P1P1 All notes All notes

Corporate governance

is the system by which organisations are directed and controlled.

A sound system of corporate governance is capable of reducing company failures in anumber of ways:

1. it addresses issues of management

This reduces the agency problem and makes it less likely that management will promote their own self-interests above

those of shareholders.

2. it helps to identify and manage the wide range of risks

These might arise from changes in the internal or external environments

3. it specifies a range of effective internal controls

that will ensure the effective use of resources and the minimisation of waste, fraud, and the misuse of company assets.

Internal controls are necessary for maintaining the efficient and effective operation of a business

4. it encourages reliable and complete external reporting of financial data

By using this information, investors can establish what is going on in the company and will have advanced warning of

any problems

5. it underpins investor confidence

gives shareholders a belief that their investments are being responsibly managed

6. it encourages and attract new investment

Corporate Governance

Main PrinciplesApproaches to Corporate Governance

6. it encourages and attract new investment

make it more likely that lenders will extend credit and provide increased loan capital if needed

There are 2 possible systems for trying to get companies to have good corporategovernance:

These are:

1. Rules based

2. Principle based

Rules-based system

In the rules-based system, companies adhere to the rules or pay penalties.

ADVANTAGES

1. Clarity

2. Standardisation

3. Penalties are a deterrent against bad CG

4. Easier compliance with the rules, as they are unambiguous, and can be evidenced

DISADVANTAGES

1. Can create just a "box-ticking" approach

2. Not suitable to all possible situations.

3. Creates unnecessary administration burden on some companies

4. One size does not necessarily fit all.

5. Expensive

Principles-based System (Comply or explain)

In the principles system, companies adhere to the spirit of the rule, or explain why it hasnt.

This does not mean the company has a choice not to adhere.

It just means it can TEMPORARILY explain why it has not.

The punishment for this non-adherence will be judged by investors.

ADVANTAGES

1. Not so rigid, allows for different circumstances.

2. Allows companies to go beyond the minimum required.

3. Less of an admin burden.

4. Can develop own specific CG and Internal controls (For example physical controls over cash will be vital to somebusinesses and less relevant or not applicable to others.

DISADVANTAGES

1. The principles are so broad that they are of very little use as a guide to best corporate government practice

2. Not easier compliance as with the rules, as they are ambiguous, and can not be evidenced

Principles v Rules More Detail

Principles

Principles

The principle of comply or explain means that companies have to take seriously the general principles of relevant

corporate governance codes.

Compliance is required under stockmarket listing rules but non-compliance is allowed based on the premise of full

disclosure of all areas of non-compliance.

It is believed that the market mechanism is then capable of valuing the extent of non-compliance and signalling to the

company when an unacceptable level of compliance is reached.

On points of detail companies could be in non-compliant as long as they made clear in their annual report the ways in

which they were non-compliant and, usually, the reasons why.

This meant that the market was then able to punish non-compliance if investors were dissatisfied with the explanation (ie

the share price might fall).

In most cases nowadays, comply or explain disclosures in the UK describe minor or temporary non-compliance.

Some companies, especially larger ones, make full compliance a prominent announcement to shareholders in the annual

report, presumably in the belief that this will underpin investor confidence in management, and protect market value.

Remember though that companies are required to comply under listing rules but the fact that it is not legally required

should not lead us to conclude that they have a free choice.

The stock market takes a very dim view of most material breaches, especially in larger companies.

Typically, smaller companies are allowed (by the market, not by the listing rules) more latitude than larger companies.

This is an important difference between rules-based and principles-based approaches.

Smaller companies have more leeway than would be the case in a rules-based jurisdiction, and this can be very important

in the development of a small business where compliance costs can be disproportionately high.

Rules

Rules-based control is when behaviour is underpinned and prescribed by statute of the countrys legislature.

Compliance is therefore enforceable in law such that companies can face legal action if they fail to comply.

US-listed companies are required to comply in detail with Sarbox provisions.

