M by
capitalising a portion of costs (i.e. capital leasing), so expenditure will be lower and
profits inflated. Window dressing like this results in misleading information and
makes investors make inaccurate decisions. To address this problem, investors need a
mediator that can guarantee the quality of corporate information. This function can
be performed by boards of commissioners, because the closeness between boards and

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management allows boards to function as transformers of information from
management to investors. In this function, the reputation of the board of
commissioners is a guarantee that its closeness with management does not undermine
its independence.

The reputation and competency of boards of commissioners ensures that

management will improve information transparency. There are two mutual conditions
to information transparency: information forcing and information validation.
Information forcing prevents management from distorting information, because
mandatory disclosure alone is not enough to ensure that investors get reliable
information. Here, boards of commissioners have a responsibility to adopt
information forcing, which means increasing the volume and quality of information
in the form of mandatory and voluntary disclosure. Competent boards will be able to
motivate management to provide reliable information so that management report
users have enough information to make economic decisions. To give an example
from the business world, if a company has high legal risk, it would help provide
investors with a picture from which they could predict the future condition of the
company if the board executed this responsibility by asking management to disclose
this legal risk. An example would be a company that could face legal charges because
of the nature of its business (such as a mining company producing waste that could
pollute the environment).

Information validation is the function of monitoring management to ensure

that accurate information is provided to stakeholders. In this position, boards are
responsible for monitoring the presentation of information before its publications, to
ensure that a high degree of accuracy and validity. Boards of commissioners not only
ask management to publish accurate information, but also ensure the reliability of
information. A very relevant example of information validation is when a board of
commissioners asks an audit committee to review the work of the internal auditor
who performed a particular audit to ensure that the information presented by

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management is valid and accurate. For firms that sell their shares to the public,
accurate and reliable information will help create efficient capital and real markets. If
the information presented by management is valid and accurate, transaction costs will
be more efficient because investors will not need to spend more to locate additional
information. Likewise in the real sector, valid and accurate information from
management will make creditor funding costs and covenants more efficient, and
attract more efficient production costs. It is here that boards help to create capital
markets and real sectors that are efficient and will create a value of the firm that is
reliable.

3. SHAREHOLDER VOICE FUNCTION

Shareholder voice function illustrates that boards are also responsible for
improving the value of the voice of investors in increasing the value of a firm. A
board’s responsibility in terms of voice function is to create equilibrium conditions by
minimising communication constraints between investors and managers. Boards must
be able to assure that optimal decisions about company operations will result in an
equal share of welfare between management and investors. Investor welfare, which is
measured from the value of the company’s shares, will be affected by the book value
of the company; when per share book value increases, it has been proven empirically
that share price will also rise, increasing investor welfare. On the other hand,
increasing investor welfare will cause investors to make decisions at meetings of
shareholders to retain management, and increase their remuneration, including in the
form of management stock ownership plans (MSOP) and employee stock ownership
plans (ESOP). If the board’s responsibility as the balancer of these two voices is well
executed, there will be a significant decrease in tension between management and
investors and an increase in investor value.

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EMPIRICAL STUDIES OF BOARDS’ RESPONSIBILITIES

Accounting figures are used to assess the health and sustainability of a

company. Managers have an incentive to manipulate accounting figures using certain
accounting methods, and by making changes to receivables loss reserves, guarantee
costs and so on. From the creditor’s perspective, bond holders and creditors will
protect their investments. A key element in protection their investments is to look at
accounting figures. Creditors use accounting figures to assess management diligence
to loan contracts.

Boards have a responsibility to monitor the financial reporting process.

Boards meet regularly with accounting staff and external auditors to review financial
reports, audit procedures and internal control mechanisms. Investors see boards as a
key element in the process of presenting relevant and reliable financial reports.

Anderson et al. (2003) tested the relationship between boards’ characteristics,

integrity of financial reports, and cost of debt. The sample of 252 industrial firms was
taken from the Lehmnan Brothers Fixed Income and S&P 500 databases. The results
of the analysis indicated that cost of debt in firms with independent commissioners
tended to be lower than in companies that had fewer independent commissioners. The
researchers also found that there was a negative relationship between the size of the
board of commissioners and cost of debt. Overall, these research results indicated that
bond holders and creditors perceive auditor independency as a key element in
determining interest expense. Creditors believe that independent commissioners can
enhance the validity of financial reports.

Dalton et al. (1998) carried out a meta-analysis to review research on the

composition of boards, management structure, and financial performance. Meta-
analysis is an in-depth study of previous research to identify factors suspected of
influencing financial performance. This meta-analysis was carried out because there
inconsistencies in the results of previous research on the influence of the composition

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of boards and management structure on financial performance. A sample was taken
from 54 researches on the influence of the composition of boards and 31 researches
on the influence of management structure on corporate performance. According to
agency theory, separating the owners of a company from its management will cause
managers to behave in a morally hazardous way. Managers, with their knowledge of
the company and their expertise, can profit from the company at the expense of
investors. Independent board members play a key role in monitoring managers to
protect investors' interests. Stewardship theory, on the other hand, says that managers
will work in the interests of investors, and for this reason the control function is
delegated to management. According to this theory, insider directors executive the
supervisory function more effectively because they have good quality information,
thus better able to evaluate mangers' performance. Research findings indicated that
there is no relationship between the composition of boards (independent and internal
directors) and financial performance.

Corporate governance has to do with providing security for investors so they

receive the returns on investment that they expect. Investors use corporate
governance mechanisms to minimize or eliminate financial and non-financial fraud in
companies. An example of financial fraud is using accounting methods to manipulate
profits or produce financial reports that do not reflect the true financial condition of
the company. Non-financial fraud includes not only fraud of shareholders, but also
fraud of consumers and government, and other crimes. Karposs and Lott (1993)
showed that there is a significant decrease in share price in companies that commit
fraud. Decreases in share price will have a significant effect on return on investment.

The main duty of boards is to protect investors’ long-term interests. Boards

assume responsibility for performing internal control and making decision for
shareholders. This responsibility is delegated because shareholders generally
diversify the risk on their investments by investing in more than one company.

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Diversification gives rise to the problem of free-riders, shareholders have no way of
ensuring that management is acting in the shareholders' interest.

