Chapter 3

Corporate governance
 Topic: To meet corporate governance
requirements
Mnemonic: SCI FIC’N (Science Fiction)
1) Shareholder contact,
2) Chairman and CEO different people,
3) Internal Audit Department,
4) Financial Experience for at least one NED,
5) Internal Control System is appropriate,
6) Committees – Audit,
7) Non-Executive Directors.
8) Remuneration,
9) Appointments etc.
 Definition
• Corporate governance is a system by
which companies are directed and
controlled.
• It covers the role of the board of directors
and the overall control environment.
 OECD principles
• The Organization for Economic Co-operation and
Development (OECD) has developed a set of
Principles of Corporate Governance, that all OECD
member countries should follow when establishing
their own required standards of corporate
governance practice.
• In the UK, best standards of corporate governance
are set out in the Combined Code on Corporate
Governance. Listed companies must follow the
Combined Code, or else explain their
noncompliance.
 OECD Principles
1) Corporate governance framework should protect
shareholder rights , ensuring fair treatment of all the
shareholder particularly minority and foreign shareholder.
2) The framework should ensure the rights of all the
stakeholder not just shareholder and should encourage the
cooperation between the entity and stakeholder in creating
wealth , job.
3) There should be disclosure and transparency.
4) The framework should ensure that timely accurate
information Is made available in all material matters.
5) The framework should ensure the strategic guidance of
entity , effective monitoring of management by the board
and board accountability to the entity and their shareholder.
 The UK Corporate Governance code

• Main principles of code are :

1) Leadership
2) Effectiveness
3) Accountability
4) Remuneration
5) Relationship with the shareholder
 Comply or Explain
• Listed companies have to state that they have
complied with the code or else explain to
shareholder why they have not.
• This allows some flexibility and non
compliance might be acceptable in some
circumstances.
 Leadership
1) Every company should be headed by an effective
management which is collectively responsible for the long
term success of the company.
2) There should be clear division …….. Between running the
board and executive responsibilities for the running of the
company business. No one individual has unfettered powers
of decision, this means that the role of CEO and Chairman
should not be performed by one person.
3) The chairman is responsible for the leadership of board
4) NED must be appointed to the board and they should have
constructively challenge and help develop proposal on
strategy , NED sit in at board meetings and have full voting
rights but do not have day to day responsibilities. Their
function is to monitor , advice warn the executive directors.
 Effectiveness
1) The board should have appropriate balance of skill , experience,
knowledge and independence.
2) New directors should be appointed by nomination committee to
ensure formal , rigorous and transparent procedures for their
appointment.
3) All the director should be able to allocate sufficient time to company
business
4) There should be induction on the joining the board and program to
update and refresh directors skill and knowledge
5) The board should be supplied in a timely manner with necessary
information.
6) The board should undertake a formal and rigorous annual evaluation
of its own performance and that of its committee and individual
directors
7) All the directors should be submitted for re-election at regular
 Accountability
1) The board should present a balanced and understandable
assessment of entity position and prospects
2) The board is responsible for determining the significant
risks, and should maintain sound risk management and
internal control systems.
3) The board should establish formal and transparent
arrangements for applying corporate reporting , risk
management and internal control principles , and for
monitoring an appropriate relationship with the company
auditor. This means that an audit committee should be
established to liaise with external and internal auditor . The
director are responsible for establishing and maintaining the
internal control system and the review of the internal audit.
 Remuneration
1) Level of remuneration should be sufficient to attract ,
retain and motivate directors of sufficient quality but
avoid paying more then is necessary.
2) A significant proportion of director remuneration should
be structured so as to link rewards to corporate and
individual performance.
3) There should be a formal and transparent procedures
for developing policy on executive remuneration and for
fixing the remuneration packages of individual directors.
No director should be involved in deciding his or her
own remuneration . This means that a remunerating
committee should be formed to fix director
remuneration.
 Relationship with shareholder
• There should be a dialogue with shareholder
based on the mutual understanding of
objectives, the board has a whole has
responsibility for ensuring that a satisfactory
dialogue with shareholder takes place.
• The board should use the AGM to
communicate with investors and encourage
their participation.
 Audit committee
• Audit committee is an operating committee of
the Board of directors charged with oversight of
financial reporting and disclosure.
•  To qualify, the committee must be composed of
outside director/ independent outside directors
with at least one qualifying as a financial expert.
• The audit committee will consist of at least three
and no more than six members of the board of
directors
 Responsibilities
1) Overseeing the financial reporting and disclosure
process.
2) Monitoring choice of accounting policies and principles.
3) Overseeing hiring, performance and independence of
the external auditors.
4) Oversight of regulatory compliance, ethics, and
whistleblower hotlines.
5) Monitoring the internal control process.
6) Overseeing the performance of the internal
audit function.
7) Discussing risk management policies and practices with
management.
 Advantages:
• By specializing in the problems of financial reporting and
thus, to some extent, fulfilling the directors' responsibility in
this area, it will allow the executive directors to devote their
attention to management.
• Shareholder and public confidence in published financial
information is enhanced because it has been reviewed by an
independent committee.
• In cases where the interests of the company, where the
executive directors and the employees have a conflict, the
audit committee might provide an impartial body for the
auditors to consult.
3. Provides better communication between the directors, the
external auditors and management.
 Disadvantages:
1) Fear that the purpose is to catch the management out.
2) There may be difficulty selecting sufficient non-
executive directors with the necessary competence in
auditing matters for the committee to be really effective.
3) The establishment of such a formalized reporting
procedure may dissuade the auditors from raising
matters of judgment and limit them to reporting only
on matters of fact.
4) Costs may be increased.
 
