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Syllabus overview - contents

• Governance and responsibility• Internal control and review• Identifying and assessing risk• Controlling risk• Professional values and ethics

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Syllabus overview – important points

• Importance of study guide (studies & revision)

• Importance of skills levels:– Level 1: Knowledge and comprehension

(Knowledge module) e.g. ‘list’, ‘define’, ‘identify’, ‘calculate’

– Level 2: Application and analysis (skills module) e.g. ‘contrast’, ‘explain’, ‘discuss’

– Level 3: Synthesis and evaluation (professional level) e.g. ‘construct’, ‘evaluate’, ‘assess’, ‘formulate’, or ‘advise’.

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Syllabus overview – exam structure• 15 minutes reading time• Section A:

– 50 marks compulsory scenario based questions

– All areas of syllabus, ethics always– Includes 4-6 professional marks for degree

of professionalism in answer – not content• Section B:

– 3 short scenario based questions of 25 marks each

– Two questions to be attempted

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Scope of Corporate Governance

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Objectives/learning outcomes• Define and explain the meaning of CG [2]• Explain and analyse the issues raised by the joint stock

company [3]• Analyse purposes and objectives of CG [2]• Explain and apply in context of CG, the key

underpinning concepts [3]• Explain and evaluate the roles, interests and

claims of stakeholders CG [3]• Explain and assess the major areas of organisational

life affected by issues in CG [3]• Analyse and discuss the role and influence of

institutional investors in CG [2]

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What is corporate governance?

“The system by which

organisations are directed and controlled”

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Objectives

Shareholder

Ownership

Directors

Control

Why do we need good corporate governance?

Objectives

Company

=/

delegate

Joint stock company is now dominant business form

Ownership and control is separate in joint stock company

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Why do we need good Corporate Governance? – company collapses

• BCCI (Unscrupulous management with no controls), (1991)

• Barings (Bank with no controls), (1995)

• Enron (Autocratic leadership trying to hide losses by boosting confidence in the company, plus a culture of success at all costs), (2001)

• WorldCom (Autocratic leadership trying to hide losses), (2002)

• Parmalat (Autocratic leadership trying to hide losses from auditors), (2003)

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Common themes in company collapses?

• Autocratic leadership• Flagrant disregard for the

rules• Shareholders’ and lenders’

interests being ignored• Little or no controls,

including the role of the external auditor

• Attempts to “talk the company up” instead of working to improve performance

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Key corporate governance concepts

ConceptDefinition Applicability to CGFairness All shareholders treated

equally

Openness/ Full disclosure of

Transparency information

Independence NEDs & auditors should be free from company

Probity/ Upright actions

Honest

Responsibility Take charge of Directors responsible for

actions running company

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Key corporate governance concepts

ConceptDefinition Applicability to CGAccountability Obligation to

report actions

Reputation If CG practices are weak

reputation is damaged

Judgement Directors must be able to

make sound judgements

Integrity Good moral &

ethical principles

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Stakeholders in CG - definition ‘Any group or individual who can affect or be

affected by the achievement of an org objectives’ Examples include:

Employees Directors Shareholders Local community Govt and its institutions Customers suppliers

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Impact of stakeholders on CG & strategy

• Different stakeholders have different & conflicting interests

• Company should prioritize its stakeholders• Stakeholders may affect strategy regarding:

– Pricing– Remuneration, health & safety at work– Environmental costs– Dividends– Product quality

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Categories of stakeholders• Internal (employees & magt) Vs

external (customers)• Narrow (most affected –

employees, magt, customers, s/holders) Vs wide (govt, community)

• Primary (needed for survival) Vs secondary

• Active (participate) Vs inactive (govt, s/holders, community)

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Categories of stakeholders• Voluntary (employees, magt) Vs

involuntary (environment, future generations, local communities, competitors)

• Legitimate (active economic relationship – magt, suppliers) Vs illegitimate (terrorists, lobby groups?)