Persons (2006) identified characteristics of corporate government that help to

reduce the possibility of non-financial fraud occurring. The characteristics of
corporate governance tested in this research were the level of independence and the
effectiveness of boards. Fama and Jensen (1983) note that boards have a
responsibility to monitor the actions of management. The more independent boards
are, the better they execute their monitoring function. This research used four
variables to measure the independency of boards: (1) percentage of independent
commissioners, (2) whether the chief executive officer (CEO) was also a
commissioner, (3) the period of office of managers and commissioners, (4)
percentage shares held by independent commissioners relative to total shares owned
by all directors. The independency of boards is low if the composition of independent
commissioners is low, if managers double as commissioners, if the period of office of
commissioners and manager sis low, and if the percentage of shares owned by
independent commissioners is small. The effectiveness of boards was measured from
the size of boards and the frequency of meetings. Effectiveness is low if the number
of commissioners is large and the number of meetings is few. This research also
incorporated other variables that could potentially affect non-financial fraud.

Non-financial data on reported fraud were taken from the Wall Street Journal
Index 1999-2002. The sample consisted of 83 firms listed on the New York Stock
Exchange. The results of the research indicated a relationship between low levels of
fraud and small sized boards, large percentage shareholdings by independent
commissioners, long periods of office of managers and commissioners, high
profitability, and, notably, an a corporate code of ethics. This suggests that regulators
should not only ensure that companies have codes of ethics, but that they implement
them.

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 Marciukaityte et al. (2006) examined whether, after fraud has occurred,
companies change their corporate governance structures, and whether these changes
in corporate governance affect company performance. Fraud data was taken from the
Wall Street Journal for the period 1978-2001. Three types of fraud were used: (1)
fraud of stakeholders, which happens when a firm implicitly or explicitly deceives in
contracts with suppliers, employees or consumers; (2) fraud of government, which
happens when firms contravene contracts with government; and (3) financial
reporting fraud, which happens when managers do not reveal the real financial
condition of the firm. The results of the research indicate that after fraud has
occurred, firms increase the number of independent commissioners on their boards,
audit committees, compensation committees, and nomination committees. Share
prices improve after changes have been made to corporate governance structure and
improvements are made to internal control systems.

The main function of board is to minimise costs arising from the separation of
owners and managers in a modern firm. Boards have a responsibility to exercise
internal control and make other decisions on behalf of shareholders. The composition
of the board is a key factor in making monitoring of the actions of managers more
effective. Fama and Jensen (1983) argue that the effectiveness of boards in
monitoring management is a function of the mix of insider and outsider board
members. Boards are not an effective instrument of internal control of there is no
limit on the spread of management. Managers are better informed about the condition
of the firm than owners are, and boards could be used as a tool by management to
take action in their interests, to the detriment of shareholders. The solution to this
agency problem is to have independent directors. Independent commissioners have an
incentive to build their reputations as experts in decision control, so they will execute
their responsibilities properly, unless they want their reputations destroyed. Research
by Rosenstein and Wyatt (1990) indicates that investors react in a positive way to
input from independent commissioners on the board. This suggests that investors

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believe that the presence of independent commissioners will protect investors'
interests. Input from independent commissioners on the board will enhance the
company's internal control function and prevent fraud.

Beasly (1996) analysed the relationship between the composition of boards of

directors and financial reporting fraud. Data were taken from 150 public companies
for the period 1980-1999. The sample consisted of 75 firms that had committed fraud
and 75 companies that had not committed fraud. The cases of fraud covered
contraventions of the rules of the Stock Exchange Commission (SEC). The results of
the research indicated that there were differences in the composition of boards of
companies that had committed fraud and of those that had not. Boards of companies
that had committed fraud had fewer independent commissioners than the boards of
companies that had not committed fraud. Having independent commissioners will
enhance the effectiveness of boards in detecting and preventing fraud. This research
also indicated that having audit committees reduces the likelihood of managers
committing fraud.

Fama (1980) indicated that incentive for independent commissioners to

undertake monitoring also comes from the job market. Independent commissioners
perform their monitoring function well because they wish to maintain their
reputations as experts in the job market. Corporate failure is the responsibility not
only of management but of boards, too. The reputation of commissioners in the job
market will be tarnished if commissioners failed to execute their responsibility to
work in the interests of the firm and increase the value of the firm.

Summary

The main responsibility of boards is assure stakeholders that management is

implementing the vision, mission and strategy of the company to optimise the value
of the firm. More specifically, the main responsibilities of boards are to ensure a high

3
degree of management accountability, improve information transparency, and execute
the shareholders' voice function.

Accountability means that boards must assure stakeholders that management

are not taking moral risks that could harm stakeholders in general, and stockholders
in particular. Boards should be able to detect all actions by management that could
increase agency cost and immediately monitor these actions to minimise the increase
in agency cost.

As well as being responsible for ensuring management accountability, boards

also have a responsibility to assure stakeholders of the importance of information
transparency. Transparency of information from management will reduce information
asymmetry and minimise distortion of the quality of information so that management
information can be used to help information users make economic decisions, such as
investment and bond purchase decisions.

The third responsibility of board is to represent the voice of shareholders.

Shareholders are the owners of the company. They are limited in the extent to which
they can participate in controlling the company. Control and monitoring by
shareholders is limited to shareholders' meetings. Under these conditions,
commissioners must function as the shareholders' voice in increasing the value of the
firm.

In both normative and empirical terms, there is evidence that execution of the
three responsibilities of boards described above will make stakeholders, and
particularly stockholders, trust management and boards more as a consequence of
increases in the value of the firm, indicated by increases in share price.

