CONCEPTUAL FRAMEWORK AND SCOPE OF CORPORATE GOVERNANCE PREPARED BY FRANCIS ZULU

CONCEPTUAL FRAMEWORK AND SCOPE OF CORPORATE GOVERNANCE

1. Definition of Corporate governance

 The system by which organizations are directed and controlled by senior officers in the interest of
shareholders and other stakeholders.
 Corporate governance is a set of relationships between a company's directors, its shareholders and
other stakeholders. It also provides the structure through which the objectives of the company are
set, and the means of achieving those objectives and monitoring performance, are determined.
 The set of processes and policies by which a company is directed, administered and controlled. It
includes the appropriate role of the board of directors and of the auditors of a company.

2. Purpose and objective of corporate governance

 The purpose is to support the system of wealth creation of capitalism
 The general objective of governance should be to constrain excessive behaviour through legislation.
 For directors, governance helps them to identify the rules of the game within which the company
should operate and to provide advice or guidance regarding best practice methods of managing the
enterprise so as to attract investment.
 For shareholders, governance helps them to create a safe environment within which they can invest
and improve accountability and responsibility.
 For governments, it helps them to provide a legal framework within which accountability can be
exacted so as to attract global investment and support the economy and society.

3. The driving forces of corporate governance

 Internationalization/globalization - This has meant that investors, and institutional investors in
particular, began to invest outside their home countries.
 Treatments of investors - The differential treatment of domestic and foreign investors, both in
terms of reporting and associated rights/dividends, also the excessive influence of majority
shareholders in insider jurisdictions, caused many investors to call for parity of treatment.
 Financial reporting issues - Issues concerning financial reporting were raised by many investors
and were the focus of much debate and litigation. Shareholder confidence in what was being reported
in many instances was eroded.
 High profile scandals - An increasing number of high-profile corporate scandals and collapses
including Enron and Polly Peck international.
 National differences - The characteristics of individual countries may have a significant influence in
the way corporate governance has developed.

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4. Scope of corporate governance

4.1 Direction
 This is an internal perspective, looking at the scope of governance activity created by and enacted
through the board of directors.
 Defining corporate structure and roles.
 Ensuring an appropriate professional culture exists within the company.
 Establishing programs, policies, procedures and rules for internal control.
 Monitoring and adapting as necessary to ensure objectives are met.

4.2. Control
 The exaction of control over the corporation is an external activity determined by the actions of
government and regulators.
 The need to pass all forms of legislation including law, health and safety and employee regulation to
provide a framework for operations.
 The need to determine rules of corporate activity through regulation of stock exchanges.
 The need to engage in dialogue with stakeholders, to listen and respond to their concerns.
 Accounting and audit standards.

5. Key principles/concepts of corporate governance

 Independence - the avoidance of being unduly influenced by vested interests and being free
from any constraints that would prevent a correct course of action being taken. It is an ability to
stand apart from inappropriate influences and be free of managerial capture, to be able to make
the correct and uncontaminated decision on a given issue. Independence of mind means
providing an opinion without being affected by influences compromising judgement.
Independence of appearance means avoiding situations where an informed third party could
reasonably conclude that an individual's judgement would have been compromised. Applies to
both auditor and non-executive directors who are playing the monitoring role in Corporate
Governance. They are considered independent when they can be expected to express their honest
and professional opinion in the best interest of the company. Thus, their opinion should avoid:
biasness, familiarity, gifts, self-interest, self-review, intimidation, advocacy, conflict of interest and
influence by others.
 Transparency/Openness - Means open and clear disclosure of relevant information to
shareholders and other stakeholders, also not concealing information when it may affect decisions.
Disclosure in this context obviously includes information in the financial statements, not just the

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numbers and notes to the accounts but also narrative statements such as the directors' report and
the operating and financial or business review. It also includes all voluntary disclosure that is
disclosure above the minimum required by law or regulation. Involves full disclosure of material
matters which could influence the decisions of stakeholders. This means not simply openness in
the reporting of information required by IFRS in the financial statements but other information
such as cash and management forecasts, environmental reports and sustainability reports. This
concept is characterized by timely disclosure which are above the requirement and the presence of
systems and procedures to govern decision making which can curb malpractices.
 Accountability – the business being answerable for its actions or directors being answerable in
some way for the consequences of their actions. For example, companies in many regimes have
been required to provide financial information to shareholders on an annual basis and hold annual
general meetings. Making accountability work is the responsibility of both parties. Directors, as we
have seen, do so through the quality of information that they provide whereas shareholders do so
through their willingness to exercise their responsibility as owners, which means using the
available mechanisms to query and assess the actions of the board.
 Responsibility - Means management accepting the credit or blame for governance decisions. For
management to be held properly responsible, there must be a system in place that allows for
corrective action and penalising mismanagement. Responsible management should do, when
necessary, whatever it takes to set the company on the right path.
 Probity / Honesty - It relates to telling the truth and not misleading shareholders and other
stakeholders. It involved abiding by the legal standards that exist in society. Lack of probity
includes not only obvious examples of dishonesty such as taking bribes, but also reporting
information in a slanted way that is designed to give an unfair impression. Requires the Board to
exercise the duty of loyalty by NOT rewarding themselves with excessive remuneration and
involving in earning management to deceive the shareholders.
 Integrity – Straight forward dealing and completeness. Integrity can be taken as meaning
someone of high moral character, who sticks to strict moral or ethical principles no matter the
pressure to do otherwise. In working life this means adhering to the highest standards of
professionalism and probity. Straightforwardness, fair dealing and honesty in relationships with
the different people and constituencies whom you meet are particularly important. Trust is vital in
relationships and belief in the integrity of those with whom you are dealing underpins this . This
integrity must withstand the influences of self-interest or the pressure placed upon an individual
by others to act in a way that would compromise the integrity of the director.
 Judgement - This relates to the ability to weigh issues, to have balance or to not be swayed by
emotive issues. Judgement means that the board making decisions that enhance the prosperity of