• Recognised (claim legitimate) Vs unrecognized

• Known about Vs unknown (nameless sea creatures, undiscovered species)

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Stakeholder claims

• Are demands on the organisation– Direct claims made by those with a ‘voice’

e.g. trade unions, shareholders, employees, customers and suppliers

– Indirect claims made by the voiceless (natural environment), powerless (small customer), not yet existing (future generations) and those remote from org

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Stakeholder mapping – Mendelow’s theory of stakeholder power

Level of interest (how much they care)

Low

High

High

Power (ability to influence

Low

Keep satisfied (e.g. institutional shareholder)

Minimal effort (e.g. govt) keep informed (e.g. community reps)

Key players (e.g. major customer)

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Stances on responsibilities towards stakeholders – Donaldson & Preston• Normative view of stakeholders (norm)

– Considers ethical & philanthropic responsibilities– Motivation is internal satisfaction, not external gain– Accepts moral duty to sustain social cohesion– Decision is seen as an end in itself, no ulterior motives

• Instrumental view of stakeholders (instruments)– Considers economic responsibilities – maximisation of

shareholder value– Decision taken if it enhances achievement of objectives– Motivation is external reward, no moral obligations– Stakeholders seen as instruments in achieving goals

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Institutional investors & CG

• Examples include pension houses, insurance companies & mutual funds

• Significant impact on CG due to:– Significant shareholdings, hence voting

power– Obligations to those whose funds they invest– Better understanding of governance issues

than individual investors

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Other org areas affected by corporate governance

Financial reporting FS to provide balanced

assessment Independent relationship

with auditors Annual report to include

responsibilities of auditors & directors

Shareholders To be provided with FS &

notice of meetings Should have regular dialogue

with company (institutional investors)

Should make considered use of their votes

AGM should be made good use of

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Conclusion – scope of CG

• Main points– Meaning and need for good CG– CG terms and concepts– Stakeholders in CG (types, categories and

claims)– Stakeholder mapping - Mendelow’s matrix– Attitudes towards stakeholders [normative

and instrumental view]

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Agency relationships & theories

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Objectives/learning outcomes• Define agency theory [2]• Define and explain the key concepts in agency

theory [2]• Explain and explore the nature of the principal-

agent relationship in the context of CG [3]• Analyse and critically evaluate the nature of

agency accountability in agency relationships [3]• Explain and analyse the following other theories

used to explain aspects of the agency relationship – i) Transaction costs theory– ii) Stakeholder theory

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Key concepts of agency theory• Agent – party that performs a task on behalf of another• Principal – party that employees an agent to perform a

task on their behalf• Agency – relationship between agent & principal• Agency costs:

– Costs incurred to align interests of principal & agent e.g. profit related bonuses, share options, & contractual penalties

– Costs incurred to monitor what agent is doing e.g. audit costs

• Stakeholders – parties with interest in org• Accountability – agent accountable to principal• Fiduciary responsibility – agent is trustee of principal:

– Must act in best interest of principal– Should not make secret profit

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Principal – agent relationships & CG

Principal - Shareholders

Task - Manage co.

Agent -Directors

Employs

Performs

Agent -Directors

Agent -Directors

Agent -Auditor

Task –Audit FS

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Principal – agent relationship & CG• Recent corporate failures due to

dysfunctional principal-agent relationships• Conflict of interests between principal and

agent causes the ‘principal – agent problem’ (e.g. Enron collapse)

• Conflict of interests caused by separation of ownership from control in joint stock co.