Sarbox compliance can also prove very expensive.

The same detailed provisions are required of SME's as of large companies, and these provisions apply to each company

listed in New York.

National differences

Developing countries

In developing economies - there are normally many SMEs. For these companies extra regulations would be very costly

So, perhaps for them the option to comply or explain is better.

This would allow those who seek foreign investment to comply more fully than those who don't want it and are prepared to

explain why

Developing countries may not have all resources that are needed for full compliance (auditors, pool of NEDs, professional

accountants, internal auditors, etc).

To help compliance, international standards help nations become competitive.

The OECD (Organisation for Economic Cooperation & Development) was established in 1961.

It is made up of the industrialised marketeconomy countries, as well as some developing countries, and provides a forum in

which to establish and coordinate policies.

The ICGN (International Corporate Governance Network) was founded in 1995 at the instigation of major institutional investors,

represents investors, companies, financial intermediaries, academics and other parties interested in the development of global

corporate governance practices

What Is a code And what is it for?

In most countries, financial accounting to shareholders is underpinned by company law and International Financial Reporting

Standards.

Some of the other activities of directors are not, and it is in this respect that countries differ in their approaches.

Codes Are intended to specifically guide behaviour where the law is ambiguous

Key Underpinning Concepts of Corporate Governance

So whats all this nonsense about then hey?? Well, for a company to be run well, and in the best interests of its shareholders, is a

bit like all good relationships. They are built on solid foundations of trust and so on so thats my little heartwarming story

Underpinning concepts of Governance

bit like all good relationships. They are built on solid foundations of trust and so on so thats my little heartwarming story

over back to the boring stuff oh but please remember these need memorising as they are a common question!

These are the underpinning concepts....

Fairness

Respecting the rights and views of any groups with a legitimate interest.

This means a lack of bias.

This is especially important where personal feelings are involved.

Responsibility

Willingness to accept liability for the outcome of governance decisions.

Clarity in the definition of roles and responsibilities.

Conscientious business and personal behaviour.

Accountability

Answerable for the consequences of actions.

Providing clarity in communication channels with internal and external stakeholders.

Development and maintenance of risk management and control systems.

Honesty/Probity

Not simply telling the truth but also not being guilty of issuing misleading statements or presenting information in confusing or

distorted way.

Truthful

Not misleading

Integrity

A person of high moral virtue. Adheres to a strict moral or ethical code despite other pressures.

It is an underlying principle of corporate governance and it is vital in all agency relationships.

Straightforward dealing.

Importance of integrity in corporate governance:

Codes of ethics do not capture all ethical situations.

Any profession (such as accounting) relies upon a public perception of competence and integrity.

It provides a basic ethical framework to guide an accountants professional and personal life.

It underpins the relationships that an accountant has with his or her clients, auditors and other colleagues.

Trust is vital in the normal conduct of these relationships and integrity underpins this.

Transparency/ Openness

Means openness (say, of discussions), clarity, lack of withholding of relevant information unless necessary.

Disclosure, including voluntary disclosure of reliable information.

Importance of transparency:

Gains trust with investors and authorities.

Underpins market confidence in the company through truthful and fair reporting.

Helps manage stakeholder claims.

Reasons for secrecy/confidentiality include the fact that it may be necessary to keep strategy discussions secret from

competitors.

And yet when I wore my transparent lecturing suit when lecturing they said it wasnt appropriate. Meh ;-)

Independence

Independence of NEDs.

Independence of the board from operational involvement.

Independence of directorships from purely personal motivation.

Reputation

Personal reputation for moral virtues.

Organisation reputation for moral virtues.

Accountancy profession reputation for moral virtues.

Directors in Corporate Governance

These are the most prominent group in corporate governance (and often the most annoying).

Seriously though they have a massive part to play in making sure the company is well run and directed (hence the name!)

Executive or non-executive

The numbers and split of executives to NEDs will partly depend upon the regulatory regime of the country.

