P1-06 Approaches To Corporate Governance

Session 6
Approaches to Corporate
Governance
FOCUS
This session covers the following content from the ACCA Study Guide.
A. Governance and Responsibility

6. Different approaches to corporate governance
a) Describe and compare the essentials of rules- and principles-based
approaches to corporate governance. Includes discussion of "comply or
explain".
b) Describe and analyse the different models of business ownership that
influence different governance regimes (e.g. family firms versus joint stock
company-based models).
c) Describe and critically evaluate the reasons behind the development and
use of codes of practice in corporate governance (acknowledging national
differences and convergence).
d) Explain and briefly explore the development of corporate governance
codes in principles-based jurisdictions.
i) impetus and background
ii) major corporate governance codes
iii) effects of
e) Explain and explore the Sarbanes-Oxley Act (2002) as an example of a
rules-based approach to corporate governance.
i) impetus and background
ii) main provisions/contents
iii) effects of
f) Describe and explore the objectives, content and limitations of corporate
governance codes intended to apply to multiple national jurisdictions.
i) Organisation for Economic Co-operation and Development (OECD)
Report (2004)
ii) International Corporate Governance Network (ICGN) Report (2005)
Session 6 Guidance
Note the commentary made in section 1.1.
Note that the key elements to understand are:
• the differences between principles-based and rules-based approaches and between insider and
outsider systems (s.2);
• the SOX approach (s.4); and
• the OECD approach to developing a broad-based set of corporate governance (CG) principles (s.5).
(continued on next page)

P1 Governance, Risk and Ethics Becker Professional Education | ACCA Course
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VISUAL OVERVIEW
Objective: To assess the factors which influence governance regimes and evaluate
development of different approaches to corporate governance.
DEVELOPMENT OF CODES
• Background
• National Differences
• Convergence
BASIS OF CODES UK CORPORATE SARBANES-OXLEY

GOVERNANCE CODE ACT (2002)
• Principles-Based
• Cadbury (1992) • Rules-Based
• Rules-Based
• Greenbury (1995) Regulation
• Ownership
• Hampel (1998) • Impact
• Insider Systems
• Turnbull (1999) • Key Requirements
• Outsider Systems
• Higgs and Smith • Criticisms
(2003)
INTERNATIONAL
OECD ICGN
• Background • Background
• Principles • Principles
Session 6 Guidance
Read section 3, as this shows how the UK Corporate Governance Code developed (note the
Illustrations).
Read section 5 (OECD) and section 6 (ICGN) to obtain a general understanding. Appreciate that
the OECD is a framework that can be used by a developing nation as the basis for its own code.
© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 6-1

Session 6 • Approaches to Corporate Governance P1 Governance, Risk and Ethics
1 Development of Codes
1.1 Background
 Previous sessions have already indicated that although the
different definitions of corporate governance are compatible,
the way in which corporate governance has developed, and is
applied in different jurisdictions, varies considerably.
 Corporate governance and effective regulation contribute to
the attractiveness of a country (in terms of inward investment
and business development) and also to the efficiency of its
capital markets and their effectiveness in the service of the
real economy.
 The Code of Corporate Governance for Bangladesh (2004)
states: "The obvious function of a Code of Corporate Governance
for Bangladesh is to improve the general quality of corporate
governance practices." The code attempts to do this by:
 defining best practices of corporate governance;
 designing specific steps that organisations can take to
improve corporate governance;
 raising the quality and level of corporate governance to be
expected from organisations;
 specifying more stringent practices than is required by
local law;
 behaviour, other than financial, needed to be provided for;
 increasing market credibility through comparable practices
and standards.
 However, the way of dealing with each element can be
different in each jurisdiction (e.g. what is best practice in one
country may not be considered best practice in another).
Example 1 Influences
Suggest SIX influences on the development of corporate

governance codes.
Solution
1.
2.
3.
4.
5.
6.
6-2 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

P1 Governance, Risk and Ethics Session 6 • Approaches to Corporate Governance
 In any one jurisdiction, the issues surrounding corporate

governance development would include:
 Board independence.
 The diversity, human and social capital within the board.
 Shareholder activism.
 Breadth and depth of public information disclosure and
sharing.
 Independence of the external auditors.
 Competence of the audit committee.
 Presence of internal control systems and support of
whistle-blowing.
 Long-term performance-related incentives.
 Transparent and independent control of the remuneration
committee.
 Transparency/protection for shareholders during mergers/
acquisitions.
 Stakeholder involvement in corporate governance.
 Employee participation in financial outcomes and collective
voice in decision-making.
Illustration 1 Timeline
The following table indicates the timeline for the development of Although a detailed
codes around the world. Many codes have since been updated. knowledge of all the
various codes is not
1992 UK (Cadbury Report leading to Combined Code 1998, expected the P1 exam
renamed UK Corporate Governance Code in 2010)
calls for knowledge
1994 Canada, South Africa (King Report)
1995 Australia, France (e.g. of the Code) and
1997 Japan, US application of "best
1998 Germany, India, Thailand practice". As the
1999 Brazil, Hong Kong, South Korea, OECD, ICGN Sarbanes-Oxley Act
2001 China, Singapore (Singapore Code) of 2002 (SOX), the
2002 US (Sarbanes-Oxley Act) OECD and the ICGN
codes are specifically
mentioned in the
syllabus, they may
1.2 National Differences be referred to in an
 The influences on the development of corporate governance examination question,
codes (discussed in Example 1) have resulted in key national although it is highly
differences between the various corporate governance codes unlikely that you will
(which reflect national and international characteristics), not only be asked for specific
details on a particular
in their approach but also in the language and meaning used.
section of these codes
 As discussed in greater detail below (and in other sessions), (e.g. see Question
key differences include: 4(b) June 2008).
 either a principle- or rules-based approach to corporate
governance codes;
 an insider or outsider ownership influence; and
 a unitary board or tiered board structures.

