Corporate governance

Objectives and importance of corporate governance

 

Corporate governance is the means by which a company is operated and controlled.

 

The aim of corporate governance is to ensure that companies are run well in the interests of their shareholders, employees, and other key stakeholders such as the wider community.

 

The aim is to try and prevent company directors from abusing their power which may adversely affect these stakeholder groups. For example, the directors may pay themselves large salaries and bonuses whilst claiming they have no money to pay a dividend to shareholders. Similarly, they may be making large numbers of staff redundant but awarding themselves a payrise.

 

In response to major scandals (e.g. Enron), regulators sought to change the rules surrounding the governance of companies, particularly publicly owned ones.

 

In the US the Sarbanes Oxley Act (2002) introduced a set of rigorous corporate governance laws. The UK Corporate Governance Code introduced a set of best practice corporate governance initiatives into the UK.

 

Advantages of a company following good corporate governance principles:

 

• Greater transparency

 

• Greater accountability

 

• Efficiency of operations

 

• Better able to respond to risks

 

• Less likely to be mismanaged.

 

Relevance of corporate governance to external auditors

 

If a company complies with corporate governance best practice, the control environment of the company is likely to be stronger. There will be a greater focus on financial reporting and internal controls which should reduce control risk and inherent risk which together reduce the risk of material misstatements in the financial statements.

 

External auditors may be required to report on whether companies are compliant with the Code. For example, in the UK, external auditors of listed entities are required to report on whether the company is compliant with the UK Corporate Governance Code.

 

There is significantly more communication between audit committees and external auditors in the current environment. If the company, including the audit committee, demonstrates good corporate governance, the external auditors have someone with which to share responsibility. This should result in the company taking more responsibility for its actions, the independence of the auditor being greater, and the overall quality of the audit being higher.

Enron

 

In the year 2000 Enron, a US based energy company, employed 22,000 people and reported revenues of $101 billion. In late 2001 they filed for bankruptcy protection. After a lengthy investigation it was revealed that Enron’s financial statements were sustained substantially by systematic, and creatively planned, accounting fraud.

 

In the wake of the fraud case the shares of Enron fell from over $90 each to just a few cents each, a number of directors were prosecuted and jailed and their auditors, Arthur Andersen, were accused of obstruction of justice and forced to stop auditing public companies. This ruling against Arthur Andersen was overturned at a later date but the damage was done and the firm ceased trading soon after.

 

This was just one of a number of high profile frauds to occur at that time.

 

The Enron scandal is an example of the abuse of the trust placed in the management of publicly traded companies by investors. This abuse of trust usually takes one of two forms:

 

• 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’.

 

In response, regulators sought to change the rules surrounding the governance of companies, particularly publicly owned ones. In the US the Sarbanes Oxley Act (2002) introduced a set of rigorous corporate governance laws and at the same time the Combined Code (now called the UK Corporate Governance Code) introduced a set of best practice corporate governance initiatives into the UK.

The Corporate Governance Code

 

The Organisation for Economic Co-operation and Development (OECD) has produced a set of six principles of corporate governance to guide policy makers when setting regulations for their own country.

 

The six OECD Principles are:

 

• Ensuring the basis of an effective corporate governance framework

 

• The rights of shareholders and key ownership functions

 

• The equitable treatment of shareholders

 

• The role of stakeholders in corporate governance

 

• Disclosure and transparency

 

• The responsibilities of the board.

 

The UK Corporate Governance Code reflects the OECD principles. The main requirements of the Code are given below.

 

Leadership

 

• Each company should have an effective board who take collective responsibility for the long term success of the company.

 

• There should be clear division of responsibilities between running the board and the running of the company. No one should have unfettered powers of decision.

 

• The chairman should lead the board and ensure it is effective.

 

• Non-executive directors should constructively challenge and help develop strategy.

 

Effectiveness

 

• The board should have the appropriate balance of skills, experience, independence and knowledge of the company.

 

• Appointment of directors should be made through a formal, transparent and rigorous process.

 

• Directors should allocate sufficient time to discharge their responsibilities.

 

• All directors should receive induction on joining the board and should regularly update and refresh their skills and knowledge.

