Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

Chapter 19

Corporate governance

Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

Learning objectives Understand the importance of corporate governance as a system by which

companies are directed and controlled, and describe the impact on stakeholders when corporate governance fails.

Explain the difference between a broad concept of corporate governance on behalf of many stakeholders, compared to the UK narrow focus of corporate governance on behalf of shareholders.

Evaluate the role of corporate governance as an ex-ante mechanism to monitor corporate behaviour compared to ex-post external audit monitoring.

Appreciate different models of corporate governance.

Describe and discuss the recommendations included in the in the UK Corporate Governance Code.

Appreciate balance on the board, board committees and current developments relating to UK corporate governance.

Understand the reporting entitys obligation to disclose corporate governance practice and appreciate the purpose of comply or explain disclosures.

Describe and discuss the recommendations of the UK Stewardship Code and evaluate the likelihood of investors effectively monitoring boards of directors.

Appreciate that governance mechanisms operate in different types of entity, including in audit firms.

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Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

Corporate Governance: Definition

Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the board include setting the companys strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The boards actions are subject to laws, regulations and the shareholders in general meeting (UK Corporate Governance Code, 2012, p. 1).

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Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

Two mechanisms for monitoring

Corporate governance is one mechanism for monitoring an agents (directors/management) progress in meeting the needs of shareholders to ensure company management is acting in the best interests of their principals; this is known as ex-ante monitoring.

Auditing is also a mechanism for monitoring corporate activity at the end of a defined period of time, once several executive decisions have been implemented; this form of monitoring is sometimes referred to as ex-post monitoring, which refers to assessing the quality of the results once the executive decisions have been taken and their effects realized.

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Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

Models of corporate governance

In broad terms, good governance refers to the framework of rules and practices by which those who control a company or organization ensure that they act with integrity and are accountable, fair and transparent to stakeholders who have a relationship with the entity.

For all models and concepts, it is important always to remember that for corporate governance mechanisms to be effective, their role is to oversee the executive and therefore must be separate from the day to day operational management of the entity.

The systems by which companies are directed and controlled will vary depending on the type of the organization and the jurisdiction in which it operates. Different jurisdictions have different legal, political and cultural systems which will determine how corporate governance is explicitly or implicitly regulated.

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Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

UK Model of Corporate Governance

The UK model is based on the underlying concepts of accountability, transparency, probity and focus on the long term success of the company. Over two decades, the FRC in the UK has published a number of evolving iterations of its corporate governance code.

The Code is not a rigid set of rules. It consists of principles (main and supporting) and provisions. The 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.

The UK model of corporate governance has at its roots, the enduring underlying approach of comply or explain.

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Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

Comply or explain

In practice, an alternative course of action to that of following a provision of the Code may be justified where the Board assess that good governance can be achieved.

Where this is the case, the directors are required to explain to shareholders, in the annual report and accounts, the circumstances and rationale for not following the provision and illustrate how the alternative practice is consistent with the related principle of the Code and will contribute to good governance.

This comply with the Code or explain to shareholders approach is seen as a flexible way of ensuring good corporate governance.

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Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

UK v US Corporate Governance

Current UK Code provides that roles of chairman of the Board and CE should not be exercised by the same person. In US, role of CE has retained a powerful influence over direction and control of companies. US response to corporate collapses such as Enron, was statutory regulation through the Sarbanes-Oxley (SOX) Act (2002), which focuses on strict ex-post audit monitoring of US-listed companies, plus legislation by SEC to scrutinize and monitor executive remuneration more closely.

But, after the recent financial crisis, the US has reacted with a further wave of legislation and more SEC proposals. But separation of chairman and CE is now encouraged by SEC and is now required for certain US entities that received state assistance in the aftermath of the financial crisis.

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Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

International models of corporate governance

EU legislation requires EU listed companies to identify the CG code used and to adopt a comply or explain approach to CG disclosures. But, in 2013, the EU Commission initiated a roadmap: Enhancing the EU Corporate Governance Framework, and identified an evaluation of the functioning of the comply or explain principle revealed considerable shortcomings

OECD has issued CG principles intended to assist national governments and regulators in developing effective CG guidance: Ensuring the basis for an effective CG framework

The rights of shareholders and key ownership functions

The equitable treatment of shareholders

The role of stakeholders in corporate governance

Disclosure and transparency, and

The responsibilities of the board.

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Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

UK CG Code: Types of company officer

Board of directors (BoD)

Chair of the board or chairman or chairperson

Chief Executive (CE) Officer (CEO)

Non-executive director (NED)

Independent non-executive director (iNED)

Company secretary

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Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

The UK CG Code, main principles (1)

Leadership

There are four main principles (A.1. to A.4.) that focus on developing governance mechanisms to ensure: The board is focused on the long-term success of the

company.

The board should not be controlled by one individual; the chairman of the board and the CEO should not be held by the same individual.

The chairman is responsible for leadership and effectiveness of the board.

The role of NEDs includes challenging and contributing to strategy development

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Use with The Audit Process: Principles, Practice and Cases, 6th edn ISBN 978-1-4080-8170-9 Iain Gray, Stuart Manson and Louise Crawford, 2015

The UK CG Code, main principles (2)

Effectiveness

There are seven (B.1. to B.7.) main principles that focus on developing governance mechanisms to ensure: Board have the necessary skills, experience, independence and

knowledge to do their duties and meet their responsibilities.

Appointment of directors to the boar