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 CHAPTER 4
EMPOWERING THE BOARD

Ten or 15 years ago, if you were invited to sit on a

company’s board of directors, it meant that you had
reached a certain level in the business world and were
being rewarded for your achievements. Today, being a
board member involves much more than just rewards: the
board member must now not only show a strong track
record, but must also bring to the table the proper skills
and competencies, a strong commitment to the firm, and a
willingness to share some of the risks-It’s still prestigious
to be a director; but now you’ve got to know your stuff
(Christian Bellavance, ca Magazine)

A managing director of a public company communicates with a minister to

ask the minister to make a public statement about plans with a high risk of loss, to the

3
effect that this is not a result of negligence by the firm. The considerable influence
this director has over a minister lies in relationship previously nurtured by the
director by doing a great deal to help the minister with his job. This non business
related expenditure was incurred without the knowledge of the company's board of
commissioners. The board did not have a complete understanding of the expenditure
incurred as a consequence of the managing director having more power than the
board. This illustration indicates that a major weakness in corporate management
today lies in the concentration of authority in the hands of management. An
imbalance of power is one of the root causes of fraud, manipulation of financial
reports, and other improprieties. The systematic problems facing Enron were a
consequence of an imbalance of this kind.
To ensure a balance of power, boards need to be empowered. Empowering the
board means that the board has the capacity and independence to monitor the
performance of management and the company. An empowered board can also
influence management to change the direction of strategy if its performance does not
meet the board's expectations; and, in the extreme, replace the company's
management.
Management and boards must have a synergetic relationship. A board as an
internal organ of the company must be empowered to carry its functions as supervisor
and advisor of management. A synergetic relationship between the board and
management will strengthen the position of the board, so that it is not simply
following the wishes of management which may well be influenced by the self
interests of the company managers. The job of management is to manage the firm,
while the function of boards is to implement control mechanisms to ensure that there
are checks and balances. Strengthening the board-management relationship will
strengthen the board’s ability to advise and to monitor company performance.
Without a balance of power, the check and balance function of boards will not
operate properly.

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DEMAND FOR EMPOWERMENT
There is a correlation between the weakness of the position of a board and the
level of misuse of authority by company managers. When a board has insufficient
power, this provides opportunities for management to take action that may be
detrimental to the company or that could trigger conflict between the board and
management, undermining company performance. There is pressure from various
quarters on companies to empower boards.
First, most investors do not want to participate directly in management of the
company, but prefer to encourage boards and the media to monitor management.
Second, with adequate power, boards have the power to replace managers who
perform poorly. Third, there is a correlation between good corporate governance that
places board in a strong position and the competitive success of a company.

INVALID ASSUMPTIONS ABOUT EMPOWERING DIRECTORS

In companies where directors are empowered, CEOs do not find their power
diminished
Managers often perceive empowering boards as a threat. Managers feel that boards
intervene where their behaviour is concerned and in the decisions they make
regarding management of the company. Managers feel that empowering boards will
diminish their power. But one can obtain power without the other losing it.
Management fears that empowering boards will diminish the management function in
the company need to be erased. The fact is that empowering boards will help
managers to run the company, provided that managers recognize that everyone in the
company shares a common vision and mission. Empowering boards must be seen as a
way of achieving the common goal of improving company performance. Balance of
power in The management-board relationship and synchronisation of vision and
mission are essential to achieving good corporate governance.

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 The assumption that boards participate actively only if a company is in crisis
is mistaken. Boards that do not participate in monitoring company performance will
fail to detect problems facing the company in a timely fashion. Problems that are not
immediately addressed and allowed to pile up will turn into an iceberg, and when it
melts, it will submerge the company. Enron is a case in point: the downfall of this
company was not only the result of mismanagement, but also of the board's failure to
execute its functions.
The boards' role as monitor varies with the complexity of the duties facing
managers. There are at least three factors that influence the processes and procedures
used by boards to monitor management: first, the board's view of managers' ideas. If
boards do not like management's ideas, they will monitor management more
frequently and more carefully. Second, the problems and complexity of the company.
If the board feels that the company is having problems, it will make more of an effort
to understand management's decisions and way of thinking than it would if the
company were not having problems. Third, market and technology changes in the
company's line of business. Firms in the technology industry are of higher complexity
because of rapid changes in technology and rapidly changing markets. Boards must
have all the necessary information to determine the direction of the company and to
give useful advice. A board's ability to continually update its knowledge and
understanding of the company's business increases the power of the board.

The question is when and to what extent should boards intervene in corporate
strategy? A line has to be drawn between boards, which contribute ideas for corporate
strategy, and management, which manages the company. Boards have to approve
company strategy and review and evaluate its results. The extent of the board's
intervention depends on the specific environment of the company, for example, in
making decisions pertaining to acquisitions, takeovers, and so on, boards must be
actively involved because these will have a significant bearing on the company's
future performance.

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THE SOURCES AND LIMIT OF DIRECTORS’ POWER

The source of directors' power depends largely on: the directors' knowledge and the
solidarity of the board as a unit. Directors work part-time in a company, while
managers are full-time company employees. Seen in terms of hours worked, it is
hardly surprising that managers have a better understanding of the complexities of the
company than directors do. From the managers' perspective, meetings with boards are
generally seen as an instrument for boards to obtain information about the company
from management. Directors do need to have data about the company, but this data
needs to be translated into information that can be used for decision making.
Financial data and other data is only a small part of the real picture. The ability to
process data into useful information and knowledge depends largely on the directors'
knowledge of the company's business. Superior knowledge is a source of power for
boards.

The knowledge that directors have comes from written information, such as
financial reports, and from oral information that comes from discussions with
managers. The challenge for boards is how to process this information into useful
knowledge at the appropriate time. Directors must also be able to understand external
factors that affect company performance, such as changes in market conditions,
technology and the economy. To be able to carry out effective evaluations of
management and approve corporate strategy, directors need not only financial
information, which provides an indicator of historical performance, but also
information about the company's progress in implementing strategy. Knowledge of
technological developments, new services and products, changes in consumer
demand, and what the company's competitors are doing is crucial.

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 The information that directors use must be a balance of financial data, which
focuses on the past, and strategic information, which focuses on the company's future
prospects.

Solidarity among board members is a source of power. Board consensus is a

powerful tool for controlling management; board consensus can replace the
management of a company that is performing badly.

WHAT MAKES AN EMPOWERED BOARD?

The following can empower boards:

a. The majority of board members come from outside the company and have no
links with the company.

b. The number of board members is kept to a minimum to foster unity among the
group. Board members should understand goals and want to achieve them.

c. Board members have experience in leadership and business, and understand the
company's business.

d. Board members communicate freely with other board members, at committee

meetings with or without management.

e. Directors receive data on the company's finances and industry performance that
enables them to understand the relative performance of the company vis-à-vis its
competitors.

EFFECTIVE EMPOWERMENT

Routine management evaluation, through regular meetings and empowerment of

existing committees, is central to effective monitoring, because it is the first step
towards empowering boards. Evaluations of management will give a clear message to
directors about the company’s performance and enhance their understanding of the

3
company. A good understanding of the company will further empower boards. These
evaluations will be beneficial for management, too, because the direct communication
between managers and directors will flag areas of concern and generate
recommendations for making improvements. Managers will also be able to discuss
their reactions.