1.3 Convergence
 Corporate governance on a national basis is appropriate
when investing and financing by companies is on a national
basis. But a set of global requirements should be applicable,
as a minimum, to entities listing or obtaining finance across
borders. Requiring companies which participate in global
capital markets to follow global rules will provide greater
protection to global investors.
 This approach was taken when the development of a set of
international financial standards (IFRS) commenced in the
mid-1970s. After some 40 years, with the programme to
converge US GAAP into IFRS, the concept of a truly global set
of standards (IFRS) looks to become a reality.
 The national differences summarised above provide a
significant hurdle (perhaps an insurmountable hurdle) to be
overcome when considering the convergence of corporate
governance codes.
 However, unlike IFRS, there does not need to be a "one size
fits all" approach to a global corporate governance code. The
key underpinning concepts of corporate governance (see
Session 1) within an appropriate ethical environment should
be able to cater to the different legal structures and cultural
identities that a global corporate governance model requires.
 Both the Organisation for Economic Co-operation and
Development (OECD) and the International Corporate
Governance Network (ICGN) have issued separate sets
of corporate governance principles with the aim that they
can be used to form the core elements of a good corporate
governance regime, which can be adapted to the specific
circumstances of individual countries and regions. These
models are discussed later in this session.
2 Basis of Codes
 Two key elements in the development of corporate governance
codes have been the legal and business cultures of the
jurisdiction in which a company operates. This has resulted in
two basics groupings when considering the basis of corporate
governance guidance:
 principles-based or rules-based; and
 insider or outsider ownership influence.
2.1 Principles-Based Approach

2.1.1 Characteristics
 Focuses on objectives rather than how these objectives might
be achieved.
 Ensures all situations can be covered through applying the
appropriate principle in the code.
 Applicable across different legal jurisdictions. The Code is the
 Flexible and adoptable to different and new situations. primary example of
 Not simply a "box ticking" exercise. a principles-based
corporate governance
 Incorporates a "comply or explain" regime (i.e. state that the code.
code was fully complied with or explain why a requirement of
the code was not applied).*

*This can be a very effective incentive to comply, as the need

to explain and the potential negative effect on the company (e.g.
reduction in share price, adverse publicity) may result in a greater
"cost" than complying. Shareholders and stock markets are entitled
to challenge the explanation for non-compliance.
In South Africa, the King Report III has moved from a "comply
or explain" approach to an "apply and explain" approach. This
approach requires a greater consideration of how a principle or a
recommended practice in King III could be applied. A board may
conclude that applying a recommended practice is not necessarily
in the best interests of the company and apply a different practice
provided that it explains the practice adopted and its reasons for
doing so. This basically means that a requirement from King III
cannot be simply "air-brushed" away in the hope that shareholders
will accept it not being implemented—something relevant has to be
implemented in its place and explained.
Illustration 2 Comply or Explain
The "comply or explain" approach is the trademark of corporate

governance in the UK. It has been in operation since the Code's
beginnings and is the foundation of the Code's flexibility. It is
strongly supported by both companies and shareholders and has
been widely admired and imitated internationally.
The Code is not a rigid set of rules. It consists of principles (main
and supporting) and provisions. The (London Stock Exchange)
Listing Rules require companies to apply the Main Principles and
report to shareholders on how they have done so. The principles are
the core of the Code and the way in which they are applied should
be the central question for a board as it determines how it is to
operate according to the Code.
It is recognised that an alternative to following a provision may
be justified in particular circumstances if good governance can
be achieved by other means. A condition of doing so is that
the reasons for it should be explained clearly and carefully to
shareholders. In providing an explanation, the company should
aim to illustrate how its actual practices are both consistent with
the principle to which the particular provision relates and contribute
to good governance and promote delivery of business objectives.
It should set out the background, provide a clear rationale for
the action it is taking, and describe any mitigating actions taken
to address any additional risk and maintain conformity with the
relevant principle. Where deviation from a particular provision is
intended to be limited in time, the explanation should indicate when
the company expects to conform with the provision.
Whilst shareholders have every right to challenge companies'
explanations, they should not be evaluated in a mechanistic way and
departures from the Code should not be automatically treated as
breaches.
Satisfactory engagement between company boards and investors
is crucial to the health of the UK's corporate governance regime.
Companies and shareholders both have responsibility for ensuring
that ''comply or explain'' remains an effective alternative to a rules-
based system.

2.1.2 Advantages
The rigour with which governance systems are applied can be
varied according to size, situation, stage of development of
business, etc. *Explanations about a
Organisations (in legal terms) choose the extent to which they particular requirement
comply, although they will usually have to "comply or explain" that would not be
in accordance with the relevant listing rules.* cost effective (e.g.
internal audit) are
Obeying the spirit of the law is better than "box ticking". better accepted by
Being aware of overall responsibilities is more important than shareholders and stock
going through a compliance exercise merely to demonstrate markets for smaller
conformance. companies.
Avoids the "regulation overload" of rules-based systems (and
associated increased business costs).*
Self-regulation (e.g. by Financial Reporting Council in the UK)
rather than legal control has proved to underpin investor
confidence.
*The cost of SOX
May be more responsive to changes in the business
compliance has been a
environment and easier to review and update (than rules- cause of considerable
based systems which require tortuous legal processes). concern in the US and
Together with disclosure requirements, the emphasis is placed for foreign companies
on the market to accept or disagree and protest.* listed in New York.
*Compliance in principles-based jurisdictions does not mean

"voluntary". The requirement to "comply or explain" is not a passive
thing—companies must adhere to "comply or explain". In fact, it is
almost the only requirement from the Code. Analysts and other stock
market opinion leaders, however, take a very dim view of significant
breaches, especially in larger companies. Companies are very well
aware of this and "explain" statements, where they do arise, typically
concern relatively minor breaches. However, companies in the UK and
elsewhere may be subject to "listing requirements" which mandate
certain other behaviours for listed companies.
2.1.3 Criticisms
The principles set may be too broad as to give guidance to
best practice.
Where the principles are tightly drafted, they may be regarded
as rules "via the back door".
For companies seeking a listing, there may be confusion over
what is or is not compulsory. Companies may conclude that
despite the "comply or explain" approach, they will have to
comply with all the requirements.
The effectiveness of the approach depends on a company's *Although the Code is
drive for complying with it, whether it is due to corporate law, principles-based, the
regulatory authorities or listing standards.* requirement to follow
There needs to be a high level of transparency with coherent it is stipulated in the
and focused disclosures, as well as a mechanism for rules-based regulatory
shareholders to hold company boards accountable. environment of the
Stock Exchange Listing
Companies not complying with the principles might be seen by Rules.
some investors in the same light as companies breaking rules.

