BEST PRINCIPLES OF CORPORATE GOVERNANCE

Advanced Audit and Assurance, Strategic Case Study / By

BEST PRINCIPLES OF CORPORATE GOVERNANCE

I believe you will agree with me when I say Corporate governance principles play a major role in an organisation’s ability to gain a competitive advantage in the industry and become successful.

Well, this statement is not just a myth but true in reality and you can relate to this as an individual.

And in today’s post, I am going to explain exactly these Corporate governance principles and how they help an organisation to gain competitive advantage.

So you will ask: “what are the principles of Corporate Governance?”

CORPORATE GOVERNANCE is the system of rules, practices and processes by which a company is directed and controlled. Corporate governance principles essentially involve balancing the interests of a company’s many stakeholders, such as shareholders, management, customers, suppliers, financiers, government and the community.

SOME ELEMENTS OF CORPORATE GOVERNANCE

  • Risk management: A need for a new look

Boards of directors are increasingly willing to take firm managerial action to mitigate the downside risks of strategic change. In February of 2005, for example, the directors of Hewlett Packard suddenly removed Carly Fiorina as CEO because of her management of the risks and slow progress of the complex HP-Compaq merger.

  • Effectiveness and Efficiency
    Good governance means that the processes implemented by the organization to produce favourable results meet the needs of its stakeholders while making the best use of resources – human, technological, financial, natural and environmental – at its disposal.
  • Accountability
    Accountability is a key tenet of good governance. Who is accountable for what should be documented in policy statements. In general, an organization is accountable to those who will be affected by its decisions or actions as well as the applicable rules of law.
  • Equity and Inclusiveness
    The organization that provides the opportunity for its stakeholders to maintain, enhance, or generally improve their well-being provides the most compelling message regarding its reason for existence and value to society.
  • Rule of Law
    Good governance requires fair legal frameworks that are enforced by an impartial regulatory body, for the full protection of stakeholders.
  • Transparency
    Transparency means that information should be provided in easily understandable forms and media; that it should be freely available and directly accessible to those who will be affected by government policies and practices, as well as the outcomes resulting therefrom; and that any decisions are taken and their enforcement are in compliance with established rules and regulations.
  • Responsiveness
    Good governance requires that organizations and their processes are designed to serve the best interests of stakeholders within a reasonable timeframe.

 SYMPTOMS OF POOR CORPORATE GOVERNANCE

  • Domination by a single individual

A feature of many corporate governance scandals has been boards dominated by a single senior executive with other board members merely act as a rubber stamp.  Sometimes the single individual may bypass the board to action his own interests. This can result in management and directors awarding themselves remuneration and company perks that do not align with company performance or shareholder interests. This is an inherent problem in agency theory.

  • Lack of involvement of the board

Boards that meet irregularly or fail to consider systematically the organization’s activities and risks are clearly weak. Sometimes the failure to carry out proper oversight is due to lack of information being provided.

  •  Lack of adequate control function

Another potential weakness is a lack of adequate technical knowledge in key roles, for example in the audit committee or in senior compliance positions. A rapid turnover of staff involved in accounting or control may suggest inadequate resources and will make control more difficult because of a lack of continuity.

  • Lack of supervision

Employees who are not properly supervised can create large losses for the organization through their own incompetence, negligence or fraudulent activity. The behaviour of Nick Leeson, the employee who caused the collapses of Barings bank was not challenged because he appeared to be successful, whereas he was using unauthorized accounts to cover up his large trading losses. Leeson was able to do this because he was in charge of dealing and settlement, a system’s weakness of lack of segregation of key roles that featured in other financial frauds.

  • Lack of independent scrutiny

External auditors may not carry out the necessary questioning of senior management because of fears of losing the audit, and internal audit does not ask awkward questions because the Chief Financial Officer determines their employment prospects. Often corporate collapses are followed by criticisms of external auditors, such as the Barlow Clowes affair were poorly planned and focused audit work failed to identify illegal use of client monies.

  • Lack of contact with shareholders

Often, board members grow up with the company and lose touch with the interests and views of shareholders. One possible symptom of this is the payment of remuneration packages that do not appear to be warranted by results.

