The types of external governance mechanisms How a governance system develops and evolves?

1. Definitions

• Corporate refers to a group or association of people, usually authorized by some form of agreement, acting as an individual (i.e.
the group), especially in business and civic activities.
• Governance is the act, manner or functioning of the rules, guidance and controls which determine a course of action through an
intended or emergent system of processes.
• internal governance Human beings organise themselves with a set of evolving norms, policies, procedures and processes that
guide individual decision making and thereby influence behaviour. A set of these mechanisms develops within a corporate entity
(internal governance)
• External corporate governance framework. These are the rules, guidance and controls arising outside of an organization that
are intended to influence the decisions, actions and behavior which occur within it
• A code of ‘best practice’ which is part of the external governance framework is a set of non-binding principles, standards and
practices, which have been recommended by a distinguished body and relate to the internal governance of companies, Law and
regulation, and many codes of ‘best practice’ are explicit expressions of public policy. What distinguishes a code of practice from
law and regulation is that codes are not mandatory in a legal sense. However, in some jurisdictions specific codes of practice have
been made mandatory either by regulation or statute. For instance, part of the Higgs recommendations was incorporated in the
Revised Combined Code, The two best-known codes of ‘best practice’ were Treadway/COSO and Cadbury. Treadway/COSO aimed
to improve corporate accountability; Cadbury sought to improve the boardroom functioning.
• System refers to a complex whole, a set of connected things or parts which cannot be subdivided without changing its nature.
• Systemic of the bodily system as a whole, something introduced in one part will not be confined to that particular part.
• Dynamic systems change with the passage of time and the parts interact to create a series of system conditions.
• Systematic a methodical, deliberate set of plans or actions.
• In terms of the corporate governance system, what is the Sarbanes-Oxley Act?

Sarbanes-Oxley is a mandatory element (i.e. law) in the external governance framework of the United States which seeks to influence
how the internal governance system operates in companies which offer their debt and/or equity to the American public. Stated another
way, it is an external governance mechanism which mandates certain activities and actions internally for a specific group of corporate
entities which includes both entities organised in the US and elsewhere

• What is the UK Combined Code?

The UK Combined Code is one of the outputs of recent corporate governance reform activities. It contains principles of good governance
and a code of best practice that were derived by one corporate governance review group from the work of two earlier groups.

[i.e. The Hampel Committee in 1997–1998) prepared the Combined Code from the work of two earlier reviews and their
recommendations – the Cadbury Committee Report on the Financial Aspects of Corporate Governance published in 1992 and the
Greenbury Report in the External Oversight for Executive Remuneration published in 1995.]

Aspects of the Higgs Review of the Role and Effectiveness of Non-executive Directors and the Smith Report on Audit Committee
Guidance, both published in 2003, were incorporated in a rewrite of the Combined Code which then was adopted as a replacement for
the original Combined Code.

 
 
The original Combined Code was incorporated into the Listing Rules on a ‘comply or explain basis’. The revised Code continues to be
required by the FSA on a ‘comply or explain’ basis for listed companies

2. Definitional problem of corporate governance

The problem that definitional inconsistency can cause is illustrated by the metaphor of the blind men and the elephant. Each ‘blind man’
‘sees’ a different aspect of the elephant by touching it and forms a mental model about the beast from that aspect alone. So the man who
touches the tail thinks that the elephant is flexible, skinny and frail; the one who feels a leg thinks that it is solid, inflexible and strong, and
so on.

In other words, every person may see a different aspect of ‘corporate governance’ and form their idea of what it is from that aspect alone.
As a result, when people talk about governance issues, each person may be referring to something different. As the fable proposes, they
may ‘rail on in utter ignorance of that each other mean. And prate about an elephant, not one of them has seen.’

The variation in definitions does matter however, and the problem that this lack of definitional consistency can create is easy to illustrate.
Lawmakers and regulators who are responsible for corporate governance policy develop their own mental models (i.e. understanding)
behind the language that they use. But directors who are legally responsible for compliance with those rules may have developed a
completely different understanding from that which the regulators intended and, as a result, may not be doing what was intended by the
rules

3. Board history, structure and formation

Until the 1980s, the number of shareholders in the UK and US was small. The numbers in continental Europe continue to be small.