 

• The board should be supplied with timely information in an appropriate form and quality.

 

• The board should undertake formal and rigorous evaluation of its performance and that of its committees and individual directors.

 

All directors should be submitted for re-election at regular intervals subject to satisfactory performance.

Accountability

 

• The board should present a balanced and understandable assessment of the company’s position and prospects.

 

• The board is responsible for determining the nature and extent of the significant risks it is willing to take in achieving its strategic objectives.

 

• The board should maintain sound risk management and internal control systems.

 

• The board should establish formal and transparent arrangements for maintaining an appropriate relationship with the company’s auditor.

 

Remuneration

 

• Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required but should not pay more than necessary.

 

• Remuneration should be designed to promote the long-term success of the company.

 

• The board should establish formal and transparent procedures for developing the policy for executive directors’ remuneration.

 

• No director should be involved in setting his own pay.

 

Relations with shareholders

 

• There should be dialogue with shareholders based on a mutual understanding of objectives.

 

• The board as a whole has responsibility for ensuring satisfactory dialogue with shareholders takes place.

 

• The board should use general meetings to communicate with investors and encourage their participation.

 

The Code 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 wealth of these companies significantly affects the health of the economies where their shares are traded.

Board composition

 

The board should comprise a balance of executive directors (headed up by the chief executive) and non-executive directors (headed up by the chairman).

 

Having a balanced board will mean that board decisions are not influenced by one group of directors.

 

The roles of the chairman and chief executive officer (CEO) should be held by two separate people to avoid concentration of power.

 

The chairman’s role

 

• Head of the non-executive directors.

 

• Enables flow of information and discussion at board meetings.

 

• Ensures satisfactory channels of communication with the external auditors.

 

• Ensures effective operation of board sub-committees.

 

• The chairman should be independent to enhance effectiveness.

The chief executive’s role

 

• Ensures the effective operation of the company.

 

• Head of the executive directors.

 

Executive directors

 

The executive directors have responsibility for running the company on a day to day basis.

 

Non-executive directors

 

The non-executive directors monitor the executive directors and contribute to the overall strategy and direction of the organisation. Non-executive directors (NEDs) are usually employed on a part-time basis and do not take part in the routine executive management of the company.

 

NEDs will

 

• Participate at board meetings.

 

• Bring experience, insight and contacts to assist the board.

 

• Sit on sub-committees as independent, knowledgeable parties.

 

At least half the board, excluding the chairman, must be independent non-executive directors. The board should determine whether directors are independent in character and judgment and whether there are relationships or circumstances which are likely to affect, or could appear to affect, the director’s judgment.

 

Independence would be deemed to be affected if a director:

 

• has been an employee of the company or group within the last five years

 

• has, or has had within the last three years, a material business relationship with the company either directly, or as a partner, shareholder, director or senior employee of a body that has such a relationship with the company

 

• has received or receives additional remuneration from the company apart from a director’s fee, participates in the company’s share option or a performance-related pay scheme, or is a member of the company’s pension scheme

 

• has close family ties with any of the company’s advisers, directors or senior employees

 

• holds cross-directorships or has significant links with other directors through involvement in other companies or bodies

 

• represents a significant shareholder

 

has served on the board for more than nine years from the date of their first election.

Advantages of participation by NEDs

 

• Oversight of the whole board.

 

• As they are independent they act as a ‘corporate conscience’.

 

• They bring external expertise to the company. Disadvantages

 

• They, and the sub-committees, may not be sufficiently well-informed or have time to fulfil the role competently.

 

• They are subject to the accusation that they are staffed by an ‘old boy’ network and may fail to report significant problems and approve unjustified pay rises.

 

Enron provides a cautionary note as its audit committee proved incapable of preventing the wrongdoing of the executive directors.

 

Committees

 

Remuneration committee

 

The role of the remuneration committee is to set the remuneration packages for the executive directors. This is to ensure that they are not paid excessive amounts but are paid fairly for their role. The committee will comprise non-executive directors.

 

Advantages:

 

• Decisions are based on agreement of several people, reducing the risk of bribes from directors in return for a higher package.

