Corporate Governance

It is a system by which companies are directed and controlled in the interest of shareholders
and other stakeholders. Governance should not be confused with management. Management
is concerned with running the business operations of a company but governance is about
giving a lead to the company and monitoring and controlling management decisions, so as to
ensure that the company achieves its intended purpose and aims.

Corporate governance has become one of the most commonly used phrases in the current
global business vocabulary. The notorious collapse of Enron in 2001, one of America’s
largest companies, has focussed international attention on company failures and the role that
strong corporate governance needs to play to prevent them.

Purpose: Monitor those parties within a company who control the resources owned by
investors.

Objective-Primary: Contribute to improved corporate performance and accountability in

creating long term shareholder value.

The main issues covered by corporate governance are:

 The role and responsibilities of the BOD.

 Composition and balance of board.
 Reliability of financial reporting
 Quality of external audit work and report
 Directors remuneration and rewards.
 Corporate Social responsibility and business ethics.

Approaches to CG

There are 2 main approaches to CG:

1. Rules based e.g Sarbanes Oxley Act in US

2. Principles based e.g Combined Code In UK

Other International Codes

The OECD has laid down 6 basic principles of Corporate Governance:

 Protection of the shareholders rights.

 Rights and equitable treatment of shareholders.
 Role and responsibility of the board.
 Role of stakeholders.
 Disclosure and transparency.
 Integrity and ethical behaviour.
Characteristics of Corporate Governance

 Discipline/Integrity-Senior management to adhere to proper behaviour.

 Transparency/Openness-Making information available to an outsider.
 Independence-avoid dominance or potential conflicts of interest. E.g appointments
and auditors.
 Accountability- account for actions taken
 Responsibility-allows for corrective actions and for penalising mismanagement.
 Fairness-the rights of various groups have to be acknowledged and respected.
 Probity/Honesty-telling the truth and not misleading shareholders.
 Reputation-keeping organisation reputation high.
 Judgement-making decisions that enhance the prosperity of the organisation.
 Social Responsibility-respond to social issues and high ethical standards.

1.1 A Impact of Corporate Governance

 Accountability
 Strengthened economy and sustainable development
 Attract investors
 Boost goodwill of company
1.1 B Impact of Corporate Governance on role of the accountant
 As provider of financial information: financial reporting is a crucial element
necessary for the corporate governance system to function effectively.
 The need for a strong and effective accounts and internal audit dept: the directors of
the company are aware that its prime responsibility to prepare the financial
information in compliance with statutory and ethical obligations, and rely on auditors’
competence to review the financial statements.
1.1 C Impact of Corporate Governance on role of the auditor
 The external auditor must review it for inconsistencies with other information within
the annual report.
 If inconsistencies are found, they may impact the audit report,
o If the inconsistency is material and directors refuse to amend the error, the
auditor may qualify the report.
o Or the auditor may give an ‘emphasis of matter’ opinion to bring the user
attention to a particular issue

There are two basic models of board structure:

1. Unitary board- all directors participate in a single board comprising both executive
and non-executive directors in varying proportion.
2. Two tier board-CG is exercised through two boards. The upper board supervises the
executive board on behalf of stakeholders. This model is adopted in Germany,
Holland, and to an extent, France. In this model although the shareholders own the
company, they do not entirely dictate the governance mechanism. This is made up of:
i. Supervisory board- the board has workers representatives and shareholders
representatives including banks’ representatives. The board has no executive function.
 ii. Management board- A mgt board or executive board, composed of entirely of
managers, will be responsible for the running of the business.

The UK Combined Code

All listed companies in the UK must comply with Combined Code. It is a principles based
approach of ‘comply or explain’ basis to CG. Listed companies must include a CG statement
in their annual report.

The main requirements of the Combined Code are:

 Chairman and CEO not same person.

 Role of Board.
 Non executive directors-NEDs.
 Audit Committee.
 Remuneration Committee.
 Nomination Committee.
 Establishment of a sound system of internal control and its annual review.
 The review of the risk management system.

Chairman and CEO

 Division of responsibilities.
 Should be different person.
 The board to appraise performance of chairperson.
 Chairperson appraise performance of CEO.
 Chairman preferably independent non executive.

Role of Board and its Role

 Ultimately accountable and responsible for the performance of the company.

 Must give strategic direction to the company and appoint CEO.
 Retain full and effective control of the company and monitor management in
implementing strategies.
 Ensure companies comply with all relevant laws and regulation and that it
communicate openly and promptly.
 Define levels of materiality and delegation.
 Identify key risks and key performance indicators.