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the organisation. This means that board members must acquire a broad enough knowledge of the
business and its environment to be able to provide meaningful direction to it. This has implications
not only for the attention directors have to give to the organisation's affairs, but also the way the
directors are recruited and trained.
 Reputation - Reputation is determined by how others view a person, organization or profession.
Reputation includes a reputation for competence, supplying good quality goods and services in a
timely fashion, and also being managed in an orderly way. Reputation is an outcome of
demonstrating adequate adherence to the other underlying principles. Reputation may be viewed
from an individual or entire board or corporate perspective.
 Fairness - requires all shareholders to be accorded equal consideration which means minority
shareholders should be treated in the same way as majority shareholders. It involves taking into
account the interests, rights and views of everyone who has a legitimate interest in the entity. A
sense of balance or even handedness when dealing with others. The directors' deliberations and
also the systems and values that underlie the company must be balanced by taking into account
everyone who has a legitimate interest in the company and respecting their rights and views. E.g.
Directors pay in relation to that received by employees and treatment of local investors vs. foreign
investors equally.
 Innovation - The ability to introduce change into the organisation or with regard to its business
positioning. The concept of innovation in the approach to corporate governance recognises the fact
that the needs of businesses and stakeholders can change over time.
 Scepticism - A degree of cynicism or reluctance to accept a given idea or belief is necessary until
such a belief has been established through reasoned and objective argument. An attitude that
includes a questioning mind, being alert to conditions which may indicate possible misstatement
due to error or fraud, and a critical assessment of audit evidence.' This does not mean that all
management decisions and evidence have to be approached with suspicion or mistrust; but that
an open and enquiring mind must always be employed. A healthy corporate culture and
environment is one that encourages and enables such scepticism to thrive.

6. Separation of ownership and control

 This is a situation in a company where the people who own the company (shareholders) are not the
same as those who control the company (Board of directors). This is so because specialist
management can run the business better than those who own the business and the original owners
can not personally contribute all the capital needed to run the business, so they have to bring in
external capital from people who are not interested in the day to day operations. Furthermore,

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shareholders are interested in the return from their investment and do not have the skills, time or
inclination to run the business on a day to day basis.

6.1. Agency theory

 An agency relationship is a contract under which one or more persons (the principals) engage another
person (the agent) to perform some service on their behalf that involves delegating some decision–
making authority to the agent
 Agency theory describes the nature of the relationship that exists or should exist between the board
of directors and the shareholders where directors act as agents of the shareholders or shareholder-
auditor relationship.
 It presupposes the existence of a separation between those that own the company (shareholders) and
the agents that manage the corporation on their behalf (the board of directors).
 Agency theory highlights the need for directors to act in the interest of shareholders.
 The existence of two parties in agency theory requires us to focus on the nature and strength of the
relationship between them. The central issue is the requirement for trust to exist between the two
parties.
 This sense of trust can then be enhanced further through the existence of regulation that forces the
board to ensure it is carrying out its duties as expected by shareholders.
 The root of the regulation is the legal requirement that: “the directors must act in the best
interests of shareholders”. This is a fiduciary obligation of the board of directors. Directors’
role is similar to that of a trustee in a trust in that they are entrusted by the shareholders to run the
company on their behalf. Directors are expected to demonstrate uncompromising loyalty to the
shareholders and to exercise due diligence in making decisions.
 Fiduciary duties definition: a duty imposed upon certain persons because of the position of trust
and confidence in which they stand in relation to another. The duty is more onerous than generally
arises
under a contractual or tort relationship. It requires full disclosure of information held by the fiduciary,
a strict duty to account for any profits received as a result of the relationship, and a duty to avoid
conflicts of interest.
 In other words, fiduciary duty is duty of care and trust which one person or entity owes to
another. It can be a legal or ethical obligation.
 The need for directors to act in accordance with regulation is a price that the directors must accept
and the shareholders must pay for in order to sustain the sense of trust.
 Fiduciary duties are owed to the entity, not to individual shareholders and directors must exercise
their powers for the proper purpose.

