3.

CORPORATE
GOVERNANCE

ACCA Muhammed Jazeem K. MCOM, PGDM

Objectives and importance of corporate governance
Corporate governance is the system by which companies are directed and controlled. Good
corporate governance is important because the owners of a company and the people who
manage the company are not always the same.

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 pay rise.

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.

Internationally the `Organisation for Economic Cooperation and Development

(OECD) recommends that the countries establish their own code of corporate
governance.

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.

Relevance of corporate governance to external auditors

If company following corporate governance, it will lead to the following: -

 Control environment of the company will be stronger

 Greater reliance on financial reporting and internal controls of the company
 It reduces risk of material misstatement in the financial statements.

ACCA Muhammed Jazeem K. MCOM, PGDM

 UK Corporate Governance Code

1. Leadership
2. Effectiveness
3. Accountability
4. Remuneration
5. Relations with shareholders

Leadership
• Each company should have an effective board who take collective responsibility for
the long-term success of the company. The board should comprise of a balance
between executive directors and non-executive directors.

• There should be clear division of responsibilities between running the board and
the running of the company’s business. 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 to enable them to discharge their respective duties
and responsibility effectively.

• 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.

ACCA Muhammed Jazeem K. MCOM, PGDM

• 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.

ACCA Muhammed Jazeem K. MCOM, PGDM

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 annual 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.

ACCA Muhammed Jazeem K. MCOM, PGDM

Corporate governance in action

ACCA Muhammed Jazeem K. MCOM, PGDM

A.Board composition

Non-executive
directors

 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.

ACCA Muhammed Jazeem K. MCOM, PGDM

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.

ACCA Muhammed Jazeem K. MCOM, PGDM

 B. Committees

1. 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 nonexecutive 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.

2. 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 favor of the same
decisions as them and can therefore influence board decisions which may
not be in the best interests of the company.

3. 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.

4. 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.

ACCA Muhammed Jazeem K. MCOM, PGDM

 C. 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. They 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 chapter ‘Internal audit’.

ACCA Muhammed Jazeem K. MCOM, PGDM

 Audit committee
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.

ACCA Muhammed Jazeem K. MCOM, PGDM

 A.Composition or Membership of audit committees
• A group of independent, non-executive directors.
• The committee should have at least 3 members.
• 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.

B.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

C. 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’).

ACCA Muhammed Jazeem K. MCOM, PGDM

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.

•staff fear that audit committee are purely looking for errors and as a result they fear
losing their job.

•non-executive directors are not full time and not employed by the business may be
overburdened with the information from different people within the company.

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

ACCA Muhammed Jazeem K. MCOM, PGDM

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:

1. 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.

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

3. 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.

4. 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.

ACCA Muhammed Jazeem K. MCOM, PGDM

 Importance of internal controls
and risk management

risks are defined as those events that may occur resulting in an undesirable outcome.
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.

Management of risk

Companies should have a risk management in place that allows them to: -

1. Identify risk
2. Assess risk
3. Put measures in place to manage the risk communicate risks to others in the
business
4. Monitor risk

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.

ACCA Muhammed Jazeem K. MCOM, PGDM

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 prioritized 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 minimizing risk is to incorporate internal controls into a company’s
systems and procedures. in practice internal controls are usually a business first
response to dealing with risks.

Internal controls are put in place by management. An example of an internal control is

a security system which prevents theft which reducing risk.

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.

ACCA Muhammed Jazeem K. MCOM, PGDM

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.

ACCA Muhammed Jazeem K. MCOM, PGDM