1. Objectives and Importance of Corporate Governance
Corporate governance is the system by which companies are directed and controlled. Its primary goal is to ensure that a company is run well in the interests of its shareholders and other key stakeholders. This helps prevent directors from abusing their power, as seen in high-profile corporate failures like Enron and Carillion.
Advantages of Good Governance
Following good corporate governance principles leads to greater transparency, accountability, and efficiency, making a company better equipped to manage risks and less likely to suffer from mismanagement.
Exam Strategy: Link to Corporate Failures
When discussing corporate governance, always link it back to the reasons for its existence. Referencing real-world failures like Enron and Carillion demonstrates a deeper understanding of why these rules and codes were introduced and why they are so important today.
2. The Corporate Governance Code
The UK Corporate Governance Code, based on principles from the OECD, provides a framework of best practices for companies, especially those that are publicly traded. It operates on a "comply or explain" basis, offering flexibility while promoting high standards. The code is divided into five main parts:
- Board leadership and company purpose: Focuses on the board's role in setting strategy, values, and promoting a positive culture.
- Division of responsibilities: Separates the roles of the chair and chief executive to prevent too much power being held by one person.
- Composition, succession, and evaluation: Emphasizes the need for a diverse and skilled board, with formal and transparent procedures for appointments.
- Audit, risk, and internal control: Details the role of the audit committee in overseeing financial reporting, internal controls, and the external audit process.
- Remuneration: Ensures executive pay is linked to long-term performance and is set by an independent committee.
3. Audit Committees
The audit committee is a key component of good corporate governance. It's a sub-committee of the board, typically made up of independent non-executive directors (NEDs), with at least one member having recent and relevant financial experience. Its primary role is oversight of financial reporting and the audit process.
Roles and Responsibilities
The audit committee is responsible for:
- Monitoring the integrity of financial statements.
- Reviewing and monitoring the effectiveness of both internal and external auditors.
- Making recommendations on the appointment and remuneration of external auditors.
- Developing a policy for non-audit services provided by the external auditor to safeguard independence.
4. Role of External Auditors
External auditors play a crucial role in corporate governance. A company with good governance principles is likely to have a stronger control environment, which reduces the auditor's risk of material misstatement. Auditors are required to assess this environment and report any significant deficiencies to those charged with governance.
In many jurisdictions, auditors are also required to report on a company's compliance with corporate governance codes, highlighting any deviations or inconsistencies they find in the company's annual report.
Test Your Understanding Questions and Solutions
The directors of Murray Co are interested in being able to report that they comply with best practice corporate governance principles and have asked for your thoughts. The finance director has provided you with the following information: The board consists of the chief executive officer, finance director, HR director, production director and sales director. In addition, there are two non-executive directors who were appointed last year by the chief executive as they are his aunt and uncle. Previously they ran their own small cafe and used a firm of accountants for all financial matters due to their own lack of expertise in that area. The contracts signed by the non-executive directors state that they are in place until they decide to leave or unless they are found guilty of misconduct. They receive an annual fee and a number of share options in Murray Co as their remuneration. Since appointment, the two non-executives have formed an audit committee consisting of themselves and the human resources director as it was felt that the finance director would not be an independent member of the committee. They have also formed a remuneration committee with the finance director and are currently in the process of proposing and approving the salaries for all of the directors for the coming year.
Required:
(a) Explain whether Murray Co is required to comply with a code of corporate governance.
(b) Explain the strengths of Murray Co's current governance arrangements.
(c) Identify and explain the weaknesses in Murray Co's current governance arrangements and for each weakness recommend an action the company should take to remedy the weakness.
Solution:
(a) Compliance with a code: As Murray Co is not yet listed, it is not required to comply with a corporate governance code. It may choose to do so voluntarily to signal good governance to stakeholders, which would be beneficial as it plans to list on a stock exchange.
(b) Strengths: The company has taken a positive step by appointing NEDs and establishing an audit committee and a remuneration committee. This demonstrates a commitment to governance principles, even if the current implementation has weaknesses.
(c) Weaknesses and recommendations:
| Weakness | Recommendation |
|---|---|
| The board has more executive directors than NEDs, which can lead to a lack of independent oversight. | Recruit and appoint at least three more independent NEDs to ensure the board is balanced. |
| The NEDs are relatives of the CEO and have a continuous contract, which compromises their independence and tenure. | Replace the current NEDs with independent individuals who are subject to annual re-election. |
| The audit committee includes an executive director (HR director) and the NEDs lack financial expertise. | Remove the HR director and appoint a new independent NED with relevant financial experience. |
| The remuneration committee includes an executive director (finance director), which is a conflict of interest. | The remuneration committee should only consist of independent NEDs to ensure fairness. |
You are the audit manager of Tela & Co, a medium sized firm of accountants. Your firm has just been asked for assistance from Jumper & Co, a firm of accountants in an adjacent country. This country has just implemented the internationally recognised codes on corporate governance and Jumper & Co has a number of clients where the codes are not being followed. One example of this, from SGCC, a listed company, is shown below. As your country already has appropriate corporate governance codes in place, Jumper & Co have asked for your advice regarding the changes necessary in SGCC to achieve appropriate compliance with corporate governance codes.
Extract from financial statements regarding corporate governance:
Jiang Sheppard is the chief executive officer and board chair of SGCC. He appoints and maintains a board of five executive and two non-executive directors. While the board sets performance targets for the senior managers in the company, no formal targets are set for the board and no review of board policies is carried out. Board salaries are therefore set and paid by Jiang Sheppard based on his assessment of all the board members, including himself, and not their actual performance.
Internal controls in the company are monitored by the senior accountant, although a detailed review is assumed to be carried out by the external auditors. SGCC does not have an audit committee or an internal audit department.
Annual financial statements are produced, providing detailed information on past performance.
Required:
(i) Explain SIX corporate governance deficiencies in SGCC, and
(ii) Recommend the changes necessary to overcome each deficiency. (12 marks)
Solution:
| Deficiency | Recommendation |
|---|---|
| Lack of separation of roles: Jiang Sheppard holds both CEO and board chair roles, concentrating too much power. | Appoint an independent NED as chair. |
| Board composition: The board has an imbalance of executive (5) and NED (2) directors. | Appoint at least three more independent NEDs to achieve a balanced board. |
| Lack of formal appointment process: Jiang Sheppard appoints all directors, which lacks transparency and may lead to biased appointments. | Establish a nomination committee with a majority of independent NEDs to manage board appointments. |
| Remuneration issues: Jiang Sheppard sets his own pay and that of other directors, which is a significant conflict of interest and may lead to excessive pay. | Establish a remuneration committee with independent NEDs to set the pay of executive directors and senior management. |
| No performance evaluation: There is no formal review of the board's performance, which removes accountability. | Implement a formal annual performance evaluation for the board and its committees. |
| Lack of oversight of internal controls: There is no audit committee or internal audit function, and internal controls are assumed to be reviewed by external auditors. This is a significant weakness in the risk management framework. | Establish an audit committee of independent NEDs and consider the need for an internal audit function. |