• CG codes & statutory regulations intended to solve the ‘principal - agent problem’

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Other accountabilities in a company

Principal Agent ResponsibilityDirectors Managers

Employees Perform given tasks

Creditors Management

Auditors Audit FS & report

Directors’ accountability is demonstrated via:FS & other reportsOther dialogue mechanisms e.g. with institutional investorsAGM

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Other theories that underpin agency theory• Stakeholder theory

– Shareholders are not the only stakeholders– Govt., employees, customers, suppliers also have

say in a company, creating principal – agent relationship

– Directors accountable to all stakeholders• Transaction costs theory

– Transaction costs normally incurred when one party is responsible to another e.g. supplier to customer

– Agency relationship exists between directors & shareholders because of transaction costs (motivation & co-ordination costs)

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Conclusion – agency theory

• Main points

– Meaning and importance of agency

– Main agency relationship in company

– Principal – agent problem

– Other theories that support agency theory

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Different approaches to regulating corporate governance

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Objectives/learning outcomes• Describe and compare the essentials of ‘rules’ and

‘principles’ based approaches to CG; discuss the concept of ‘comply or explain’ [3]

• Describe and analyse the different models of business ownership [2]

• Describe and critically evaluate the reasons behind the development and use of codes of practice in CG

• Explain and briefly explore the development of CG codes in principles-based jurisdictions [2]

• Describe and explore the objectives, content and limitations of, CG codes intended to apply to multiple national Jurisdictions – OECD & ICGN [2]

• Explain and explore the Sarbanes-Oxley Act (2002) as an example of a rules-based approach to corporate governance [2]

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Rules based approach to CG• CG regulated by rules • Focuses on ‘letter of the law’ (box

ticking), rather than ‘spirit of the law’• E.G. US Sarbanes-Oxley Act 2002• Advantages:

– Acceptability of behaviors clearly defined– Compliance likely to be prevalent– Reduces discretion of managers/auditors

• Disadvantages:– Ill-equipped for new circumstances– Compliance punitive to SMEs

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Sarbanes – Oxley (Sarbox) Act 2002

• Introduced in USA in 2002 following collapse of Enron & WorldCom

• Effect of Sarbox– Enforcement easier due to clear definition of

personal responsibilities & punishment– More documentation required on internal

controls

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Main contents of Sarbox• Auditor independence (Other services

restricted, partner to be rotated every 5 yrs)• Audit committee (Company disallowed from

trading if no audit committee)• Internal control reports (Annual report to

include report on ICs)• Financial disclosures (FS to be certified by

directors, more disclosures of off-balance sheet transactions)

• Establishment of Public company accounting oversight board –to set audit standards & discipline audit firms

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Principles based approach to CG• CG regulated by principles in codes of best

practice• Compliance with principles is voluntary• Either comply or explain why not• E.g. UK Combined Code• Advantages:

– Harder to circumvent than rules– Can deal with new circumstances

• Disadvantages/limitations:– Non-compliance difficult to enforce– Inconsistent application due to different interpretation

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Development of principles based CG

Combined Code ‘98

Greenbury ’95 -directors’ perks

Cadbury ‘92 -general CG

Turnbull ’98 internal controls

Hampel ’98 – general CG

Smith ’03 – Audit committee Higgs ’03 - NEDs

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Impact of Combined code

• Organisational changes e.g. board make up

• More transparency due to increased disclosure

• Investors more aware of & expect good CG

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CG codes for multiple jurisdictions – OECD principles of CG

• OECD provides international forum to establish & co-ordinate economic policies

• Contents:– Rights of shareholders– Equitable treatment of shareholders– Role of stakeholders in CG– Disclosure & transparency– Responsibilities of the board of

directors

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CG codes for multiple jurisdictions – ICGN Statement on global CG principles

• ICGN set up to develop global CG practices

• Contents of code:– Corporate objectives– Disclosure & transparency– Audit– Boards & remuneration– Duties/rights of

shareholders

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Limitations of international CG codes

• Codes voluntary, not legally enforceable unless included in national statutes

• Parts of codes not applicable due to differences in company ownership models

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Conclusion – approaches to regulating CG

• Main points– Rules based approach (Sarbox)– Principles based approach (combined code)– Codes for multiple jurisdictions (OECD and

ICGN)

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Board of directors

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Objectives/learning outcomes• Explain and evaluate responsibilities of boards of directors [3]• Describe, distinguish between and evaluate the cases for

and against, unitary and two-tier board structures [3]• Describe the characteristics, board composition and types of

directors • Describe and assess the roles and responsibilities of NEDs [3]• Describe and analyse the general principles of legal and

regulatory frameworks within which directors operate on corporate boards[2]