Until recently, the stock exchanges were run like exclusive clubs.

Traditionally, the network of boardroom directors has been small and operated like an exclusive club. The members knew one another and
appointments were easy to gain for someone who was a member of the ‘club network’, but difficult for an outsider.

Governance within these clubs was self-regulating. It was based upon personal integrity – and this was considered a higher duty than any
set by law – with exclusion from the club the consequence of a failure in this duty. This was a sanction viewed by insiders as the height of
personal and family humiliation. (Self-regulating club-Network of like-minded directors)

In the past, the typical director’s day was short and the lunches were long, and often held in private dining rooms. The lunch service for
directors of large listed firms usually was lavish and the wine extraordinary. Any real business was conducted over port and cigars following
several hours of congenial social discussion. Attendance at a once-a-month board meeting and collecting the director’s fee was not difficult
– and writers have parodied this to good effect in many stories.

This was a comfortable life for those who were lucky enough to be one of the inner-circle of participants. It was easy because directors had
position and power while managers did all the work and took all the risk.

Although directors may have had a very small role, it was a role to which many aspired for many reasons, not least the power and prestige.

Around the world, the director’s role has had similar characteristics. Most boardrooms place a significant emphasis on ‘getting along’. Before
Enron, ask a board chairman about the qualities they sought in a new addition to the board and the words they would use were
‘considered’, ‘thoughtful’, ‘good chemistry’, ‘consensus builder’.

Financially literate, inquisitive or challenging were not qualities sought in directors. Conflict in the boardroom was considered a sign of
failure, and those who asked too many awkward questions often found themselves ejected from the club. The emphasis was on being a
director and what it created for the holder of the role. Historically, this has been much more important to those in the inner circle than the
practice of directing.

The history of the first board of directors is lost in the mists of time. However, by 1600, the concept of a board of directors was
written into the charters of English joint stock companies (e.g. the East India Company). How the directors chose to fulfil their job
was a matter for them to decide, but by the nineteenth century, there was an extensive judicial debate about the duties of company
directors. Much of this debate took the form of questioning whether the directors were more appropriately regarded as agents of the
shareholders or as trustees. In both the arguments and the cases, the history of the aristocratic estate was obvious:

ƒ As agents, the directors were seen as standing in the same position vis-à-vis the shareholders as a steward stands in relation to his
lord of the estate.
ƒ As trustees, directors of limited liability companies were seen as the successors of directors of unregistered companies, which were
created as trusts under a deed of settlement.

 
 
Hence, whichever analysis was used to determine the duties of the director, it was derived by the courts from duties arising from and
developed by the aristocratic estates. Also, in the UK, company law was interpreted by the Courts of Chancery whose main activity had
been dealing with settlements and trusts. Attitudes held by many Chancery lawyers reflected those derived from their experience with the
administration of trusts and estates.

Chancery judges regarded a company as somewhat like a trust, and the company’s articles of association as akin to a deed of settlement;
therefore they could readily apply their precedents drawn from cases involving the settlement of land to a company whose purpose was the
exploitation of land (in the form of a concession that could be seen as analogous to a lease).

In developed economies, the responsibilities of the directors of companies are set out in the external governance framework – law,
regulation, codes and norms – and these vary between jurisdictions.

Laws and regulations are set by government and are mandatory. A Code is non-mandatory. Some regulators (e.g. in the UK the FSA) may
decide to adopt a code (or a part of a code) and make it part of the body of regulations. In this case, they could make it mandatory. In
other words, it must be done. Alternatively, they could make it ‘comply or explain’. In other words, do it or explain why the company has
not done it. It would be up to the regulators to determine what happens if a company fails to do what they require. Of course, what they
can do could be limited by other aspects of the legal system.

Companies specify the actual design of their Board structures in their articles and bye-laws and these must be compliant with the legal
requirements of the jurisdiction in which they have been organised.

