Lecture 6 - Corporate Governance

Question 1

Firms accountable to whom, and why

Answer 1

Explanations come from 3 main theoretical perspectives
Legitimacy theory
Agency theory
Stakeholder theory

Question 2

Agency theory

Answer 2

Organisation as a network of agency relationships
An agency is a principal -agent relationship where:
The principle delegates power and resources to the agent
Expects from the agent to make decisions and take actions to help achieve principal’s objectives
For that agent is paid an agreed upon remuneration

• angel you theory being a nephew-classical economic perspective assumes that the primary objective of a firm is shareholders wealth maximisation

Question 3

Agency problem

Answer 3

Information asymmetry allows agent to act opportunistically to maximise his or her own benefits rather than to maximise shareholders wealth

Agency theory is concerned about how this agency problem can be mitigated

Question 4

Stakeholder theory

Answer 4

Based on the system theory
- assumes that a firm is an open system of its environment
- a firm interacts with the environment in terms of:
The firm receives inputs from environment
The firm converting those input into useful output
The firm provide output to the environment

• a firm interacts with its stakeholders
• a stakeholder is any human agency that can be influenced by or can itself influence the activities of the organisation. An organisation likely therefore to have many stakeholders
• firms should be accountable to not only shareholders but also to stakeholders
• corporations should be driven by the need to balance the competing objectives of different stakeholders.

Question 5

Legitimacy theory

Answer 5

According to Gray, Owen and Adams 1996
At its simplest form, argued that organisations can only continue to exist if the society in which they are based perceives the organisation to be operating to a value system which is commensurate with the society’s own value system

• hence, corporations are accountable to the society at large and continue to legitimise their existence in the society.
• if not firms cannot survive - no continuous support from the society for their existence and growth.

Question 6

Stakeholder theory governance

Answer 6

Failures of big corporations affect the social welfare
Focus is not not necessarily on the shareholders but more the social welfare: unemployment, impact upon public finance, public expenditure cuts and so on
- so firms should be governed begetter to avoid systemic failures, which would result in a loss of social welfare

Question 7

Agency theory governance

Answer 7

Takes much narrow on the governance problem
Separation of ownership and management and the possibility of agency problem
Hence, corporate governance is to mitigate the agency problem between shareholders and directors.

Question 8

Corporate governance - stakeholder theory

Answer 8

The system of checks and balances, both internal and external to companies which ensures that companies discharge their accountability to all their stakeholders and act in a socially responsible way in all areas of their busInes activity.

Question 9

Corporate governance - Agency theory

Answer 9

Role is to protect and advance interests of the shareholders through setting the strategic direction of a company and appointing and monitoring capable management to achieve this

Question 10

Responsibilities of the board of directors

Answer 10

Setting the company’s strategic aims
Providing the leadership to put them into effect
Supervising the management of the business
Reporting to shareholders on their stewardship

• The board’s actions are subject to laws, regulations and the shareholders in general meeting

Question 11

Cadbury report - 1992

Answer 11

Recommendations:

• separate chairman and chief executive director
• appoint independent non-executive directors to oversee executive directors
• set up nomination committee to appoint all directors (executive and non-executive)
• Executive members serve no more than 3 years
• Set up remuneration committee with all or part non-executive directors
• Set up audit committee with all non-executive directors
• Introduce comply or explain approach

Question 12

Vital development

Answer 12

The combined code:
Recommendation of Hampel report
Combined recommendations from Cadbury, Greenbury and Hampel

25th June 1998
London Stock Exchange published the combined code
All listed companies were to comply after 31 Dec 1998

Question 13

Uk Corporate Governance Code

Answer 13

Continuous update on this code
June 2006, June 2008 and last updated September 2012
No longer maintained and published by LSE, but responsibility of Financial Reporting Council (FRC)
When updated in May 2010 also changed its name

Question 14

Preface

Answer 14

While in law the company is primarily accountable to its shareholders, and the relationship between company and its shareholders is also main focus of the Code, companies are encouraged to recognise the contribution made by other providers of capital and to confirm the board’s interest in listening to the views of such providers insofar as there are relevant to the company’s overall approach to governance”

Question 15

Main principles of the governance code

Answer 15

Leadership 
Effectiveness 
Accountability 
Remuneration 
Relationships with shareholders 
Comply or explain approach still remains

Question 16

Leadership

Answer 16

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 at the head of the company between the running of the board and the executive responsibility for the running of the company’s business
No one individual should have unfettered powers of decision making
The chairman is responsible for leadership of the board and ensuring its effectiveness on all aspects of its role
As part of their role as members of a unitary board, non executive directors should constructively challenge and help develop proposals on strategy

Question 17

Effectiveness

Answer 17

Board and its committees should have the appropriate balance of skills, experience, independence and knowledge of the company
Formal, rigorous and transparent procedure for the appointment of new directors to the board
All directors should be able to allocate sufficient time to the company
Directors should receive induction on joining the board
Supposed in a time,y manner with information in a form and of quality appropriate to enable it to discharge its duties
Board should undertake a formal and rigorous annual evaluation of its own performance and of its committee and individual directors
All directors should be submitted for re-election at regular intervals, subject to continued satisfactory performance

Question 18

Accountability

Answer 18

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 maintain sound risk management and internal control systems.
Board should establish formal and transparent arrangements for considering how they should apply the corporate reporting and risk management and internal control principles and for maintaining and ppropriate relationship with the company’s auditor

Question 19

Audit committee

Answer 19

A separate section of the annual report should describe the work of the committee in discharging its responsibilities

• the significant issues that is considered in relation to the financial statements and
• how these issues were addressed
• information on the length of tenure of the current audit firm
• if the information provides non-audit services

Question 20

Remuneration - principle of the governance code

Answer 20

• 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 directors remuneration should be strutted so as to link rewards to corporate and individual performance
• formal and transparent procedure for developing policy
• no director should be involved in deciding his or her own remuneration

Question 21

Relations with shareholders

Answer 21

Should be a dialogue with shareholders based on the mutual understanding of objectives
Board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place.
The board should use the AGM to communicate with investors and to encourage their participation

Question 22

Earnings management

Answer 22

Accomplished through managerial discretion over accounting choices and operating cash flow

Question 23

UK governance code - key aspects

Answer 23

Single board collectively responsible for the sustainable success of the company. (Unitary board)

Checks and balances include:
Separate chairman And chief executive
A balance of executive and independent non-executive directors. A balance in terms of diversity, including gender.
Strong, independent audit and remuneration committees.
Annual evaluation by the board of its performance
Transparency on appointments and remuneration
Effective rights for shareholders, who are encouraged to engage with the companies in which they invest.
A

Question 24

Positive accounting theory

Answer 24

Efficiency perspective
- accounting policies adopted reflect the underlying financial performance of the company.

Opportunistic perspective

• managers will opportunistically select particular accounting methods whenever they believe that this will lead to an increase in their personal wealth.
• managers opportunistically select particular accounting methods in preference to others