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6.2. Agency costs

 Direct costs include - Directors remuneration and the cost of financial accounting for disclosure.
 Sum of principal monitoring expenditure - Fee payable to both the non-executive directors and
the external auditors. Time spent by the shareholders in attending the AGM and dialogues with
management.
 Agent’s bonding expenditure - Time spent by the directors in meeting with the institutional
shareholders during the dialogues.
 Residual loss - Loss resulting from directors misusing their positions.

6.3. Duties of directors as agents

 Performance – if paid, directors have a contractual obligation to perform as agreed (if unpaid,
no such obligation).
 Obedience – directors should act strictly in accordance with the principal’s instructions
 Skill and care – directors should act with such a degree of skill and care as may reasonably be
expected from a person with such experience and qualifications.
 Personal performance – directors should only delegate their assignments where they have no
reason to believe that the person to whom the work is delegated is not capable of proper
performance.
 Avoid conflicts of interest – eg should not sell his own property to the entity, even though it
may be at an independent, arm’s length valuation
 Confidence – agents should not disclose confidential matters about the principal, even after the
agency agreement has ended.
 Accounting for benefits – agents must account to the principal for any undisclosed benefit
which they receive as a result of their office as agent because ownership of an entity is
necessarily separated from the management, problems may result.
6.4. Agency problem
 The need to make managers be motivated to act in the best interest of the shareholders and the
company as a whole. For this reason, shareholders will want to build safeguards to ensure that the
managers run the business in the interest of all the stakeholders and not just in the interest of
managers.

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 Directors may choose to pursue strategies more beneficial for their own interest rather than the
entity’s. For example, hold a board meeting where they vote themselves huge salaries, bonus
shares and huge compensation if they are sacked even under modesty profits.
 Directors will almost certainly have a different attitude to risk, and risk management, since it is
not
their own investment which they are risking.
 If management have only a small beneficial interest in the entity (or even none at all ) then they
may well pursue activities which improve short term results (therefore improving their current
bonuses) to the exclusion of more far–sighted strategies which would be of greater benefit to the
entity in the longer term
 Ultimately, shareholders have the right to decide who shall (and who shall not) be directors of
their
Entity. But this is, in practical terms, very much a theoretical power. Generally, shareholders
neither have the dynamism nor organization to effect such a change in the composition of the
board.

6.5. Overcoming the agency problem – Alignment of interests (goal congruence)

 Incentives designed to align interests include: profit related pay, share issue schemes, for
instance on the occasion of a management buy–out, share option schemes. But for all of these
there is a natural tendency for management to adopt creative accounting to manipulate the profit
figure upon which these incentives are based.
 Vote the directors out at the AGM.
7.0. Stakeholder theory
 Argues that managers have duty of care, not just to the owners of the company in terms of
maximizing shareholder value, but also to the wider community of interest (stakeholders).
 Stakeholder theory states that relationships exist between all entities in society and that no entity
acts in isolation.
 It identifies the relationships that exist beyond the traditional shareholder relationship and examines
the nature and strength of these relationships.
 Organisational relationships exist with regard to many stakeholder groups: employees, customers,
suppliers, governments, communities and environment and Ecology.

8.0. Stewardship theory

 Managers are stewards of the assets charged with their employment and deployment in ways
consistent with the overall strategy of the organization.

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 Other interest groups take little or no part in the running of the company and receive information via
established reporting mechanism e.g. audit reports and annual reports
 Owners have the right to dismiss their stewards if they are dissatisfied via a vote at an annual general
meeting.
9.0. Key issues in corporate governance
 The role of the board
 Duties of directors
 Composition and balance of the board
 The quality of financial reporting and auditing
 Directors' remuneration and rewards
 Responsibility of the board for risk management and internal control systems
 Rights and responsibilities of shareholders
 Corporate social responsibility and business ethics
 Public and non-governmental bodies corporate governance

10.0. Sample examination standard type of questions

1. Explain the meaning of corporate governance and agency relationships, and contrast how the
objectives of corporate governance differs between a large listed company and a small company
delivering public sector services such as solid waste management.
2. Describe ways in which the accountability of local councils such as the Chilanga Town Council can be
improved.
3. Explain the nature of the agency problem that exists in many corporate and public sector organization
with relevant examples and suggest ways of addressing it.
4. Explain what an 'agency cost' is and discuss the problems that might increase agency costs for any
company of your choice.
5. Define 'transparency' and evaluate its importance as an underlying principle in corporate governance
and in relevant and reliable financial reporting in any organization.
6. Define and explain the importance of 'integrity' and 'probity in the context of the University.
7. Identify and elaborate on the FIVE underlying principles of corporate governance.
8. Define independence and how it can be achieved by an external auditor.
9. Elucidate the importance of fairness and honest in public sector governance.
10. Explain the meaning of probity when maintaining professional business relationship.
11. Identify and elaborate on the FIVE factors that triggered corporate governance.
12. Critically examine the concept of separation of ownership and control.
13. Discuss the fiduciary duty of directors.

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14. Identify and elaborate the duties of directors as agents.

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