-The UK has long held to the concept of a Unitary Board. Cadbury defined the Unitary Board as ‘a Board made up of a combination of
executive directors, with their intimate knowledge of the business, and of outside, non-executive directors, who can bring a broader view to
the company’s activities, under a chairman who accepts the duties and responsibilities which the post entails’.

Under a UK Unitary Board, all directors are equally responsible in law for the Board’s actions and decisions and for many acts of the
company. Of course certain directors, whether executive or non-executive, will have particular responsibilities for which they are
accountable to the Board. This very much recognises that, in practice, executive and non-executive directors will contribute in different
ways to the Board, but legally in the UK, they are equally responsible.

-Continental Europe, on the other hand, commonly has a two tier board structure. In Germany this includes a Management Board which
comprises only executive directors and is responsible for the day-to-day management of the company and a Supervisory Board comprising
independent directors, usually representing large shareholders, and representatives of some key stakeholder groups such as employees and
pensioners.

The role of the Supervisory Board is to oversee the Management Board. The legal responsibilities assigned to boards vary between
jurisdictions.

-The US has developed a model which appears to be a Unitary Board in concept and construction but typically is comprised of non-
executive directors except for the CEO, who also is the chairman of the board. In practice, most US listed companies also have an executive
committee that runs the day-to-day business of the enterprise, but the legal responsibilities of the executive committee are not defined in
law as if the members of the executive committee were directors. They are not directors unless they also sit on the board of directors.

4. Board of director’s role

The responsibilities undertaken by directors arise from law, regulation, and, in common law countries, decisions by judges. These
mandatory responsibilities have developed over time. Norms of expected social behaviour will also influence how directors execute their
legal responsibilities. In contrast, recommended ‘best practices’ may, or may not, influence how directors do their job.

In other words, legal mandates and non-mandatory recommendations influenced by social norms affect boardroom practice. In the UK, the
responsibility of directors is not determined by the kind of financial products which an institution trades. The responsibilities of directors
include:

ƒ Directors owe a duty of care to the Company although they should have regard for the interests of shareholders, potential
shareholders, employees and creditors.
ƒ All directors of a company have the same duties; there are no classes of directors.
ƒ Directors who act properly are not liable for company debts, except where they have guaranteed them, but breach of duty or
improper act can create director liability for company debt.
ƒ Directors may not exceed the ‘objects’ set out in the Memorandum of Association.
ƒ Directors must respect all limitations imposed in the Articles of Association.
ƒ Duties must be carried out with reasonable competence and a higher standard is expected of those directors with professional
qualifications or particular skills.
ƒ Errors in judgement will not give rise to liability, but negligence can do so.

 
 
ƒ Diligence is expected of directors in executing their duties; acts of omission such as chronic non-attendance at board meetings may be
treated as a default.

The board of directors is responsible for presenting a ‘balanced and understandable assessment of the company’s position
and prospects’. In order to achieve this, the board is required to:

ƒ maintain a sound system of internal control;

ƒ review internal control system at least once a year and report to shareholders that they have done so;
ƒ Review annually all controls, including financial, operational and compliance controls and risk management.

The problem for directors of those banks which did not control their risks appropriately is that they have failed to ensure that their company
has a sound system of internal control and that its risks are managed appropriately. The list of boards that have failed in this regard is long
(e.g. Enron, WorldCom, Marconi, Vivendi) and now it is getting longer (e.g. Merrill Lynch, RBS, HBOS). These boards failed the shareholders
whose investments disappeared. They failed the creditors who financed acquisition sprees. They failed employees, many of whom have
found that their hope for future employment is tainted by close connection with a financial scandal. Pensions have been wiped out, leaving
many people facing an uncertain future.

It is not necessary to be an expert in complex financial products to supervise the management of them. However, it can make it more
difficult to fulfil the responsibilities unless a director is diligent and unafraid to question management. First and foremost they need to have
the support of experts who do understand the technical issues.

