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ACCA P1 Governance, Risk and Ethics

Carl R. Burch


I put together these P1 notes when studying for the exam. Thought that it would be good to share them with you. Good luck with your Exam. If you have comments or questions you can reach me at the following email addess: carl.burch@hocktraining.com

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Table of Contents


Governance and Responsibility


















B. Internal Control and Review










C. Identifying and Assessing Risk








D. Controlling and Managing Risk








E. Professional Values and Ethics
















A. Governance and Responsibility

1. The Scope of Governance

a) Define and explain the meaning of corporate governance.


The OECD says corporate governance is a:

…set of relationships between a company’s directors, its shareholders and other stakeholders.

…structure through which the objectives of the company are set, and the means of obtaining these objectives and monitoring performance.

The IIA says governance is:

…the system by which a company is controlled and directed. Governance includes the rules and procedures for making decisions on corporate affairs to ensure success while maintaining the right balance with stakeholders’ interest.

Governance is the leadership and direction given to a company so that it can achieve the objectives of its existence.

Note: Important points are boxed.

Cadbury Report of 1992 said:

…Corporate Governance is the system by which organizations are directed and controlled.

Explain the meaning of governance:

Governance is the leadership and direction given to a company so that it achieves the objectives of its existence.

Management is about making business decisions: governance is about monitoring and controlling decisions.

Governance is not about formulating business strategy for the company. However, the responsibility of the board and senior managers for deciding strategy is an aspect of governance.

Benefits to having GOOD corporate governance processes:

The company will have improved risk management system.

There will be clear accountability for executive decision making.

It focuses management attention on introducing appropriate systems of internal control.

It encourages ethical behavior and a CSR (Corporate Social Responsibility) perspective.

It can help safeguard the organization from the misuse of assets and possible fraud.

It can help to attract new investment into a company.

Seeks to put limits on excessive director remuneration.

Downside to governance:

It could develop an excessively risk adverse culture amongst mangers.

There could be too much reporting and not enough time to seek and pursue profit making activities.

It could damper entrepreneurial activities.

There could be too much excessive supervision, red tape and bureaucracy.

The cost of operating internal controls exceeds any possible benefits.

There is the possibility that the focus on meeting different stakeholder expectations will confuse management as to their corporate responsibilities.

b) Explain, and analyze the issues raised by the development of the joint stock company as the dominant form of business organization and the separation of ownership and control over the business activity.

Joint stock companies have multiple shareholders. The shareholders own the company but generally do not run the company. There is a separation of ownership and control. In order to maintain control over the company, shareholders elect a board of directors who have oversight authority. The board then hires the CEO who is then responsible for putting together the management team to run the company.

Since management does not have a vested interest in the company, they might not care as much whether the objectives of the company are met.

c) Analyze the purposes and objectives of corporate governance.

Purpose of Governance:

The purpose of corporate governance is to facilitate the effective, entrepreneurial and prudent management that can deliver the long-term success of the company.

Good corporate governance should contribute to better company performance by helping a board discharge its duties in the best interest of the shareholders. If it is ignored, the consequences may well be vulnerability or poor performance. Good governance should facilitate efficient, effective and entrepreneurial management that can deliver shareholder value over the longer term.

d) Explain, and the apply in context of corporate governance, the key underpinning concepts of:

i. Honestly/probity – Be honest that statements about the company are truthful. Not putting a spin on the facts.

ii. Accountability – The emphasis is the managers accountability to the shareholders, but also accountable to other possible stakeholders.

iii. Independence – The emphasis is making sure that there are truly non- executive directors on the board who are free to critique the job performance of management. Independence is not having a ‘conflict of interest’ issue.

iv. Responsibility – The board has a responsibility to oversee the work on management. The board should also retain responsibility for certain key

decisions, such as setting strategic objectives and approving critical capital investments.


Decision making / judgment – All directors are expected to have sound judgment and to be objective in making their judgments. The OECD says ‘the board should be able to exercise judgment on corporate affairs independent, in particular, from management.’


Reputation – A company’s reputation, if good, is built on success and management competence. However, it might take years for a company to gain its reputation and only a day for it to get ruined. Companies that are badly governed can be at risk of losing goodwill – from investors, employees and customers.


Integrity – This is similar to honestly, but it also means behaving in accordance with high standards of behavior and a strict moral or ethical code of conduct. This means ‘doing the right thing.’ ‘Being a straight shooter.’


Fairness – This means that all shareholders should receive fair treatment from the directors (one share – one vote). This also means taking into account the other stakeholders of the company, such as suppliers, creditors, employees, local community, etc.


Transparency / openness – This means not hiding ‘anything.’ Transparency means clarity. This involves full disclosure of material matters which could influence the decisions of stakeholders.

Note: A good way to remember the key concepts of corporate governance is to think of the mnemonic HAIRDRIFT.

e) Explain and assess the major areas of organizational life affected by issues in corporate governance.

i. Duties of directors and functions of the board (including performance measurement). Directors have a fiduciary duty to act in the best interest of the company. They need to use their powers for proper purpose, avoid conflicts of interest and exercise a duty of care.

ii. The composition and balance of the board (and board committees). Boards must be balanced in terms of skill and talents from several specialisms relevant to the organization’s situation and also in terms of age (to ensure senior directors are brining on newer ones to help succession planning).

iii. Reliability of financial reporting and external auditing. The reliability of the financial reports is crucial to ensuring that management is held accountable. External auditors need to make sure that they are getting the right information in order to verify the reliability of the financial reports. External auditors cannot be fearful of asking awkward questions because of fear of losing the audit.

iv. Director’s remuneration and rewards. Directors’ remuneration has to be seen as being fair. Excessive salaries and bonuses has been seen as one of the major corporate abuses for a number of years.

v. Responsibility of the board for risk management systems and internal control. Boards should meet regularly as to provide proper oversight for risk management and internal control systems. Without proper oversight, the organization may have inadequate systems in place for measuring and reporting on risks.


The rights and responsibilities of shareholders, including institutional investors. Shareholders should have the right to receive all material information that may affect the value of their investment and to vote on measures affecting the organization’s governance.

vii. Corporate social responsibility and business ethics. Corporate social responsibility and business ethics is an important part of the corporate governance debate. At this point, there is not any real consensus about these issues.

The South African King report commented that “The relationship between a company and its stakeholders should be mutually beneficial.” “This inclusive approach is the way to create sustained business success and steady long-term growth in corporate value.”

However, the Hampel report emphasized responsibility towards shareholders and states that it is impractical for boards to be given lots of responsibilities towards the wider stakeholder community.

f) Compare, and distinguish between public, private and non-governmental organizations (NGO) sectors with regard to the issues raised by, and scope of, governance. THESE ANSWERS MIGHT NEED EXPANDING.

Public Sector – Governance requirements stress the need for assessing the effectiveness of policy and arrangements for dialogue with users of services.

Private – The private sector is concerned with the continued existence of the company. Therefore, having good governance processes is of vital importance.

NGOs – Non-governmental organizations provide services which are not normally provided by either public or private organizations. Therefore, they need governance processes which can ensure that they are providing the ‘best’ service possible.

g) Explain and evaluate the roles, interests and claims of, the internal parties involved in corporate governance.

i. Directors – Have an operational role in running the company, developing strategies, etc. Concerning corporate governance, directors have the role to act responsibly; to act with honesty; be accountable, etc. (HAIRDRIFT).

ii. Company Secretaries – Company secretaries are an officer of the company and as such they have an operational role in the company. For example, company secretaries might sign some contracts, or declare some relevant matters to the proper authorities. They also have role to play in corporate governance by making sure that the directors are complying with corporate governance.

Some of the functions / responsibilities of the company secretary are listed below:

Should be responsible for providing relevant, reliable and timely information to all directors, so that they are able to make well-informed judgments in contributing to decision-making by the board.

Should be an ‘expert’ on the regulations and corporate governance, so that he can advise the board on any matters in which a governance issue should be considered.

Although the chairman should be responsible for induction of new directors and continuing professional development of established directors, the company secretary is likely to be given the responsibility for organizing induction and, where appropriate, CPD for directors.

The chairman is also responsible for the performance appraisal of the board, board committees and individual directors.

The company secretary should be the first point of contact for any NED wanting assistance or information from the company.

iii. Sub-board management – If a manager is not on the board, then he or she is considered to be part of sub-board management. This person might be the purchasing agent, human resource manager, etc. Concerning operational roles, directors develop strategies to achieve some objective, and it will be the sub-board managers who have to take the strategy and develop the tactics to achieve the objectives of the organization.

iv. Employees – Employees have an operational role to carry out the tactical plans of the sub-board management. As far as corporate governance, the employees have the responsibility to comply with the corporate governance systems in place and adopt appropriate culture. They need to implement the risk management and control procedures and to report back if controls are not working as they should.

v. Unions – Unions have a responsibility to protect the interest of the employees. As such, the ability of management to alter its working practices, for example, may depend on obtaining the cooperation and support of the trade unions.

h) Explain and evaluate the roles, interest and claims of, the external parties involved in corporate governance.

i. Shareholders (including shareholders’ rights and responsibilities) – The role of governance is to protect the rights of all shareholders, including the right to vote for board members, etc.

ii. External Auditors – Auditors try to influence to the company to present reliable and accurate financial statements. Auditors can also influence by recommending ways to improve the strength of internal controls within the company. They can also provide other audit services such as social and environmental audits. They can also highlight governance and reporting issues of concern to investors.

iii. Regulators – Regulators (i.e., SEC, etc.) have a role of making sure that public companies’ financial information is transparent, reliable and accurate. Regulation can be defined as any form of interference with the operation of the free market. This could involve regulating supply, price, profit, quantity, entry, exit, information, technology, or any other aspect of production and consumption in the market.

iv. Government – Like regulators, the government has a role to make sure that regulators are doing their job in making sure that public companies are abiding by the laws and regulators of the country.

v. Stock exchanges – Public companies list their shares on regulated stock exchanges, such as New York Stock Exchange, NASDAQ, American Stock Exchange, London Stock Exchange, and many others. Stock exchanges are privately owned and thus they need to protect their reputation. Stock exchanges are regulated and thus require listed companies to abide by governmental regulations.

Stock exchanges are important because they provide regulatory frameworks in principles-based jurisdictions. Stock exchange regulation can therefore have a significant impact on the wary corporate governance is implemented and companies report.

vi. Small investors (and minority rights) – The role of governance is to protect the interest of the minority shareholders; to make sure that their voices are heard and that they are treated equally.

vii. Institutional investors (Analyze and discuss the role and influence of institutional investors in corporate governance systems and structures, for example, the roles and influences of pension funds, insurance companies and mutual funds) - Institutional investors manage funds of individual investors. They are organizations which pool large sums of money and invest those sums in security, real property and other investment assets. They can also include operating companies which decide to invest its profits to some degree in these types of assets.

Major institutional investors are:

Pension funds.

Insurance companies.

Investment and unit trusts.

Venture capitalist organizations.