 

• No director is involved in setting his own pay.

 

• Performance related elements will be included to avoid the risk that directors are rewarded for poor performance.

 

Nomination committee

 

The role of the nomination committee is to decide on appointments of executive directors. This is to ensure the best person for the job is recruited. The majority of this committee should be non-executive directors.

 

Advantages:

 

• Reduces the risk of ‘jobs for the boys’. Executive directors might appoint other directors who they are friends with or used to work with but wouldn’t necessarily have the skills required.

 

• Reduces the risk of improperly affecting board decisions. Executives might appoint people to the board they know will vote in favour of the same decisions as them and can therefore influence board decisions which may not be in the best interests of the company.

Risk committee

 

The risk committee will be responsible for advising the board on the company’s risk appetite, reviewing and approving the risk management strategy and advising the audit committee and board on risk exposures.

 

Audit committee

 

The audit committee will take responsibility for financial reporting and internal control matters. Audit committees are covered in more detail in the next section.

 

Internal audit

 

Internal audit has an important role to play in assisting the board fulfil their corporate governance responsibilities.

 

Internal audit will work closely with the audit committee. The audit committee will:

 

• Ensure that the internal auditor has direct access to the board chairman and to the audit committee and is accountable to the audit committee.

 

• Review and assess the annual internal audit work plan.

 

• Receive periodic reports on the results of internal audit work.

 

• Review and monitor management’s responsiveness to the internal auditor’s findings and recommendations.

 

• Meet with the head of internal audit at least once a year without the presence of management.

 

• Monitor and assess the effectiveness of internal audit in the overall context of the company’s risk management system.

 

The roles and functions of internal audit are covered in the  ‘Internal audit’.

An audit committee is a committee consisting of non-executive directors which is able to view a company’s affairs in a detached and independent way and liaise effectively between the main board of directors and the external auditors.

 

Membership of audit committees

 

• A group of independent, non-executive directors.

 

• The committee should have at least 3 members (2 for smaller companies).

 

• At least one member should have recent and relevant financial experience with an appropriate professional accountancy qualification.

 

• Committee members should be independent of operational management.

 

• Appointments to the audit committee should be made by the board on the recommendation of the nomination committee.

 

• Appointments should be for a period of up to 3 years, extendable by no more than two additional 3 year periods.

 

The objectives of the audit committee

 

• Increasing public confidence in the credibility and objectivity of published financial information (including unaudited interim statements).

 

• Assisting directors (particularly executive directors) in meeting their responsibilities in respect of financial reporting.

 

• Strengthening the independent position of a company’s external auditor by providing an additional channel of communication.

 

The function of the audit committee

 

• Monitoring the integrity of the financial statements.

 

• Reviewing the company’s internal financial controls.

 

• Monitoring and reviewing the effectiveness of the internal audit function.

 

• If no internal audit function is in place, they should consider annually whether there is a need for one and make a recommendation to the board. The reasons for there being no internal audit function should be explained in the annual report.

 

• Making recommendations in relation to the appointment and removal of the external auditor and their remuneration.

 

• Reviewing and monitoring the external auditor’s independence and objectivity and the effectiveness of the audit process.

 

• Developing and implementing policy on the engagement of the external auditor to supply non-audit services.

 

• Reviewing arrangements for confidential reporting by employees and investigation of possible improprieties (‘whistleblowing’).

Benefits

 

• Improved credibility of the financial statements through an impartial review of the financial statements and discussion of significant issues with the external auditors.

 

• Increased public confidence in the audit opinion as the audit committee will monitor the independence of the external auditors.

 

• Stronger control environment as the audit committee help to create a culture of compliance and control.

 

• The internal audit function will report to the audit committee increasing their independence and adding weight to their recommendations.

 

• The skills, knowledge and experience (and independence) of the audit committee members can be an invaluable resource for a business.

 

• It may be easier and cheaper to arrange finance, as the presence of an audit committee can give a perception of good corporate governance.

 

• It will be less of a burden to meet listing requirements if an audit committee (which is usually a listing requirement) is already established.