Condition for independence of a director of the board: A director is presumed not independent if any of the following conditions exist:

ƒ has been an employee of the company or group within the last five years;
ƒ has had a material business relationship with the company either directly, or as a partner, shareholder, director or senior employee
within the last three years, of a body that has such a relationship with the company;
ƒ has received or receives additional remuneration from the company apart from a director’s fee, participates in the company’s share
option or a performance-related pay scheme, or is a member of the company’s pension scheme;
ƒ has close family ties with any of the company’s advisers, directors or senior employees;
ƒ holds cross-directorships or has significant links with other directors through involvement in other companies or bodies; represents
a significant shareholder; or
ƒ has served on the board for more than nine years from the date of their first election

Audit Committee Role

The Revised Combined Code in the United Kingdom states that the board should establish an audit committee of at least three, or in the
case of smaller companies, two members. The UK rules state that all of the audit committee members should be independent non-executive
directors. The board should satisfy itself that at least one member of the audit committee has recent and relevant financial experience.

• Monitor and review the effectiveness of the company’s internal audit function
• Monitor the integrity of the financial statements of the company
• To make recommendations to the board in relation to the appointment of the external auditor and to approve the remuneration
and terms of engagement of the external auditor
• Following appointment by the shareholders in general meeting to monitor and review the external auditor’s independence,
objectivity and effectiveness
• To develop and implement policy on the engagement of the external auditor to supply non-audit services

The Smith Report (2003)

5. System view of corporate governance

1. Internal Governance& external Governance framework definition

2. System Defination and examples
3. Dynamic system definition and examples
4. System Vs individual
5. Governance reform from a system view
6. System Feedback & reluctance from Human to accept the idea

Human beings organize themselves with a set of evolving norms, policies, procedures and processes that guide individual decision making
and thereby influence behavior. A set of these mechanisms develops within a corporate entity (internal governance). A set also forms
outside of the entity and seeks to influence decision making and behaviour occurring within it (external governance – laws, regulations,
codes of conduct and social norms).

 
 
This implies that there is a structure of interacting functions, or subsets, which combine together and form a system of governance. In other
words, it suggests that corporate governance is a complex system. If so, it should be viewed as a system. However, this requires different
assumptions and analytical tools.

System vs. Individual Assumptions

The historic approach to governance reform has assumed that the individual matters, and as a result we tend to find that regulators issue
many rules which are designed to guide individuals. However, W. E. Deming estimated that, for production workers, 94% of their job
performance came from the system and that improvement in individual and organisational performance requires improvement in the
system.A system approach provides an alternative paradigm to consider – that most of the variation in performance in a governance system
is produced by system factors not by the individuals who operate within the system. As a consequence, the system itself is open to analysis
not just the decision-making by individuals. In other words, it is fundamentally different to analyse the problems of bonuses and payoffs
and make recommendations for reform from a system perspective.

Characteristics of a Dynamic System

What appears to distinguish a system from its parts is that dividing a system will change its nature. For instance, a cup of flour or a loaf
of bread may change shape and size when divided, but they do not change their nature. They are still flour and bread. In
contrast, an elephant is a biological system made up of a complex set of interconnected parts. Divide the elephant in half and
the result is not two small elephants. Similarly, a bicycle is also a system. Remove the spokes from the wheels and what
remains is not a bicycle but a pile of scrap. Similarly, change the organisation of authority or take the accounting function out
of a company and its behaviour would change dramatically. Some complex systems are dynamic – an elephant is dynamic as it is born,
grows, matures and then ages over time – a bicycle is not, although leave one in the rain and its system may change over
time.Governance systems are dynamic social systems and they can change with the passage of time as their parts interact. As
a consequence, changes to one part will affect other parts and may stimulate changes within them. A social system is embedded in the day-
to-day context where people make decisions and take actions within an organisation, so changing the people is unlikely to change the
observable behaviours or performance unless the system is changed.

Reform from a System View

Social and economic systems are complex dynamic systems, and the study of their influence on individual human behaviour is a discipline in
its own right called system dynamics. System dynamics and quality management provide a different way of thinking about reform issues
and the design of potential solutions to the corporate behaviours which society finds problematic.