Example 2 Developing Countries

Suggest reasons as to why a principles-based approach to corporate governance may be
preferable in developing countries.
Solution
2.2 Rules-Based Approach

2.2.1 Characteristics
 Focuses on definite achievements rather than underlying The primary example
factors and/or principles. of a rules-based
 Prescribed set of requirements. approach is the
 Emphasis placed on obeying the letter of the rule. Sarbanes-Oxley Act
(2002) enshrined in
 Can ensure compliance through adopting a checklist approach. US corporate law.
 Clear distinction between compliance and non-compliance
("yes/no").
 Easy for oversight to ensure that rules have been followed.
 Black/white with no shades of grey in between.
2.2.2 Advantages
One set of rules applies to all companies. Every company
knows exactly what is required and all stakeholders know
what the rules are.
The rules are legally binding and enforceable in law.
Non-compliance is punishable by fines or ultimately (in
extremis) by delisting and director prosecutions. This might
deter companies from illegal business practises.
Greater government control may promote confidence in the
system.
2.2.3 Criticism
One set of rules applies to all companies, even though rules
for some companies may not be relevant and will involve *In getting the various
significant cost beyond any benefit obtained. bank crisis bailout
Rules tend to be rigid and may not cover all possibilities, thus packages through
leaving gaps to be exploited. Companies may design systems the US Congress,
and procedures specifically to exploit such gaps. the lawmakers had
to accept various
The effectiveness of the approach depends on a company's amendments from
drive for applying, whether due to corporate law, regulatory a number of US
authorities or listing standards. congressmen which
Unless the penalties for non-compliance are severe, some had nothing to do with
rules may be ignored. banks or the crisis.
This was the only way
Lack of flexibility in updating the rules. A legal process will be they could be certain
required, which will take time and often means the process is of getting the required
undertaken by lawmakers who may not fully understand the level of support from
needs of companies and stakeholders or will push their own Congress.
interests.*

2.3 Ownership
 A country's corporate governance system will be affected by:
 how companies finance themselves; and
 the structure of corporate ownership.
 In many European countries, in Latin-influenced countries (e.g.

South America) and in Asia, publicly listed companies tend to
be owned by a small number of major shareholders. These are
usually members of the company's founding families or a small
group of shareholders such as banks or the government. These
organisations are referred to as "insider systems".
 In the Anglo-Saxon (sometimes referred to as Anglo-American)
world (e.g. UK, US, Canada, Australia) there is dispersed
ownership of listed corporate equity among a large number of
outside investors.
 With most of the major shareholders being institutional
investors (i.e. investing on behalf of pension schemes,
investment funds, etc) about 20% of shareholders are private
individuals. Such ownership structures are referred to as
"outsider systems".*
*Outsider systems
2.4 Insider Systems tend to develop in
jurisdictions where
 In these systems, the roles of banks, families and non- there is a strong legal
financial corporations are crucial. There are close ties between protection of minority
owners and managers. Company ownership is concentrated shareholders.
in the hands of a few, families take active part in management
and there is marked separation of control and cash-flow rights
(e.g. through the use of preferential voting shares held by
family members).
 Insider systems are often referred to as "relationship-based"
systems because of the close ties between companies and
their shareholders.*
*"Insider" systems
2.4.1 Advantages may take different
Reduced agency problem as owners are involved in institutional forms.
management. For example:
• In Germany, banks
Better alignment of interests of the management and
or other industrial
shareholders, as they are often the same people.
firms are often the
Family control helps to protect shareholders' interest against main shareholders;
managerial abuses, because the controlling owner and the • In Sweden and
manager are often the same person. Italy, families are the
Long-term view on the business as the controlling family is main shareholders—
likely to commit more human capital to the firm and cares the Wallenbergs in
more about its long-run value. Sweden (estimated
to control 40% of the
Protection against hostile takeovers as most of the wealth of the Swedish
shareholders must agree to the takeover. stock market) and the
Better strategic management as group decisions are prevalent. Agniellis in Italy (Fiat,
Juventus, Cushman &
Quality of decision-making is enhanced in ambiguous and
Wakefield);
uncertain situations when diverse perspectives are shared.
• In France, the
Sharing is encouraged when people are in similar social
largest shareholding
positions.
role is usually taken
Stronger ethical values as the "family honour" is at stake. by the state.