There are several criteria for effective evaluation:

a. Evaluation must be performed continuously, through mechanisms established by

the company’s articles of association.

b. Evaluate annual and long-term performance, and compare these with other
companies in the same industry

c. Evaluate the appropriateness of management goals to the goals of the company

d. Managers must have individual performance evaluations

e. Boards must evaluate management performance.

THEORY OF FRIENDLY BOARDS

Boards have the legal authority to make decisions in the company. Boards must
review and approve operations, financial and strategic plans. To reduce the moral
hazard that arises when managers select projects that do not maximise shareholder
value, managers must have approval from the board. Under these circumstances, the
boards participate actively in decision making and monitoring. But this does not
negate the responsibilities of directors, and management may not hide behind the
board. The remain responsible both institutionally and individually.

As well as being responsible for monitoring the firm, a board must also give
advice to managers about the direction of company strategy. Because directors do not
work full time in a company, they need to get financial and non-financial information
from managers. If managers provide reliable information, the directors will be able to
offer good advice.

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 Boards assume the dual role of monitoring and giving advice to manages.
When boards implement the monitoring function intensively, managers are faced with
a trade off in sharing information. On the one hand, boards will provide better advice
if mangers provide them with reliable information. On the other hand, the information
the managers provide will help the board to better understand the condition of the
firm. And if the board knows that the company is slipping or is below the industry
average, it will intervene in managerial decision-making.

The board’s role as supervisor and advisor complement each other, because
boards use information from managers to make better recommendations and
implement better policy. To motivate managers to provide information, shareholders
would be best off electing friendly directors who focus not only on the supervisory
function but on the advisory function, too.

Adams and Ferreira (2005) tested the theory of friendly boards. Emphasis on
the control function by independent directors will have adverse consequences,
because managers will tend to reduce the amount of information they provide, and in
turn, the advice they are given will not be the best. Thus, increasing the number of
independent directors will reduce shareholder value. Shareholders will benefit if
increasing the number of independent directors leads to better disclosure practices.
Adams and Ferreira showed that the model of management-friendly boards could be
optimal.

An interesting finding from the Adams and Ferreira study was that
independent directs are not influenced by company performance. Contrary to research
by Ezzamel and Watson (1993), Pearce and Zara (1992), Rosenstein and Wyatt
(1990) showed that there is a positive correlation between the composition of boards
and company performance. The inconsistency in the results of research on the effect
of independent directors on corporate performance may be because definition of

4
‘independent’ is ambiguous. Is an independent director one that has no contractual
relationship with managers, or someone who is not a major shareholder? The
independence of directors cannot be defined in terms of whether or not there is a
contractual relationship with mangers, but in terms of whether they are independent
in action.

Summary

There is an invalid theory about the power of boards: that empowering boards
will undermine the authority of management. This is not, in fact, the case. A
competent board will create a positive synergy. When boards have adequate
authority, management will be better able to improve its performance. A close
relationship between management and board make it possible to realise the
company’s vision, mission and strategy.

The time has passed when directors were just bodies in chairs, given facilities
without contributing to the value of the firm. They must have adequate authority and
power to advise and supervise management. There is abundant evidence that an
overpowered management and underpowered board will diminish both internal
performance and market performance. Just look at the state-owned enterprises of the
past with their powerless and incompetent boards: their management were
uncontrollable and distorted corporate performance, and in some instances, even
destroyed the firm completely.

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 CHAPTER 5
NEW TOOLS FOR BOARDS

Today, the presence of institutional investors, regulatory bodies, the press, and
the fear of legal retribution has made the boards of directors of public companies
search more actively for practical steps for strategic management. There is a
difference in perspective between that of boards of directors and that of boards of
commissioners. Boards of directors/managers are expected to translate strategic
vision into actual operations. They must focus on the strategic path to maximising

4
corporate profitability. Therefore, optimal performance standards are needed to
motivate members of the organisation. Boards of commissioners, on the other hand,
are responsible for representing the investors’ perspective. Boards of commissioners
evaluate the validity of strategies that are implemented, by comparing current returns
on a particular strategy with possible returns on other feasible strategies. Although
they have different perspectives, the difference diminishes when boards of directors
and boards of commissioners build strategy.

STRATEGIC AUDIT

A strategic audit, which is designed to give credibility to management

leadership, is an effective strategy for anticipating problems and showing to
shareholders that the board of directors is committed to and is implementing good
governance. A strategic audit must be directed by independent commissioners, and
the board of commissioners must set the key criteria for monitoring strategic results.

The elements of a strategic audit are:

1. Setting criteria

It is important that in setting criteria for a strategic audit, the criteria

are objective. The criteria must also be familiar and easily understood, and use
acceptable financial performance indicators. This is because; a) the
responsibility of the board of commissioner is to understand the impacts of
strategies adopted in appraising shareholder value, and this requires a
financial-based performance evaluation; b) managers are familiar with the
product market and the company’s particular problems, and have access to a
phenomenal quantity and range of data, giving them an advantage over the
board of commissioners.

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 These criteria must also focus on sustainable levels of shareholder
return and investment, and allow for income flow comparisons across
companies, and comparison of investment alternatives across firms in the
same industry and in other industries.

The criteria must also reflect fundamental economic realities, such as

shareholder loyalty depending on competitive ROI (return on investment).
Other criteria commonly used to evaluate alternative strategies are CFRIO
(cash flow return on investment), EVA (economic value added), and TSR
(total shareholder return). However, since each of these measures has its own
strengths and weaknesses, a board of commissioners must make the best
analysis possible and use only one.

2. Designing and maintaining databases

The process of identifying effective strategies requires boards of

commissioners to control not only the performance criteria but also to
maintain a database of these criteria. There are several options here. One is to
ask the CEO to employ staff to do this. But this could result in conflict of
interests arising from staff working with sensitive data. Another option is to
request the services of an external consultant to design a database and collect
data the board of commissioners wishes to monitor. The best solution is to
engage an external auditor, who will evaluate the design and data collection
carried out by the external consultant. This will ensure that there is
consistency in maintenance, documentation and reporting in the long term.

