Chapter 9 - Corporate Governance

Question 1

Define corporate governance

Answer 1

The system by which companies are directed and controlled in the interest of shareholders and other stakeholders

Question 2

What does the code tend to cover?

Answer 2

• The role of the board of directors
• The reliability of financial reports and the relationship between the company and its auditors
• The interest of the company’s shareholders in the company

Question 3

What does the listing Rules of the London Stock Exchange require each listed company to state in its annual reports?

Answer 3

• How it has applied the principles of the UK Corporate Governance Code
• Whether or not it has complied with the provisions of the Code throughout the accounting period

Question 4

The principles of the UK Corporate Governance Code relate to which areas?

Answer 4

• Leadership
• Effectiveness
• Accountability
• Remuneration
• Relations with shareholders

Question 5

How do you understand Leadership in corporate governance?

Answer 5

Every company should be headed by an effective board which is collectively responsible for the long-term success of the company. There should be a clear division of responsibilities. The chairman is responsible for leadership of the board and ensuring its effectiveness. Non-executive directors should constructively challenge and help develop proposals on strategy.

• There should be a clear division of responsibilities between running the board (the role of the chairman) and the executive responsibility for the running of the company’s business (the role of CEO). The roles of chairman of the board and CEO should not be held by the same individual.

Question 6

What are the responsibilities of Chairman?

Answer 6

• provide leadership to the board, supplying vision and imagination, working closely with the CEO
• take a leading role in determining the composition and structure of the board which will involve regular assessment of the: size of the board; balance between executive directors and NEDs; interaction, harmony and effectiveness of the directors
• set the board’s agenda and plan board meetings
• chair all board meetings, directing debate toward consensus
• ensure the board receives appropriate, accurate, timely and clear information
• facilitate effective contribution from NEDs
• hold meetings with the NEDs, without the executive directors present
• chair the AGM and other shareholders’ meetings, using these to provide effective dialogue with shareholders
• discuss governance and major strategy with the major shareholders
• ensure that the views of shareholders are communicated to the board as a whole

Question 7

What are the responsibilities of CEO?

Answer 7

• develop and implement policies to execute the strategy established by the board
• assume full accountability to the board for all aspects of company operations, controls and performance
• manage financial and physical resources
• build and maintain an effective management team
• put adequate operational, financial, planning, risk and internal control systems in place
• closely monitor operations and financial results in accordance with plans and budgets
• interface between board and employees
• assist in selection and evaluation of board members
• represent the company to major suppliers, customers, professional associations, etc.

Question 8

What are functions of NED?

Answer 8

NED should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible. They are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing and where necessary, removing executive directors, and in succession planning.

Question 9

What are the roles of NED and explain each of them.

Answer 9

1. Strategy role - this recognises that NEDs have the right and responsibility to contribute to strategic success, challenging strategy and offering advice on direction.
2. Scrutinising role - NEDs are required to hold executive colleagues to account for decisions taken and results obtained.
3. Risk role - ensure the company has an adequate system of internal controls and systems of risk management in place
4. People role - NEDs oversee a range of responsibilities with regard to the appointment and remuneration of executives and will be involved in contractual and disciplinary issues

Question 10

How a NED can be effective?

Answer 10

• build a recognition by executives of their contribution in order to promote openness and trust
• be well-informed about the company and external environment in which it operates
• have a strong command of issues relevant to the business
• insist on a comprehensive, formal and tailored induction, continually develop and refresh their knowledge and skills to ensure that their contribution to the board remains informed and relevant
• ensure that information is provided sufficiently in advance of meetings to enable thorough consideration of the issues facing the board
• insist that information is sufficient, accurate, clear and timely
• uphold the highest ethical standards of integrity and probity
• question intelligently, debate constructively, challenge rigorously and decide dispassionately
• promote the highest standards of corporate governance and seek compliance with the provisions of the combined code wherever possible.

Question 11

What are the reasons for NEDs independence?

Answer 11

• To provide a detached and objective view of board decisions
• To provide expertise and communicate effectively
• To provide shareholders with an independent voice on the board
• To provide confidence in corporate governance
• To reduce accusations of self-interest in the behaviour of executives

Question 12

What are the situations in which NEDs are likely not to be independent?