  • Emphasis on short-term profitability

Emphasis on success or getting results can lead to the concealment of problems or errors, or manipulation of accounts to achieve desired results.

  • Misleading accounts and information

Misleading figures are often symptomatic of other problems (or are designed to conceal other problems) but clearly poor quality accounting information is a major problem if markets are trying to make a fair assessment of the company’s value. Giving out misleading information was a major issue in the Enron scandal as discussed previously.

CORPORATE GOVERNANCE THEORIES

The debates about the place of governance are founded on four differing views associated with the ownership and management of organisations. These theories include:

  • Stewardship theory

This theory means that management is the steward of the assets of the organization and good governance requires active participation from all members. Management will act primarily as stewards of the organization.

  • Stakeholder theory

This means that management has a duty of care to the organization, its owners, and to its wider stakeholders.

  • Agency theory

This means that management will act in an agency capacity, seeking to serve their own self-interest and looking after the performance of the company only where its goals are co-incident with their own. Agency theory aims to ensure that managers pursue effectively shareholders’ best interest.

  • Transaction cost theory

This theory means the way the company is organized or governed determines its control over transactions. Management will be opportunistic. Like agency theory, transaction cost theory aims to ensure that management effectively pursues shareholders’ best interest.

STAKEHOLDERS

Stakeholders can be defined as anyone affected by the organisation. It’s important to know who your stakeholders are and what they want, because if the stakeholders are unwilling to cooperate you may find it difficult to put a strategy into action.

 Stakeholders include:

  • Shareholders
  • Employees
  • Managers/directors
  • Suppliers
  • Customers
  • Competitors
  • The government
  • The local community

Stakeholders can be classified as:

  • Internal Directors: managers and employees
  • Connected Shareholders: lenders, suppliers, customers
  • External: Government, local populace, pressure groups, trade unions, non-governmental organisations, regulatory agencies.

BOTTOM LINE?

Corporate governance is about ensuring that companies are run well in the interests of their shareholders and the wider community. The following points explain gives us an idea

  • The need to improve corporate governance came to prominence in the

The UK in the 1980s, following the high profile collapses of a number of large companies (Maxwell, Polly Peck, BCCI, etc.).

  • Poor standards of corporate governance had led to insufficient controls being in place to prevent wrongdoing in the US in the 1990s, as demonstrated by the collapses at Enron and WorldCom.
  • The authorities internationally have now been working for a number of years to tighten up standards of corporate governance.
  • Good corporate governance is particularly important for publicly traded companies because large amounts of money are invested in them, either by ‘small’ shareholders or from pension schemes and other financial institutions.
  • The well-publicised scandals mentioned above are examples of abuse of the trust placed in the management of publicly traded companies by investors. This abuse of trust usually takes one of two forms (although both can happen at the same time in the same company):

– The direct extraction from the company of excessive benefits by management, e.g. large salaries, pension entitlements, share options, use of company assets (jets, apartments etc.)

– manipulation of the share price by misrepresenting the company’s profitability, usually so that shares in the company can be sold or options ‘cashed in’.

DEVELOPMENT OF CORPORATE GOVERNANCE

The need for regulation of how companies are run in a Good Corporate Governance manner came to implementation in the year 1991 in the UK.

During the 1990s in the UK, there were three separate committees set up to consider aspects of corporate governances which each produced a report.

These were:

The Cadbury Report in 1992, which focused on the control functions of boards and on the role of auditors

The Greenbury Report in 1995, which focused on the setting and disclosure of directors’ remuneration

The Hampel Report in 1998, which brought together the previous recommendations and submitted a proposed code to the Stock Exchange which listed companies, should comply with.

The Stock Exchange published the final version of its ‘Principles of good governance and code of best practice’ (known as the Combined Code) in June 1998. Listed companies now have to disclose how they have applied the principles and complied with the Code’s provisions in their annual report and accounts. The auditors have to express an opinion on this statement.

Then the Financial Reporting Council in June 2010 revised and renamed the code as The U.K. Corporate Governance Code. Which applies to all quoted entities and every entity must report on:

  • How it has applied the code
  • Whether or not; if not why?