2.4.2 Disadvantages
Little separation of ownership and control may lead to abuse
of power.
Less transparency—minority shareholders may not be able to *The feuding between
obtain information. the German Dassler
brothers led to them
Banks (even if they are shareholders) tend not to monitor
splitting their original
family-run companies effectively.
sports shoes company
Family feuds add to the cultural complexity of insider to form Adidas and
companies.* Puma in 1948. The
Poorer legal protection for minority shareholders. "Block rivalry continued to
such an extent that
holders", rather than external shareholders, discipline and
both companies "took
monitor the company's management and therefore the
their eye off the ball"
empowerment of external minority shareholders is not a and allowed Nike to
social necessity. claim the No. 1 position
Misuse of funds through self-dealing or "tunnelling" of value in sports and leisure
from firms where the controlling shareholder owns a small wear as well as
fraction of the cash-flow rights (lower down in the pyramid) innovation.
to firms where the controlling shareholder owns a large
fraction of cash-flow rights (higher up in the pyramid).*
Reluctance and unwillingness to recruit outsiders to hold
influential positions and appoint independent NEDs.
Jurisdictions where insider systems dominate tend not to
develop corporate governance structures until absolutely *Parmalat (Italy) is
an example of insider
necessary (often too late). For example, where it takes
system abuse, where
a major scandal to force implementation of corporate
family members
governance procedures. siphoned off money
The stock market may not be considered an "open system", as borrowed by Parmalat
one family member selling shares can have a significant effect for personal use and
on that market.* for investing in other
family business.
2.5 Outsider Systems Another example is
Satyam (India), where
 "Outsider" refers to systems and corporate governance where similar techniques (such
listed companies are controlled by their managers but owned as siphoning USD4
by outside shareholders, resulting in a separation of ownership million each month for
and control. 13,000 non-existent
employees) appear to
 The role of the securities markets is crucial. A first indicator
have been used.
of "outsider-domination" is a comparatively high stock market
capitalisation as a percentage of gross domestic product (GDP).
This indicates that the high level of equity issued by the major
listed companies (e.g. the "top 100") is the dominant form of
funding (rather than the debt bias found in insider systems).
There is simply too much equity in issue for it to be held by
a small number of shareholders (e.g. family insiders). *The Asian financial
 Furthermore, in such systems ownership is normally crisis of 1997 was
primarily caused by
dominated by portfolio-oriented institutional investors, with
the lack of appropriate
ownership stakes of typically less than 3% per investor. Such corporate governance
owners undertake their governance functions "outside" the structures to counter
company and do not generally involve themselves in active abuses in the insider
management. system.

2.5.1 Advantages 2.5.2 Disadvantages

Manager-ownership separation has Diffuse ownership can create potential
fostered more robust legal and agency problems and increase agency
governance developments to protect costs.
shareholders, particularly minority The interests of management may not
shareholders. always align with the shareholders.
Hostile takeovers are more frequent and Larger shareholders often require short-
can act as a disciplining mechanism on term gains and are therefore more likely
company management. to "exit" (i.e. sell the shares) than stay
Management is subject to shareholder for the longer-term when companies fail
approval through the use of voting rights. to meet expectations.
Shareholders may use legal and
regulatory features to empower
information gathering, oversight and
control (e.g. directors' remuneration
disclosures, non-executive boards
elected by shareholders).
3 UK Corporate Governance Code*
*This and the following sections provide an overview of the

development of the major codes based on a principles-based It is important to
approach (UK Corporate Governance Code), a rules-based approach appreciate how the
(SOX) and an international approach (OECD and ICGN). Throughout Code was developed
this Study System the Code has been referred to as being an based on principles
example of "best practice" supported, as necessary, by examples rather than rules.
based on SOX, other codes and guidelines. Many of the original
recommendations
 A prime example of a principles-based code. Many other have been
jurisdictions (e.g. South Africa, Singapore, Hong Kong) operate incorporated into,
and enhanced in,
similar codes primarily because of their historical links to the UK.
the current UK Code.
 Development of the UK code was driven by various financial Questions will not be
scandals of the 1980s and early 1990s (e.g. Barlow Clowes, set on the old reports
Polly Peck, BCCI and in particular, Maxwell). now incorporated
 The UK Corporate Governance Code is a combination of a in the Code, but on
number of original codes: current best practice
and application of
 Cadbury Report (1992), Greenbury Report (1995) and
the Code's principles
Hampel Report (1998). (e.g. advantages
 Combined Code (1998) comprising the above three reports. of principles-based
 Turnbull Report (1999) issued to assist companies in codes in developing
applying the Combined Code. nations, benefits
of separating the
 Higgs Report and Smith Review (2003).
roles of the CEO
 Revised Combined Code (2004) incorporating Higgs and and chairman and
Smith recommendations. the impact of the
 Combined Code (2006, 2008)—minor working adjustments. principles-based
system on an insider
 UK Corporate Governance Code (2010)—minor working
(or family) dominated
adjustments and renamed. company when
 UK Corporate Governance Code (2012)—small number of listed).
additional requirements.

3.1 Cadbury Report, 1992
Illustration 3 Cadbury Report
Cadbury Report (forerunner to the Combined Code):

"The effectiveness with which boards discharge their responsibilities
determines Britain's competitive position. They must be free to
drive their companies forward, but exercise that freedom within a
framework of effective accountability. This is the essence of any
system of good corporate governance.
"We believe that our approach, based on compliance with a voluntary
code coupled with disclosure, will prove more effective than a statutory
code. It is directed at establishing best practice, at encouraging
pressure from shareholders to hasten its widespread adoption, and at
allowing some flexibility in implementation. We recognise, however
that if companies do not back our recommendations it is probable that
legislation and external regulation will be sought to deal with some
of the underlying problems which the report identifies. Statutory
measures would impose a minimum standard and there would be a
greater risk of boards complying with the letter, rather than with the
spirit, of their requirements."
 Following the many governance failures, as noted above, Sir

Adrian Cadbury was asked to investigate the British corporate
governance system and to suggest improvements to restore
investor confidence in the system.
 The final report set out recommendations on the arrangement
of company boards and accounting systems to mitigate
governance risks and failures.
 Rather than taking a statutory route, the report recommended
a principles-based approach supported by "comply or explain".
 The main recommendations were:
 the appointment of NEDs;
 an audit committee to oversee greater control of financial
reporting; and
 the separation of the role of the chair and chief executive.
3.2 Greenbury Report, 1995

 Following public concern about executive remuneration (large
pay increases, large gains from share options and excessive
compensation for departing directors) in the recently
privatised utility industries (e.g. gas, electricity) a working
party was established under the chairmanship of Sir Richard
Greenbury.
 The final report recommended:
 establishing a remuneration committee to determine
directors' remuneration;
 a nominations committee to oversee new appointments to
the board; and
 detailed reporting to shareholders on the workings of both
committees.