Answer 12

• Material business relationship with company in last 3 years
• Employee in last 5 years
• Cross directorship in other companies
• Receive other remuneration from the company besides the director’s fee
• close family ties with director
• significant shareholder
• served on board more than 9 years

Question 13

What are the main responsibilities and duties of the nominations committee?

Answer 13

• Review regularly the structure, size and composition of the board and make recommendations to the board
• Consider the balance between executives and NEDs on the board of directors
• Ensure appropriate management of diversity to board composition
• Provide appropriate balance of power to reduce domination in executive selection by the CEO / chairman
• Regularly evaluate the balance of skills, knowledge and experience of the board
• Give full consideration to succession planning for directors
• Prepare a description of the role and capabilities required for any particular board appointment including that of the chairman
• Identify and nominate for the approval by the board candidates to fill board vacancies as and when they arise
• Make recommendations to the board concerning the standing for reappointment of directors
• Be seen to operate independently for the benefit of shareholder

Question 14

The board should establish an audit committee of how many independent NEDs?

Answer 14

There should be at least three, or in the case of smaller companies two independent non-executive directors.

Question 15

What are audit committee’s roles?

Answer 15

• to monitor the integrity of the financial statement of the company and any formal announcements relating to the company’s financial performance, reviewing significant financial reporting judgements contained in them;
• to review the company’s internal financial controls and, unless expressly addressed by a separate board risk committee composed of independent directors, or by the board itself, to review the company’s internal control and risk management systems;
• to monitor and review the effectiveness of the company’s internal audit function;
• to make recommendations to the board, for it to put to the shareholders for their approval in general meeting, in relation to the appointment, re-appointment and removal of the external auditor and to approve the remuneration and terms of engagement of the external auditor;
• to review and monitor the external auditor’s independence and objectivity and the effectiveness of the audit process, taking into consideration relevant UK professional and regulatory requirements;
• to develop and implement policy on the engagement of the external auditor to supply non-audit services, taking into account relevant ethical guidance regarding the provision of non-audit services by the external audit firm, and to report to the board, identifying any matters in respect of which it considers that action or improvement is needed and making recommendations as to the steps to be taken

Question 16

How often the board should conduct a review of the effectiveness of the company’s risk management and internal control systems and who they should report their finding and what should it contain?

Answer 16

The board should at least annually conduct a review of the effectiveness of the company’s risk management and internal control systems and should report to shareholders that they have done so. The review should cover all material controls, including financial, operational and compliance controls.

Question 17

How the remuneration should be set in a company?

Answer 17

Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully, but a company should avoid paying more than is necessary for this purpose. A significant proportion of executive’s remuneration should be structured as to link rewards to corporate and individual performance.

Question 18

What are the duties of remuneration committee?

Answer 18

• The performance related elements of executive directors’ remuneration should be stretching and designed to promote the long-term success of the company
• The remuneration committee should judge where to position their company relative to other companies. But they should use such comparisons with caution in view of the risk of an upward ratchet of remuneration levels with no corresponding improvement in performance.
• They should also be sensitive to pay and employment conditions elsewhere in the group, especially when determining annual salary increases
• Levels of remuneration for non-executive directors should reflect the time commitment and responsibilities of the role. Remuneration for non-executive directors should not include share options or other performance-related elements. If, exceptionally, options are granted, shareholder approval should be sought in advance and any shares acquired by exercise of the options should be held until at least one year after the non-executive director leaves the board. Holding of share options could be relevant to the determination of a non-executive director’s independence.
• The remuneration committee should carefully consider what compensation commitments (including pension contributions and all other elements) their directors’ terms of appointment would entail in the event of early termination. The aim should be to avoid rewarding poor performance. They should take a robust line on reducing compensation to reflect departing directors’ obligations to mitigate loss.
• The board should establish a remuneration committee of at least three, or in the case of smaller companies, two, independent non-executive directors. In addition the company chairman may also be a member of, but not chair, the committee if he or she was considered independent on appointment as chairman. The remuneration committee should make available its terms of reference, explaining its role and the authority delegated to it by the board. Where remuneration consultants are appointed, a statement should be made available of whether they have any other connection with the company.
• The remuneration committee should have delegated responsibility for setting remuneration for all executive directors and the chairman, including pension rights and any compensation payments. The committee should also recommend and monitor the level and structure of remuneration for senior management. The definition ‘senior management’ for this purpose should be determined by the board but should normally include the first layer of management below the board level.
• The board itself or, where required by the Articles of Association, the shareholders should determine the remuneration of the non-executive directors within the limits set in the Articles of Association. Where permitted by the Articles, however, the board may delegate this responsibility to a committee, which might include the chief executive.
• Shareholders should be invited specifically to approve all new long-term incentive schemes and significant changes in existing schemes, save in the circumstances permitted by the listing rules.