3. Strategic Audit Committee

The audit committee must select the criteria for auditing strategic
performance, including database design, and establish the audit process. This
will improve the integrity and continuity of data collection and reporting, and
identify problems to be discussed with the directors. The strategic audit

4
 committee is the equivalent of the audit committee in Indonesian legislation
pertaining to organizational structure. The strategic audit committee focuses
on reviewing corporate strategy, which can also be done by an audit
committee.

4. Relations with directors

The review process aims to discuss strategic performance with the

CEO, in order to alleviate any hostile atmosphere within the organisation.

5. Readiness to do the task

The board of commissioner must watch out for signs of weaknesses in

the company’s strategic mission, and for events that indicate opportunities for
adjusting strategic direction. There are several events that may require special
meetings with the strategic audit committee include:

On this basis, the board of directors cannot work alone to operationalise corporate
strategy. Maximising performance requires evaluation of their performance by the
audit committee and independent commissioners.
Research results show that the size and composition of boards affects the
company activities. The size and composition of the boards of directors can affect the
effectiveness of monitoring. The size and composition of boards of directors also
affects the relationship between managerial and institutional investors and company
performance. According to Pfeffer (1973), expanding the size and diversity of
membership of the board of directors will be beneficial to the company because it
creates networks with external stakeholders and guarantees a supply of resources.
Hermalin and Weisbach (1988) stated that outside directors, as well as being
more effective in monitoring management, are also tools for disciplining managers,
and minimizing inefficiencies and low levels of performance. Outside directors
contribute to the value of firm through evaluation and strategic decision making
(Brickley and James, 1987).

4
 Fama and Jensen (1983) claim that brining in outside directors will enhance
the performance of the board and reduce the likelihood of managers expropriating
shareholder wealth.
Beasly (1996) showed that firms that engage in fraud have a significantly
lower percentage of outside directors than firms that do not engage in fraud.

FORENSIC ACCOUNTING
Several empirical studies have shown that bad corporate governance will undermine a
company’s performance. Sliding company performance will prompt management to
behave in an opportunistic way, by manipulating reported profits to ensure they
receive their bonuses. As a consequence, the reliability of the financial reports will be
in doubt. Boards function to prevent opportunistic behaviour by management that
would be detrimental to investors.
Forensic accounting is expertise in financial and non-financial auditing
exercised to investigate problems that cannot be solved by conventional accounting or
auditing methods (Bologna and Lindquist, 1995). As a discipline, forensic accounting
requires financial expertise, knowledge of fraud, and an understanding of the realities
of business and of the prevailing system of law or legislation. This implies that
forensic accountants are equipped not only with expertise in financial accounting, but
in internal control systems and the law, as well as with investigatory and
interpersonal skills. Forensic accounting can be used as a tool to protect shareholders
from management's opportunistic behaviour. By helping the firm to prevent and
detect fraud, forensic accounting can help a firm adopt good corporate governance, as
follows:
First, corporate governance. Forensic accountants can help formulate and
develop governance policy, establish appropriate responsibilities for boards and audit
committees, ensure a fair allocation of power among management, boards and
investors, and ensure that there are codes of ethics for employees and managers.
Codes of ethics need to be enforced if managers display unacceptable behaviour.

4
 Second, fraud prevention. Forensic accountants know that the best way to
prevent fraud is to set up efficient control systems, including a good environmental
control system that are based on management philosophy about ethical behaviour and
corporate governance policy, good accounting systems that guarantee the accuracy of
recording, classifying and reporting of relevant transactions, and strong control
procedures that provide security of assets, appropriate authority, and appropriate
audit mechanisms.
Third, creating a positive working environment. A fraud prevention
programme will also create a positive working environment. For example, highly
motivated employees will not be tempted to misuse their authority. Forensic
accountants can guarantee that governance policy is created to avoid high risk
environments.
Fourth, creating effective communication. Communication is a key element in
ensuring that employees and investors, management and boards have exercised their
rights and responsibilities. Effective communication must flow not only from the top
down, but also among employees. Forensic accountants can support the dissemination
of information on governance and ethics policy to the relevant people.
Fifth, vigilant oversight. For all systems to work properly, continuous
monitoring and evaluation is required to ensure that these systems are functioning
properly. Forensic accountants can monitor management commitment, management
procedures, and employee activity.
Sixth, establishing consequences. The possibility of punishment prevents a
person from committing fraud. Forensic accountants can hep prepare policy that
prevents criminal action.

Seventh, fraud investigation. Forensic accountants can ensure the integrity of

financial reports by actively investigating fraud, identifying areas of risk, and
investigating financial and accounting anomalies.

4
Summary

In the second millennium, business is very different from business in the first
millennium. The use of advanced technology totally changes the strategy and
operation of firms in competition. As a consequence, there has also been a shift in
corporate fraud, from blue collar crime to white collar crime. Competition strategy
has changed too, with the shift in competition from the real world to the virtual
world.

Two new tools have been introduced to handle this condition. First is the
strategic audit. This is an audit to determine whether a company’s operations are in
keeping with strategy outlined by top management. The second is forensic auditing.
This is not the same as a normal financial audit. In a forensic audit, the auditor goes
beyond the scope of a normal audit to include the possible impacts of the audit
findings. Here, corporate risk may be analysed, which means that the auditor must
have knowledge of accounting, strategy and law. In a forensic audit, the auditor is an
audit team and the audit is carried out together by the members of the team.

Forensic audits are useful for: building good corporate governance, preventing
fraud before it happens, creating a positive work environment, building effective
communication between organs inside and outside the company, and ensuring that
systems within the company operate properly.