Institutional investors will have a lot of influence in the management of corporations because they will be entitled to exercise the voting rights in a company. They can actively engage in corporate governance. Furthermore, because institutional investors have the freedom to buy and sell shares, they can play a large part in which companies stay solvent, and which go under. Influencing the conduct of listed companies, and providing them with capital are all part of the job of investment management.

Intervention by institutional shareholders:

Under extreme circumstances, the institutional shareholders may intervene more actively, by, for example, calling a company meeting in an attempt to unseat the board. Reasons why institutional investors might intervene:












Poor operational performance.

Management is dominated by a small group of executive directors, with NEDs failing to hold them accountable.

Major failure of internal controls, particularly in the area such as health and safety, pollution or quality.

Failure to comply with laws and regulations or governance codes.

Excessive levels of director’s remunerations.

Poor attitudes towards corporate social responsibility.

2. Agency Relationship and theories

a) Define and explore agency theory.

Agency theory is a theory of the relationship between the principal and an agent.

In limited companies, the directors and senior managers act as agents of the shareholders, who own the company.

Agency theory is based on the view that when an agent represents a principal, the self-interest of the agent is different from the interests of the principal. Without suitable controls and incentives, the agent will make decisions and actions that are in his or her own interest rather than those of the principal.

Agency theory is relevant to corporate governance because many of the measures recommended for good governance are concerned with controls and incentives that will persuade agents to act in the shareholders’ best interest.

o For example, controls are applied through accountability and incentives are given in remuneration packages.

b) Define and explain the key concepts in agency theory:

i. Agents – The agents are the directors and senior management of the company. They are selected and hired to run the company in the best interest of the shareholders.

ii. Principals – The principals are the shareholders. They elect the board and the board hire the CEO who is in charge of putting the management team together.

iii. Agency – An agency relationship arises when one or more persons (the principals) engage another person (the agent) to perform some service on their behalf that involves delegating some decision making authority to the agent (Jensen and Meckling).

iv. Agency costs – Agency costs are the costs of having an agent make decisions are behalf of a principal. Applying this to corporate governance, agency costs are the costs that the shareholders incur by having managers run the company instead of running the company themselves. There are three costs associated with agency costs:

Cost of monitoring. The owners of the company have to establish systems to monitor the actions and performance of management, to try to ensure the management is acting in the best interest of the company.

Bonding costs. These are costs to provide incentives to managers to act in the best interest of the company.

Residual loss. Costs to the shareholders of management decisions that are not in the best interest of the shareholders (but in the interest of the managers themselves).

Agency costs = monitoring costs + bonding costs + residual costs.

v. Accountability – Agents should be held accountable for their decisions and actions. Accountability means:

Having to report back to the principal to give an account of what has been achieved.

Having to answer questions from the principals about the performance and achievements.

Having the power to reward or punish the agent for good or bad performance.

Greater accountability should reduce agency problems because it provides management with an incentive to achieve performance which is in the best interest of the shareholders. However, incentives should not be excessive where the cost of the incentive is greater than the benefit that the monitoring provides.

vi. Fiduciary responsibilities Fiduciary duty is a duty of the agent to act for the good of the company. A person with fiduciary duty is in a position of trust.

However, the existence of fiduciary duty is not sufficient to insure that there is good corporate governance.

Evan and Freeman argued that management bears a fiduciary relationship to stakeholders and to the corporation as an abstract entity. It must act in the interests of the corporation to ensure the survival of the firm, safeguarding the long-term stakes of each group.

The main fiduciary duties of directors are:


Act in the best interest of the company.


Avoiding conflict of interest.


Using powers of proper purpose.


Having a duty of care.

vii. Stakeholders – Stakeholders are parties (both internal and external) who have an interest in well-being of the company. The different stakeholders include: management, shareholders, vendors, creditors, board of directors, employees, regulators, pressure groups (like PETA, Green Peace, etc.), auditors, and the local community.

c) Explain and explore the nature of the principal-agent relationship in the context of corporate governance.

Jensen and Meckling defined the agency relationship as a form of contract between the company’s owners and its managers, where the owners appoint an agent to manage the company on their behalf.

The owners expect the agents to act in the best interest of the owners. Ideally, the ‘contract’ between the owners and managers should be sure that he managers always act in the between interest of the owners. However, it is impossible to arrange the ‘perfect contract’, because decisions by the

managers affect their own personal welfare as well as the interest of the owners.

This raises a fundamental question. How can managers, as agents of their company, be induced or persuaded to act in the best interests of the shareholders?

d) Analyze and critically evaluate the nature of agency accountability in agency relationships.

In the context of agency, accountability means that the agent is answerable under his contract to his principal and must account for the resources of his principal and the money he has gained working on his principal’s behalf.

Two issues with the idea of agents being held accountable:

1) How does the principal enforce this accountability?

2) What if the agent is accountable to parties other than his/her principal? – How does he/she reconcile possible conflicting duties.

e) Explain and analyze the following other theories used to explain aspects of the agency relationship.

i. Transaction costs theory.

Transaction cost theory was developed by Coase and Williamson is an economic theory. Is based on the idea that companies have to decide which activities are needed to be performed ‘in house’ and which activities it can buy from external sources. It attempts to provide an explanation of the actions and decisions of managers that are not consistent with rationality and profit maximization.

Williamson argued that the actions and decisions of managers are based on a combination of bounded rationality and opportunism.

Bounded rationality means that the manager will have limited understanding of alternatives. This may imply that they will play it safe and concentrate only on safe markets.

Opportunism means that managers make decisions based on their own personal interests.

Conclusion: Managers should be controlled to prevent them from acting in their own interests rather than in the best interest of the shareholders.

This theory is consistent with agency theory and provides a theoretical justification for the need for rules or principles of good corporate governance.

Need to make sure that the objectives of management and the shareholders are congruent.

ii. Stakeholder theory.

Companies provide not only wealth to the shareholders, but they provide jobs to a employees and contribute the national and local economies.

Companies are corporate citizens and thus they have a responsibility to society.


There is a close link between stakeholder theory and CSR.

In addition to providing returns to shareholders, companies have a responsibility to its employees, customers, governments, communities, suppliers, lenders and the general public.

Accountability is an important aspect of responsibility. This means that companies not only should report to its shareholders, but also provide information to its stakeholders, either by producing more reports or by including more information in its annual reports. This might explain the publication by some companies of an annual sustainability report and employee reports for the benefit of the company’s employees.

Mendelow’s power/interest matrix. Interest is horizontal, and power is vertical.

Four quadrants – Ignore, Keep informed, Keep satisfied, and Key Players.

Level of Interest






Keep Informed

Keep Satisfied

Key Players

Ignore quadrant – Stakeholders who are in this category can be ignored by the company. In this quadrant might be the government, or some shareholders, or employees who really don’t have any power or interest. However, this does not take into account any moral or ethical considerations. It is simply the stance to take if strategic positioning is the most important objective.

Keep Informed – Most shareholders would fall into this quadrant. You need to keep shareholders informed of what’s going on (e.g., annual report), but they don’t exert much power. However, stakeholders in this quadrant can increase their overall influence by forming coalitions with other stakeholders in order to exert a greater pressure and thereby make themselves more powerful.

Keep Satisfied – In this quadrant the stakeholder doesn’t have much interest but does have strong power over the company. All these stakeholders need to do to become influential is to re-awaken their interest. This will move them across to the right and into the high influence sector, and so the management strategy for these stakeholders is to ‘keep satisfied.’

Key players – Key players are those who have the greatest influence on the company. This question here is how many competing stakeholders reside in that quadrant of the map. If there is only one (e.g., management) then there is unlikely to be any conflict in a given decision-making situation. If there are several, then there are likely to be difficulties in decision-making and ambiguity over strategic direction.

Different categories of Stakeholders:

As far as stakeholders, have to understand the differences on how to categorize stakeholders. Including:

Internal and external stakeholders. This is probably the easiest distinction between stakeholders.












External stakeholders will include customers, competitors, suppliers, and so on.

Some stakeholders might be more difficult to categorize, such as trade unions that may have elements of both.

Narrow and wide (Evans and Freeman).


Narrow are those that are most affected by the org. policies and will usually include shareholders, management, employees, suppliers, and customers who are dependent upon the organization’s output.


Wide are those not so much affected, including government, less- dependable customers, the wider community, etc.

The Evans and Freeman model may lead some to conclude that an organization has a higher degree of responsibility and accountability to its narrower stakeholders.

Primary vs. secondary (Clarkson).


A primary stakeholder is one without whose continuous participation the corporation cannot survive as a ‘going concern.’ So primary are those that do influence the company and those that do not (i.e. shareholders, customers, suppliers and government (tax and legislation)).


Secondary are those that the org. does not directly depend upon for its immediate survival (e.g. broad communities and perhaps management, since management can be replaced.

Active and passive stakeholders (Mahoney).

o Active stakeholders are those who seek to participate in the organization’s activities. These stakeholders may or may not be part of the formal structure. Management and employees obviously fall into this active category, but so may some parties from outside an organization, such as regulators, environmental pressure groups, and possibly large investors (i.e. institutional investors).

o Passive stakeholders are those who do not normally seek to participate in an organization’s policy making. This is not to say that passive stakeholders are any less interested or less powerful, but they do not seek to take an active part in the organization’s strategy. Passive stakeholders will normally include most shareholders, government, and local communities.

Voluntary vs. involuntary.


Voluntary include the employees (those with transferable skills), most customers, suppliers and shareholders.


Involuntary are those who do not chose to be stakeholders, but are so nevertheless, for example, local communities, future generations, and most competitors.

Legitimate vs. illegitimate.


This one is more difficult and it might depend on your viewpoint. While those with an active economic relationship with an organization will almost always be considered legitimate, others that make claims without such a link, or that have no mandate to make a claim, will be considered illegitimate by some.


While a terrorist would be considered illegitimate, there is more debate on the legitimacy of the claims of lobby groups, campaigning organizations, and non-governmental/charitable organizations.

Recognized vs. unrecognized.

o This categorization follows on from the debate over legitimacy. If an organization considers a stakeholder’s claim to be illegitimate, then the organization would not recognize the stakeholder’s claim when making a decision.

Known and unknown.

o Finally, some stakeholders are known about by the organization in question and others are not. This means, of course, that it is very difficult to recognize whether the claims of unknown stakeholders (e.g., nameless sea creatures, communities in close proximity to overseas suppliers, etc.) are considered legitimate or not. Some say that it is a moral duty for organizations to seek out all possible stakeholders before a decision is taken and this can sometimes result in the adoption of minimum impact policies. For example,, even though the exact identify of a nameless sea creature is not known, it might still be logical to assume that low emissions can normally be better for such creatures than high emissions.

Instrumental and normative motivations of stakeholder theory.


The instrumental viewpoint – is that organizations only take shareholder opinions into account only insofar as they are consistent with the economic objectives of the company.