First, to describe a system, it is necessary to describe both the separate functions and their interconnections (i.e. interactions).

It is important to note that the conditions existing in a system at a particular point in time influence both decision making and the behaviour
of the individuals who operate within that system. For example, financial accounting is, arguably, the most important measure of
organisational performance because it is reported to shareholders. Yet the financial reporting required of a bank is not designed to reflect
the contingent and long term risks to the institution. Is it any wonder that some boards did not manage these risks effectively?

Similarly, external reporting of accounting performance influences decisions about performance targeting and compensation internally.
Shareholders and ratings agencies do not receive information on embedded risks and so their decisions on share value and credit condition,
respectively, are determined by the information to which they have access.

Deming, the man who developed modern quality management, argued that poor quality in a manufacturing or service setting
is the result of problems with the system, not the people working within it. In other words, employees do not typically make
defective parts; systems do. As a result, while a code of conduct (e.g. the Combined Code) sounds nice, it misses the real
issue – it makes no changes to the system and hence may have little or no effect on behaviours in most organisations.

How can a board make the right decision about executive pay if information it receives on performance does not take proper account of the
risks which are hidden in the products which are sold?

Similarly, ask OTC traders to ‘maximise shareholder returns’ but make them operate within an internal governance system that pays them
on the current period profits on the trades and which does not take account in their pay of the risks in the products and they will seek to
deliver that performance which is targeted.

In a booming economy, these governance mechanisms may appear to deliver, but should it be any surprise during an economic downturn
when inappropriate behaviours occur (e.g. boosting sales by offering incentives to purchase more than is reasonably needed, mis-valueing
assets).

Also, feedback structures exist in complex human systems. These operate in a way that is similar to the cycling in the theoretical
model of control described in Module 5. Humans operate in a circular environment where each action affects conditions and any changed
conditions become the basis for future actions in an unending cycle.

 
 
Because people are interconnected, these cycles are intertwined. Forrester describes this as a long cascade of chains of actions where each
person continually reacts to the echo of their own past actions and the past actions of others. If a board determines a pay structure
which is out of synch with competitors, then it will have an effect. If it is better than the norm, others will change theirs. If it
is worse than the norm, the best staff may leave.

Feedback structures within any system can overwhelm the decision making of individuals. The work context created by
an internal governance system guides individuals and provides feedback on their behaviour and decisions, both positive and negative, and
this influences their future decisions. Changing personnel may have little or no effect on the behaviour stimulated by the context.

There is a reluctance on the part of people to accept such a notion – that a human system is fundamentally the same as a physical
or biological system, except perhaps more complex and more difficult to understand.

Perhaps this is because it offends a cherished belief that people are free to make their own decisions. However, look at the evidence. For
instance, every US presidential candidate since Lyndon Johnson has pledged to reduce the national budget, but none has succeeded in
doing so. Only an expanding economy has saved the American government from insolvency. Its political system dominates the decisions
made by individuals, no matter how powerful

6. Factors to decide on where to list

1. Availability of liquidity and secondary market

France has a small share market, and limited liquidity in secondary share trading within that market. In contrast, the United States
and United Kingdom have large liquid capital markets. A flotation in the US or UK is likely to net significantly more cash for the
company, but both countries have well-developed external governance frameworks that impose many more requirements on listed
companies than found in France.
2. Market for the product usage

It makes sense to seek investment capital where the products will be sold. So seeking funds in Asia or in lesser developed
countries does not make sense. This is a European company with EU and US markets for its products. Asian product markets will
need to wait for Avoir to satisfy Western demand for the technology.

3. Listing and governance requirements

For example, in the United States there are few requirements about corporate form and internal governance mechanisms relating
to the operation of a company, whereas in France all listed companies must use the legal structure of a Societé Anonyme (SA),
which is the subject of detailed statutory prescription about the internal structure and organization of the company. Avoir is not on
SA; it is organised as a small business, and operates under a corporate form designed mainly to limit the owner’s personal
exposure to the risks of trade liabilities, a SARL (Societé à Responsabilité Limité). A SARL is subject to minimal regulation,
concerned mostly with company registration. Thus, no matter where the company floats, it may need to reorganise itself into
another corporate form.