3.3 Hampel Report, 1998

 Established to review the workings of the Cadbury and
Greenbury Reports.
 Recommended combination of the two Codes into a Combined
Code, plus further requirements relating to:
 communication with shareholders; and
 the balance between implementing controls and allowing
companies to find their own ways of applying corporate
governance principles.
3.4 Turnbull Report, 1999

 A working party led by Nigel Turnbull was established to
provide assistance for companies in reporting how they had
applied the Combined Code and its principles.
 The report covered operational and financial controls based on
high-level principles of good governance rather than rules or
detailed checklists.
The main recommendations of the Turnbull Report are:
Boards must make an annual statement on the effectiveness
of internal controls.
Boards, not operational managers, are responsible for risk
management and internal control.
All internal controls should be considered, not just financial
reporting, using a "risk-based" approach.
Boards should continue to review application of the guidance,
to embed the controls in how a company operates, with
procedures to identify and report weaknesses.
The external auditor's responsibility over internal controls
should not increase.
3.5 Higgs Report and Smith Review, 2003

 Following the Enron scandal in the US and the implementation
of SOX, an extensive review of UK corporate governance was
carried out to establish whether there were any lessons to be
learnt for UK companies.
 The review resulted in two reports, the Higgs Report and the
Smith Review.
 The Higgs Report dealt mainly with the role of NEDs (see
Session 3).*
 The Smith Review concentrated on the role of the audit
committee (see Session 10).
*Higgs also
reconsidered, in the
Illustration 4 Higgs light of SOX, the
continued use of
a principles-based
"The comply or explain approach offers flexibility and intelligent
approach.
discretion and allows for valid exception to the sound rule. The
brittleness and rigidity of legislation cannot dictate the behaviour, or
foster the trust, I believe is fundamental to the effective unitary board
and superior corporate performance."
—Higgs, Higgs Report, 2003

4 Sarbanes-Oxley Act (2002)
4.1 Rules-Based Regulation

 For historical reasons, a rules-based approach to regulation
is firmly embedded in the US approach to dealing with most
issues (e.g. corporate governance, US GAAP).
 Therefore, following the high-profile collapses of Enron and
WorldCom and the serious short comings with US corporate
governance that these and other collapses showed, the US
Congress passed the Sarbanes–Oxley Act in 2002 (shortened
to "Sarbox" or "SOX").
 Named for Paul Sarbanes and Michael Oxley, who were the
legislation's main architects, SOX is mandatory. All listed
organisations, large or small, must comply.*
*Because of its mandatory nature and the severe penalties for non-
compliance, an extensive compliance consultancy industry evolved
around accountants and management consultants. Companies had
to get their SOX detail right the first time; there was no leeway for
error. The introduction of SOX for most companies was therefore a
very costly exercise.
4.2 Impact
 One of the (many) major criticisms of SOX was that it
assumes a "one size fits all" approach to corporate governance
provisions (rules-based disadvantage). The same detailed
provisions are required of small- and medium-sized companies
as are required of the largest companies listed on the New York
Stock Exchange (regardless of the fact that it may be a part of
a company listed in another jurisdiction).
 Many of the SOX requirements also apply to foreign companies
listed in the US as well as foreign subsidiaries of US-listed
companies.
 Commentators noted that the number of initial public offerings
(IPOs) fell in New York after the introduction of SOX as
new listings were made on exchanges that allowed a more
flexible, lower-cost approach (e.g. London's principles-based
approach).* *Many of the
requirements in SOX
4.3 Key Requirements mirror those already
in other corporate
codes but put them
4.3.1 PCAOB
into a rules-based
 The establishment of a new regulator, the Public Company framework.
Accounting Oversight Board (PCAOB) with powers to set
auditing, quality control, independence and ethical standards,
plus inspection and disciplinary powers (see Session 17).

4.3.2 Boards and Committees

 The majority of directors on a board must be independent.
 Audit, nominations and remuneration committees must
consist of 100% independent directors. All must have general
experience of the responsibilities of the committee (e.g. Audit
Committee members must be able to read and understand
financial statements) and at least one member of each
committee must have relevant "expert" experience (e.g. an
Audit Committee member must have senior management,
consultancy or academic experience in financial reporting).
4.3.3 Audit Committees

 Audit committees are responsible for the fiscal integrity of the
company, overseeing the accounting and financial reporting
process and audits of the financial statements.
 Exclusive hiring, firing and spending authority over the
external auditor.
 Approval of auditing and non-auditing services (which must
not be carried out by the auditors).
 External auditor to report directly to the Audit Committee.
 Review the external auditor's independence and work.
 Receive reports from the auditor on critical accounting
policies; receive reports from the auditor on discussions
with management on alternative GAAP, their effects and the
auditor's preference; receive reports from the auditor on
material communications with management.
 Discuss annual and quarterly statements with management
and auditors.
 Discuss any financial information provided for press releases
and rating agencies.
 Resolve management and auditor disagreements over
financial accounting treatments.
 Establish procedures to deal with external complaints
concerning accounting, internal controls or auditing matters.
 Set up whistle-blowing procedures.
4.3.4 Responsibilities of CEO and CFO

 Must certify that there are no untrue statements of material
fact in financial results presented in quarterly and annual
reports and that the statements fairly represent the financial
condition of the company. *Certifying officers will
 Are responsible for effectiveness of internal controls and face penalties up to:
must attest to the scope and adequacy of the internal control • $ 1,000,000 in fines
structure (including a statement on the effectiveness of and/or up to 10
controls) and procedures for financial reporting in annual years' imprisonment
reports (see Sessions 9 and 11).* for "knowing"
violations.
4.3.5 Registered Accounting Firm • $ 5,000,000 in fines
 The registered accounting firm (auditor): and/or up to 20
years' imprisonment
 must attest to and report on effectiveness of the internal for "wilful"
control structure and procedures for financial reporting; and and "knowing"
 cannot provide services to audit clients which are not violations.
directly related to the audit.