• Define, explore and compare the roles of the CEO and chairman [3]

• Describe and assess the importance and execution of, induction and CPD for directors [3]

• Explain and analyse the frameworks for assessing the performance of boards and individual directors [2]

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Key terms

– Director– Executive director– Non-Executive

director (NED)– Shadow director– MD/CEO– Chairman of

board of directors

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Board of Directors - provisions

1. Chairman/ CEO roles to be separated

2. Balance of EDs and NEDs, at least ½ to be NEDs

3. New directors to be properly briefed/inducted into the company

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Key roles & responsibilities of directorsProvide leadershipRepresent company view

to publicDetermine strategic aimsAppoint MD, chairman,

company sec & directors Monitor managementRisk managementAssess own performance

annually

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Key roles & responsibilities of directorsAcquire resourcesHold regular meetings Submit themselves for re-

election regularly Set formal schedule of

matters for board decisions

If a plc set up audit, remuneration & nomination committees

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Difficulties of boards achieving their roles

• Dependence on magt for info• Dominance by MD/CEO• Occasional meetings mean

directors unfamiliar with each other

• Self review threat in assessing own performance & that of MD

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Board structure

Board structure

Supervisory board

Management board

Unitary Two - tier

Agent -Directors

Single board (EDs & NEDs)

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Board structure – unitary boards• Structure common in UK

& USA• Single board responsible

for both management (EDs) & control (chairman & NEDs)

• All directors have equal legal & executive status & accountability

• All directors owe same duties

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Board structure – unitary boardsAdvantages include:• NEDs bring independent

scrutiny, experience & expertise due to equal status as EDs

• Board dominance reduced• Strategy development

improved due to inclusiveness of board

• Larger single board has more viewpoints than two-tier board

• Board accountability is enhanced as all directors have same duties

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Board structure – two-tier boards• Consists of supervisory &

management boards• Supervisory board led by

chairman responsible for:– Appointment & removal of

magt board– Oversight of magt board &

company

• Magt board led by CEO responsible for day to day running of co. & magt issues

Supervisory

board

Magt board

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Board structure – two-tier boards• Advantages:

– Allows networking with many stakeholders

– Goal congruence enhanced– More objective in decisions

• Disadvantages:– Supervisory board lacks

sufficient info– Too many different views

due to diverse shareholder make-up

– Magt board may lack independence if appointed by supervisory board & vice versa

Supervisory

board

Magt board

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Board composition

Chairman

Sales director

6 NEDsAgent -Directors

CEO/MD

FD/CFO Production director

Technical director

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Roles of NEDs in CG

Roles of NEDs

Strategy development

Risk magt

People – appoint EDs

Scrutinize performance

1) Roles fulfilled thru:General board discussionMembership on board committees

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Threats to independence of NEDs

Threats

Extra perks

Employee in last 5 yrs

Board membership (>9 yrs)

Significant shareholding

Business deals

(within 3 yrs)Family ties

with EDs

Joint/cross

directorships

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Limitations of NEDs in improving CG

Limitations

No independence

Dependence on EDs for info

No business knowledge

No HR issues e.g. induction, appraisal

Limited time

Inability to resist pressure from EDs – e.g. numbers

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Roles of Chairman of board

Roles

Provide Leadership

Comms to public

Ensure info availability

Set board structure

Encourage Stakeholder dialogue

Enhance NEDs participation

Chair meetings

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Roles of CEO/MD

Roles

Strategy execution

Represent employees

Implement ICs

Build magt team

Assist Board selection

Monitor operations

Resource magt

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Induction of directors• Company should

have formal induction program for new directors

• Program to be tailor made

• Activities should be adequate to enable director:– Know business– Link with company’s

people

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Induction of directors• Induction program

activities to include:– Meeting with senior

magt– Visit company sites– Meet employees– Presentations on

company’s products, services, constitution, group structure, risks, assets, liabilities, customer, suppliers, performance indicators & regulations