7. What are the critical success factors (CSFs) of a successful capital market?

There will be CSFs which are specific to the circumstances of each market, however there are some general CSFs which should apply
everywhere. These are about ‘trust’. Generally, it is believed that it is difficult to have an efficient and reliable financial market without
broad-based trust in all aspects of the market. There must be a belief that all counter-parties to a transaction will fulfil their obligations, or
else few people will be willing to enter into a capital market transaction unless it was very heavily discounted to make the risk worthwhile.
The beliefs necessary to make a financial market viable include the beliefs that:

ƒ those issuing financial instruments have the ability and the intent to fulfil their obligations;
ƒ the financial instruments are valid and what they purport to be;
ƒ sellers will deliver what they have agreed to sell at the time and place agreed;
ƒ purchasers will pay the price at the time, place and in the form agreed;
ƒ all pertinent information about the issuers are available and can be relied upon;
ƒ the financial instruments can be valued accurately with the available information;
ƒ all relevant information is available to all parties to the transactions.

8. Listing requirements in LSE as per the combined code (Adopted as best practice)

1. Balancing the Board

2. Open Process of Board Appointments

 
 
3. Hold Regular Meetings, Committee Structures and Provide Information to the Board
4. Director Remuneration
5. Splitting the Roles of Chairman and Chief Executive
6. Relations with Shareholders
7. Training and Development for Directors
8. Accountability and Audit

If the company lists its shares on the London Stock exchange, they will be expected to follow UK best practice on boardroom
practices. What changes will be needed in order for MFG to satisfy the recommended governance standards? Justify your
answer by stating each of the major requirements and then what the company should do about it. Define the terminology that
you use.

1. Balancing the Board

Hampel and Higgs endorsed the Cadbury Code recommendation that boards should:

ƒ Maintain a ‘balance’ between independent non-executive directors and executive directors. Specifically, independent directors should
make up at least one-third of the board membership (increased to one-half by the post-Higgs revision to the Combined Code).
ƒ The Code states that the ‘role of a non-executive director is to bring independent judgement to the Board.’ This means that the
majority of the non-executive directors should be independent of management and free from any business or other relationship that
could “materially interfere with the exercise of their independent judgement”.
ƒ The Code requires that the annual report of all UK listed companies identify the directors who meet this standard.
ƒ It is also recommended that the members of the board should have sufficient experience and skills which will enable the directors to
oversee the management of the company and its resources.

2. Open Process of Board Appointments

The Combined Code requires all but the smallest companies to set up a nominating committee to oversee appointments to the board.

ƒ This committee should have a majority of non-executive directors.

ƒ Its members should be identified in the annual report. Biographical information on all nominated directors should accompany their
nominations, the information being sufficiently detailed that shareholders can assess their respective relevant experience and
qualifications.
ƒ The notice period or contracts for all directors should not be longer than one year. All directors, both executive and non-executive,
should stand for election at least every three years.

MFG should establish an independent nominating committee to assist it with the identification of the skills required and the people who will
fulfil those requirements. The company should name a senior independent director.

3. Splitting the Roles of Chairman and Chief Executive

“Power tends to corrupt, and absolute power corrupts absolutely.”

Lord Acton

Cadbury was unequivocal that concentration of too much power in one person has been a key enabler in many corporate failures. Notable
examples of what can happen when power is concentrated include BCCI, WorldCom, Tyco and Maxwell.

The UK Combined Code and the post-Higgs Revised Combined Code emphasise the need to have a clear and compelling justification for
combining the roles of chairman and chief executive. It also asks that boards name a senior independent non-executive director in its
annual report. This role is ‘expected to provide an additional route for concerns to be conveyed to the Board and an early warning system
for poor management’.

4. Hold Regular Meetings, Committee Structures and Provide Information to the Board

All directors should be properly briefed on all matters relevant to their role and responsibilities. The effectiveness of the Board is dependent
on the information it receives. The Combined Code requires management to provide the Board with appropriate information and on a timely
basis. The Code also names the chairman as key to ensuring that all directors are properly briefed.