The normative viewpoint – takes a more moral stand. Based on the moral philosophy of Immanuel Kant (1724-1804) who believed the each of us has a moral duty to account for each other’s concerns and opinions.

Kant talked about the civil duty, which he believed important in maintaining and increasing overall good in society.

3. The Board of Directors

a) Explain and evaluate the roles and responsibilities of boards of directors.

The board should be responsible for making major policy and strategic decisions. Directors should have a mix of skill and their performance should be assessed regularly. Boards are collectively responsible for:

Promoting the success of the company

Providing leadership and direction.

Managing risks and instituting the appropriate systems of internal controls.

Supervising lower levels of management and employees.

Setting the strategic goals and targets of the company.

Ensuring that the necessary financial and human resources are in place.

Reviewing managerial performance.

Other responsibilities are:

Monitoring the CEO.

Overseeing the implementation of corporate strategy.

Monitoring risks, control systems and systems of CG.

Monitoring HR issues like succession planning, training, remuneration, etc.

Ensuring the effective communication of strategic plans to stakeholders.

It was suggested by UK Cadbury report that, as a principle of good corporate governance, there should be a formal list of matters reserved for collective decision- making by the board. These matters include:

Strategy – approving long-term objectives, deciding commercial strategy, approving budgets, oversight of operational performance.

Investments – approving major capital investments, major contracts, acquisitions and disposals.

Decisions on capital structure and financing.

Decisions on major organization and management re-organization.

Review of the effectiveness of internal controls and risk management systems. This function might be delegated to internal auditing, if the company has an internal auditing function.

Communication with shareholders.

executive directors and other senior executive




Appointments to the board.

Company policies.

Proposing dividends.

b) Describe, distinguish between and evaluate the cases for and against, unitary and two—tier board structure.

In most countries, companies have a single board of directors (unitary board). This board would consist of executive and non-executive directors, with a chair and a CEO.


consisting of:










A management board of executive directors (headed by the CEO or managing director).


The management board reports to the supervisory board.


Is responsible for day-to-day running of the business.

A supervisory board of NED (headed by the chair of the company).


This board has no executive function; however it may review the company’s direction and strategy. It is meant to safeguard shareholder interest.


Receives formal reports of the state of the company’s affairs and finance.


It approves the accounts and may appoint committees and undertake investigations.

In a 2-tier company board structure:

Membership of the two boards is entirely separate.

The effectiveness of this type of structure will depend on the relationship between the chair and CEO. In public companies:

It is usual in a unitary board for most non-executive directors (NEDs) to be classified as independent.

Most NEDs in a supervisory board would not be regarded as independent. In a 2-tier board structure, NEDs on the supervisory groups often are:


Represent interest groups (e.g., employees or major shareholders), or


Former executive directors of the company, possibly former members of the management board who have now retired form the company.

2-tier board



Responsibilities for management and governance are clearly separated.

Supervisory board can be very large.

Supervisory board membership recognizes interests of stakeholders groups.

Decision-making might be slower than with a unitary board.

Executive directors and NEDs have different responsibilities and duties.

Might be the risk of conflict between the two boards.

Risk of conflict between interest groups on the supervisory board

Unitary board



Unitary boards can be small in size because there are no requirements to appoint directors who represent stakeholder interest groups.

Can also get too large if not careful.

It is easier for the NEDs and the executive directors to work co-operatively.

If there is a conflict between chair and CEO, this can negatively affect the company.

Unitary boards work towards a common goal, which is what the board considers to be in the best interest of the shareholders and others.

As with any board, there not be a consensus of what the goals are.

c) Describe


(including defining executive and non-executive directors (NED).








The Combined Code states that at least one half of the board members should be independent non-executive directors, with a minimum of 3 NEDs. There has to be a balance between EDs and NEDs.

The Combined Code also states that a former CEO of a company should not move on to become the company chairman. The Combined Code argues that the power of chairman and CEO should not be held by one individual because it gives too much power on the board to that individual.

Board composition:

A chairman, who may be any executive director but is usually a NED.

Sometimes a deputy chairman.

A chief executive officer, who an executive director.

Other executive directors, possibly including the CFO, COO, and others.

Other NEDs.

Balance of Power:

The board should contain a suitable balance of power in order to prevent one person or group of people from dominating the decision making of the board.

When there are several independent minded individuals on the board, it is more likely that the interest of the shareholders, and possibly also other stakeholders in the company will be properly represented.

Several ways to achieve suitable balance:


The same individual should not hold the position of CEO and chairman at the same time.


The roles of the CEO and chairman should be specified formally so that one individual is not able to take responsibilities away from the other. There needs to be a written charter.


There needs to be the presence of independent non-executive directors on the board. The Combined Code states that for large stock market companies, a majority of the board should be independent NEDs



There should be a senior NED with sufficient strength of character to challenge both the chairman and CEO if this seems necessary. This person needs to be able to ask hard questions.


The NEDs must be effective in their roles. They need to be able to give sufficient time to the company.


Some decision making should be delegated to the board committees to remove decision making from directors in cases where there is a conflict of interest, or to act as a check on some of the activities of executive directors (for example the audit committee).

Executive and NEDs:

Executive directors are directors who also have executive management responsibilities in the company. They are normally full-time employees.


not have any executive management







They are not employees of the company.


They are not full-time. When they are appointed, there should be a clear understanding about how much time (each month or each year) the NED will probably be required to give to the company’s affairs.

d) Describe and assess the purposes, roles and responsibilities of NEDs.

The Higgs report commented that the role of the NED is frequently described as having two main elements: (1) monitoring executive activity and (2) contributing to the development of strategy.

Higgs identified four roles for NEDs.

1) Strategy. Should contribute development of the company’s business strategy.

2) Scrutinizing performance. The NEDs need to scrutinize the performance of management.

3) Risk management/Internal control. NEDs should satisfy themselves that financial information produced by management is reliable. They need to satisfy themselves that financial controls and systems of risk management are ‘robust and defensible.’

4) People. They should be involved in the people side of running the company, including their roles on the nomination committee and remuneration committees. NEDs are responsible for deciding the level of remuneration of executive directors. They also have a prime role in appointing and removing senior management, and in succession planning.

Cross-directorship is a situation where the executive director of one company (company A) sits on the board of another company (company B). At the same time, a executive director of company B, sits on the board of company A. When this situation exists, the NEDs involved might be reluctant to criticize each other.

In practice, many companies do not allow cross-directorships.

Some of the problems that can occur with the appointment of NEDs:

Lack of independence if appointed by the NED.

Lack of authority to impose their views.

Often confined to represent the views of the stakeholders.

A limited amount of time they can devote to the board.

May be a difficulty in recruiting good NEDs – limited supply.

Ways to ensure independence:

Not involved in share scheme.

Their service should not be pensionable.

Should be for a specific period.

The NED should not have any business, financial or other connection with the company-apart from fees and shareholdings.

Re-appointment should not be seen to be automatic.

The full board should decide on their selection and appointment.

NED must be able to take external professional advice where necessary and the costs of same have to be borne by the company.

e) Describe and analyze the general principles of legal and regulatory frameworks within which directors operate on corporate boards.

Duties while in office:

Legal rights and responsibilities. Directors are entitled to fees and expenses according to the company’s constitution. Directors have a duty of care to show reasonable competence and may have to indemnify the company against loss caused by their negligence. Directors are also said to be in a fiduciary position in relation to the company.

Duty to act within powers. Directors have to operate in accordance with the company’s constitution and only to exercise powers for the purpose for what they were elected for.

Duty to promote the success of the company. The law should encourage long-termism and regard for all stakeholders by directors and that stakeholder interests should be pursued in an enlightened and inclusive way.

Duty to exercise independent judgment. This means that directors should not delegate their powers of decision-making or be swayed by the influence of others.

Duty to exercise reasonable skill, care and diligence. Directors have the duty of care to show reasonable skill, care and diligence.

Duty to avoid conflict of interest. A director is an agent of the company. A director would be in breach of fiduciary duty to the company, for example, if he puts his or her own interests first, ahead of the interests of the company. A breach of fiduciary duty would also occur if a director has an interest in a contract with the company but fails to disclose this interest to the rest of the board and obtain their approval.

Duty not to accept benefits from third parties. This duty prohibits the acceptance of benefits (including brides) from third parties conferred by reason of them being a director, or doing, (or omitting to do) something as a director.

Duty to declare interest in proposed transaction or arrangement. Directors are required to disclose to the other directors that nature and extent of any interest, direct or indirect, that they have in relation to a proposed transaction or arrangement with the company.

Insider dealing / trading.


An insider is someone who has business connection with an entity as a result of which they may acquire relevant information.


Insider dealing is where a person with inside information buys or sells shares or securities in an entity.


An insider in possession of unpublished price sensitive information should not deal.


An offense is also committed if the insider encourages another person to deal.


The person dealing as a result of that encouragement, and believing the source to be an insider, is also committing an offense.


Disclosure of insider information, other than in the proper course of employment to an authorized person, is also an offense.

Leaving Office:

Departure from office. A director may leave office in the following ways:




Not offering him or herself for reelection.




Dissolution of the company (e.g. bankruptcy).


Being removed from office.


Prolonged absence (generally more than 6 months).


Being disqualified.


Agreed departure.

Time limited appointments. Ordinary directors may have to retire from the board on reaching a retirement age or may not be able to seek reelection.


Time-limited appointments. Existing directors are required to stand for re-election at regular intervals.


Fixed term contracts. NEDs are usually appointed for a fixed term. In the UK, normal practice is for 3-years. At the end of this term, the appointment might be renewed for a further 3-years.

Retirement by rotation. It is usual for directors who retire by rotation and stand for re-election to be reelected by a very large majority. In the UK, most companies include in their constitution a requirement that one-third of directors should retire each year by rotation and stand for re-election. This means that each director stands for re-election every three years. (this is why appointments of NEDs are for periods of 3-years.)

Service contracts. Executive directors have service contracts with the company. A service contract includes terms such as entitlement to

remuneration including pension rights, and a minimum notice period for termination of office.

Removal. When a director performs badly, it should be expected that he or she will be asked by the board or the company chairman to resign. This is the most common method by which directors who have ‘failed’ are removed from office. When a director is removed from office, he or she retains contractual rights, as specified in his or her contract of employment. This could involve a very large payment.

Disqualification. The corporate law of a company might provide for the disqualification of any individual acting as a director of any company, where the individual is guilty of behavior that is totally unacceptable from a director. This could include:


When a director is bankrupt.


Director is suffering from a mental disease.


Director has been found guilty of a crime in connection with the formation or management of a company.

f) Define, explore and compare the roles of the CEO and the board chairman.

Role of the CEO:

The CEO is responsible for the executive management of the company operations.

The CEO is the leader of the management team, and all senior managers report to the CEO.

If there is an executive management committee for the company, the CEO should be the chairman of this committee.

The CEO reports to the board on the activities of the entire management team, and is answerable to the board for the company’s operational performance.

Risk management. The CEO is responsible to manage the company’s risk profile.