Non executive directors(NEDs)

NEDs are employed on a part time basis. They are not involved in the routine executive
management of the company. Their roles are:

 Provide advice and direction to the company’s management in the development and
evaluation of its strategy.
 Monitor the company’s legal and ethical performance.
 Represents the shareholders’ interests-no agency issue to reduce shareholders’ value.
  Determine appropriate levels of remuneration for executives.

Remuneration Committee

It plays a key role in establishing remuneration arrangements. The committee will be staffed
by independent non executives directors, thus ensuring that executive directors do not set
their own remuneration levels. The committee determines the remuneration policy on behalf
of the board and the shareholder.

Nomination Committee

Responsible for recommending the appointments of new directors to the board.

Audit Committees

The board should establish an audit committee of at least three, or in the case of smaller
companies two members, who should all be independent non executives directors. At least
one member of the audit committee has recent and relevant financial experience.

1.2 A Functions or work done by audit Committee

 Reviews the scope, results, cost effectiveness, independence and objectivity of
external audit and internal audit.
 Review of internal controls procedures, accounting policies, management
information, the annual FS.
 Ensure that the external auditors have performed an effective, efficient and
independent audit.
 Deal with external auditors criticisms of management and ensure that the
recommendations of internal and external auditors have been implemented.
 Review board papers.
 Remind board of their rights, duties and responsibilities.

1.2 B Advantages

 Improve the quality of financial reporting, by reviewing financial statements on behalf

of the board.
 Create a climate of discipline and control which will reduce the opportunity for fraud.
 Enable NEDs to contribute an independent judgement and play a positive role.
 Help the finance director- a forum where he can raise issues of concern.
 Increase public confidence in the credibility and objectivity of financial statements.

1.2 C Disadvantages

 Misunderstanding- fear that purpose is to catch management out and be a threat to

their authority or take some of their authority.
 Too detailed- NEDs being overburdened with detail.
 Cost- increase entity cost as the entity has to remunerate both executive and non
executive directors.
  Powerful role of NEDs- as the audit committee will be made up mainly of NEDs, the
board may see this as a means of decreasing their power and possibly letting other
people run the company.
 Coercive: risk that it may substitute or go beyond management responsibilities.

1.2 D Objectives

 Increase public confidence regarding credibility and objectivity in reporting.

 Assist directors in meeting their responsibilities regarding financial reporting
 Strengthen the independence of audit function.
 Improve communications between directors, auditors and management.

Board Committees

Main purpose: enable board of directors to delegate responsibilities for key areas. Thus
BOD can focus on strategy consist of: NEDs with expertise and skills in areas such as
auditing.

Positives:

 Give advisory opinion to BOD

 Bring independence of thought and discussion and decisions.
 Bring check and balance over executive powers.

Important:

 They do not have decision making power( only BOD decide)

 Is complementary to BOD.( not supplementary or competing with board)
 Report to BOD
 Are watchdogs on behalf of shareholders. Look at interest of shareholders
 Detailed focus on board matters

Internal Audit And Risk Management

The internal audit’s job may be to assist the board in risk management by:
 Providing objective assurance on the adequacy and effectiveness of the risk
management and internal control framework.
 Helping improve the processes by which risks are identified and managed.
 Helping strengthened and improve the risk management and internal control
framework.
 Provide advice on the design, implementation and operation of control systems,
identify opportunities to make control savings, and promote a risk and control culture
within the organisation.
 Act as facilitators, guiding managers and staff through a self assessments process,
perhaps by leading workshops.
Question 1-June 2005
You are a recently qualified Chartered Certified Accountant in charge of the internal audit
department of ZX, a rapidly expanding company. Turnover has increased by about 20% p.a.
for the last five years, to the current level of $50 million. Net profits are also high, with an
acceptable return being provided for the four shareholders. The internal audit department was
established last year to assist the board of directors in their control of the company and to
prepare for a possible listing on the stock exchange. The Managing Director is keen to follow
the principles of good corporate governance with respect to internal audit. However, he is
also aware that the other board members do not have complete knowledge of corporate
governance or detailed knowledge of International Auditing Standards.