THE UK COMBINED CODE

There are 45 ‘code provisions’ which include the following:

Board members

  • The roles of Chair of the Board and Chief Executive should be separated unless the company publicly justifies reasons for not doing so
  • The identification of a senior independent director
  • Not less than one-third of the board comprises non-executive directors
  • The majority of non-executive directors should be independent

Board structure and function

  • There should be a nominations committee (unless the board is small)
  • The formalisation of the role of Chairman in ensuring that all directors are properly briefed on issues arising at board meetings
  • The audit and remuneration committees must only be of non-executive directors
  • Directors should, at least annually, conduct a review of the effectiveness of the group’s system of internal controls and should report to shareholders that they have done so.

Remuneration of directors

  • Performance-related elements should form a significant proportion of the total remuneration package

Conduct of AGMs

  • Announcement of proxy votes at AGMs
  • Unbundling of resolutions
  • sending out the notice of the AGM and the related voting papers at least 20 working days before the meeting

There is also a requirement that companies consider:

  • A reduction of the notice period of directors to one year or less
  • Early termination arrangements
  • The extent to which the principal shareholders should be contacted about directors’ remuneration
  • Whether the remuneration report should be voted on at the AGM

GOVERNANCE PRINCIPLES

Most corporate governance codes are based on a set of principles founded upon ideas of what corporate governance is meant to achieve. This is based on a number of reports.

1) To ensure adherence to and satisfaction of the strategic objectives of the organisation, thus aiding effective management.

2) To minimize risk, especially financial, legal and reputational risks, by ensuring appropriate systems of financial control are in place, systems for monitoring risk, financial control and compliance with the law.

3) To promote integrity, that is straightforward dealing and completeness.

4) To fulfil responsibilities to all stakeholders and to minimize potential conflicts of interest between the owners, managers and wider stakeholder community.

5) To establish clear accountability at senior levels within an organisation. However, one danger may be that boards become too closely involved with day-to-day issues and do not delegate responsibility to management.

6) To maintain the independence of those who scrutinize the behaviour of the organisation and its senior executive managers.

Independence is particularly important for non-executive directors, and internal and external auditors.

7) To provide accurate and timely reporting of trustworthy/independent financial and operational data to both the management and owners/members of the organisation to give them a true and balanced picture of what is happening in the organisation.

8) To encourage more proactive involvement of owners/members in the effective management of the organization through recognizing their responsibilities of oversight and input to decision-making processes via voting or other mechanisms.

Organisation for Economic Co-operation and Development

OECD PRINCIPLES OF CORPORATE GOVERNANCE:

  1. The right to shareholders:

Shareholders should have the right to participate and vote in general meetings of the company elect and remove members of the board and obtain relevant and material information on a timely basis. Capital markets for corporate control should function in an efficient and timely manner.

2) The equitable treatment of shareholders:

All shareholders of the same class of shares should be treated equally, including minority shareholders and overseas shareholders impediments to cross-border shareholding should be eliminated.

3) The role of stakeholders:

Rights of stakeholders should be protected. All stakeholders should have access to relevant information on a regular and timely basis. Performance-enhancing mechanisms for employee participation should be permitted to develop. Stakeholders, including employees, should be able to freely communicate their concerns about illegal or unethical relationships to the board.

4) Disclosure and transparency:

Timely and accurate disclosure must be made of all material matter regarding the company, including the financial situation, foreseeable risk factors, issues regarding employees and other stakeholders and governance structure and policies. The company approach to disclosure should promote the provision of analysis or advice that is relevant to decisions by investors.

5) The responsibilities of the board:

The board is responsible for the strategic guidance of the company and for the effective monitoring of management. Board members should act on a fully informed basis, in good faith, with due diligence and care and in the best interest of the company and its shareholders. They should treat all shareholders fairly. The board should be able to exercise independent judgement; this includes assigning independent non-executive directors to appropriate tasks.

WHAT IS THE PURPOSE OF OECD PRINCIPLES?

The OECD Principles of Corporate Governance are intended to:

  • assist Member and non-Member governments in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate governance in their countries
  • to provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance.

 

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