Liaison with stakeholders. The CEO need to deal with those interested in the company.

Role of the Chairman:

The chairman must act as the spokesperson of the board.

Is the conduit of communication between the CEO and the shareholders.

Ensuring that the board as a whole and also individual directors contribute effectively to the work of the board.


Sets the agenda for the board meetings.


Provides suitable information before each board meeting.


At board meetings, encourages open dialogue between members of the board.


Helps non-executive directors to contribute effectively to the company.

The chairman is responsible for the effectiveness of the board. He is therefore responsible for:


The induction of all new directors, and


The annual performance review of the board, board committee and individual directors.

Also sets the ‘tone at the top.’

Should be the advocate of ethical behavior in the company.

An effective chairman should establish a close working relationship with the CEO and should ensure that all decisions by the board are implemented.

He or she should promote ‘best practice’ in corporate governance and high standards of ethical conduct by the company and its employees.

He or she should provide ‘leadership’ for the company are represent its views with external stakeholders, including the shareholders.

Summary of the roles of CEO and Chairman



Executive director. Full time employee

Part-time. Usually independent.

Reporting Lines


Reporting Lines

All executive managers’ report, directly or indirectly, to the CEO.

No executive responsibilities. Only the company secretary and the CEO report to the chairman directly, on matters relating to the board.

The CEO reports to the Chairman and to the board generally.


Main responsibilities


Main responsibilities






Leader of the board, with responsibility for its effectiveness.






To make sure that the board fulfills its role successfully.






To ensure that all directors contribute to the work of the board.


Managing the company’s risk profile.


Implement board decisions.








Division of responsibilities: The role of the CEO and chairman should be separated. The CEO runs the company and the chairman runs the board. Reasons to separate:

The separation of roles avoids any conflicts of interest.

It is difficult to make the CEO accountable if there is no one senior to him or her.

The board can make the CEO more accountable for management of the company if there is a separate Chairman of the board.

The UK 2 nd Combined Code suggests that the retired CEOs should not become Chair of the same company. The main concern is that he or she would interfere too much in the running of the company by the new CEO.

The Cadbury report stated that if the roles were combined, there should be a strong independent element to the board with NED’s. Higgs states that one senior member of the NED’s should be appointed who would be available to shareholders who had concerns that could not be resolved through normal channels.


g) Describe









continuing professional development of directors on boards of directors.

The UK Higgs report provides guidance on the development programs.

Induction of new directors:

When directors are appointed to the board of a company, they are expected to bring the benefits of their knowledge, skill and experience to the discussions of the board.

Directors need to build an understanding of the nature of the company, its business and its markets. This includes:


The company’s culture and values.


The company’s products and/or services.


The structure of the company/subsidiaries/joint ventures.


Major risks and risk management strategy.


Key performance indicators.


Regulatory constraints.

Build a link with the company’s people.


Meet with senior management.


Visit company sites.


Participate in the board’s strategy development.


Briefing on internal procedures.

Build an understanding of the company’s main relationships including meeting with auditors.


Major customers.


Major suppliers.


Major shareholders.

Continuing Professional Development:

CPD is necessary to make sure that directors remain up to date on their relevant professional knowledge.

Higgs report suggests that CPD of potential directors should concentrate on the role of the board, obligations and entitlements of existing directors and the behaviors need for effective board performance.

Topics for professional development would include financial management training, HR issues, CG developments, risk management updates on legal and regulatory issues, audit practice and procedures, financial reporting and strategic planning.

h) Explain and analyze the frameworks for assessing the performance of boards and individual directors (including NEDs) on boards.

Performance of the board:

Aim is to improve board effectiveness, maximizing strengths and tackling weaknesses.

Performance of individual directors and the board as a whole needs to be appraised regularly. In the UK there is a requirement for an annual performance review. Ideally, the assessment should be by an external third party who can bring objectivity to the process.

Performance of the whole board needs to include:


A review of the board’s systems (conducting meetings, work of committees, quality of written documentation).


Performance measurement in terms of standards it has established, financial criteria, and non-financial criteria relating to individual directors.


Assessment of the board’s role in the organization (dealing with problems, communicating with stakeholders).

Higgs Report lists a number of criteria that can be used to monitor the effectiveness of boards.


Performance against objectives.


Contribution to strategic development.


Contribution to risk management.


Contribution to the development of corporate culture.


Appropriate composition of the board and committees.


Effectiveness of responses to crises and problems.


The proper delegation of matters to lower levels and the reservation of matters for board decision.


Effectiveness of internal and external communications.


The extent to which the board is kept appraised of developments.


The effectiveness of the board committees.


The quality of information supplied to board members.


The number of board meetings held.


The extent to which the board has met all legal, financial reporting, regulatory and CG requirements.

Performance of individual directors: Need to use the following criteria when judging the performance of the individual director.

Independence: This means avoiding conflict of interest.

Preparedness: The director knows the key staff, organization structure, industry and regulatory background.

Practice: The director participates in board meetings, questions, insists on obtaining information, and undertakes CPD.

Committee work: The director participates fully in audit, risk and nominations committees (remunerations for NEDs).

Development: The director makes suggestions as to strategic choice and direction.

If the director considers performance to be unsatisfactory, he should consider ways of encouraging directors to improve their performance.

4. Board Committees

a) Explain and assess the importance, roles and accountabilities of, board committees in corporate governance.

A board committee is a committee set up by the board, and consisting of selected

directors (both executive and non-executive), which is given responsibility for monitoring a particular aspect of the company’s affairs for which the board has

reserved the power of decision-making.

The role of a committee is to monitor an aspect of the company’s affairs, and:

Report back to the board, and

To make recommendations to the board.

The full board should make a decision based on the committee’s recommendations.

If a board was to reject the recommendations of a committee, then the board needs

to give a very good reason for doing so.

A board committee needs to meet with sufficient frequency to enable it to carry out its

responsibilities. It is important to remember, however, that a board committee is not a

substitute for executive management and a board committee does not have executive powers. A committee might monitor activities of executive managers, but it does not take over the job of running the company from management.

b) Explain and evaluate the role and purpose of the following committees in effective corporate governance.

i. Remuneration committees.

The Remuneration Committee deals with the remuneration of executive directors and senior managers.

Some believe that the remuneration of directors should be linked to company performance.

Level of remuneration should be sufficient to attract and retain and motivate directors to do a good job, but should not pay them more than is necessary for this purpose.

There should be a final and transparent procedure for developing policy on executive remuneration and for fixing the remuneration package of individual directors.

No director should be involved in deciding his or her own remuneration.

There should be limited contracts of service periods, ideally for one year.

The committee should be made up of independent NEDs.

ii. Nominations committees.

The Nominations Committee has the responsibility to identify and recommend individuals for appointment to the board and executive director. The committee should play an active role in the company’s succession planning.

This means planning for the eventual retirement of the:


The board chairman, and

Possibly the finance director.

In addition, the NC should consider:

The desirable size of the board.

The skills of the board members. Combined code recommends at least one NED have financial experience (aka qualified accountant).

The need to attract board members from a diversity of backgrounds.

The balance between ED and NEDs. The combined code says that there should be a balance with a minimum of 3 NEDs.

iii. Risk committees.

There needs to be a way for companies to manage their risk. Risks include:

Business and strategic risks, and

Risk of errors, fraud, losses, breakdowns, etc.

This board would have oversight responsibility for risk and internal control.

Typical roles of the Risk Committee:

To agree with the RM strategy.

Receive and review RM reports from all operational departments.

Monitor overall exposure and specific risks.

Assess the effectiveness of the RM strategy.

Provide guidance to the main board.

Work with the AC on designing and monitoring IC’s for the mitigation and management of risk.

Prepare reports on risks and draft the RM strategy note for the annual accounts.

To assist in determining a company’s risk appetite. The board will determine the level of risk the company is willing and able to take on.

iv. Audit committees.

The audit committee is considered to be the most important board committee. The UK Cadbury report emphasized the importance of internal audit having unrestricted access to the audit committee.

The board should establish an AC of at least three, or in the case of smaller companies, two, independent NEDs.

The board should be satisfied that at least one member of the AC has recent and relevant financial experience.

The AC needs to ensure that the external auditors are completely independent of the company and its subsidiaries, and that they are working in the best interests of the shareholders. The audit committee should ensure that the company complies with all laws and regulations applying to it, and that the necessary reports are filed with the authorities.

The AC needs to review and discuss with management and the external auditor the effects of changes in accounting standards, and the implications of these proposed changes.

Needs to ensure that both the external and internal auditors have sufficient resources to carry out their defined roles.

Needs to act as a mediator between management and auditors when there is a difference of opinion.

Needs to recommend on the appointment or replacement the external auditor, who shall report directly to the Audit Committee. If the board does not accept the AC’s recommendation, it should include the reasons in the annual report.

Needs to be directly responsible for the compensation and oversight of the work of the external auditor.

Role and responsibilities of the Audit Committee:

An AC of independent NEDs should liaise with external audit, supervise internal audit and review the annual accounts and internal controls.

To monitor the integrity of the financial statements of the company, and any formal announcements relating to the company’s financial performance, reviewing significant financial reporting judgments 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 the external auditor.

o The external auditor reports directly to the audit committee.

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.

There are several reasons why an audit committee is beneficial to an organization. 1) Independence of the external auditors. The committee selects the external auditor and thus can eliminate some pressure that the executive management might try to apply. 2) Competence of the external auditor. The committee also assesses the competence of the external auditor. 3) Providing an assessment of the financial statements and audit process. The committee reports to the board on matters that they consider relevant, with regard to financial statements and audit process. Its responsibility is to ensure that the statements are reliable. 4) Independence of the internal auditor. The committee helps to ensure the independence of the internal audit function by having the IAF functionally report to the committee and not to someone in management.


Increase public confidence.

5. Directors’ remuneration

a) Describe and assess the general principles of remunerations.

i. Purposes. There are two purposes of any remuneration package:

1) The package should be designed to attract qualified people to the company; however, it should not be more than necessary,

2) It should provide incentive for the director. The amount that the company will pay will depend upon:


What other companies are paying, and


How many suitable candidates are available.

ii. Components. When a remuneration package is designed for a director or senior manager, it should consider:


Each separate element in the package, and also


All the elements in the package as a whole.

The components include both short-term and long-term incentives, between cash and equity and between current pay and pension rights.

For example, a director may be paid an average basic salary, but may receive a generous pension entitlement and an attractive long-term incentive scheme.

Another director might receive a low basic pay, but a very attractive short-term bonus incentive scheme.

iii. Links to strategy. Any director’s remuneration package should be linked to the company achieving its long-term objectives. This could entail the company giving the directors the right to purchase shares at a specified exercise price over a specified time period in the future. This provides incentive for the directors to do what they have to do to raise the price of the shares.

iv. Links to labor market conditions. Any remuneration package has to be linked to local market conditions. Again, every company needs to be able to attract and retain qualified personnel, but companies need to make sure that they are not over compensating its directors.

of various components of remuneration

b) Explain





packages on directors’ behavior.

i. Basic salary will be in accordance with the terms of the directors’ contract of employment, and is not related to the performance of the company or the director.