Required:
Write a memo to the board of ZX that:
(a) Explains how the internal audit department can assist the board of directors in
fulfilling their obligations under the principles of good corporate governance. (10 marks)
(b) Explains the advantages and disadvantages to ZX of an audit committee. (10 marks)
(20 marks)

(a) Memo

From: Chief Internal Auditor

To: Board of ZX
Subject: Role of Audit Committee
Date: June 2005

 Board papers review- review to the board and papers produced by board to ensure
they are accurate, understandable, and relevant and present a balanced assessment of
company information and prospects.
 Internal controls-as board need to maintain sound internal control system, internal
audit can assess the controls and its effectiveness and recommend improvement if
need be.
 Good financial reporting(application of ISA and IAS) and disclosures- board need to
prepare FS according to required accounting framework. Internal audit is up to date
on the framework and hence can counsel board on this issue. It can also ensure that
the framework is being complied with appropriate disclosures in FS.
 Ensure adherence to CG principles- internal audit must stress that CG is implemented.
Key element of CG is audit committee which among others establish a formal line of
communication with external auditors. Audit committee also ensure that both internal
and external auditor work together to ensure that the internal control is strong.
 Act as bridge between external auditor and BOD. There is a list of matters that the
external auditors must communicate to the board. Internal audit can follow up that
only appropriate information is furnished to the board by the external auditor.
 Induction, training and briefing of new directors about CG and keep them updated all
the time.
 Remind board members of their rights, responsibilities and duties in relation to GC
and the result of non compliance.

(b) refer to 1.2 B and 1.2 C

Question 2-June 2006
You are the audit manager of Tela & Co, a medium sized firm of accountants. Your firm has
just been asked for assistance from Jumper & Co, a firm of accountants in an adjacent
country. This country has just implemented the internationally recognised codes on corporate
governance and Jumper & Co has a number of clients where the codes are not being
followed. One example of this, from SGCC, a listed company, is shown below. As your
country already has appropriate corporate governance codes in place, Jumper & Co have
asked for your advice regarding the changes necessary in SGCC to achieve appropriate
compliance with corporate governance codes.
Extract from financial statements regarding corporate governance
Mr Sheppard is the Chief Executive Officer and board chairman of SGCC. He appoints and
maintains a board of five executive and two non-executive directors. While the board sets
performance targets for the senior managers in the company, no formal targets or review of
board policies is carried out. Board salaries are therefore set and paid by Mr Sheppard based
on his assessment of all the board members, including himself, and not their actual
performance. Internal controls in the company are monitored by the senior accountant,
although detailed review is assumed to be carried out by the external auditors; SGCC does
not have an internal audit department. Annual financial statements are produced, providing
detailed information on past performance.

Required:
Write a memo to Jumper & Co which:
(a) Explains why SGCC does not meet international codes of corporate governance
(b) Explains why not meeting the international codes may cause a problem for SGCC,
and
(c) Recommends any changes necessary to implement those codes in the company.
(20 marks)
(a)
Memo
From: A Manager, Tela & Co
To: Jumper & Co
Subject: Corporate Governance in the SGCC Company
Date: June 2006
Following your request on international codes of CG, please find hereunder my views and
recommendations on SGCC:

CEO and Chairman

o The CEO and the chairman are the same person.
o Good CG suggest that CEO and chairman of the board must be 2 different people.
o Chairman controls the board whereas CEO runs the company.
o It is suggested that a second person be appointed as chairman of the board.
o Too much power is vested upon Mr Sheppard.
The board
o More executives than NEDs
o Good CG indicates that there must be a balance between executives and non
executives.
o Executives can dominate the board proceedings.
o It is suggested that there must be a majority of non executives.
o Otherwise the board will have executive powers.

Appointments
o Too much power vested upon Mr Sheppard.
o He can appoint any one he wishes to appoint as board member.
o No care about the quality of director.
o Suggested to set up a nomination cttee comprising of at least 3 NEDs.

Internal control and internal audit

o Internal control systems being reviewed properly.
o Does not have an internal audit dept.
o The ICS appears to be weak.
o Good CG suggest that the control system to be monitored and internal audit dept be in
place.
o Recommendation – set up and internal audit dept.
- Internal audit dept to report to an audit cttee.

Remuneration
o Board members’ pay is set by Mr Sheppard.
o The remuneration structure is not transparent and Mr Sheppard sets his own pay.
o Set remuneration without assessing suitable criteria.
o Recommendations- set up of a remuneration cttee.
- Set remuneration levels for the board, taking into account
current salary levels and the performance of board members.
- Remuneration should be linked to performance, to encourage a
high standard of work.

Financial Statements
o FS provide information on past results of the company.
o IFRSs state that when preparing Fs mgt should make an assessment of the company’s
ability to continue as a going concern.
o FS should also contain information about the future development and some forecasted
financial figures to help investors to take decisions.
o Advisable for SGCC to include information about future operations.

Risk Management
o No mention about risk management.
o Good CG suggest that risk mgt is effected by the BOD, mgt and all employees in
accordance with their defined roles within the organisation.
 o Recommendations- board must communicate its risk mgt policies to mgt and all
employees.
- The board is responsible to the total process of risk mgt.

I hope this information is useful. Please contact me again if you require any further
assistance.

Sincerely,

XXX