 

Problems

 

• Difficulties recruiting the right non-executive directors who have relevant skills, experience and sufficient time to become effective members of the committee.

 

• The cost. Non-executive directors are normally remunerated and their fees can be quite expensive.

 

 

FRC Guidance on audit committees

 

• This guidance is designed to assist company boards when implementing the Corporate Governance Code.

 

• Companies with a premium listing are required to comply with the Code or explain why they have not done so.

 

• Audit committee arrangements should be proportionate to the task and will vary according to size and complexity of the company.

 

• There should be a frank, open working relationship and a high level of mutual respect between audit committee chairman and board chairman, the chief executive and the finance director.

 

• Management is under an obligation to ensure the audit committee is kept properly informed. All directors must cooperate with the audit committee.

• The core functions of audit committees are oversight, assessment and review. It is not the duty of the audit committee to carry out functions that belong to others. For example, they should make sure there is a proper system in place for monitoring of internal controls but should not do the monitoring themselves.

 

• The board should review the audit committee’s effectiveness annually.

 

The audit committee should:

 

• Receive induction and training for new members and continuing training as required.

 

• Hold as many meetings as the roles and responsibilities require and it is recommended that no fewer than three meetings are held.

 

• Meet the external and internal auditors without management at least annually to discuss any issues arising from the audit.

 

• Report to the board on how it has discharged its responsibilities.

 

• Ensure the interests of the shareholders are properly protected in relation to financial reporting and internal control.

 

• Review and report to the board on the significant financial reporting issues and judgments in connection with the preparation of the financial statements.

 

• Consider the appropriateness of significant accounting policies, significant estimates and judgments.

 

• Receive reports from management on the effectiveness of systems and the conclusions of any testing carried out by internal and external auditors.

 

• Review the systems established by management to identify, assess, manage and monitor financial risks.

 

• Monitor and review the effectiveness of the company’s internal audit function. Where there is no internal audit function the audit committee should consider annually the need for one and make a recommendation to the board.

 

• Review whistleblowing arrangements by which staff of the company may raise concerns about possible improprieties in financial reporting and other matters, in confidence.

Annual report

 

A separate section of the annual report should describe the work of the committee. Specifically:

 

• A summary of the role of the audit committee.

 

• The names and qualifications of all members of the audit committee during the period.

 

• The number of audit committee meetings.

 

• The significant issues that the committee considered in relation to the financial statements and how these issues were addressed.

 

• An explanation of how it has assessed the effectiveness of the external audit process and the approach taken to the appointment or reappointment of the external auditor.

 

• If the external auditor provides non-audit services, how auditor objectivity and independence is safeguarded.

 

• Where there is a disagreement between the audit committee and the board which cannot be resolved, the audit committee should have the right to report the issue to shareholders as part of its report within the annual report.

 

• The chairman of the audit committee should be present at the AGM to answer questions.

 

External audit matters

 

The audit committee is responsible for making a recommendation on the appointment, reappointment and removal of the external auditors.

 

FTSE 350 companies should put the audit out to tender at least once every ten years to enable the audit committee to compare the quality and effectiveness of the services provided by the incumbent auditor with those of other firms.

 

The audit committee should:

 

• Annually assess and report to the board on the qualification, expertise and resources, and independence of the external auditors and the effectiveness of the audit process.

 

• Investigate reasons for the resignation of the external auditor and consider whether any action is required.

 

• Assess the independence and objectivity of the external auditor annually.

 

• Set and apply a formal policy specifying the types of non-audit service which are pre-approved, require approval or are not allowed.

 

• Agree a policy for employment of former employees of the external auditor taking into account the Ethical Standards, paying particular attention to people who were part of the audit team. The audit committee should consider whether there has been any impairment of the auditor’s independence and objectivity in respect of the audit.

 

• Monitor the external audit firm’s compliance with ethical standards relating to partner rotation and fee levels.

 

5         Auditor reporting responsibilities

 

ISA (UK) 700 requires the auditor to report by exception in the auditors’ reports of companies disclosing compliance with the UK Corporate Governance Code where the annual report includes:

 

• A statement given by the directors that they consider the annual report and accounts taken as a whole is fair, balanced and understandable and provides the information necessary for shareholders to assess the entity’s performance, business model and strategy, that is inconsistent with the knowledge acquired by the auditor in the course of performing the audit.