4.3.6 Codes of Business and Ethics

 These must be in place (and disclosed) for directors, officers
and employees (Session 18).
 All material off-balance sheet liabilities, transactions and
obligations must be disclosed.
 Altering, destroying, mutilating, concealing, falsifying records,
documents or tangible objects with the intent to obstruct,
impede or influence a legal investigation is punishable by
unlimited fines and up to 20 years' imprisonment.
 Accountants who knowingly and wilfully violate the
requirements to maintain all audit or review papers for a
period of five years will be subject to unlimited fines and up to
10 years' imprisonment.
 Listed companies cannot avoid SOX by delisting, unless after
delisting they have fewer than 300 US shareholders—once
"SOXed, always SOXed".
 Employees and the auditor are guaranteed protection against
the company if they disclose confidential information to parties
involved in a fraud claim (whistle-blowing protection).
4.4 Criticisms
The main criticism of SOX concerns the initial set-up costs
and the annual costs of compliance (including the costs of the
PCAOB).*
Because of the rapid enactment of SOX, many critics argued
*SOX supporters claim
that it was not thoroughly thought through and in some areas
that the increased
was more of a "knee-jerk", overkill reaction. The authors and costs are necessary to
supporters of SOX reject such claims. ensure that confidence
Company and auditor regulators outside of the country is restored and retained
objected to the initial "SOX or nothing" approach taken by in the US market.
the American regulators in requiring any foreign company
listed in the US to be subject to the full requirements of SOX
regulation. There was a strong feeling that US regulators
considered any foreign regulatory regime inferior to SOX
(when in many areas it was at least equal, if not superior).*
*In the area of auditor regulation and inspection, progress was made
in 2005 by the UK and European authorities in getting the PCAOB to
accept that a number of European auditor regulatory authorities were
equivalent to the PCAOB and did not therefore require a full PCAOB
inspection. Even so, in some areas a PCAOB inspector may accompany
local national inspectors when they hold meetings with auditors.
Audit fees have significantly increased because of the

increased workload in dealing with internal controls.
Auditors are considered to be the "winners" through providing
consultancy on SOX compliance and other services to firms
that are not their audit clients.
A consultancy industry has grown up around SOX, focussing
company attention on complying with all aspects of the
legislation regardless of size and relevance—a "scare factor".

Illustration 5 Comments on SOX
Against
"The new laws and regulations have neither prevented frauds nor
instituted fairness. But they have managed to kill the creation
of new public companies in the U.S., cripple the venture capital
business and damage entrepreneurship. According to the National
Venture Capital Association, in all of 2008 there have been just
six companies that have gone public. Compare that with 269
IPOs in 1999, 272 in 1996 and 365 in 1986. Faced with crushing
reporting costs if they go public, new companies are instead selling
themselves to big, existing corporations. For the last four years
it has seemed that every new business plan in Silicon Valley has
ended with the statement "And then we sell to Google". The
venture capital industry is now under water, paying out less than
it is taking in. Small potential shareholders are denied access
to future gains. Power is being ever more centralized in big,
established companies. For all of this, we can first thank Sarbanes-
Oxley. Cooked up in the wake of accounting scandals earlier this
decade, it has essentially killed the creation of new public companies
in America, hamstrung the NYSE and Nasdaq (while making the
London Stock Exchange rich) and cost U.S. industry more than $200
billion by some estimates."
—Wall Street Journal, 21 December 2008
For
"I am surprised that the Sarbanes-Oxley Act, so rapidly developed
and enacted, has functioned as well as it has ... the act importantly
reinforced the principle that shareholders own our corporations
and that corporate managers should be working on behalf of
shareholders to allocate business resources to their optimum use."
—Alan Greenspan
"Sarbanes-Oxley helped restore trust in US markets by increasing
accountability, speeding up reporting, and making audits more
independent."
—Christopher Cox, SEC
"Corporate boards are working better. The responsibilities that
should have been there all along, but got shifted to the CEO,
are back in the board's hands, particularly with independent
audit committees." —William Donaldson, SEC
5 OECD
5.1 Background
 For more than 40 years, the OECD has been one of the world's
largest and most reliable sources of comparable statistics
and economic and social data. As well as collecting data,
the OECD monitors trends, analyses and forecasts economic
developments and researches social changes or evolving
patterns in trade, environment, agriculture, technology,
taxation and more.
 The OECD provides a setting where governments compare
policy experiences, seek answers to common problems,
identify good practice and coordinate domestic and
international policies.

 The OECD brings together governments of countries

committed to democracy and the market economy from
around the world to:
 support sustainable economic growth;
 boost employment;
 raise living standards;
 maintain financial stability;
 assist other countries' economic development; and
 contribute to growth in world trade.
5.2 Principles
 Originally published in May 1999 (updated in 2002 and revised
in 2004), the OECD Principles of Corporate Governance
(www.oecd.org) responded to growing awareness of the
importance of good corporate governance for investor
confidence and national economic performance.
 The Principles are a living instrument offering non-binding
standards and good practices as well as guidance on
implementation, which can be adapted to the specific
circumstances of individual countries and regions.
 It also represents the first initiative by an inter-governmental
organisation to develop increased transparency, integrity
and the rule of law as core elements of a good corporate
governance regime.
 Therefore, the Principles can be used:
 as a benchmark by governments as they evaluate and
improve their laws and regulations; and
 by private sector parties which have a role in developing
corporate governance systems and best practices.
 to embrace different models that exist.* *For example, they
do not advocate
 The Principles cover five areas: any particular board
1. Rights of shareholders—protection of shareholders' structure and the term
rights and key ownership functions. "board" as used in the
document is meant to
2. Equitable treatment of shareholders—ensuring the embrace the different
equitable treatment of all shareholders, including minority national models of
and foreign shareholders. board structures found
3. Role of stakeholders—recognising the rights of in OECD countries.
stakeholders (including employees) as established by law In the typical two-
and encouraging active cooperation between corporations tier system, found
and stakeholders in creating wealth, jobs and financial in some countries,
sustainability. "board" as used in
the Principles refers
4. Disclosure and transparency—ensuring that timely and to the "supervisory
accurate disclosure (transparency) is made on all material board" and "key
matters regarding the corporation, including the financial executives" refers to
situation, performance, ownership and governance of the the "management
company. board". In systems
where the unitary
5. Responsibilities of the board—ensuring the strategic board is overseen by
guidance of the company, the effective monitoring of an internal auditor's
management by the board and the board's accountability board, the term
to the company and its shareholders (the responsibilities of "board" includes both.
the board).