Question 19

Should the remuneration committee have responsibility for NED remuneration?

Answer 19

The remuneration committee should not consider NED remuneration. This should be decided by the board as a whole and/or shareholders depending on the specific requirements in the company Articles of Association

Question 20

Define remuneration

Answer 20

Remuneration is defined as payment or compensation received for services or employment and includes basic salary, bonuses and any other economic benefits

Question 21

How the remuneration package should be set for directors?

Answer 21

The remuneration package should be motivational, not too small or too easily earned. The remuneration committee should design a package that attracts, retains and motivates the director. This should take into account the market rate i.e. comparable companies remuneration packages.

Whatever remuneration package is determined, it is essential to ensure that the directors’ objective is to do a good job for the stakeholders of the company

Question 22

What are the components of the directors’ remuneration package?

Answer 22

• Basic salary - covering the job itself, the skills required, the directors’ performance, their contribution to company strategy and market rates;
• Performance-related pay - remuneration dependent on the achievement of some performance measure. This could be short-term e.g. a bonus paid to the directors at the end of the accounting year for achieving a certain level of profit or earnings per share, or long-term e.g. executive stock options. Stock/share options are contracts that allow the director to buy shares at a fixed price. If the share price rises above the exercise price the director can sell the shares at a profit. This encourages the director to manage the company in such a way that the share price increases, therefore share options are believed to align the directors’ goals with those of the shareholders. Problems arise when the directors’ actions are solely focussed on the share price to the exclusion of other stakeholder objectives. Also, if the share price rises too much the director could be tempted to sell their shares and retire, which defeats the objective of trying to tie the director in to the company for the long-term.
• Pension contributions - the remuneration committee should consider the pension consequences of increase in basic salary;
• Benefits in kind - are various non-wage compensations e.g. a company car, or health insurance.

Question 23

What are features of ESOP?

Answer 23

An Executive Share Options (ESOPs) are part of a manager’s remuneration package. The features are as follows:

• Each eligible manager is granted an allocation of options as part of his or her annual remuneration . The number of options will generally be decided by the remuneration committee, comprising non-executive directors.
• The options themselves will normally have a strike price that is equal to, or slightly higher than, the share price at the date the options are granted.
• There is usually a vesting period of a few years that must pass before the options can be exercised. If the manager resigns or leaves the company during that period then the options will lapse.
• The options can normally be exercised on a specific date at the end of the vesting period.

Question 24

What are the main reasons why shareholders might be keen to reward their directors with options?

Answer 24

1. If the directors hold large number of options then they will have a financial incentive to maximise the share price. Provided the share price exceeds the exercise price at the relevant date the directors can exercise their options and buy shares for less than their market value. They will then either retain those shares as an investment (acquired at bargain price, so providing an attractive return) or resell them at a guaranteed capital gain. If the share price does not rise during the vesting period then the directors will receive little or no value and so they will have a direct financial stake in delivering an increased share price.
2. An investment opportunity that would be attractive to the shareholders because the potential returns are high might be unacceptable to the directors because they will be exposed to the risks of it going wrong and the loss of their jobs. For example, a new product that fails might have a very limited impact on shareholders’ total investment portfolio but could end the careers of the directors who were responsible for recommending that it should proceed.

