Chapter 11 - Corporate governance

Question 1

Corporate governance

Answer 1

The means by which a company is operated and controlled.

The aim is to ensure companies are run well in the interests of their shareholders and the wider community.

Question 2

The corporate governance code

Answer 2

1. Leadership
   - Each company should have an effective board with responsibility for long term success of the company.
   - Clear division of responsibilities between running the board and running of the company.
   - No one should have unfettered powers of decision.
   - The chairman should lead the board and ensure it is effective.
   - NEDs should constructively challenge and help develop strategy.
2. Effectiveness
   - The board should have balance of skills, experience, independence and knowledge of the company.
   - Appointment of directors should be made through a formal, transparent and rigorous process.
   - Directors should allocate sufficient time to discharge their responsibilities.
   - The board should be supplied with timely information in an appropriate form and quality.
   - The board should undertake formal and rigorous evaluation of its performance, its committees and individual directors.
   - All directors should be submitted for re-election at regular intervals subject to satisfactory performance.
3. Accountability
   - The board should present a balanced and understandable assessment of the company’s position and prospects.
   - The board is responsible for determining the nature and extent of the significant risks it is willing to take in achieving its strategic objectives.
   - The board should establish formal and transparent principles for maintaining an appropriate relationship with the company’s auditor.
4. Remuneration
   - Levels of remuneration should be efficient to attract, retain and motivate directors of the quality required but should not pay more than necessary.
   - A significant performance of the executive directors should be performance related.
   - The board should establish formal and transparent procedures for executive directors remuneration.
5. Relations with shareholders
   - There should be a dialogue with shareholders based on a mutual understanding of objectives.
   - The board as a whole has responsibility for ensuring satisfactory dialogue with shareholders takes place.
   - The board should use the AGM to communicate.

Question 3

Corporate governance in action

Answer 3

1. Segregation of roles
   The chairman and CEO should be held by 2 separate people.
   The chairman should preferably be independent to enhance effectiveness.
2. Board composition
   Should be a balance of executive directors and NEDs.
   The executives run the company on a day to day basis.
   The NEDs monitor the executive directors and contribute to the overall strategy and direction of the organisation.
3. Audit committee
   Responsibility for financial reporting and internal control matters.
4. Remuneration committee
   Set the remuneration packages for the executive directors to ensure they are not paid excessive amounts.
   The committee will be comprised of NEDs.

Advantages:

• based on agreement of several people reducing risk of bribes from directors in return for a higher package.
• no director is involved in setting his own pay
• performance related elements will be included to avoid the risk directors are awarded for poor performance.

5. Nomination committee
   Decide on appointments of executive directors to ensure e best person is recruited for the job.
   The committee will be comprised of NEDs.

Advantages:

• Executive directors might appointed other directors who they are friends with or used to work with but not necessarily be the person with the required skills.
• Reduces the risk of improperly affecting board decisions. Executives might appoint people to the board they know will vote in favour of the same decisions as them and influence board decisions which may not be in the best interests of the company.

6. Risk committee
   Responsible for risks of the company and deciding on the appropriate risk management approach.

Question 4

The Roles of the board members

Answer 4

1. Segregation of Roles
   The chairman and CEO should be held by different people to reduce the power of prominent board members.
2. The chairman’s role
   - Head of NEDs
   - Enables flow of information and discussion at board meetings
   - Ensures satisfactory channels of communication with the executive directors.
   - Ensure the effective operation of sub committees of e board.
3. The CEOs role
   - Ensures the effective operation of the company.
   - Head of the executive directors.
4. NEDs
   Usually employed on a part time basis and do no take part in the routine executive management of the company.
   - Participation at board meetings.
   - Provision of experience, insight and contacts to assist the board.
   - Membership of sub-committees as independent, knowledgable parties.

Advantages of NEDs:

• Oversight of the whole board.
• Often act as a corporate conscience.
• Bring external expertise to the company.

Disadvantages of NEDs:

• May not be sufficiently well informed or have time to fulfil the role competently.
• May fail to report significant problems and approve unjustified pay rises.

Question 5

Membership of audit committees

Answer 5

1. Independent NEDs
2. At least 3 members (2 for smaller companies).
3. At least 1 member with recent and relevant financial experience with an appropriate accountancy qualification.
4. Committee members should be independent of operational management.
5. Appointments should be made by the board on the recommendation of the nomination committee.
6. Appointments should be for a period of up to 3 years, extendable by no more than two additional 3 year periods.

Question 6

Objectives of the audit committee

Answer 6

1. Increasing public confidence in the credibility and objectivity of published financial information.
2. Assisting directors in meeting their responsibilities of financial reporting.
3. Strengthening the independent position of a company’s external auditor by providing an additional channel of communication.

Question 7

Function of an audit committee.

Answer 7

1. Monitor integrity of the FS.
2. Review the company’s internal financial controls.
3. Monitoring and reviewing the effectiveness of the internal audit function.
4. If no internal audit is in place, they should consider annually whether there is a need for one and recommend to the board. The reasons for no IA function should be explained in the annual report.
5. Making recommendations in relation to the appointment and removal of the external auditor and their remuneration.
6. Reviewing and monitoring the external auditor’s independence, objectivity and effectiveness of e audit process.
7. Developing and implementing policy on the engagement of the external auditor to supply non-audit services.
8. Reviewing arrangements for confidential reporting by employees and investigation of possible improprieties.

Question 8

Benefits

Answer 8

1. Improved credibility of the FS through an impartial review of the FS and discussion of significant issues with the external auditors.
2. Increased public confidence in the audit opinion, as the audit committee will monitor the independence of the external auditors.
3. Stronger control environment, helps to create a culture of compliance and control.
4. The internal audit function will report to the audit committee increasing their independence and recommendations.
5. The skills, knowledge and experience (and independence) of the audit committee members can be an invaluable resource for a business.
6. It may be easier and cheaper to arrange finance as can give a perception of good corporate governance.
7. It would be less burdensome to meet listing requirements if an audit committee is already established.

Question 9

Problems

Answer 9

1. Difficulties recruiting the right non executive directors who have relevant skills, experience and sufficient time to become effective members of the committee.
2. The cost. NEDs are normally remunerated and their fees can be quite expensive.

Question 10

Risk management

Answer 10

Risk management can involve:

1. Transferring the risk to another party e.g. By taking out insurance or outsourcing part of the business.
2. Avoiding the risk by ceasing the risky activity.
3. Reducing the risk implementing effective controls.
4. Accepting the risk and bearing the cost and consequence if the risk happens.