5.2.1 Rights of Shareholders

 Secure methods of ownership, registration and transfer
of shares.
 Receive relevant information on the corporation on a timely
and regular basis, including the voting procedures that govern
general shareholder meetings.
 To participate in, and to be sufficiently informed on, decisions
concerning fundamental corporate changes, including effective
participation in general shareholder meetings.
5.2.2 Equitable Treatment of All Shareholders

 All shareholders have effective redress for violation of their
rights.
 All shareholders of the same series of a class are treated
equally.
 Minority shareholders are protected from abusive actions of
the majority holders.
 Any changes in voting rights are approved by those classes of
shares which are negatively affected.
 Processes and procedures for general shareholder meetings
allow for equitable treatment of all shareholders.
 Insider trading and abusive self-dealing is prohibited.
 Members of the board and key executives disclose to the
board whether they, directly, indirectly or on behalf of third
parties, have a material interest in any transaction or matter
directly affecting the corporation.
5.2.3 Role of Stakeholders

 Effective redress for violation of their rights.
 Access to relevant, sufficient and reliable information on a
timely and regular basis.
 Able to freely communicate their concerns about illegal or
unethical practices to the board and their rights should not be
compromised for doing this.
5.2.4
Disclosure and Transparency
 Financial and operating results of the company, company
objectives and major share ownership and voting rights.
 Information about the board members and key executives on
their remuneration policy, qualifications, the selection process,
other company directorships and whether they are regarded
as independent by the board.
 Related party transactions, foreseeable risk factors and issues
regarding employees and other stakeholders.
 Governance structures and policies, in particular, the content
of any corporate governance code or policy and the process by
which it is implemented.
 Annual audit undertaken by an independent, competent and
qualified auditor accountable to the shareholders.

5.2.5 Responsibilities of the Board

 The board as a whole (including independent NEDs) is able
to monitor the day-to-day activities of the entity's executive
management and in particular the CEO.
 No one individual executive, or group of executives, should
dominate the direction and strategy of the company or benefit
themselves or others under their influence.
 For key oversight roles, independent committees should be
established (e.g. Audit Committee, Nomination Committee,
Remuneration Committee).
 The board (as a whole) should:
 Act on a fully informed basis, in good faith, with due
diligence and care and in the best interests of the company
and its shareholders.
 Apply high ethical standards and exercise objective
independent judgement on corporate affairs, taking into
account the interests of all stakeholders.
 Review and guide corporate strategy, major plans of action,
risk policy, annual budgets and business plans.
 Set performance objectives, monitor implementation
and corporate performance and oversee major capital
expenditures, acquisitions and divestitures.
 Ensure the integrity of the corporation's accounting and
financial reporting systems (e.g. independent audit, control
systems, risk management procedures, financial and
operational control, compliance with the law and regulations).
 Monitor and manage potential conflicts of interest of
management, board members and shareholders, including
misuse of corporate assets and related party transactions.
 Assign independent NEDs to tasks where there is a
potential for conflict of interest (e.g. review of related
party transactions, nomination of key executives and board
remuneration).
 Select, compensate, monitor and, when necessary, replace
key executives and oversee succession planning.
 Align key executive and board remuneration with the
longer-term interests of the company and its shareholders.
 Monitor effectiveness of governance practices and make
changes as needed.

6 ICGN
6.1 Background
 The International Corporate Governance Network
(www.icgn.org) was founded in 1995 at the instigation of
major institutional investors.
 It represents investors, companies, financial intermediaries,
academics and other parties interested in the development of
global corporate governance practices.
6.1.1 Primary Purposes

 To provide an investor-led network for the exchange of
views and information about corporate governance issues
internationally.*
 To examine corporate governance principles and practices.
*Through this process,
 To develop and encourage adherence to corporate governance the ICGN believes
standards and guidelines. that companies
 To generally promote good corporate governance. can compete more
effectively and
6.1.2 Committees economies can best
prosper. The ICGN
 Current policy related committees include: also believes that it is
 Accounting and Auditing Practices Committee in the public interest
 Anti-Corruption Practices working group to encourage and
enable the owners
 Corporate Governance Principles Review Committee of corporations to
 Cross-Border Voting Practices Committee participate in their
 Director and Shareholder Engagement working group governance.
 Executive Remuneration Committee
 Non-financial Business Reporting Committee
 Shareholder Responsibilities Committee
 Shareholder Rights Committee
6.2 Principles
 Originally issued in 1999, the principles were revised and
reissued in 2005 following the update of the OECD Principles
in 2004. A further extensive review and revision was carried
out in 2009.
 The Principles are drafted to be compatible with other
recognised codes of corporate governance, although in some
circumstances, the ICGN Principles may be more rigorous.