Question 25

Explain relations with shareholders.

Answer 25

The chairman should ensure that the view of shareholders are communicated to the board as a whole. The chairman should discuss governance and strategy with major shareholders. The senior independent director should attend sufficient meetings with a range of major shareholders to listen to their views in order to help develop a balanced understanding of the issues and concerns of major shareholders.

The chairman should arrange for the chairmen of the audit, remuneration and nomination committees to be available to answer questions at the AGM and for all directors to attend.

Question 26

Which of the following are principles of the UK Corporate Governance Code: (Select all that apply.)

A The role of chair and CEO should be separate
B Non-executive directors should be appointed
C The board should meet once per month
D The board is responsible for determining the nature and extent of the significant risks the company will face

Answer 26

A, B, D

Question 27

What is Turnbull report? According to it, what company should do?

Answer 27

This is the most specific report regarding the requirements for internal control. The Turnbull report required that internal controls should be established using a risk-based approach. Specifically a company should:

• Establish business objectives
• Identify the associated key risks
• Decide upon the controls to address the risks
• Set up a system to implement the required controls, including regular feedback

In addition, the Turnbull Report addresses the responsibilities of directors and management in relation to risk and control.

Question 28

Turnbull went on to suggest that directors should review internal controls under the five headings identified by COSO in 1992. What are those 5 headings?

Answer 28

• Control environment
• Risk assessment
• Control activities
• Information and communication
• Monitoring

Question 29

The Turnbull report requires that:

A Internal controls should be established using a risk-based approach
B The CEO and chairman are separate roles
C An audit committee is set up
D Director’s remuneration is fully disclosed

Answer 29

A

Question 30

The principles of good corporate governance in the UK Corporate Governance Code include: (Select all that apply.)

A   Leaedership
B   Efficiency
C   Accountability 
D   Remuneration
E   Relations with shareholders

Answer 30

A, C, D, E

Question 31

When reviewing reports on internal control, the board should:

Answer 31

• consider the significant risks and how they have been identified, evaluated and managed
• assess the effectiveness of the internal controls for managing each significant risk
• consider whether any controls are weak and action is necessary to strengthen them

Question 32

The annual assessment of the system of internal control should consider:

Answer 32

• the changes since the assessment carried out in the previous year
• the scope and quality of management’s ongoing monitoring of risks and of the system of internal control
• the extent and frequency of the communication of the results of this monitoring to the board
• the extent and frequency of internal control weaknesses and failing that have been identified during the year
• the effectiveness of the company’s public reporting processes

Question 33

The annual report should provide sufficient meaningful and high-level information to enable the shareholders to understand the main features of the company’s risk management processes and system of internal controls.

At the very least, the board should disclose:

Answer 33

• that there is an ongoing process for identifying, evaluating and managing the significant risks faced by the company
• that this process has been in place throughout the year
• that the process is regularly reviewed by the board, and
• that it accords with the Turnbull Guidance

Question 34

What are particular criticisms of the relationship between auditors and directors?

Answer 34

• Remuneration of the auditors - decided by the directors
• Appointment of the auditors - at the discretion of the directors in practice
• Reports of the auditors - received by the directors
• The directors had the power to give other lucrative work to auditors

Question 35

What are the responsibilities of the audit committee?

Answer 35

• review of the financial statements, and any interim reports produced
• Review of the company’s system of internal financial controls
• Discussion with the auditors about any significant matters that arose on the audit
• Review of the internal audit programme and significant findings of the internal auditors
• Recommendations on the appointment and removal of auditors
• The setting of the audit fee in discussion with the auditors
• Review of the audit report and any management letter provided by the external auditors
• Review all the company’s internal control and risk management systems (unless this is delegated to a separate risk committee
• Ensure that a system is in place for whistleblowing

Question 36

What are the key roles of the audit committee?

Answer 36

The key roles of the audit committee are ‘oversight’, ‘assessment’ and ‘review’ of other functions and systems in the company.