Instead it is determined by the experience of the director and what other companies might be prepared to pay for the director’s service (the market rate).

ii. Performance related bonuses. Directors may be paid a cash bonus for good (generally accounting) performance. To guard against excessive payouts, some companies impose limits on bonus plans as a fixed percentage of salary or pay.

o There is also something called ‘Transaction bonuses’ which is where the CEO get a bonus for acquisitions, regardless of subsequent performance, possibly indeed further bonuses for spinning off acquisitions that have not worked out.

iii. Shares and share options (share schemes). Share schemes are used to provide long-term incentive which gives the executives a personal interest in the performance of the company’s share price over a period of several years. Since they have an incentive, they will do (or should do) what they can to improve the financial performance and longer-term prospects.

Problems with these share schemes are:


Executives might be motivated by short-term targets and cash bonuses than by longer term targets and share awards.


If share price falls because of a general decrease in the market, the options might be worthless, therefore, not providing much incentive for the executive to perform.


Share schemes are often for a three year period. The executive receives an award of fully-paid shares, or is able to exercise share options after three years. If the executive sells the shares, his or her interest in the company comes to an end.

(The UK 2 nd Combined Code states that non-executive directors should not normally be offered share options, as options may impact upon their independence).


Loyalty bonuses are intended to get directors to stay with the company for an extended period of time. For example, if a director’s contract expires, the director may be paid a bonus for extending the contract.

v. Benefits in kind could include transportation (e.g., a car), health provisions, life assurance, holidays, expenses and loans.

The remuneration committees should consider the benefit to the director and the cost to the company of the complete package.

Also, the committee should consider how the director’s package relates to the package for employees. Ideally, perhaps, the package offered to the directors should be an extension of the package offered to the employees.

vi. Pension benefits. Many companies offer pension contributions for directors and staff. In some cases, however, there may be separate schemes available for directors at higher rates than for employees.

The Combined Code states that as a general rule, only basic salary should be pensionable.

The Code emphasizes that the remuneration committee should consider the pension consequences and associated costs to the company’s basic salary increases and any other changes in pensionable remuneration, especially for directors close to retirement.

c) Explain and analyze the legal, ethical, competitive and regulatory issues associated with directors’ remuneration.

It needs to be a principle of corporate governance that the shareholders of the company be given the full information about the remuneration of the company’s directors. This information is important so they understand the link between the director’s remuneration and company performance.

In the UK, quoted companies are required to publish a director’s remuneration report each year. The report must contain extensive disclosures about director’s remuneration. It is general practice to include the report in the annual report and accounts.

Some of the information in the remuneration report must be audited by the company’s auditors. Other parts of the report are not subject to an audit.

Shareholders must vote at the company’s annual general meeting on a resolution to approve the report. This is an advisory vote only, and the shareholders do not have the power to reject the report or amend the remuneration of any director or senior executive.

Information that is subject to audit includes:

The remuneration for the year for each director, analyzed into salary and fees, bonuses, expenses received, compensation for loss of office and other severance payments, and non-cash benefits.

For each director, details of interests in share options, including details of options awarded or exercised during the year, options that expired during the year without being exercised, and any variations to the terms and conditions relating to the award or exercise of options.

For options exercised during the year, the market price of the shares when the options were exercised should also be shown.

For options have not been exercised, the report should show the exercise price, the date from which the options may be exercised and the date they expire.













Details should also be provided of any large payments made during the year to former directors of the company.

Ethical issues about remuneration.

There are some well-recognized ethical issues that affect the reputation and public perception of companies. The ethical issues include:

The rate of increase in the director’s pay has been much greater than the rate of increase in the pay of other employees.

A survey conducted by KPMG (2005) found that bonus payments to senior executives had risen at a fast rate, but the pay rate increase was not linked to long-term strategy of the company and the shareholder value.

o This meant that directors were paid large bonuses but were not adding value to the company.

Research by Income Data Service in the UK in 2006 stated that directors were now earning almost 100 times as much in annual remuneration than other full-time workers, compared with about 40 times as much in 2010. This gap is continuing to increase.

6. Different approaches to corporate governance

a) Describe and compare the essentials of ‘rules’ and ‘principles’ based approaches to corporate governance. Includes discussion of ‘comply’ or ‘explain.’

An example of a ‘rules’ based approach to corporate governance is Sarbanes-Oxley. An example of a ‘principles’ based approach to corporate governance is the UK Combined Code.

Rules-based approach to corporate governance is based on the view that companies must be required by law to comply with established principles of good corporate governance.

There are advantages with a rules-based approach:

Companies do not have a choice of ignoring the rules.

All companies are required to meet the same minimum standards of corporate governance.

Investors’ confidence in the stock market might be improved if all the stock market companies are required to comply with recognized corporate governance rules.

Disadvantages are:

The same rules might not be suitable for every company, because the circumstances of each company are different. A system of corporate governance is too rigid if the same rules are applied to all companies.

There are some aspects of corporate governance that cannot be regulated easily, such as negotiated the remuneration of directors, deciding the most suitable range of skills and experience for the board of directors, and assessing the performance of the board and its directors.

A principles-based approach to corporate governance is an alternative to a rules- based approach. It is based on the view that a single set of rules is inappropriate for every company. Circumstances and situations differ between companies. The circumstances of the same company can change over time. This means that:

corporate governance practices can differ between




companies, and

The best corporate governance practices for a company might change over time, as its circumstances change.

In the UK, the Combined Code is the relevant code of corporate governance for listed companies. All UK listed companies must comply with rules known as the Listing Rules, which are issued and enforced by the financial markets regulator.

Advantages of principles-based:

It avoids the need for inflexible legislation that companies have to comply with even though the legislation might not be appropriate.

It is less burdensome in terms of time and expenditure.

A principles-based approach allows companies to develop their own approach to corporate governance that is appropriate for their company.

Enforcement on a Comply or Explain basis which means that companies can explain why they are not in compliance with a specific provision.

A principles-based approach accompanied by disclosure requirements put the emphasis on investors making up their own minds about what businesses are doing.

Criticism of principles-based approach:

Criticized as so broad that they are of very little use as a guide to best corporate governance practice.

Hampel report comments about tick-boxing are incorrect.

Investors cannot be confident of consistency of approach. Clear rules mean that the same standards apply to all directors.

Which is more effective. It has been suggested that that the burden of the detailed rules in the US, especially the requirements of section 404, has made the US an unattractive country for foreign companies to trade their shares. As a result, many foreign companies have chosen to list their shares in countries outside the US, such as the UK.

Comply or Explain

The ‘comply’ or ‘explain’ approach is the trademark of corporate governance in the UK. The Listing Rules require companies to apply the Main Principles and report to shareholders on how they have done so. The principles are the core of the Code and the way in which they are applied should be the central question for a board as it determines how it is to operate according to the Code.

It is recognized that an alternative to following a provision may be justified in particular circumstances if good governance can be achieved by other means. If a company is in breach of the Code then the reason for the breach should be clearly and carefully explained to shareholders. In providing an explanation, the company should aim to illustrate how its actual practices are both consistent with the principle to which the particular provision relates and contribute to good governance.

In their responses to explanations, shareholders should pay due regard to companies’ individual circumstances and bear in mind, in particular, the size and complexity of the company and the nature of the risks and challenges it faces. While shareholders have every right to challenge companies’ explanations if they are unconvincing, they should not be evaluated in a mechanistic way and departures from the Code should not be automatically treated as breaches. Shareholders should be careful when responding to the statements from companies in a manner that supports the ‘comply or explain’ process and bearing in mind the purpose of good corporate governance.

Smaller companies may judge that some of the provisions are disproportionate or less relevant in their case. Some of the provisions do not apply to companies below the FTSE 350. However, such companies may nonetheless consider that it would be appropriate to adopt the approach in the Code and they are encouraged to do so.

b) Describe and analyze the different models of business ownership that influence different governance regimes (e.g., family firms versus joint stock company-based models).

Insider structures – This is where a company listed on a stock exchange is owned and controlled by a small number of major shareholders. The shareholders may be members of the company’s founding family, banks, other companies or the government.

o Family companies are perhaps the best example of insider structures. In this case, agency problems are not really an issue because there is no separation between management and owners – they’re one and the same.

Advantage of insider system:


Easier to establish ties between owners and managers.


Agency problem is reduced and costs of monitoring is also reduced, if management is involved in management.


Even if owners are not involved in management, it should be easier to influence company management through ownership and dialogue.


A smaller base of shareholders may be more flexible about when profits are made and hence more able to take a long-term view.



May be discrimination against minority shareholders.


Evidence suggests that controlling families tend not to monitor effectively by banks or by other large shareholders.


Insider systems do not develop more formal governance structures until they need to.


Insider firms, particularly family firms, may be reluctant to employ











independent NEDs.



Succession issues may be a major problem. A vigorous company founder may be succeeded by other family members who are less competent or dynamic.

Outsider systems – Outsider systems are ones where shareholding is more widely dispersed, and there is the manager-ownership separation. Sometimes called Anglo-Saxon regimes.

Advantages of outsider systems:


Provides an impetus for the development of more robust legal and governance regimes to protect shareholders.


Shareholders have voting rights that they can use to exercise control.


Hostile takeovers are far more frequent, and the threat of these acts as a disciplining mechanism.



Companies are more likely to have an agency problem and significant costs of agency.


The larger shareholders in these regimes have often had short-term priorities and have preferred to sell their shares rather than pressurize the directors to change strategies.

c) Describe and critically evaluate the reasons behind the development and use of codes of practice in corporate governance (acknowledging national differences and convergence).

The international guidelines include the OECD principle and ICGN report.

These guidelines came about because of the increase in international trade and cross-border links leads to increased pressure for the internationally comparable practices and standards.


This is particularly true for accounting and financial reporting.


Increasing international investment and integration of international capital markets has also led to pressure for standardization of governance guidelines, as international investors seek reassurance about the way their investments are being managed and risks involved.

Not surprisingly, convergence models that have been developed lie between the insider/outsider models, and between profit-orientated and ethical stakeholder approaches.

The result of encouraging better standards of CG should be that:


Better governance will attract more investment from global investor.


Companies will benefit from more investment finance, to increase their profits.


National economies will benefit from having strong and profitable companies.

Disadvantages of international codes of CG:

These international codes can often represent an attempt to find the lowest common denominator.

Attempts to find global solutions can be difficult because of differences in legal systems, financial systems, cultures, economies and structures of CG.

International guidelines will be based on practice in a number of regimes; accordingly it may lag behind changes in the more advanced regimes.

These international guidelines have no legal status.

d) Explain and briefly explore the development of corporate governance codes in principles-based jurisdictions.


Impetus and background:

Principles-based is based on the view that a single set of rules is inappropriate for every company. The UK Cadbury report suggested that a voluntary code coupled with disclosures would prove to be more effective than a statutory code in promoting the key principles of openness, integrity, and accountability.