NEDs are independent and are not involved in the day to day running of the business

Internal actors (in CG)Directors in Corporate Governance

Non executives

Investors and regulators prefer there to be more NEDs, due to their independent scrutiny of the company.

Remember that the execs should be working in the best interests of the shareholders and its partly the NEDs job to ensure they

do

Legal responsibilities

So here we are looking at the legal side of what they need to do to help run and direct the company well (corporate governance)

In a unitary board structure (the one where theres just one board - see later sections), all directors share legal responsibility for

company activities and all are accountable to the shareholders.

Notice that directors are all responsible for each others decisions - this is important - it means everyone is looking to ensure each

other does the job well (see collective responsibility below)

In most countries, all directors are subject to retirement by rotation, where they either step down or offer themselves for

reelection (by the shareholders) for another term in office.

This gives shareholders a chance to not re-elect rubbish directors!

Collectively responsible

Directors are collectively responsible for the companys performance, controls, compliance and behaviour.

So theres no hiding place for them hopefully

Board roles

1. They must comply fully with relevant regulatory requirements that will include legal, accounting and governance frameworks.

2. The board of directors must discuss and agree strategies to maximise the long-term returns to the companys shareholders.

Company secretary

Compulsory

In most countries, the appointment of a company secretary is a compulsory condition of company registration.

This is because the company secretary has important responsibilities in compliance, including the responsibility for the

timely filing of accounts and other legal compliance issues.

So as well as making sure her nails are well manicured it is his/her legal responsibility to ensure all the admin that comes

with PLCs are adhered too.

Even though I joke about this - it is actually a vital role. The legal frameworks are there to try and protect the stakeholders

Advises legal responsibilities

The company secretary often advises directors of their regulatory and legal responsibilities and duties.

Loyal to company

His or her primary loyalty is always to the company.

In any conflict with another member of the company (such as a director), the company secretary must always take the side

most likely to benefit the company

Technical knowledge

In many countries he (get me being all modern!) must be a member of one of a list of professional accountancy or company

secretary professional bodies

Company secretary

Major roles include:

1. Maintaining the statutory registers

2. Ensuring the timely and accurate filing of audited accounts and other documents to statutory authorities

3. Providing members (eg shareholders) and directors with notice of relevant meetings

4. Organising resolutions for and minutes from major company meetings (like the AGM)

Sub-board management

Sometimes referred to (ambiguously) as middle management, managers below board level are a crucial part of the governance

system.

It is the employees, led by subboard management, that implement strategies, meet compliance targets and collect theinformation and data on which boardlevel decisions are made.

Effectiveness

Depends on the extent to which organisational activities are controlled and coordinated.

Strategic drift can occur, especially in large organisations, when this vital control and coordination is ineffective.

It is the sub management which can prevent the strategic drift by making sure the policies decided by the board are actually

followed through

Sub board management

Employee representatives

Trade unions represent employees in a workplace;

membership is voluntary and its influence depends on how many of the workforce are members

Corporate Governance role

Trade unions are able to deliver the compliance of a workforce.

If a strategy needs a high level of commitment, a union can help to unite the workforce behind the strategy and ensure

everybody is committed to it.

How do they do this?

United front

This can also mean that management and workforce are seen as united by external stakeholders; making the

achievement of strategies more likely.

Keeps management abuses at bay

A trade union can be a key actor in the checks and balances of power within a corporate governance structure.

This can often work to the advantage of shareholders, especially when the abuse has the ability to affect

productivity.

Help effectiveness of company

Unions are often good at highlighting management abuses such as fraud, waste, incompetence and greed

Help to control the employees

Where a good relationship exists between union and employer, then productivity of employees tends to increase

Employee Representatives

Where a good relationship exists between union and employer, then productivity of employees tends to increase

Stock exchanges

Shares are bought and sold through stock exchanges.

Each keeps an index of the value of shares on that exchange; In London, for example, the FTSE All Share (Financial Times Stock

Exchange) index is a measure of all of the shares listed in London.