The audit committee should review the significant financial reporting issues and judgements in connection with the preparation of the company’s financial statements. Management is responsible for preparing the financial statements and the auditors are responsible for preparing the audit plan and carrying out the audit.

Question 37

During preparation of financial statements, audit committee needs to consider:

Answer 37

• the significant accounting policies that have been used, and whether these are appropriate
• any significant estimates or judgements that have been made, and whether these are reasonable
• the method used to account for any significant or unusual transactions, where alternative accounting treatments are possible
• The clarity and completeness of the disclosures in the financial statements

Question 38

In relation to internal controls, the audit committee should

Answer 38

• review the company’s internal financial controls
• review all the company’s internal control and risk management systems, unless the task is taken on by a separate risk committee or the full board
• give its approval to the statements in the annual report relating to internal control and risk management
• receive reports from management about the effectiveness of the control systems it operates
• receive reports on the conclusions of any tests carried out on the controls by the internal or external auditors.

Question 39

Where a company does have an internal audit function, the audit committee has an important role in preserving the independence of the internal audit function from pressure and interference. It order to do so, the audit committee should:

Answer 39

• approve the appointment or termination of appointment of the head of internal audit
• ensure that the internal auditor has direct access to the board chairman and is accountable to the audit committee
• review and assess the annual internal audit work plan
• receive a report periodically about the work of the internal auditor
• review and monitor the response of management to the findings of internal auditor
• monitor and assess the role and effectiveness of the internal audit function within the company’s overall risk management system

Question 40

The audit committee is responsible for oversight of the company’s relations with its external auditors. The audit committee should:

Answer 40

• have the primary responsibility for making a recommendation to the board on the appointment, re-appointment or removal of the external auditors
• ‘oversee’ the selection process when new auditors are being considered
• approve (though not necessarily negotiate) the terms of engagement of the external auditors and the remuneration for their audit services
• have annual procedures for ensuring the independence and objectivity of the external auditors
• review the scope of the audit with the auditor, and satisfy itself that this is sufficient
• make sure that appropriate plans are in place for the audit at the start of each annual audit
• carry out a post-completion audit review

Question 41

Company follows a principles based code of corporate governance and has both an audit committee and a risk committee. Which of the following roles would be carried out by the audit committee? (Select all that apply.)

A Review of the financial statements, and any interim reports produced
B Review of the company’s system of internal financial contorls
C Discussion with the auditors about any significant matters that arose on the audit
D Recommendations on the appointments and removal of the auditors
E Act on any recommendations put forward by the auditors in the management letter
F Review all the company’s internal control and risk management systems

Answer 41

A, B, C, D

Question 42

Within the UK Corporate Governance Code it states that the chairman should arrange for several stakeholder groups to attend the AGM. These include: (Select all that apply.)

A The audit, remuneration, and nomination committees
B The directors
C The CEO
D The chairpersons of the audit, remuneration and nomination committees
E All non-executive directors

Answer 42

B, C, D

Question 43

Responsibilities of an audit committee include: (Select all that apply.)

A Review of the financial statements and any interim reports produced
B Review of the company’s system of internal financial controls
C The detection of fraud
D Ensuring a system is in place for whistleblowing

Answer 43

A, B, D

Question 44

List SOX key points

Answer 44

Key points of Sarbanes-Oxley act:

1. Auditor Independence - Auditors are restricted in the additional services they can provide to an audit client
2. Audit committee - Company must have an audit committee - will be restricted from trading if it does not have one
3. Audit partner - senior partner must be changed every five years
4. Restrictions on dealing - Directors prohibited from dealing in shares at ‘sensitive times’
5. Increased financial disclosures - financial reports to detail off balance sheet financing
6. Internal control report - Annual report must include statements concerning the internal control systems in the company
7. Certification of accuracy of financial statements - Must be vouched for by CEO and CFO.

Question 45

Generally share options should not be awarded to non-executive directors. However, if they are awarded, when can the non-executive director sell them?

Answer 45

One year after leaving the non-executive board

Question 46

Which of the following are usually staffed by non-executive directors?

A The risk committee
B The nominations committee
C The audit committee
D The remuneration committee

Answer 46

B, C, D