The development of CG practices in the UK is interesting because it helps to show how different aspects of CG emerged whenever problems with CG became known. In other words, codes of CG are reactive, not proactive.


Major corporate codes:

The Cadbury report (1992). This was the first CG code in the UK. It was a reaction to several financial scandals involving listed UK companies. The main problems were considered to be in the relationship between auditors and boards of directors. There was thought that commercial pressures on both directors and boards caused pressure to be exerted on auditors, and too often, auditors gave in (capitulated). Problems were also perceived in the ability of the board to control their organizations.

CG responsibilities:


Directors are responsible for CG.


Shareholders are linked to the directors through the financial reporting system.


Auditors provide shareholders with an external opinion on the director’s financial reports.

o Other concerned users, particularly the employees are indirectly addressed by the financial statements. Code of ‘best practice’: The primary aim was to all UK listed companies, but the directors of all companies were encouraged to use the Code.

The Greenbury Code (1995):


This had to do with remuneration packages of directors.


The code established principles for the determination of director’s pay and detailing disclosures to be given in the annual reports and accounts.

The Hampel report (1998):

o Aimed to restrict the regulatory burden on companies and substituting principles for detail whenever possible.


Effects of:

Recommendations of Cadbury:


Board should meet on a regular basis in order to retain control and monitor management.


Should be clear division of responsibilities at the head of the company, with no one person having complete power.


Should be at least 3 NEDs on the board, a majority of whom should be independent of management.


Report contains provisions about the length of service contracts and disclosure of remuneration that are developed further in the Greenbury and Hampel reports.


Audit committee is a board committee. It should liaise with internal and external auditors and provide a forum for both to express their concerns. The committee needs to review half yearly and annual statements.


Annual report should present a balanced and understandable assessment of the company’s position. Statements should be made about the company’s going concern and the effectiveness of its internal controls.

Recommendations of Greenbury:


The remuneration committee should determine executive director’s remuneration and that this committee should be comprised solely of NEDs.


Directors’ service contracts should be limited to one year.

Recommendations of Hampel report:


The accounts should contain a statement of how the company applies the CG principles.


The accounts should explain their policies, including any circumstances justifying departure from best practices.

The London Stock Exchange issued the 1 st Combined Code in 1998, which was derived from the recommendations of Cadbury, Greenbury and Hampel reports.

The 2 nd Combined Code took the 1 st Combined Code and includes the following reports:


The Turnbull Report (1999 and revised 2005) focused on risk management and internal controls.


The Smith Report (2003) discussed the role of the audit committee.


The Higgs Report (2003) focused on the role of the NED.

e) Explain and explore the Sarbanes-Oxley Act of 2002 as an example of a rules- bases approach to corporate governance.

i. Impetus and background: SOX was a reaction to the Enron scandal of 2002. The main reasons why Enron collapsed was over-extension in energy markets, eventually too much reliance on derivatives’ trading which eventually went against the company, breaches of federal law, and misleading and

dishonest behavior. However, the scandal exposed a number of weaknesses in the CG:

Lack of transparency in the accounts. Enron used a number of SPE to keep debt off the books (off balance sheet).

Ineffective CG arrangements. NEDs were weak and there were conflicts of interest (e.g., the chair of the audit committee was Wendy Gramm, whose husband, Senator Gramm, received substantial political donations from Enron.).

Inadequate scrutiny by the external auditors.

Information asymmetry. This is an agency problem when directors/managers know more than the investors. The investors included the employees who tied up their wealth in Enron shares only to see Enron shares become worthless. However, many of Enron directors sold their shares when they began to fall.

Executive compensation methods. This was meant to align the interest of the shareholders and managers.

ii. Main provisions/contents:

The Sarbanes-Oxley Act of 2002 was signed into law on July 30, 2002. The Act contains far-reaching provisions affecting publicly-held companies, their officers and directors, and the independent auditors who audit their financial statements.

1) The Act established the Public Company Accounting Oversight Board (PCAOB) - This Board is charged with overseeing the audits done by public accounting firms. The Board, whose members are appointed by the SEC, has five financially-literate members from the private sector. Two of the members must be or have been certified public accountants. The remaining three must not be and cannot have been CPAs. The Chair may be held by one of the CPA members only if that member has not been a practicing CPA for five years.

The responsibilities of the PCAOB include:

Registering public accounting firms that audit publicly listed companies;

Establishing auditing, quality control, ethics, independence and other standards relating to the preparation of audit reports for issuers;

Conducting inspections of registered public accounting firms, annually for firms that audit more than 100 issuers and every three years for others;

Conducting investigations and disciplinary proceedings and imposing appropriate sanctions;

Enforcing compliance with the Act, the rules of the Board, professional standards, and securities laws relating to audit reports and the obligations of accountants for them; and

Management of the operations and staff of the Board.

2) Prohibited activities to maintain auditor independence - It is unlawful for any registered public accounting firm to provide any non- audit services to an issuer along with the audit. These include:

Bookkeeping or other services related to the accounting records or financial statements of an audit client;

Financial information systems design and implementation;

Appraisal or valuation services, fairness opinions or contribution- in-kind reports, or actuarial services;

Internal audit outsourcing services;

Management functions, broker or dealer, investment adviser, or investment banking services;

Legal services or expert services unrelated to the audit; or











3) Auditor rotation required – The lead audit or coordinating partner must rotate off the audit every five years.

4) Auditor reporting to audit committees – The audit firm must report to the audit committee all critical accounting policies and practices to be used, all alternative treatments of financial information that have been discussed with management, the ramifications of the use of these alternative disclosures and treatments, and the treatment preferred by the firm.

5) Conflicts of interest – The CEO, CFO, and Controller, Chief Accounting Officer or any person in an equivalent position cannot have been employed by the company’s audit firm during the one-year period preceding the audit.

6) Audit committees:

Members of the audit committee shall be members of the board of directors of the issuer but otherwise shall be independent.

The audit committee is to be directly responsible for the appointment, compensation, and oversight of the registered public accounting firm employed to perform the audit.

The audit committee is to establish procedures for the “receipt, retention, and treatment of complaints” received by the issuer regarding accounting, internal controls, and auditing.

The audit committee shall have the authority to engage independent counsel or other advisors as necessary to carry out its duties, and the issuer shall provide appropriate funding to the audit committee

7) Corporate responsibilities:

The CEO and CFO shall prepare a statement that accompanies the audit report to certify the “appropriateness of the financial statements and disclosures contained in the periodic report, and that those financial statements and disclosures fairly present, in

all material respects, the operations and financial condition of the issuer.” A knowing and intentional violation gives rise to personal liability.

Each annual report of an issuer must contain an “internal control report” which states the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting. It must also contain an assessment, as of the end of the issuer’s fiscal year, of the effectiveness of that internal control structure and procedures for financial reporting.

The issuer’s auditor shall attest to and report on the assessment made by the management of the issuer in accordance with standards for attestation engagements issued or adopted by the Board. The auditor’s evaluation should not be a separate engagement or a basis for increased charges or fees.

It is unlawful for any officer or director of an issuer to attempt to fraudulently influence, coerce, manipulate or mislead any auditor engaged in the performance of an audit in order to render the financial statements materially misleading.

If an issuer is required to make a restatement due to material noncompliance with financial reporting requirements, the CEO and the CFO shall forfeit any bonus or other incentive-based or equity-based compensation they have received during the twelve months following the issuance or filing of the document and any profits realized from the sale of securities of the issuer during that period.

Insider trades (purchases or sales) are prohibited during any pension fund blackout periods.

All material off-balance sheet transactions and other relationships with unconsolidated entities that may have a material current or future effect on the financial condition of the issuer are to be disclosed in each annual and quarterly financial report.

Personal loans from an issuer to any director or executive officer are prohibited.

Company insiders must promptly notify the SEC whenever they buy or sell company stock.

8) Directives to the SEC: The SEC was directed to issue rules regarding:

Enhanced disclosure of off-balance-sheet transactions;

An internal control report to be included in each annual report;

Disclosure by each issuer as to whether it has adopted a Code of Ethics for its senior financial officers, and the contents of that Code.

Disclosure by each issuer as to whether at least one member of its audit committee is a “financial expert.”

Revised regulations concerning disclosure on Form 8-K to require immediate disclosure of any change in, or waiver of, an issuer’s Code of Ethics. Furthermore, issuers must disclose information on material changes in their financial condition or operations on a rapid and current basis.

9) Whistleblowing provisions:

Employees of issuers and accounting firms were extended “whistleblower protection” that would prohibit their employers from taking actions against them. Whistleblowers were also granted a remedy of special damages and attorney’s fees.


iii. Effects of:

There are about 1500 non US companies, including many of the world’s largest that list their shares in the US. These companies therefore need to be in compliance with SOX.

There is criticism that SOX conflicted with local CG customs, and following intense round of lobbying from outside the US, changes to the rules were secured. For example, German employee representatives, who are non-management, can sit on audit committees, and AC do not have to have board directors if the local law says otherwise, as it does in Japan and Italy.

Also, since the US is such an influence overseas, SOX may influence certain jurisdictions to adopt a more rules-based approach.

Describe and explore the objectives, content and limitations of, corporate governance codes intended to apply to multiple national jurisdictions.

i. OECD report of 2004: The objective of OECD is to encourage development in the world’s economy. The principles of OECD are the minimum for corporate governance since the confidence of the investors is dependent on the quality of corporate governance in companies whose shares are traded on the stock market.

Principles are:

To assist governments of countries to improve the legal, regulatory and institutional framework for corporate governance in their countries, and

Provide guidance to stock exchanges, investors and companies on how to implement best practice in corporate governance.

ii. ICGN report of 2005: The ICGN is a voluntary association of major institutional investors, companies, financial intermediaries and other organizations. Its aim is to improve corporate governance practices around the world, in all countries where institutional investors seek to invest.

The principles of ICGN are similar to those of OECD, in that they deal with transparency and disclosure, rights and responsibilities of the shareholders, and the role structure of the board of directors.

Limitations of International Codes or Statements of Principles

There are several limitations to these international codes:

Because they apply to all countries they can only be general principles. They cannot be detailed guidelines and because they are not detailed, they are of limited practical value.

The main objective is to raise standards of corporate governance in the ‘worst’ countries. They are of less value in countries where corporate governance is well established, such as in Europe, USA, etc.

Unlike national laws and codes, there is no regulatory authority to force compliance.

7. Corporate governance and corporate social responsibility

a) Explain











Corporate social responsibility (CSR) refers to the responsibilities that a company has towards society. CSR can be described decision-making by a business that is linked to ethical values and respect for individuals, society and the environment, as well as compliance with legal requirements.

CSR is related to the idea that as well as their responsibilities to shareholders, boards of companies are also responsible to the general public and other stakeholder groups.

Carroll’s model of social responsibility suggests there are four ascending levels of social responsibility. Lower levels should be generally addressed first, although true responsibility can only be demonstrated with reference to all four.