4
 CHAPTER 6. THE AUDIT COMMITTEE
AND OTHER SUPPORTING COMMITTEES

The audit committee has the separate task of helping the board of
commissioners to fulfil its responsibility to provide comprehensive supervision. The
audit committee helps the board of commissioners to monitor financial reporting by
management to enhance the credibility of financial reports. In undertaking its duties,
the audit committee sets up formal communication between the board, management,
external auditors and internal auditors (Bradbury et al., 2004). The audit committee
acts as liaison in the event of a difference of opinion between management and

5
auditors concerning interpretation and application of the Generally Accepted
Accounting Principles (Klien, 2002).
Members of the audit committee should be independent commissioners, who
are free from day-to-day managerial duties and whose main responsibility is to assist
the board of commissioners undertake its responsibilities, particularly with regard to
corporate accounting policy, internal supervision, and financial reporting systems. In
general, the audit committee has responsibilities in three areas (FCGI, Volume II, p
12):
a. Financial reporting

The responsibility of the audit committee in the area of financial reporting is

to ensure that financial reports prepared by management give a true picture of the
following: 1) financial condition, 2) business results, 3) long-term plans and
commitments.
The scope of implementation in this area encompasses:
1. Giving recommendations to the external auditor
2. Examining matters pertaining to the external auditor:
a. Auditor’s letter of appointment
b. Audit cost estimate
c. Auditor’s visit schedule
d. Coordination with internal audit
e. Monitoring audit results
f. Evaluating implementation of the auditor’s work
3. Evaluating accounting policy and policy-related decisions
4. Examining financial reports, including:
a. Interim financial reports
b. Annual reports
c. Auditors’ opinions and management letters

5
 Evaluation of accounting policy and policy decisions can be effectively
performed by obtaining a brief summary from officers in the company’s accounting
department.
b. Corporate governance
The audit committee’s responsibility in the area of corporate governance is to
ensure that the firm has been run legally, carried out its business in an ethical way,
and performed effective monitoring of conflicts of interest and of fraud by company
employees.
The scope of implementation in this area encompasses:
1. Evaluating company policy relevant to compliance with laws and regulations,
ethics, conflicts of interest, and investigation of fraud and deception.
2. Monitoring ongoing and pending judicial processes pertaining to corporate
governance where the company is a party to the process.
3. Investigating major cases of conflict of interest, fraud and deception.
4. Requiring the internal auditor to report on corporate governance audit findings
and other key findings.
c. Corporate control
The audit committee’s responsibility in the area of corporate control includes
having an understanding of problems and potential risks and of internal control
systems, and monitoring control processes performed by the internal auditor. The
scope of the internal audit must include review and evaluation of the adequacy and
effectiveness of internal control systems.
d. A member of the audit committee:
• Has a high level of integrity, competence and knowledge, adequate experience
appropriate to their educational backgrounds, and good communication skills.
• Has an educational background in accountancy or finance
• Has sufficient knowledge to read and understand financial reports.

5
 • Has sufficient knowledge of capital market legislation and other relevant
legislation.
• Has not been employed in a public accountant's office, a legal consultant's
office, or by any organization that provides audit, non-audit, or consultancy
services to the listed or public company concerned, during the 6 (six) months
prior to being appointed by the board of commissioners.
• Has not been authorised or responsible for the planning, management, or
control the operations of the listed or public company in the 6 (six) months
prior to being appointed by the board of commissioners, expect as an
independent commissioner.
• Has no direct or indirect shareholding in the listed or public company. In this
event that a member of the audit committee obtains shares as the consequence
of peristiwa hokum amaka, the said member is required to have disposed of
these shares within 6 (six) months of their acquisition.
• Has no:
a. Family relations, by marriage or descent to the second degree, either
horizontal or vertical, with members of the board of commissioners or
board of directors or with shareholders of the listed or public company;
b. Direct or indirect business relations associated with the operations of the
listed or public company.

Pursuant to Decree of the Capital Market Supervisory Board No. 29/PM/2004,

which aims to reduce the lag in submission of the financial statements of listed
companies to the public and the Capital Market Supervisory Board as of the end of
the 2002 fiscal year, listed companies are required to make public financial reports as
follows: 1) annual reports, no later than three months after the date of the accountant's
opinion of the financial report, 2) mid year reports: (a) one month after the date of the
financial report, if unaudited, (b) two months after the date of the financial report, if

5
the audit is limited, (c) three months after the date of the financial report, if there is an
auditor's opinion. One task of the audit committee that lies within the scope of its
responsibility for corporate governance is to assess corporate policy with regard to its
compliance with the law. Thus, the presence of an audit committee as an institution
will have a bearing on the company's compliance with Capital Marketing Supervisory
Board regulations concerning the timely publication of financial reports. In other
words, the reporting lag for a company that has a audit committee will be shorter than
that of a company that does not have an audit committee.
A company that has an audit committee that comprises entirely of independent
members, at least one of whom has knowledge of accounting and finance, and that
holds meetings three times a year, will have few problems with its financial reporting
(McMulen and Ragahunandan, 1996).
One of the tasks of the audit committee is to recommend an external auditor to
audit the company's financial reports. According to De Angelo (1981), the quality of
an audit depends on the possibility of the auditor detecting fraud in the accounting
system and reporting fraud. Thus, a good quality audit can improve the quality of the
company's financial reporting and reduce the asymmetry of information between
management and shareholders. Verschoor (1993) states that supervision of an
external audit should enhance auditor independency, thus making the audit more
effective. The presence of an audit board correlates with fewer claims from
shareholders of fraud, fewer illegal acts, and fewer changes of auditor when there is a
difference of opinion between the company and the auditor (McMulen, 1996).
On improving the effectiveness of audit committees, the Blue Ribbon
Committee (BRC) says that an audit committee will improve financial reporting it the
committee comprises independent, financially literate, fully committed members and
convenes regular meetings. Bryan et al. (2004) tested whether the BRC
recommendation will improve the quality of profit reporting by analysing profit
informativeness and transparency of reporting to determine whether these were better
in companies that had audit committees, as suggested by the BRC. ERC was used as

5
proxy for profit informativeness, and the level of accrual mispricing (overpricing) as
the proxy for transparency. The sample was 1,291 firms listed in 1996 Fortune 500
for the period 1996 – 2000. It was found that ERC was stronger when the audit
committee was independent and financially literate, and accrual overpricing was
smaller when the audit committee was independent and held regular meetings.
Overall, the results of the research indicated that independent and effective audit
committees will improve the quality of financial reporting; a finding that supports the
recommendations of the BRC and the 2002 Sarbanas-Oxley Act.
Qin (2006) analysed the impact of the financial expertise of the audit
committee on quality of profit as measured in terms of profit-return. The sample used
consisted of 92 firms from 43 public industries in the United States. The research
findings indicated that a company that had an audit committee with professional
accounting expertise had better quality of profit. There was a positive correlation
between accounting expertise on the audit committee and quality of profit.
The new NYSE regulations for corporate governance require audit
committees to discuss and review assessments of corporate risk and hedging
strategies. They are also additional requirements regarding the composition and
financial knowledge of the directors on the board and the audit committee. Dionne
and Triki (2005) analysed these new regulations in terms of more profitable hedging
decisions for shareholders. They found that the requirements pertaining to the
composition and independency of audit committees benefited shareholders, but that
audit committee members having an accounting background was not particularly
important. Notably, they found that the directors with financial backgrounds
encouraged corporate hedging, and that active directors with an accounting
background did not play active roles in many policies. The results of this research
also suggested that there was a positive correlation between hedging and company
performance, indicating that shareholders were better off with directors with financial
backgrounds sitting on the board and the audit committee. These findings support