 The relevant sections are:

 Corporate objectives
 Corporate boards
 Corporate culture
 Risk management
 Remuneration
 Audit
 Disclosure and transparency
 Shareholder rights
 Shareholder responsibilities.
 The ICGN has also published a number of policies addressing
in greater detail certain of the Principles (e.g. the policy
statement on directors' remuneration and the statement on
anti-corruption practices).
Example 3 International Codes

Discuss the limitations of international corporate governance codes.
Solution

Becker Professional Education | ACCA Course Session 27 • IAS 7 Statement of Cash Flows
Summary
 Strong corporate governance encourages investment, strengthens the capital markets and
invites foreign capital.
 Codes of corporate governance:
• provide best-practice guidance;
• deﬁne speciﬁc steps to improve governance;
• describe expected behaviour; and
• increase market credibility.
 Codes may be influenced by the advantages of diversity of human capital on the board,
independence from executive management, promotion of shareholder activism and
increased public communication. Codes of ethics can be accomplished through a variety
of processes, including a competent, strong audit function, a transparent and independent
remunerations process and employee participation in financial outcomes.
 Corporate governance tends to be principles-based (e.g. the Code) or rules-based (e.g.
SOX). Different countries tend to have different board structures (i.e. unitary v multi-
tiered), and different ownership characteristics (i.e. insider v outsider). The principles,
however, are the important thing and should allow a variety of styles to serve the same end.
 Rules-based systems tend to have much higher implementation and ongoing costs.
 The Code places responsibility for internal controls with the board of directors. SOX
established the Public Company Accounting Oversight Board (PCAOB) with power to
set auditing, quality control, independence and ethics standards. The PCAOB also has
inspection and disciplinary powers.
Session 6 Quiz
Estimated time: 15 minutes
1. List EIGHT issues surrounding corporate governance development. (1.1)

2. Compare the advantages of a principles-based system with those of a rules-based system. (2)
3. Explain the major difference between an insider system and an outsider system.
(2.4, 2.5)
4. State THREE recommendations from the Turnbull Report. (3.4)
5. List the key requirements of SOX. (4.3)
6. State the FIVE OECD Principles of Corporate Governance. (5.2)
7. Describe the purpose of the ICGN. (6.1.1)
Study Question Bank

Estimated time: 30 minutes
Priority Estimated Time Completed
Q9 Corporate Governance Standards 30 minutes

Becker Professional Education | ACCA Course
Session 6
Session 27 • IAS 7 Statement of Cash Flows
EXAMPLE SOLUTIONS
Solution 1—Influences
 Corporate ownership and financing structure
 Legal system
 GAAP (although converging to IFRS)
 Government policies
 Culture and social attitudes
 History
 State of the economy (local and global)
 Capital inflows
 Globalisation and the free movement of capital
 Cross-border institutional investment
Solution 2—Developing Countries

 Developing countries' economies tend to be dominated by small- and
medium-sized enterprises (SMEs). It would be very costly, and
probably futile, to attempt to burden small businesses with regulatory
requirements comparable to larger concerns.
 Having the flexibility to "comply or explain" allows for those seeking
foreign equity to increase compliance while those with different
priorities can delay full compliance. In low-liquidity stock markets
(such as those in some developing countries) where share prices
are not seen as strategically important for businesses, adopting a
more flexible approach might be a better use of management talent
rather than "jumping through hoops" to comply with legally binding
constraints.
 The state needs to have an enforcement mechanism in place to deal
with non-compliance and this itself represents a cost to taxpayers
and the corporate sector. Developing countries may not have the full
infrastructure in place to enable compliance (auditors, pool of NEDs,
professional accountants, internal auditors, etc) and a principles-
based approach goes some way to recognise this.

Solution 3—International Codes
 There is no single international model of corporate governance.
Different legal systems, institutional frameworks, traditions and
culture mean that a range of different approaches have developed
around the world.*
 However, common to all good corporate governance regimes is a *The concept
high degree of priority placed on the interests of shareholders, who of International
place their trust in corporations to use their investment funds wisely Accounting Standards
and effectively. was first established
 In addition, the best-run companies recognise that business ethics in the mid-1970s.
and corporate awareness of the environmental and societal interest It took at least 30
of the communities in which they operate can have an impact on the years for them to
reputation and long-term performance of companies. become, more or
less, the de facto set
 Limitations of corporate governance codes, therefore: of financial reporting
● To be acceptable to the majority of countries, the code will need standards (IFRS)
to take the lowest common denominator. Thus it may be fairly acceptable around the
tame and bland. world. Similarly with
● Global differences in legal structures, financial systems, International Auditing
corporate ownership, culture and economies will make it hard to Standards (ISAs).
strengthen any of the principles.
● As the code will need to be based on best practice of a number
of jurisdictions, development will always lag changes in the most
advanced countries.
● The codes will have no legislative power and may not even be
supported by national stock exchanges or governments.*
*In spite of the above limitations, the OECD and the ICGN codes have:
• highlighted the contributions good governance can make to
companies;
• emphasised specific dangers that have contributed to governance
failure;
• provided benchmarks and a solid starting point; and
• promoted good practice.

NOTES

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Session 6

A. Governance and Responsibility

(continued on next page)

Ali khan - rajaali321@yahoo.com

BASIS OF CODES UK CORPORATE SARBANES-OXLEY

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Suggest SIX influences on the development of corporate

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 In any one jurisdiction, the issues surrounding corporate

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2.1 Principles-Based Approach

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*This can be a very effective incentive to comply, as the need

Illustration 2 Comply or Explain

The "comply or explain" approach is the trademark of corporate

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*Compliance in principles-based jurisdictions does not mean

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Example 2 Developing Countries

2.2 Rules-Based Approach

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 In many European countries, in Latin-influenced countries (e.g.

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2.5.1 Advantages 2.5.2 Disadvantages

3 UK Corporate Governance Code*

*This and the following sections provide an overview of the

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3.1 Cadbury Report, 1992

Illustration 3 Cadbury Report

Cadbury Report (forerunner to the Combined Code):

 Following the many governance failures, as noted above, Sir

3.2 Greenbury Report, 1995

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3.3 Hampel Report, 1998

3.4 Turnbull Report, 1999

3.5 Higgs Report and Smith Review, 2003

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4 Sarbanes-Oxley Act (2002)

4.1 Rules-Based Regulation

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4.3.2 Boards and Committees

4.3.3 Audit Committees

4.3.4 Responsibilities of CEO and CFO

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4.3.6 Codes of Business and Ethics

Audit fees have significantly increased because of the

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