Companies have economic responsibilities to

shareholders who require a good return on their investment, to employees who want fair employment conditions and reasonable wages, to customers who want value for money, the suppliers who want to get paid on time and others.

2) Legal responsibilities: Companies have an obligation to respect society’s moral views as expressed in legislative codes. Obeying these laws must be the foundation of an organization’s compliance with social responsibilities.

1) Economic responsibilities:

3) Ethical responsibilities: Apart from compliance with legal requirements, companies should act in a fair and just way even if the law does not compel them to do so.

4) Philanthropic responsibilities: According to Carroll, these are desirable requirements as opposed to mandatory. They include charitable donations and contributions to local community projects.

The principles of CSR. There are five main aspects.

1) A company should operate in an ethical way, and with integrity.

2) A company should treat its employees fairly and with respect.

3) A company should demonstrate respect for human rights. For example, a company should not tolerate child labor.

4) A company should be a responsible citizen in its community.

5) A company should do what it can to sustain the environment for future generations. This could take the form of:

Reducing pollution of the air, land or rivers and seas.

Developing a sustainable business, whereby all the resources used by the company are replaced.

Cutting down the use of non-renewable (and polluting) energy resources such as oil and coal and increasing the use of renewable energy sources (water, wind).

Re-cycling of waste materials.

b) Discuss and critically assess the concept of stakeholders and stakeholding in organizations and how this can affect strategy and corporate governance.

The concept of corporate citizenship and corporate social responsibility is consistent with a stakeholder view of how a company should be governed. A company has responsibilities not only to its shareholders, but also to its employees, all its customers and suppliers, and to society as a whole.

In developing strategies for the future, a company should recognize these responsibilities. The objective of profit maximization without regard for social and environment responsibilities should not be acceptable.

Problems of dealing with stakeholders: When dealing with stakeholders, certain problems could arise, such as:

Dealing with stakeholders may be time consuming and expensive.













There may be a conflict between company and stakeholders on certain issues when they are trying to collaborate.

Full consensus is difficult or impossible to achieve and the solution may not be strategically desirable.

Social Responsibilities can impact what companies do in a number of ways, such as:

Objectives and mission statements. A company that publicizes a mission statement and mentions its social objectives is a sign that the board believes that they have a significant impact on strategy.

Ethical code of conduct. Having a code a conduct is a way for the company to signify its pursuit of good corporate behavior.

Corporate social reporting and social accounts. As part of social responsibility, a company may decide to report on its ethical and social conduct, or possibly produce social accounts showing quantified impacts on each of the organization’s stakeholder constituencies.

Corporate governance. Impacts on CG could include representatives from key stakeholder groups on the board, or perhaps even a stakeholder board of directors.

c) Analyze and evaluate issues of ‘ownership,’ ‘property,’ and the responsibilities of ownership in the context of shareholding.

This is based on the idea that as a shareholder, you have to not only consider the return you get on the share but you need to also consider your responsibility as a

shareholder to society as a whole. This means that as a shareholder, you should be insisting that those managing the company carry out a policy that is consistent with the public welfare.

Problem with this theory is the great dispersion of shareholders. This means that shareholders with small percentages holdings have negligible influence on managers.

The idea of ownership responsibility has had a significant influence because of the importance of institutional investors. Not only do they have a level of shareholdings that can be used to pressure managers, but they also have a fiduciary responsibility as trustees on behalf of their investors.

d) Explain the concept of the organization as a corporate citizen of society with rights and responsibilities.

Corporate citizen of society is a business strategy that shapes the values underpinning a company’s mission and the choices made each day by its executives, managers and employees as they engage with society. Three core principles define the essence of corporate citizenship, and every company should apply them in a manner appropriate to its distinct needs (Boston Center for Corporate Citizenship):

1) Minimizing harm.

2) Maximizing benefit.

3) Being accountable and responsive to stakeholders.

Matten suggested the following three views of Corporate Citizenship:

1) Limited view – A limited approach, restricted to local charitable donation and sponsorship of local community projects or activities where he positive PR is seen as justifying the expense.

2) Equivalent view – This is a wider approach – partly voluntary (local activities), partly imposed by legislation (e.g., requirements to comply with EPA regulations and CG codes). CSR activities are focused on a wider class of stakeholders, based on meeting economic, legal and ethical requirements.

3) Extended view – Organizations adopt an active social citizenship approach based on respect for the citizen’s rights and the idea of the social contract. Under the extended view, organizations will promote:


Social rights – for example, decent working conditions no matter what the legal requirements are.


Civil rights – for example, employees right to join a trade union.


Political rights – for example, allowing employees to be active in politics.

8. Governance: reporting and disclosure

a) Explain and assess the general principles of disclosure and communication with shareholders.

The general principles of disclosure and communication are covered under the Turnbull report.

The original Combined Code in 1998 included provisions relating to the responsibility of the board for the effectiveness of the system of internal control and risk management. The Turnbull Committee was established by the Institute of Chartered Accountants in England and Wales (ICAEW), and was given the task of providing guidelines to companies about this aspect of the Combined Code. The Turnbull Report was published in 1999.

General principles of disclosures:

Here are the disclosure requirements:

The governing body acknowledges responsibility for the system of internal control;

An ongoing process is in place for identifying, evaluating and managing the significant risks;

An annual process is in place for reviewing the effectiveness of the system of internal control;

There is a process to deal with the internal control aspects of any significant problems disclosed in the annual report and accounts.

What information should be disclosed? There are three main categories of information that investors need from a company.

Financial information about the past performance of the company, its financial position and its future prospects.

Information about the ownership of shares in the company, and voting rights associated with the shares. This is important for global investors, who may have problems with investing in companies where there is a majority shareholder, or where there is a complex structure of share ownership, or where some shareholders have more voting rights than other shareholders.

Corporate governance information. This is explained in more detail later.

There are several basic principles for disclosure and communication of information.

The information should be reliable.

Information should be understandable.

Information should be timely.

When information is disclosed by companies, it should be equally available to all investors. The OCED Principles state that the way information is distributed should enable users to access relevant information in an equal, timely and cost-efficient manner.











The opportunities for exploiting confidential information to make a personal profit should be minimized. By making information available to investors quickly, opportunities for insider dealing should be reduced.

b) Explain









Annual reports must convey a fair and balanced view of the organization. They should state whether the organization has complied with governance regulations and codes. It is considered best practice to give specific disclosures about the board, internal control reviews, going concern status and relations with stakeholders.

CG codes recommend that the annual reports of listed companies should state the extent to which the company has complied with relevant laws, regulations and CG codes, the areas of non-compliance and reasons for such non-compliance.

Recommended disclosures include:


Information about the board of directors.











Remuneration Committee.



An explanation of directors’ and auditors’ responsibilities in relation to the accounts.


Details of the external auditors, noting any changes and steps taken to ensure auditor objectivity and independence when non-audit services have been provided.


A statement from the directors as to the effectiveness of internal controls, including risk management.


A statement on relations with, and dialogue with shareholders.



A statement that the company is a going-concern.



A sustainability report, including the nature and extent of social, ethical, health and safety and environmental management policies and procedures.

Good disclosure helps reduce the gap between the information available to directors and the information available to shareholders, and addresses one of the key difficulties of the agency relationship between directors and shareholders.


c) Define








corporate information in normal reporting cycle.

Mandatory means that it is required by the government and by the accounting standards. For example, companies have to disclose:

Statement of Income (Comprehensive income).

Statement of Cash flow.

Financial position.

Auditor’s report.

Statement of going concern.












Directors’ remuneration.

Voluntary can be defined as any disclosure above the mandated minimum. This is information is not required to be published but often is because it gives stakeholders information that they like to see.

Statement of risk.

The chairman’s statement.

Statement of social and environmental report.

Segmental data, etc.

Advantages to disclosing information voluntarily.

Wider information provision. Would give stakeholders a better idea of the environment within which the company is operating and how it responds to its environment.

Different focus of information.

d) Explain and explore the nature of, and reasons and motivations for, voluntary disclosure in a principles-based reporting environment (compared to, for example, the reporting regime in the USA).

Voluntary disclosure can be defined as any disclosure above the mandated minimum. Examples include the CEO’s report, a social/environmental report, additional risk or segmental data.

Disclosing information voluntarily, going beyond what is required by law or listing rules can be advantageous for the following reasons:


Wider information provision. Going beyond should give shareholders a better idea of the environment within which the company is operating and how it is responding to that environment. This enables investors to carry out a more informed analysis of strategies that the company is pursuing, and reducing information asymmetry between directors and shareholders.


Different focus of information. Voluntary information can focus on future strategies and objectives, giving readers a different perspective to compulsory information that tends to be focused on historical accounting data.


Assurance about management. Gives investors another yardstick to judge the performance of management. Demonstrates managements concern for all aspects of company performance.


Consultation with equity (institutional) investors. The voluntary disclosures a company makes can be determined by consulting with major equity investors, such as institutional shareholders on what disclosures they would like to see in the accounts.

The UK government set the process when trying to decide what voluntary disclosures to include.

o The process should be planned and transparent, and communicated to everyone responsible for preparing the information.


The process should involve consultation within the business and with shareholders and other key groups.


The process should ensure that all relevant information should be taken into account.


The process should be comprehensive, consistent and subject to review.

e) Explain and analyze the purpose of the annual general meeting and extraordinary general meetings for information exchange between board and shareholders.

The AGM (Annual General Meeting) is the most important formal means of communications. Governance guidance suggests that boards should actively encourage shareholders to attend the AGM.

Hampel report contains recommendations on how the AGM can be used to enhance communications with shareholders:

Notice of AGM and related papers sent to shareholders at least 20 days before the AGM, and held at least once a year.

Companies should provide business presentation at the AGM, with Q&A sessions.

Chair of the key sub-committees should be available to answer questions.

Shareholders should be allowed to vote separately on each substantially separate issue. “Bundling” unrelated proposals in a single resolution should cease.

Companies should propose a resolution at the AGM relating to the report and accounts.

The UK stewardship code 2010, emphasizes the importance of institutional investors attending AGMs and using their votes, to translate their intention into practice. Also, institutional investors should provide their clients with details of how they’ve voted.

Codes with international jurisdictions, such as OECD principles, emphasize the importance of eliminating impediments to cross-border voting. Cross- border voting is a problem in Europe. Problems include:


Communication problems, and


Also, legal uncertainty as to who actually is entitled to determine how the votes on the shares are cast.


Describe and assess the role of the proxy voting in corporate governance.

A shareholder has the right to vote.

However there may be a case where the shareholder cannot be at the meeting to vote, so the shareholder appoints an agent (proxy) the right to vote on his/her behalf.

There are rules governing the use of proxies, such as


Does the proxy have to be a member (part of management),


Does the proxy has the right to speak, and

o When can the proxy vote.

Proxy form can allow the shareholder either to instruct the proxy how to vote on some or all the motions, or nominate someone attending the meeting (often a director) to exercise the shareholders’ vote at his discretion.

