CHAPTER 5

CORPORATE GOVERNANCE
 CHAPTER 5: CORPORATE GOVERNANCE

• DEFINITION OF CORPORATE GOVERNANCE AND

5.1 SYMPTOMS OF POOR CORPORATE GOVERNANCE

• GOVERNANCE STRUCTURES
5.2

• THE ROLE OF EXTERNAL AND INTERNAL AUDIT

5.3
5.1. DEFINITION OF CORPORATE GOVERNANCE AND
SYMPTOMS OF POOR CORPORATE GOVERNANCE
5.1.1. Definition of corporate governance

What is governance?
Governance is the system by which an
organisation is directed and controlled so that
its objectives are achieved in an acceptable
and sustainable manner.
5.1. DEFINITION OF CORPORATE GOVERNANCE AND
4.1. GOVERNANCE AND ETHICS
SYMPTOMS OF POOR CORPORATE GOVERNANCE
5.1.1. Definition of corporate governance

Why is governance an important issue?

Governance has become a very major business in recent
year because, simply put, in getting things done a
business’s managers very often lose sight of:
• whom they are seeking to benefit, and
• the fact they should not harm others
This is often referred to as the agency problem.
5.1. DEFINITION OF CORPORATE GOVERNANCE AND
4.1. GOVERNANCE
SYMPTOMS AND ETHICS
OF POOR CORPORATE GOVERNANCE
5.1.1. Definition of corporate governance

Why is governance an important issue?

Agency problem: Shareholders and management
Managers of a company are there to ensure that the interests of
the shareholders, who in large companies are not usually also the
managers, are looked after. Managers therefore effectively act as
the ‘agents’ of the shareholders when managing the company,
though not in the full legal sense. This means that:
• Ownership and control are separated, and
• Conflicts arise between the interest of those in control of the
company and those who own it.
5.1. DEFINITION OF CORPORATE GOVERNANCE AND
4.1. GOVERNANCE
SYMPTOMS AND ETHICS
OF POOR CORPORATE GOVERNANCE
5.1.1. Definition of corporate governance

Why is governance an important issue?

Agency problem: Shareholders and management
Historically, when managers ran a company in a way that
suited their own interests, without due regard to the interests
of the shareholders, they often got away with it because:
• They had better information than the shareholders about
what was going on
• They were not sufficiently accountable for their
stewardship, decisions and actions.
5.1. DEFINITION OF CORPORATE GOVERNANCE AND
4.2. CORPORATE
SYMPTOMS GOVERNANCE
OF POOR CORPORATE GOVERNANCE
5.1.1. Definition of corporate governance

What is corporate governance?

 Corporate governance is the set of relationships between a
company’s management, board, shareholders and other
stakeholders that provides the structure through which the
company’s objectives are set, attained and monitored. It
specifies the distribution of rights and responsibilities
between stakeholders, and establishes rules and procedures
for making decisions about the company’s affairs
5.1. DEFINITION OF CORPORATE GOVERNANCE AND
4.2. CORPORATE
SYMPTOMS GOVERNANCE
OF POOR CORPORATE GOVERNANCE
5.1.2. Symptoms of poor corporate governance

 Domination of the board by a single individual or group,

with other board members merely acting as a rubber stamp
 No involvement by the board: meeting irregularly, failing to
consider systematically the organization’s activities and
risks, or basing decisions on inadequate information
 Inadequate control function, for instance no internal audit,
or lack of adequate technical knowledge in key role, or a
rapid turnover of staff involved in accounting or control
5.1. DEFINITION OF CORPORATE GOVERNANCE AND
4.2. CORPORATE
SYMPTOMS GOVERNANCE
OF POOR CORPORATE GOVERNANCE
5.1.2. Symptoms of poor corporate governance

 Lack of supervision of employees

 Lack of independent scrutiny by external or internal auditors
 Lack of contact with shareholders
 Emphasis on short-term profitability, leading to concealment
of problems or errors, or manipulation of financial
statements to achieve desired results
 Misleading financial statements and information
 4.2. CORPORATE GOVERNANCE
5.2. GOVERNANCE STRUCTURES

The set of legal or regulatory methods put in place in

order to ensure effective corporate governance.

There are two basic governance structures:

• Statutes
• Codes of practice
5.2. GOVERNANCE STRUCTURES
4.2. CORPORATE GOVERNANCE
5.2.1. Principles-based approach to governance structures

1. Promote transparent and efficient financial market,

be consistent with the rule of law and clearly articulate
the division of responsibilities among different
supervisory, regulatory and enforcement authorities.
5.2. GOVERNANCE STRUCTURES
4.2. CORPORATE GOVERNANCE
5.2.1. Principles-based approach to governance structures

2. Protect and facilitate shareholders’ rights, including the following basic

rights:
• To have secure methods of ownership registration
• To convey and transfer share
• To obtain relevant and material information on the company on a timely
and regular basis
• To participate in and vote at general meetings, including the right to ask
questions of the board.
• To elect and remove members of the board
• To share in the company’s profits
• To participate and be involved in fundamental company changes such as
amendments to the company’s constitution
5.2. GOVERNANCE STRUCTURES
4.2. CORPORATE GOVERNANCE
5.2.1. Principles-based approach to governance structures