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CPD for directors• Company should

have formal CPD program for all directors

• Program to be tailor made

• Activities should be adequate to enable director:– Know role of board– Obligations– Conduct as a director

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CPD for directors

• CPD program should update & expand knowledge of:– Soft skills (influencing,

negotiation, board dynamics, chairing meetings)

– Strategy generation– Resource magt– Risk magt

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Performance evaluation of board• Evaluation to be tailor made & done at

least once p.a.• Evaluation to include performance of :

– Board as a whole– Board committees– Individual board members

• Third party may be contracted to enhance objectivity

• Results to be discussed appropriately

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Evaluation of board as a whole

Issues to cover

Objectives met?

Up to date with IT/laws?

Board relationships & comms

Board composition

Crisis magt

Info available? Effective risk magt

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Evaluation of directors

Issues to cover

Preparedness for meetings

Diplomacy

Relations with others

Contribution to strategy

CPD activities

Value of expertise to co.

Understanding co.

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Legal & regulatory frameworks for directors – rights & responsibilities

• Duties defined in company constitution, CA 2006 & common law

• Duty of care & skill:– Act to the best of their ability– Act as a reasonable person in that position

• Fiduciary duties– Avoid conflicts of interest (disclose secret profit)– Act in best interests of members– Use powers for rightful purposes

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• Time-limited appointments– All directors to

retire at first AGM– Subsequently a

third to retire by rotation annually

– Directors to be re-elected every 3 yrs

Legal & regulatory frameworks for directors

• Service contracts– Includes key

dates, duties, remuneration, termination & ordinary employment terms

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• Disqualification:– No involvement in

company magt– Court or

constitution gives grounds

– Grounds include wrongful& fraudulent trading & breach of CA 2006

Legal & regulatory frameworks for directors

• Insider dealing/trading– Illegal purchase or

sale of shares by insider (e.g. director)

– Criminal offence

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Conclusion – boards of directors

• Main points– Meaning and importance of directors in CG– CEO and board chairman– Executive directors and NEDs– Importance of NEDs in CG– Assessment of board performance– Unitary and two-tier boards– Induction and CPD for directors

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Board committees and

Directors’ remuneration

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Objectives/learning outcomes• Explain and assess the importance, roles and

accountabilities of, board committees in CG [3]• Explain and evaluate the role and purpose of various

committees in effective CG [3]• Describe and assess the general principles of

directors’ remuneration [3]• Explain and assess the effect of various components

of remuneration packages on directors’ behaviour [3]• Explain and analyse the legal, ethical, competitive and

regulatory issues associated with directors’ remuneration [3]

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Board committees

Remuneration Nomination Risk

Role Risk magt

Composition Mostly NEDs

Accountable Board or to audit

committeeImportance ensure board

In CG balance

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Responsibilities of remuneration committee

• Set remuneration policy for directors & senior magt

• Set detailed remuneration for directors & senior magt & agree compensation for loss of office of EDs

• Ensure that provisions of statutes & codes of ethics are met

• Report directors’ remuneration to shareholders

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Responsibilities of nominations committee

• Review board composition regularly

• Review balance of skills on board

• Succession planning for directors

• Devise job descriptions for board

• Recommend nominations & reappointment

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Responsibilities of risk committee

• Set the risk policy

• Advise board on risk magt issues

• Review system of internal control & recommend improvements

• Reinforce control consciousness through risk magt & internal control activities

• Ensure appropriate disclosures are made as per IFRS and CA 2006

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Remuneration – general principles• Remuneration includes basic salary, bonuses,

share options, pension & other economic benefits• Purposes of remuneration policy:

– Attract employees to company– Retain employees– Motivate employees

• Determinants of remuneration:– Nature of job– Skills of employee– Performance of employee in job– Market rates (pay higher, same as or lower than)– Employee’s overall contribution to strategy

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Remuneration – general principles