 Combined Code: provisions that auditors are required to review

• (a) The directors should acknowledge their responsibility for preparing the accounts in
the annual report.
• (b) The board should, at least annually, conduct a review of the effectiveness of the
• company's system of internal controls and should report to shareholders that they have
done so.
• (c) The board should establish an audit committee of at least three independent non
executive directors, at least one having recent and relevant financial experience.
• (d) The audit committee should have written terms of reference.
• (e) Terms of reference for the audit committee should be made available and described
in the annual report.
• (f) The audit committee should review whether staff feel able to raise concerns about
• financial reporting or other matters.
• (g) The audit committee should monitor and review the effectiveness of the internal
audit activities.
• (h) The audit committee should have primary responsibility for making a
recommendation on the appointment, reappointment and removal of the external
auditors.
• (i) The audit committee should describe in the annual report the safeguards adopted by
external auditors to protect their independence where they provide other services
 Those charged with governance (ISA
260)
• ‘Those charged with governance’ means
those entrusted with the supervision,
control an direction of an entity and would
therefore include the audit committee and
non-executive directors. They only include
management when it performs such
functions
 Procedures
• Such communications should be on a sufficiently prompt basis
to enable those charged with governance to take appropriate
action. All communications will be before the financial
statements are finalized.
• The form of communications and the addressee of
communications should be established at an early stage in the
audit process (i.e. planning).
• Before reporting issues to the board, auditors should first
discuss those matters with management. This gives
management an opportunity to provide further information or
explanations.
• If possible, matters should be addressed to the audit
committee, or to the board if there is no audit committee.
Matters that should be communicated

• Refer to the article (ISA 260) those

charged with governance
 Question 1(Dec 2011)

• (a) Explain what is meant by ‘corporate governance’ and why it is

important. (3 marks)
• (b) Serena VDW Co has been trading for over 20 years and obtained a
listing on a stock exchange five years ago. It provides specialist training in
accounting and finance.
• The listing rules of the stock exchange require compliance with corporate
governance principles, and the directors are fairly confident that they are
following best practice in relation to this. However, they have recently
received an email from a significant shareholder, who is concerned that
Serena VDW Co does not comply with corporate governance principles.
• Serena VDW Co’s board is comprised of six directors; there are four
executives who originally set up the company and two non-executive
directors who joined Serena VDW Co just prior to the listing. Each director
has a specific area of responsibility and only the finance director reviews
the financial statements and budgets.
• The chief executive officer, Daniel Brown, set up the audit committee and he
sits on this sub-committee along with the finance director and the non-
executive directors. As the board is relatively small, and to save costs.
 Question 1(Dec 2011)
• Daniel Brown has recently taken on the role of chairman of the board.
It is the finance director and the chairman who make decisions on the
appointment and remuneration of the external auditors. Again, to
save costs, no internal audit function has been set up to monitor
internal controls.

• The executive directors’ remuneration is proposed by the finance

director and approved by the chairman. They are paid an annual
salary as well as a generous annual revenue related bonus.
• Since the company listed, the directors have remained unchanged and
none have been subject to re-election by shareholders.
• Required:
• Describe SIX corporate governance weaknesses faced by Serena
VDW Co and provide recommendations to address each weakness,
to ensure compliance with corporate governance principles. (12
marks)
 Question 2(June 2009)
• Conoy Co designs and manufactures luxury motor vehicles. The
company employs 2,500 staff and consistently makes a net profit of
between 10% and 15% of sales. Conoy Co is not listed; its shares are
held by 15 individuals, most of them from the same family. The
maximum shareholding is 15% of the share capital.
• The executive directors are drawn mainly from the shareholders. There
are no non-executive directors because the company legislation in
Conoy Co’s jurisdiction does not require any. The executive directors
are very successful in running Conoy Co, partly from their training in
production and management techniques, and partly from their ‘hands-
on’ approach providing motivation to employees.
• The board are considering a significant expansion of the company.
However, the company’s bankers are concerned with the standard of
financial reporting as the financial director (FD) has recently left Conoy
Co. The board are delaying provision of additional financial
information until a new FD is appointed.
 Question 2(June 2009)

• Conoy Co does have an internal audit department, although the chief

internal auditor frequently comments that the board of Conoy Co do not
understand his reports or provide sufficient support for his department
or the internal control systems within Conoy Co. The board of Conoy Co
concur with this view. Anders & Co, the external auditors have also
expressed concern in this area and the fact that the internal audit
department focuses work on control systems, not financial reporting.
Anders & Co are appointed by and report to the board of Conoy Co.
• The board of Conoy Co are considering a proposal from the chief internal
auditor to establish an audit committee. The committee would consist of
one executive director, the chief internal auditor as well as three new
appointees. One appointee would have a non-executive seat on the
board of directors.
• Required:
• Discuss the benefits to Conoy Co of forming an audit committee. (12
marks