3. Ensure the equitable treatment of all shareholders, including

minority and foreign shareholders. All shareholders should have
the opportunity to obtain effective redress for violation of their
rights:
• All shareholders in the same class should be treated equally
• Insider trading should be prohibited
• Director and key managers should disclose whether they have
an interest in material transactions entered into by the
company.
5.2. GOVERNANCE STRUCTURES
4.2. CORPORATE GOVERNANCE
5.2.1. Principles-based approach to governance structures

4. Recognise the rights of stakeholders established by

law or through mutual agreements, and encourage active
co-operation between companies and stakeholders in
creating wealth, jobs, and the sustainability of financially
sound entities.
5.2. GOVERNANCE STRUCTURES
4.2. CORPORATE GOVERNANCE
5.2.1. Principles-based approach to governance structures

5. Ensure that timely and accurate disclosure is made on

all material matters, including the company’s:
• Financial position and performance
• Ownership
• Objectives
• Board remuneration policy
• Related party transactions
• Foreseeable risk factors.
5.2. GOVERNANCE STRUCTURES
4.2. CORPORATE GOVERNANCE
5.2.1. Principles-based approach to governance structures

6. Ensure the strategic guidance of the company by

the board, the effective monitoring of management
by the board, and the board’s accountability.
5.2. GOVERNANCE STRUCTURES
4.2. CORPORATE GOVERNANCE
5.2.1. Principles-based approach to governance structures

Principle 5 enshrines in particular:

• The need for and status of the external audit, and
• The need for an effective approach to the provision of analysis
or advice by analysts, brokers, rating agencies and others, that is:
– Relevant to decisions by investors
– Free from material conflicts of interest that might compromise the
integrity of their analysis or advice.
5.2. GOVERNANCE STRUCTURES
4.2. CORPORATE GOVERNANCE
5.2.2. Shareholder-led approach to governance structures

Greater emphasis has been placed on the role of shareholders in governance

structures. This is because they are market-based financial systems where
institutional shareholders have very high levels of investment in the shares of
leading companies
“Institutional shareholders” is a board term for organizations which invest
money on behalf of other people. They comprise:
- Insurance companies
- Pension funds
- Investment trusts
- Investment managers who acts as agents of the above bodies
5.3. THE4.2.
ROLES OF EXTERNAL AND INTERNAL
CORPORATE GOVERNANCE AUDIT
5.3.1. The role of external audit
 The financial statements of larger companies are subject to external
audit each year by an auditor carrying out an independent and
objective investigation, unless they are exempted.
 The purpose of the external audit is to issue an opinion in an audit
report whether the financial statements produced by the directors
give a ‘true and fair view’ of the financial performance of the company
during the reporting period and of its financial position as at the end
of the period. Auditors of listed companies also have to report on:
• The directors’ remuneration report
• The company’s compliance
• External auditors are appointed by a shareholder vote, following
recommendations by the board and audit committee.
5.3. THE4.2.
ROLES OF EXTERNAL AND INTERNAL
CORPORATE GOVERNANCE AUDIT
5.3.1. The role of external audit
 Shareholders often believe the external auditor’s opinion
means that the financial statements of the company are
‘correct’. If the published financial statements are
subsequently found to be incorrect, perhaps due to a
fraud, shareholders then blame the auditor for:
• Failing to spot the problem
• Lacking objectivity
• Failing to challenge the views of the company’s
management about accounting policies and the
accounting treatment of certain items.
5.3. THE4.2.
ROLES OF EXTERNAL AND INTERNAL
CORPORATE GOVERNANCE AUDIT
5.3.1. The role of external audit
 In fact, although the external audit must be conducted to
professional standards, the external auditor is not
responsible for detecting fraud and error. The responsibility
for preventing and detecting fraud and error lies with:
• Directors, who are required by the UK Corporate
Governance Code and the FRC’s guidance on internal
control to satisfy them selves that the systems of internal
control and risk management are working effectively.
• Management, who implement and monitor the system of
internal control determined by the directors.
5.3. THE4.2.
ROLES OF EXTERNAL AND INTERNAL
CORPORATE GOVERNANCE AUDIT
5.3.1. The role of external audit

The role of the external audit is a key issue in corporate

governance, but in relation to corporate governance as
a system the external auditor simply reports an
independent and expert opinion on how the company is
complying with the UK Corporate Governance Code.
The responsibility to do something about it remains
with the directors and shareholders.
5.3. THE4.2.
ROLES OF EXTERNAL AND INTERNAL
CORPORATE GOVERNANCE AUDIT
5.3.2. The role of internal audit
Internal audit: A semi-independent part of the company
which monitors the effective operation of its internal
control and risk management systems. Internal audit is
itself a key element of the company’s system of internal
control.
5.3. THE4.2.
ROLES OF EXTERNAL AND INTERNAL
CORPORATE GOVERNANCE AUDIT
5.3.1. The role of external audit
The independence of internal auditors should be preserved so they can carry out the
following tasks based on detailed reviews of areas of the company:
• Assessing how risks are identified, analysed and managed
• Advising management on embedding risk management processes into business
activities
• Advising management on improving internal controls
• Ensuring that assets are being safeguarded
• Ensuring that operations are conducted effectively, efficiently and economically in
accordance with the company’s policies
• Ensuring that laws and regulations are complied with
• Ensuring that records and reports are reliable and accurate
• Helping management to detect or deter fraud
• Helping management to identify savings and opportunities.