5
empirical evidence in favour of having directors with a university education on the
board and audit committee
In compliance with the 2002 Sarbanas Oxley Act, the NYSE requires that
there be financial expertise on the audit committee. But the definition of financial
expertise is a controversial issue; one that reached a peak when the stock exchange
adopted a definition of financial expertise that was broad in scope. Dhaliwal et al.
(2006) analysed the relationship between three definitions of financial expertise
pertinent to the audit committee (accounting expertise, finance expertise, and
supervisory expertise) and quality of accruals. The sample used in this research
consisted of firms on the Investor Responsibility Research Center (IRRC) board
practice database, from 1995-1998, which were 1,114 firms from 53 industries. The
research findings indicated a positive correlation between accounting expertise and
quality of accruals. This suggests that the current definition of financial expertise is
too broad, and in the future, the focus should be on the accounting expertise of the
audit committee.

OTHER SUPPORTING COMMITTEES

In a complex business environment, delegation of tasks to committees will
improve time effectiveness and efficiency. Formation of committees on boards will
increase the effectiveness of boards because specialisation allows board members to
carry out tasks suited to their expertise and education, thus producing better policy
and action. Specialisation will also improve time efficiency.
However, in practice, specialisation can result in unwelcome consequences,
for example: committees are often able to make proposals, but not decisions;
decisions are made by the board as a whole. Another unfavourable consequence is
that the feeling of fellowship among board members is upset because of the limited
participation of board members who do not sit on a particular committee. One way to
address the problems that arise from the formation of committees within boards is to

5
have clear instructions regarding the operationalisation of the committees and full
reports on the committees’ operations to the board.
Committees, other than the audit committee, that could be formed to lighten
the workload of boards include:
a. Nomination Committee
The duties of this committee are:
- selecting managers’ profiles
- selecting board members
- assessing the independency of directors
- evaluating management and boards
- management development as a part of human resource development
and recruitment policy
b. Remuneration Committee
The task of the remuneration committee is to monitor managers’ salaries,
including performance rewards for managers.
c. Risk management committee
One of the principles of transparency in corporate governance is adoption of
enterprise-wide risk management. The purpose of risk management is identify
risk, measure risk, and deal with risk above a certain level of tolerance. In
enterprise-wide risk management, risk is not only specific/unsystematic risk
such as financial risks including non payments, industrial action and third-
party claims, but also market/systematic risk. Examples of market/systematic
risk are inflation, recession and so on. A rise in world oil prices as the result
of a knock-on effect outside the control of the company will have an effect on
the firm’s performance. But can the company’s managers be blamed for
factors outside their control? The process of identifying risks and setting up
measures to minimise or manage risk are crucial. These measures are a
demonstration of the company’s responsibility to its stakeholders.

5
 This committee aims to understand corporate risk and monitor the balance
between risk and returns, ensuring that an effective risk management system
is in place.
d. Corporate governance committee
This committee is responsible for monitoring implementation of corporate
governance and compliance with corporate governance standards.
e. Financial committee
Formation of committees should be flexible, that is, appropriate to the needs
of the firm and the type of firm.
According to Murphy (2004), sufficient compensation is enough to attract a person to
a good, promising career in corporate management. Recent changes have made it
difficult to make remuneration systems fair. This is very complex problem. There will
be conflict at the firm level, and many difficulties will ensue. But today’s wise and
forward-looking managers can gain a competitive advantage by making difficult
choices about remuneration, governance, and relations with the capital market.
Appropriate investment in the integrity of the organisation and systems will have
short-term and long-term advantages. Wise board members and CEOs will encourage
this type of investment because they understand that properly functioning monitoring
and governance systems will ensure not only the success of the organisation, but also
personal success. Damage to personal reputations and the reputations of organisations
make headlines in the USA and the world over.
Current scandals over the allowances and perquisites given to CEOs have
fuelled debate about limiting compensation for executives and improving the
structure of corporate governance. Several things can be done to improve in this area:
require that compensation committees be more independent, require executives to
hold equity in the company, require improved disclosure of executive compensation,
increase the participation of institutional investors in corporate governance (including
executive compensation), and require firms to make stock options an expense in the
profit and loss statement (Matsumara and Shin, 2005)

5
 Gore et al. (2005) analysed the relationship between the monitoring
environment and the level of equity incentives for CFOs (chief financial officers).
Data covered 3,628 firms with data on their CFOs in the ExecuComp database, from
1993 to 2001. The research found a negative correlation between the CFO’s portfolio
of options and the existence of a finance committee and CFOs with a financial
background. These research findings are consistent with financial expertise on the
board and in the CEO being a significant factor in the determination of equity
incentives for CEOs.
According to Ferrarini and Moloney (2005), there has been a divergence
among the countries in the European Union (EU) when it comes to establishing
structures for executive remuneration. There are marked differences in the adoption
of best practices in paysetting and disclosure of executive pay. This divergence is in
keeping with the predictions of agency theory. Although in 2004 the EU adopted two
key recommendations on executive pay, the results of this research indicate that
reforms in the EU should proceed with caution. Harmonisation should be limited, and
the sole focus should be on disclosure. Disclosure is central to adopting effective
incentive contracts that can manage the agency cost of executive pay between
countries where corporate governance systems of dispersed ownership and
blockholding are adopted, without intervention in governance structure and options.
Other intervention in the payment process could give rise to divergent competitive
risk.
Calcagno and Renneboog (2004) demonstrated that equity seniority and
managerial compensation have important implications for the design of remuneration
contracts. Traditional literature assumes that equity takes priority over remuneration,
but this has been proven otherwise, notably in the case of bankruptcy regulations and
observed practice. Theoretically, including equity risk will change the incentive to
give managers higher performance-related incentives (the contract substitution
effect). If managerial compensation is of higher priority than equity claims, the
greater the leverage the lesser the power of the incentive scheme, and the higher the

5
base wage. In the case of junior compensation, the focus is more on pay for
performance incentives. Empirical research suggests the remuneration seniority as the
base wage is significantly higher and performance bonuses lower in firms that are
financially distressed.