The MFG board should set up a committee structure including:

ƒ Nominating

 
 
ƒ Audit
ƒ Remuneration

5. Director Remuneration

The Code addresses the level and the make-up of remuneration as well as procedures for setting it and disclosure requirements.
Remuneration should be sufficient to attract and retain directors needed to run the company, but companies should avoid paying more than
necessary. A significant proportion of each executive director’s package should be linked to corporate and personal performance. The broad
aim should be to reward good performance, not poor performance.

Companies should have a formal remuneration committee, made up of fully independent non-executive directors, which makes
recommendations on remuneration.

6. Relations with Shareholders

Both the shareholders and the company have responsibilities towards each other. The shareholders should vote and their voting should be
considered carefully. Companies should be ready to enter into dialogue with institutional shareholders. Shareholder meetings can be used to
communicate more effectively with private shareholders. Counting votes cast by absent shareholders, reporting those votes at shareholder
meetings and placing separate issues into substantially separate resolutions to be voted on separately would aid in that regard. Attendance
at shareholder meetings by the chairmen of the board committees (remuneration, audit and nominating), and providing a reasonable
opportunity for questions from the floor, were also recommended.

MFG should set up a schedule for (and ensure that these are delivered) formal communications with shareholders and hold formal annual
general meetings. Each shareholder should receive the same information and it should be provided at the same time in order to ensure that
no one is disadvantaged by asymmetric information.

7. Training and Development for Directors

The Combined Code states that training and development is an important part of good governance. All directors should have appropriate
training when appointed to the board of a listed company and subsequently, when necessary. It is the board’s responsibility to ensure that
training is available to all directors.

8. Accountability and Audit

The board of directors is responsible for presenting a ‘balanced and understandable assessment of the company’s position
and prospects’. In order to achieve this, the board is required to:

ƒ Maintain a sound system of internal control;

ƒ Review the internal control system at least once a year and report to shareholders that they have done so;
ƒ Review annually all controls, including financial, operational and compliance controls and risk management;
ƒ Consider the need for an internal audit function which is focused on all aspects of internal control including business risk assessment,
financial management, asset safeguarding and legal compliance;
ƒ Convene at lease one annual general meeting of shareholders each year.

It is also recommended, but not required, that boards should establish audit committees comprised of at least three non-executive,
independent directors which operate under written terms of reference and committee members should be named in the annual report. The
committee should review the scope and results of the audit, its cost effectiveness and the objectivity and independence of the auditors, as
well as monitor non-audit services performed by the auditors in order to maintain auditor objectivity.

9. Audit committee and best practices

The Smith Report (published in January of 2003) provided guidance on audit committee practice which included:

ƒ Monitor the integrity of the financial statements of the company

ƒ Review the company’s internal financial control system
ƒ Unless addressed by a separate risk committee or by the board itself, review the risk management systems
ƒ Monitor and review the effectiveness of the company’s internal audit function
ƒ Make recommendations to the board in relation to the appointment of the external auditor
ƒ Approve the remuneration and terms of engagement of the external auditor following appointment by the shareholders in a general
meeting
ƒ Monitor and review the external auditor’s independence, objectivity and effectiveness
ƒ Develop and implement policy on the engagement of the external auditor to supply non-audit services

 
 
The Smith Report recommendations do not stray far from the traditional audit of the financial accounts. For example, the report does not
address any of the newly emerging audit areas, such as environmental audits, ethical and community accountability, or the audit of non-
financial measures.