 

• A section describing the work of the audit committee that does not appropriately address matters communicated by the auditor to the audit committee.

 

• An explanation, as to why the annual report does not include such a statement or section, that is materially inconsistent with the knowledge acquired by the auditor in the course of performing the audit.

 

• Other information that, in the auditor’s judgment, contains a material inconsistency.

 

Other countries may have different reporting requirements in accordance with local legislation and regulations.

 

Risk management in practice

 

Companies face many risks, for example:

 

• The risk that products may become technologically obsolete.

 

• The risk of losing key staff.

 

• The risk of a catastrophic failure of IT systems.

 

• The risk of changes in government policy.

 

• The risk of fire or natural disaster.

 

Companies need mechanisms in place to identify and then assess those risks. In so doing, companies can rank risks in terms of their relative importance by scoring them with regard to their likelihood and potential impact. This could take the form of a ‘risk map’.

 

A risk map enables the company to assess the likelihood or probability of a risk occurring and the likely impact to the company if it does happen.

Once identified and assessed, the company must decide on appropriate ways to manage those risks.

 

Risk management can involve:

 

• Transferring the risk to another party e.g. by taking out insurance or outsourcing part of the business.

 

• Avoiding the risk by ceasing the risky activity.

 

• Reducing the risk by implementing effective controls.

 

• Accepting the risk and bearing the cost and consequence if the risk happens. This may be likely for risks which are deemed low in terms of probability or impact on the company.

 

A risk that ranked as highly likely to occur and high potential impact on the business would be prioritised as requiring immediate action. A risk that was considered both low likelihood and low impact might be ignored or insured against.

 

Internal controls and risk management

 

One way of minimising risk is to incorporate internal controls into a company’s systems and procedures.

 

Director’s responsibilities in respect of risk

 

It is the director’s responsibility to implement internal controls and monitor their application and effectiveness.

 

The risks considered by management are numerous. They come from both external, environmental sources and internal, operational ones. The main aim of risk management is to protect the business from unforeseen circumstances that could negatively impact the profitability of the company and stop it achieving its strategic goals.

 

Auditor’s responsibilities in respect of risk

 

Auditors are not responsible for the design and implementation of their clients’ control systems. Auditors have to assess the effectiveness of controls for reducing the risk of material misstatement of the financial statements. They incorporate this into their overall audit risk assessment, which allows them to design their further audit procedures.

 

In addition to this, auditors are required, in accordance with ISA 265, to report significant deficiencies in client controls and any significant risks identified during the audit to those charged with governance.

 

Corporate governance

 

Test your understanding 1

 

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 café 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:

 

• Explain whether Murray Co is required to comply with a code of corporate governance.

 

• Explain the strengths of Murray Co’s current governance arrangements.

 

• 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.

 

Test your understanding 2

 

You are the audit manager of Tela & Co, a medium sized firm of accountants. Your firm has just been asked for assistance from Jumper & Co, a firm of accountants in an adjacent country. This country has just implemented the internationally recognised codes on corporate governance and Jumper & Co has a number of clients where the codes are not being followed. One example of this, from SGCC, a listed company, is shown below. As your country already has appropriate corporate governance codes in place, Jumper & Co have asked for your advice regarding the changes necessary in SGCC to achieve appropriate compliance with corporate governance codes.

 

Extract from financial statements regarding corporate governance:

 

Mr Sheppard is the chief executive officer and board chairman of SGCC. He appoints and maintains a board of five executive and two non-executive directors. While the board sets performance targets for the senior managers in the company, no formal targets are set for the board and no review of board policies is carried out. Board salaries are therefore set and paid by Mr Sheppard based on his assessment of all the board members, including himself, and not their actual performance.

 

Internal controls in the company are monitored by the senior accountant, although 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:

 

• Explain SIX corporate governance deficiencies in SGCC, and

 

• Recommend the changes necessary to overcome each deficiency.