In New York, it is the Dow Jones index and in Hong Kong, it is the Hang Seng index.

Role in Corporate Governance

Listing rules are sometimes imposed on listed companies often concerning governance arrangements not covered elsewhere by

company law.

In the UK, for example, it is a stock exchange requirement that listed companies comply with the Combined Code on Corporate

Governance

Procedure for obtaining a listing on an international stock exchange

Normally, obtaining a listing consists of three steps:

External Actors (in CG)Stock exchanges

1. legal

2. regulatory

3. compliance

Steps:

1. In the UK a firm seeking listing must register as a public limited company.

This entails a change in its memorandum and articles agreed by the existing members at a special meeting of the company.

2. The company must then meet the regulatory requirements of the Listing Agency which, in the UK, is part of the Financial ServicesAuthority (FSA).

These requirements impose a minimum size restriction on the company and other conditions concerning length of time trading.

3. Once these requirements are satisfied the company is then placed on an official list and is allowed to make a public offering of itsshares.

4. Once the company is on the official list it must then seek the approval of the Stock Exchange for its shares to be traded.

In principal it is open to any company to seek a listing on any exchange where shares are traded.

5. The London Exchange imposes strict requirements and invariably the applicant company will need the services of a sponsoringfirm that specialises in this type of work.

The advantages of seeking a public listing

1. It opens the capital market to the firm

2. It offers the company access to equity capital from both institutional and private investors and the sums that can be raised areusually much greater than can be obtained through private equity sources.

3. Enhances its credibility as investors and the general public are aware that by doing so it has opened itself to a much higher degreeof public scrutiny than is the case for a firm that is privately financed.

The disadvantages of seeking a public listing

1. A distributed shareholding does place the firm in the market for corporate control increasing the likelihood that the firm will besubject to a takeover bid.

2. There is also a much more public level of scrutiny with a range of disclosure requirements.

3. Financial accounts must be prepared in accordance with IFRS or FASB and with the relevant GAAP as well as the Companies Acts.

4. Under the rules of the London Stock Exchange companies must also comply with the governance requirements of the CombinedCode

Shareholders and other investors

Now time for the big boys the most important external actors in corporate governance.

They do, after all, own the business that we are looking to run and direct properly.

Other Investors include fixedreturn bondholders

Agency relationship

The shareholders are the principals . They expect agents (directors) to act in their best economic interests

An agency relationship is one of trust between an agent and a principal which obliges the agent to meet the objectives placed

upon it by the principal.

As one appointed by a principal to manage, oversee or further the principals specific interests, the primary purpose of agency isto discharge its fiduciary duty to the principal

Agency costs

Shareholders

Shareholders incur agency costs in monitoring the agents (directors).

If they didnt have to keep checking the managers then there would be agency costs.

When a shareholder holds shares in many companies, the total agency costs can be prohibitive;

shareholders therefore encourage directors rewards packages to be aligned with their own interests so that they feel less need

to continually monitor directors activities.

So lets look at some examples of costs of monitoring and checking on directors behaviour

1. Attending relevant meetings (AGMs and EGMs)

2. Studying company results

3. Making direct contact with companies

Types of Investor

Small investors

Individuals who hold shares in unit trusts, funds and individual companies.

They typically buy and sell small volumes and tend to have fewer sources of information than institutional investors.

They also often have narrower portfolios, which can mean that agency costs are higher, as the individuals themselves

study the companies they have invested in for signs of changes in strategy, governance or performance.

Institutional investors

The biggest investors in companies, dominating the share volumes on most of the worlds stock exchanges.

Examples include Pension funds, insurance companies and unit trust companies each fund being managed by a fund

manager.

Fund managers have some influence over the companies so need to be aware of the performance and governance of

many companies in their funds, so agency costs can be very large indeed.

When should institutional investors intervene in company affairs?