A problem is that unless the proxy card is very elaborately worded, it cannot anticipate all the possible amendment to the resolution(s) sent out in the notice of meeting.


If a substantial amendment is carried, the proxy’s authority to vote is unaffected, but he/she no longer has instructions as to how he/she should vote.


The proxy should exercise his/her discretion in whatever fashion he/she honestly believes is likely to reflect the wishes of the shareholder.

B. Internal Control and Review

1. Management control systems in corporate governance

a) Define and explain internal management control.

Control is defined as:

….“any action taken by management to enhance the likelihood that established goals and objectives will be achieved. Controls may be preventive, directive or directive. The concept of a system of control is the integrated collection of components and activities that are used by an organization to achieve its goals and objectives.”

Turnbull Report defined control as:

The policies, processes, tasks, behaviors and other aspects of the company taken together:

Help operate effectively and efficiently. These operational controls should allow the company to respond in an appropriate way to significant risks to achieving the company’s objectives. ‘This includes the safeguarding of assets from inappropriate use or loss and fraud and ensuring that liabilities are identified and managed.’

Help ensure the quality of external and internal financial reporting (financial controls).

Help ensure the compliance with applicable laws and regulations, and also with internal policies for the conduct of business (compliance controls).

Explain internal management control:

A theorist called Emmanuel states that any control system has 4 characteristics.

1) There has to be a set the objectives. The purpose of all control systems is to try and guide the organization towards desired goals and objectives.

2) There has to be a plan. In a typical accounting control system – a plan is prepared – the budget.

3) Have to be able to measure the results. The output from the process is compared against the standard.

4) Have

take corrective action. Any deviations (variances) must be



The Cynbernetic control model has 6 key stages:


2) Setting targets.

3) Measure outputs.

4) Comparing achievements with targets.

5) Identifying corrective action.

6) Implementing corrective action.

Identification of system objectives.

The Turnbull Guidelines state that a sound system of internal control should:

Be embedded in the operations of the company and form a part of its culture.

Be capable of responding quickly to risks as they evolve.

Include procedures for reporting significant weaknesses and failures of control to the appropriate level of management.

Limitations of internal controls:

IC can only provide reasonable assurance, not a guarantee.

There is the possibility of management override of controls.

There is the possibly of collusion between 2 or more employees to commit fraud.

There is the possibility that a mistake happening.

The costs outweigh the benefits of implementing the controls.

Poor judgment in decision-making.

b) Explain and explore the importance of internal control and risk management in corporate governance.

A company’s system of internal control has a key role in the management of risks that are significant to the fulfillment of its business objectives. A sound system of internal control contributes to safeguarding the shareholders’ investment and the company’s assets.

The board of directors is responsible for the effectiveness of the system of internal control and risk management and there should be regular review of internal control and risk management. The board has to delegate responsibility for implementing controls.

Organizations need to develop risk management strategies in order to deal with the potential for losses. How it deals with potential losses is by having strong internal controls.

Internal control facilitates the effectiveness and the efficiency of operations, helps ensure the reliability of internal and external reporting and assists compliance with laws and regulations.

Effective financial controls, including the maintenance of proper accounting records, are an important element of internal control. They help ensure that the company is not unnecessarily exposed to avoidable financial risks and that financial information used within the business and for publication is reliable. They also contribute to the safeguarding of assets, including the prevention and detection of fraud.

Turnbull emphasizes that internal controls need to be changed and reviewed to take account of an organization’s changing environment. A sound system of internal control therefore depends on a thorough and regular evaluation of the nature and extent of the risk to which the company is exposed. Since profits are, in part, the reward for successful risk-taking in business, the purpose of internal control is to help manage and control risk appropriately rather than to eliminate it.

Benefits vs. costs. It can sometimes be difficult to estimate the benefit arising from having an internal control until such time as an organization suffers a loss from not having such an internal control.

Turnbull states that in order to determine its policies in relation to internal controls and decide what constitutes a sound system of internal control, a board should consider the following:


The nature and extent of the risks facing the company.


The categories of risk deemed acceptable.


The likelihood of risks materializing.


The company’s ability to reduce the negative consequences of risks that do materialize.


The costs of operating the controls vs. the benefit obtained in managing the risk.

c) Describe the objectives of internal control systems.

Based on the Turnbull guidelines, an internal control system encompasses the policies, processes, tasks, behaviors and other aspects of a company that, taken together:

1) Facilitate its effective and efficient operation by enabling it to respond appropriately to significant business, operational, financial, compliance and other risks to achieving the companies’ objectives. This includes the safeguarding of assets from inappropriate use or loss and fraud and ensuring that liabilities are identified and managed.

2) Help ensure of internal and external reporting. This requires the maintenance of proper records and processes that generate a flow of timely, relevant and reliable information from both within and outside the organization.

3) Help ensure compliance with applicable laws and regulations, and also internal policies and procedures with respect to the conduct of business.

d) Identify, explain and evaluate the corporate governance and executive management roles in risk management (in particular the separation between responsibility for ensuring that adequate risk management systems are in place and the application of risk management systems and practices in the organization).

The board has overall responsibility for risk management as it is an essential part of its corporate governance responsibilities.

Responsibilities below board level will depend on the extent of delegation to line managers and whether there is a separation of risk management function.

The board responsibility:

Helps to determine risk management strategy and has a monitoring function regarding risks.

Set appropriate policies on internal controls and seeks assurances that the internal control system is functioning effectively.

Needs to communicate the organization’s strategy to employees.

The CEO:

Has ownership of the risk management and internal control system.

Has to consider the risk and control environment, focusing on how to promote the right culture.

Should also monitor other directors and senior staff, particularly those whose actions can put the company at significant risk.

The Risk Management Committee:

Boards also need to consider whether there should be a separate board committee, with responsibility for monitoring and supervising risk identification and management.

o If the board does not have a separate risk management board, then the audit committee will be responsible for risk management.

e) Identify and assess the importance of the elements or components of internal control systems.

Based on COSO, there are five components of internal control. These are:

1) Control Environment.

2) Risk Assessment.

3) Control Activities.

4) Information and Communication.

5) Monitoring.

In the following we discuss each component in more detail.

Control Environment:

The control environment provides the foundation for all the other components, influencing the control consciousness of all the people in the organization. It sets the tone for the entire organization.

There are seven primary principles behind building a solid control environment. These seven principles are:

1) Having integrity and ethical values. Integrity and ethical values have to be set by top management and the board. As the saying goes: “Employees do as management does, not as they say.”

2) Having a commitment to financial reporting competencies. This means having the right people in the right positions.

3) Having the right human resource policies and procedures. Proper human resource management is making sure the company has the right policies and procedures to help facilitate control over company operations.

4) Properly assigning decision-rights.

5) Understanding management’s philosophy and operating style. This means having the “right tone at the top.”

6) Having proper board and audit committee oversight. Proper oversight is making sure the goals of the board and audit committee are in line with the goals of management.

7) Having the right organizational structure.

Note: The mnemonic is IC HAMBO.

Internal controls are more likely to function well if management believes that the controls are important and communicates that support to employees at all levels. If management believes controls are meaningless or even an obstacle, employees will notice this attitude. And in spite of formal policies saying otherwise, employees will then view internal controls as “red tape” to be “cut through” to get the job done.

Organizations with effective control environments set a positive “tone at the top.”

They transmit guidance both verbally and by example, communicating the entity’s values, standards and code of conduct, and they follow up on violations. There are mechanisms to encourage employee reporting of suspected violations, and disciplinary actions are taken when employees fail to report them.

They foster a “control consciousness” by setting formal and clearly communicated policies and procedures that are to be followed at all times, without exception, and which result in shared values and teamwork.

They specify the competence level needed for particular jobs, hire and retain competent people, and assign authority and responsibility appropriately.

The board of directors is responsible for setting corporate policy and for seeing that the company is operated in the best interest of shareholders. The attention and direction provided by the directors is critical. The board consists of both inside and outside directors who have adequate expertise and who are active and involved. Independence from management is critical, so that if necessary, difficult and probing questions will be raised.

A company’s organizational structure is key to its ability to achieve its objectives because the organizational structure provides the framework for all its activities.

Aspects of establishing an organizational structure include:

Defining the key areas of authority and responsibility and delineating reporting lines.

The company’s organizational structure should be whatever suits its needs. It may be centralized or decentralized. It may have direct reporting relationships or reporting may be more like a matrix. It may be organized by industry, product line, geographical location or distribution network, or it may be organized functionally.

Authority and responsibility should be delegated to the extent necessary to achieve the organization’s objectives.

The control environment is influenced by the fact that all individuals in the organization realize that they will be held accountable.

Risk Assessment:

Within the control environment, management is responsible for the assessment of risk. A risk is anything that endangers the achievement of an objective. The questions should always be asked: What could go wrong here? What assets do we need to protect?

Risk assessment is the process of identifying, analyzing, and managing the risks that have the potential to prevent the organization from achieving its objectives. Assessment of risk involves determining the volume of transactions and the average dollar amount per transaction, the dollar value of assets that are exposed to loss, as well as the probability that a loss will occur.

The company’s objectives must be established before the risks can be assessed. Risk assessment forms the basis for determining how the risks (external or internal) should be managed.

External risks include changes in technology, changes in the market in which an entity operates, new legislation bringing new requirements, natural disasters, economic changes, a failure of a key supplier, or being sued, defrauded, or robbed.

Internal risks include employee embezzlement accompanied by falsification of records to conceal the theft, lack of compliance with government regulations, or other illegal acts by employees, such as taking a bribe. They can include disruption in computer systems, poor management decisions, errors, or accidents. Changes in management responsibilities can affect control activities, and an ineffective board or audit committee may leave openings for fraudulent actions on the part of anyone in the organization.

Control Activities:

After the risks have been assessed, controls should be designed to limit the risk. To accomplish this, control activities are implemented. Control activities are the policies that address the identified risks and the procedures that ensure that management directives are carried out, thus helping ensure that the organization’s objectives will be achieved. Thus, controls should be designed to limit risk, wherever risk exposure is determined to exist, for the purpose of protecting the organization’s ability to achieve its objectives.

This risk could be in the form of loss of assets, or it could be a misstatement of accounting or management information. The identified risks cannot be completely eliminated, but designing appropriate control activities and ensuring that those control activities are implemented can minimize them.

In addition, management must comprehend laws and regulations imposed on the organization from the outside and ensure that compliance policies and procedures are in place.

Control activities can be preventive, to avoid the occurrence of an unwanted event; detective, to detect the occurrence of an unwanted event; directive, to ensure the occurrence of a desirable event; or corrective, to correct an occurrence of an

undesirable event. A control activity can also be compensating, to compensate for what appears to be a weakness in controls.

Preventive: Segregation of duties, suitable authorization of transactions, checking creditworthiness of customers before goods are shipped. These may be “yes/no” controls that check if a certain condition exists.

Directive: For example, managers of a construction company instructing project managers to hire