• Remuneration strategy should consider:– Mix of cash & benefits in kind e.g. childcare,

holiday, company car & medical schemes– Short term goal congruence e.g. profit related bonus

– Long term loyalty e.g. share based payments gratuity & pension

– Availability of cash

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Directors’ remuneration - components

Components

Basic salary

Benefits in kind

Shares & share options

Performance - related

Loyalty bonusGoal congruence

Attract & motivate

Retention

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Directors’ remuneration – other issues

Other issues

Legal - compensation

Regulatory – disclosure & increase in package

Competitive - adequacy

EthicalFat cat pay Underperforming co.Effect on package

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Conclusion – scope of CG

• Main points– The need for board committees– Roles of remuneration, nomination and risk

committees– Importance of fair remuneration for directors– General principles of directors’ remuneration– Components of directors’ remuneration

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• Corporate social responsibility (CSR) and reporting and disclosure

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Objectives/learning outcomes• Explain and explore social responsibility in the context of CG

[2]• Explain the concept of the organisation as a corporate citizen of

society with rights and responsibilities [3]• Explain and assess the general principles of disclosure and

communication with Shareholders [3]• Explain and analyse ‘best practice’ CG disclosure

requirements [2]• Distinguish between mandatory and voluntary disclosure [2]• Explain and explore the nature of, and reasons and

motivations for, voluntary disclosure in a principles-based reporting environment [3]

• Explain and analyse the purposes of the AGM and EGM [2]• Describe and assess the role of proxy voting in CG [3].

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Social responsibility• Meaning – consideration & managing

impact of organisation on stakeholders• Doing more than legal requirements• Stakeholders in CSR:

– Environment– Employees– Shareholders– Suppliers– Customers– Local community

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Classes of CSR (why engage in CSR)

Classes of corporate social responsibilities:– Legal & economic (Basic, clear-cut operational

responsibilities e.g. for products, jobs & economic growth – required for survival)

– Ethical (Responsibilities to stakeholders e.g. employees, environment & customers beyond legal and economic needs)

– Philanthropic (Newly-emerging responsibilities for major & general social problems e.g. poverty & disease)

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Examples of CSR

• Limiting pollution even if no regulations exist

• Making products to ensure recycling is possible

• Making food menus healthier even if current menus are legal

• Equal opportunities for all, even if discrimination is not illegal

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Organisation as a corporate citizen

• Organisation considered a citizen

• A citizen has rights & responsibilities

• Expectations of companies’ CSR have grown

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Governance: reporting & disclosure

• Disclosure of info required by shareholders to make investment decisions

• AGM & Annual Report major media for disclosure

• Chairman & NEDs encouraged to dialogue with major shareholders

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Importance of dialogue/disclosure of info

• Directors understand interests & concerns of shareholders

• Shareholders understand what company is trying to do

• Increased shareholder interest enhances accountability of magt

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Best practice disclosure requirements

• Financial & operating results• Company objectives• Major share ownership • Directors’ details &

remuneration• RP & RPT• Major risks & how they are being managed• Effectiveness of internal controls

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Mandatory Vs Voluntary disclosure

Disclosure

Voluntary – chosen by co.

Mandatory – required by law/rules

E.g. annual accounts & compliance with Combined code

E.g. CSR, environmental policies & compliance therewith

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Benefits of voluntary disclosure in principles based reporting environment

Transparency hinders unethical conduct

Helps in attracting capital

Improves public understanding

Provides additional info to investors

Voluntary disclosure - benefits

Marketing tool

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General meetings & proxy voting• Importance of AGM & EGM

as a means of communication

• Issues dealt with at AGM:– Approval of dividends– Presentation of annual report– Appointment/remuneration

of directors & auditors• Shareholders unable to

attend meeting may appoint rep (proxy) to attend & vote

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Conclusion – CSR and disclosure

• Main points– Meaning of CSR– Why companies engage in CSR– Need for disclosure of info to shareholders– Good practice disclosure requirements– Importance of the AGM and proxy voting in

CG