 

Test your understanding 3

 

Cocklebiddy Co, a listed company, is currently reviewing its corporate governance practices to ensure they are compliant with regulations. The following is a description of the corporate governance policies they have in place:

 

• A remuneration committee comprising 3 non-executive directors.

 

• An audit committee comprising the finance director, the chief executive and 2 non-executive directors.

 

• Separate people taking on the roles of chairman and chief executive.

 

• Which of the following best defines Corporate Governance? A Corporate governance refers to the importance a company

attaches to systems and controls.

 

B Corporate governance is the means by which a company is operated and controlled.

 

C Corporate governance is the extent to which a company is audited, both internally and externally.

 

D Corporate governance is an appraisal activity as a service to the entity.

 

• In terms of the structure of the audit committee of Cocklebiddy Co, which of the following actions should be taken to become compliant with corporate governance regulations?

 

A  A minimum of one non-executive director should be recruited

 

B A minimum of one non-executive director should be recruited and the finance director should be removed

 

C A minimum of one non-executive director should be recruited and the finance director and chief executive should be removed

 

D  No action necessary

 

 

• Which TWO of the following are functions of audit committees?

 

• Planning the annual external audit.

 

• Reviewing the effectiveness of internal financial controls.

 

• Reviewing and monitoring the external auditor’s independence.

 

• Processing year-end journal adjustments to the financial statements.

 

• (i) and (iv)

 

• (i) and (iii)

 

• (ii) and (iv)

 

• (ii) and (iii)

 

• Cocklebiddy Co does not currently have an internal audit function. Which of the following summarises the requirements of corporate governance regulations in respect of internal audit?

 

• The audit committee must review the need for an internal audit function on an annual basis

 

• The audit committee must establish an internal audit committee as soon as possible

 

• There must either be an audit committee or internal audit function in place but there is no requirement to have both

 

• The finance director must review the need for an internal audit function and should make a request to the audit committee if it is decided that an internal audit function would be beneficial

 

• Which of the following is the main purpose of the remuneration committee?

 

• To ensure that the costs of the company are kept under control

 

• To ensure no director is involved in setting his own pay and the pay that is set is at an appropriate level

 

• To ensure decision making power for the company is not concentrated in the hands of one individual

 

• To ensure executives are paid a large basic salary irrespective of performance

 

Corporate governance

 

 

6      summary

Test your understanding 1

 

• As Murray Co is not yet listed on a stock exchange, it is unlikely that they are required to comply with a code of corporate governance. They may wish to voluntarily comply in order to send out a positive signal to stakeholders about how the company is managed and governed.

 

Once the company is listed on a stock exchange it will need to become fully compliant.

 

• The company does have some non-executive directors who will bring an independent view to decision making and will have the power to balance the views of the executive directors.

 

They have established an audit committee. This means that there should be a group of people focused on all accounting, financial reporting and auditing matters within the company.

 

There is also a remuneration committee which should bring some independence and fairness into the decisions on salaries and rewards of the directors.

 

(c)

 

Weakness	Recommendation
There are not enough non-	At least three more NEDs need to
executive directors.	be recruited to ensure a balanced
Corporate governance principles	board.
require the board to be balanced,
and currently the executive
directors outweigh the NEDs.
This means that the executives
could ensure all of their proposals
are passed at board meetings
which reduces the effectiveness of
the NEDs.

 

 

Corporate governance

 

	There does not appear to be a	One of the newly appointed NEDs
	chairman.	should be asked to take on the
	Corporate governance principles	role of chairman.
	require that there is a chief
	executive in charge of running the
	company and an independent
	chairman to run the board.
	This is to ensure there is not too
	much power in the hands of one
	person and so these two roles
	cannot be fulfilled by the same
	person.
	The current NEDs do not appear	The two NEDS need to be
	to be independent. The logic for	replaced by independent people.
	NEDs is to being an independent
	view to the board and to feel
	comfortable challenging the
	decisions of the executive
	directors.
	As the two current NEDs are
	related to the CEO, it is unlikely
	they would challenge any of their
	decisions making them ineffective.
	The NEDs appear to have a	All new NED contracts should
	continuous contract.	make it clear that there will be a
	In order to make sure they work in	re-election process every three
		years,
	the company’s best interests, all
	directors should be subject to re-
	election at regular intervals. This
	does not appear to be the case
	here.
	The NEDs have share options as	All new NED contracts should
	part of their remuneration.	have remuneration based on a flat
	Corporate governance principles	fee that is adequate for the role
		but not excessive.
	make it clear that in order to
	maintain their independence,
	NEDs should be paid a flat fee for
	their services and it should not be
	related to company performance.