Summary

The adoption of good corporate governance requires that committees be set up

to help the board of commissioners perform its duties. These committees must be
independent and are responsible to the board of commissioners. One such committee,
which more than 90 percent of public companies in Indonesia now have, is the audit
committee, which helps the board of commissioners direct management to improve
the effectiveness and efficiency of the company. The audit committee is responsible
for performing reviews of internal audits and of work related to financial matters.
Committees that must adopt good corporate governance are the remuneration and
nomination committees. It is the job of the former to fact find and conduct analyses to
set appropriate remuneration for management and commissioners, while the latter is
responsible for helping the board of commissioners nominate people for strategic
positions in the company and whose names will be put forward at a general meeting
of shareholders.
Another key committee is the risk management committee. The Enron scandal
left stakeholders with no choice but to require that management anticipate risks that
could destroy the company. The risk management committee helps the board of
commissioners to assess and anticipate corporate risk and find solutions to avoid or
minimise this risk. Another committee gaining in importance is the investment
committee. Many firms are less then prudent in their investments and this could be
harmful to the company. Thus, the board of commissioners needs help to monitor and
advise on all major investments.

6
CASE STUDIES

CASE 1.
At a routine meeting between the board of commissioners and the board of
directors, the main agenda was to discuss three issues: the decline in the company’s
performance, a cooperation agreement with the Ministry of Agriculture, and the
findings of an internal audit on fraud in the regional office. Following are the minutes
of the meeting.
.
The meeting opened at 08.30, Monday, November 21, 2006, chaired by the President
Commissioner and attended by all directors and members of the board of
commissioners.

President Commissioner (PC): The prognosis as of the end of 2006 for financial
performance shows that bottom line earnings did not achieve
the 2006 target.

Independent Commissioner /Chair of Audit Committee (IC): The audit committee’s

analysis indicates that the most significant deviations are a
20% increase in marketing costs and personnel costs of 15%
higher than planned. These increases were not offset in any
way by an increase in revenue; in fact revenue was down 6
percent. This resulted in a decrease in bottom line earnings of
Rp 48 billion or 8 percent.

Commissioner/Chair of Remuneration and Nomination Committee (Co): The increase

in personnel costs is accounted for largely by an increase in
non-target related production bonuses, and by an increase in
directors’ salaries. This across the board allocation of
production bonuses should be reviewed. Directors’ salaries
are still below the market average.

Managing Director (MD): From the start, I completely disagreed with these across
the board production bonuses; they must be based on
achievement of targets. But unions union oppose switching to
a merit system. If there has been a decrease in revenue this is
due to two things: first, a shift in consumption patterns

6
 resulting in a drastic reduction in demand for ready-to-eat
foods; and second, the cancellation of a government contract
cut from the national budget.

Human Resources Director (HRD): To add to what the MD said, as far as I’m aware,
our employees are overpaid. Our competitors record far
higher sales than we do, and their employees are on lower
wages than ours are.

PC : Could the board of directors not negotiate with the unions?

Discussion about financial performance and human resources continued for more
than an hour. Over the past two years the company’s performance has not been
satisfactory. The market has meted out its punishment, with a 10 percent fall in share
price.

Discuss how the board of commissioners could intervene, both in its advisory and
supervisory functions, in this situation.

From 09.45, the meeting continued with a discussion of the cooperation agreement
with the Ministry of Agriculture.

PC: We, the board of commissioners, have just received an invitation to sign a
cooperation agreement between our company and the Ministry of Agriculture. We
have no idea how this came about; the first we knew of it was when we received this
invitation.

IC: I’ve reviewed this cooperation agreement, which includes establishing a network
of distributors of agricultural commodities and fertiliser, at the company’s expense.
As far as I’m concerned the outputs are not clear, and fertiliser distribution is not our
core business.

PC: Why were we, the board of commissioners, not involved in discussions about this
before now?

MD: The board of directors felt that this was a technical issue, so we regarded as
being within the jurisdiction of the board of directors.

PC: This is a policy issue, which requires the approval of the board of commissioners.
How did this happen?

6
Discussion of the cooperation agreement continued for 60 minutes and ended in
dispute. The secretary of the board of commissioners and the risk management
committee will discuss the issue and report the board of commissioners forthwith.

Discuss how the board of commissioners and board of directors should best
approach this relationship.

The meeting continued with discussion of fraud in the regional offices, which was
regarded as misuse of authority and corporate fraud. It was agreed that this would
be reported to the appropriate authorities. The meeting closed at 12.30.

CASE 2
PT ‘Transportasi Cepat Indonesia’ (PT TCI) is a publicly listed transport company,
operating since 1953. Up until the 1980s, PT TCI was a profitable firm with growing
assets and revenue. At the end of the 1980s, the government issued a policy
deregulating land, air and marine transportation. As a result of this policy,
competition in the transportation business became very tight. PT TCI was directly
affected by this policy and the ensuing business climate, and in the mid 1990s, began
suffering continuous losses and started having liquidity problems. In response to this
deteriorating condition, management began running up significant debts to continue
operating the business. Early in 2000, shareholders replaced the board of directors
three times. The latest board of directors was appointed in early 2004.

The new board of directors adopted a new strategy of cost cutting and repairing the
company’s transportation equipment. In early 2006, the public accountant that
audited PT TCI published the audit findings, gave the financial report prepared by
management, which showed profits of Rp 38 billion, an unqualified opinion.
Following the publication of the accountant’s report, an independent commissioner
who is also chair of the audit committee, asked the audit committee to perform a
review of the findings of the public accountant’s audit. The outcome was that the
independent commissioner believed the accountant’s report to be in error. According
to the independent commissioner, the profit and loss statement prepared by
management should have reported a loss of Rp 8 billion. The independent
commissioner stated this openly and his comments were published in the press.

This sparked internal dispute between management and the public accountant on the
one hand, and the independent commissioner on the other. The dispute continued and
affected the operations of the company.

Questions:

1. Did the independent commissioner do the right thing?

6
 2. What should management have done?
3. How should this problem be resolved?

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