There is only one paragraph in the Smith Report devoted to ‘whistleblowing’:

ƒ Review arrangements by which staff of the company may raise, in confidence, concerns about possible improprieties
ƒ Ensure that arrangements are in place for the proportionate and independent investigation
ƒ Ensure appropriate follow-up action takes place
ƒ Any other matters relevant to the audit committee’s responsibilities

There is also a troubling question and answer in Smith. (Page 24, section entitled “Background report”). Question: What is an audit
committee for? The answer given is:

ƒ Primary role is to ensure the integrity of financial reporting and the audit process
ƒ Ensure that the external auditor is independent and objective and does a thorough job
ƒ Ensure that the company has sound internal financial control systems and systems for the control of non-financial risks of the kind
dealt with in the Turnbull Report

The Smith Report does not reflect on the audit committee’s role in the ‘report on corporate governance’ required by the UK listing rules.
Also, it seems to miss the Cadbury vision – A board that reviews internal control, not just internal financial control, and is responsible for
the system of corporate governance.

The Turnbull guidance sets out best practice on internal control for UK listed companies, and assists them in applying sections of the
Combined Code.

10. Issues with financial reporting

The financial reporting process might be criticized in several key areas, including:

ƒ Financial reports are backward looking, artificial, imprecise representations of a stream of economic activities.
ƒ The processes commonly used to assemble the data which makes up a financial statement may permit manipulation of that data.
ƒ As designed, financial reports may not support the needs and analytical methods employed by many users of the statements.

Extra credit:

There are different ways to ‘tell the story’ of company performance. For instance, the income statement is like a carefully edited motion
picture which uses accounting methods to tell an episode in the story of an entity’s economic activities during a specific period of time (e.g.
a month, quarter-year, a half-year or a year). This is a continuing story, so the first frame of the film picks-up where the last episode ended
(i.e. the beginning balance sheet). The last frame of this episode is frozen for examination until the story picks up where it left off for the
next episode (i.e. the ending balance sheet). Balance sheets are, in effect, regularly spaced pictures in a story about an economic operation.

The statement of changes is rather like the ‘story board’ used in the film industry. It tells a bit about what and why things are reported in
the income statement and have changed in the balance sheet.

However, there are other ways to ‘tell the story’. A set of financial accounts prepared on a cash basis would be like telling the story through
the eyes of only one person, so the story unfolds as that person experiences it. In contrast, the ‘accrual’ method story required by GAAP
would tell all of the significant events as they happen, so that the story is known completely to the film viewer as it happens. The same
story is reported under each method of presentation, but the impression the story leaves and its ability to support decision-making can be
very different.

11. Accounting restatement

An accounting restatement is a correction to published financial information and a republication of those adjusted statements. It sounds
simple but restatements are rarely simple. Restatements can be a result of:

i. changes in accounting method, something that may or may not be of concern, or

ii. an unintentional misstatement of earnings or balances which has been discovered and it requires a correction to previous periods,
or
iii. an intentional fraud.

 
 
If the number of accounting statements grew as the number of firms in the reporting population grew, no conclusion whatsoever can be
made except that further investigation of the data and circumstances would be needed.

More restatements do not necessarily mean that more companies are engaged in irregularities. An increase could be the result of many
other things:

i. Growth in the population of companies – the rate is the same but the number increases because it reflects the growth in the
population of companies.
ii. An economic downturn – it tends to be accompanied by more reporting problems.
iii. More problems being disclosed and this could be for many reasons including:
ƒ More whistleblowers (e.g. something has made it easier to whistle like a new ‘whistleblower’ channel).
ƒ The recent change to new and better audit methods that are more effective at finding issues than previously used
methods.

12. Principles of crisis leadership

1. Perception is reality and rarely can a mistake in crisis management be recovered later.
2. Be up-front and honest, you’ll be found out if you’re not.
3. Respond quickly; the longer you delay, the worse the crisis becomes.
4. Show empathy and caring – a crisis invariably involves human lives.
5. Don’t be defensive or challenging: you’ll only fight a losing battle and waste valuable time.
6. Detail action steps the company will take to help remedy the current situation, and provide the public with action steps as well.
7. Communication (Staff, Managers, Media, customers and share holder)
8. Legal advice
9. Provide help lines, compensation or funding and on-the-scene spokespersons.
10. Detail the steps the company will take to avoid similar occurrences in the future.
11. Deliver public messages from the highest level within the organization.
12. Practice and preparation improve performance in the heat of a crisis.