 

		An executive director sits on the	The HR director should be
		audit committee.	removed from the audit committee
		The sub-committees are meant to	and one of the newly appointed
			NEDs should take their place.
		be independent and so it is
		required that only NEDs sit on the
		audit committee.
		Nobody on the audit committee	When recruiting the new NEDs the
		has financial experience.	company should look for at least
		In order to provide valuable input	one person with a financial
			background to sit on the audit
		into the accounting and auditing
			committee.
		process, at least one member of
		the audit committee should have
		financial experience.
		An executive director sits on the	The finance director should be
		remuneration committee.	removed from the remuneration
		It is a requirement of corporate	committee and one of the newly
			appointed NEDs should take their
		governance principles that no
			place.
		director should be involved in
		setting their own remuneration as	The remuneration committee
		this could lead to excessive pay	should set the salaries for the
		being awarded.	executives and the executives
			should determine the
			remuneration of the NEDs.
		Test your understanding 2
		Why the corporate governance	Recommendation
		code is not met and why this
		may cause problems
		Mr Sheppard is chief executive	Another person should be
		and chairman of the company.	appointed as chairman as this
		Mr Sheppard has too much power	role should be independent.
		over the key decisions of the
		company.
		The board ratio is 5:2 in favour of	Three more non-executive
		the executive directors.	directors should be appointed to
		Executive directors can dominate	balance the board.
		board decisions which may not be
		in the best interests of the
		shareholders.

 

 

	Mr Sheppard appoints all	A nomination committee
	directors to the board.	comprising non-executive
	Mr Sheppard may appoint	directors should be established to
		appoint directors and ensure
	directors who will support his
		there is no bias.
	voting at board decisions.
	There may be no clear and
	transparent process for
	determining appointments.
	Mr Sheppard sets the pay of the	A remuneration committee
	directors as well as setting his	comprising non-executive
	own pay.	directors should be established to
	Mr Sheppard may pay directors	set the pay of the executive
		directors. The committee should
	more if they agree to back his
		make sure the pay is based on
	decisions. He may pay himself
		performance of the company and
	more than he deserves.
		the directors.
	The board’s performance is not	Performance targets should be
	reviewed.	set and performance against
	If performance is not reviewed	these targets monitored on a
		regular basis. Directors should be
	there is no accountability for poor
		required to explain any under-
	performance.
		performance.
	The board may not be as
	effective as it could be at
	maximising shareholder wealth.
	It is believed that the external	An internal audit function should
	auditor monitors the internal	be established to assess the
	controls.	effectiveness of the internal
	The external auditor will only look	controls.
	at controls relevant to the audit but
	this cannot be relied on to
	determine the effectiveness of the
	internal control systems across
	the company.
	There is no audit committee.	An audit committee should be
	Corporate governance codes	established comprising non-
		executive directors and they will
	require an audit committee to be
		be the main point of contact for
	established to take responsibility
		internal auditors and external
	for the oversight of financial
		auditors.
	reporting and audit matters.

 

Test your understanding 3

 

(1)	B	The means by which a company is operated and
		controlled.
(2)	C	The audit committee should comprise 3 non-
		executive directors. The chief executive and finance
		director should not be members of the audit
		committee.
(3)	D	Reviewing the effectiveness of internal financial
		controls and reviewing and monitoring the external
		auditor’s independence.
(4)	A	There is no requirement for a company to have an
		internal audit function. The audit committee should
		review the need for one on an annual basis if the
		company does not have one.
(5)	B	Directors should not be involved in setting their own
		pay. Remuneration should be performance related.
		Remuneration should be sufficient to attract, retain
		and motivate but should not be excessive.