Concerns over strategy

Consistent underperformance (without explanation)

NEDs not doing their job properly

Internal Controls persistently failing

Failure to comply with laws and regulations

Inappropriate remuneration policies

Poor approach to social responsibility (reputation risk)

Auditors

The most obvious role of audit in corporate governance is to report to shareholders that the accounts are accurate (a true and

fair view is the term used in some countries.

A qualified audit report is an important signal to markets about the company.

Other services

These sometimes include social and environmental advice and audit.

Auditors and regulators in CG

Regulators and governments

This usually applies to companies or sectors involved in areas considered strategically or politically important by governments

Examples

The control of monopolies

The supply of water or energy

NON-CORPORATE CORPORATE GOVERNANCE

Public sector organisations

Public sector organisations are state controlled.

They can be parts of government departments (eg. hospitals and schools), or local government authorities, nationalised

companies and non-governmental organisations (NGOs)

Their aim is to implement parts of government policy.

Government likes to keep control over such parts, as it is deemed so important it cannot be trusted to private shareholders

and their profit motive alone.

For a nationalised rail service, for example, some loss-making route services may be retained in order to support economic

development in a particular region.

Such service delivery objectives are often underpinned by legislation.

Non Corporates"Non corporate" Corporate Governance

Agency relationship in the Public Sector

In private companies, the owner/manager split creates an agency problem - this still exists within the public sector.

Management serve the interests of the taxpayer who, though, are likely to seek objectives other than long run profit

maximisation.

This causes a problem however. The taxpayer/electorate does not have one simple goal (like shareholders have that of

profit maximisation).

So public servants, elected and non-elected, try to interpret the taxpayers best interests

So there will be a problem of establishing strategic objectives and monitoring their achievement.

The millions of taxpayers and electors in a given country are likely to want completely different things from public sector

organisations.

Some will want them to do much more while others, perhaps preferring lower rates of tax, will want them to do much less

or perhaps not to exist at all.

This can be called the problem of fitness for purpose.

It is normal to have a limited audit of public sector organisations to ensure the integrity and transparency of their financial

transactions, but this does not always extend to an audit of its performance or fitness for purpose.

Many nationalised companies have recently been privatised.

Moving from state control to having to comply with company law and relevant listing rules, in the process creating large

new companies in industries such as energy, water, transport and minerals.

This change means competition. It changes the skills needed by executive directors, so is usually accompanied by a

substantial internal culture change

Charities and voluntary organisations

There is often a third sector, charities and voluntary organisations, the first two being business and the state.

These exist for a particular social, environmental, religious, humanitarian or similar benevolent purpose and often enjoy tax

privileges and reduced reporting requirements.

In exchange, a charity must demonstrate its benevolent purpose and apply for recognition by the countrys charity

commission or equivalent.

Then there is the agency problem between the donors and the charity.

Will the donations be used fully for the purpose?

Hence the need for very strong regulation

Some charities voluntarily provide full financial disclosures and this places increased pressure on others to do the same.

A common way to help to reduce the agency problem is to have a board of directors overseen by a committee of trustees

(sometimes called governors).

The trustees here act in a similar way to NEDs, and will generally share the values of the charities purpose

Charities can exhibit their effectiveness by using a social or environmental audit-type framework, including a regular and

transparent report on how the charity is run and how it has delivered against its stated objectives.

This increases the confidence and trust of all of the main stakeholders: service users, donors, regulators and trustees and

reduces the agency problem

Purpose Agents Principals Typicalgovernancearrangements

Public listedcompanies

Maximisationof long-termshareholderreturns

Directors Shareholders Executive boardmonitored by non-executive directorsand non-executivechairman.

Public sector Implementationof governmentpolicy

Variouslayers ofservice anddepartmentalmanagers

Ultimately,taxpayers and,in ademocracy,voters (thetwo are oftensimilar)

Complex politicalstructures seekingto interpret thewishes of taxpayersand the best wayto deliver services

Charities andvoluntaryorganisations

Achievement ofbenevolentpurposes

Directors andservicemanagers

Donors andothersupportersprovide the

Ideally, anexecutive boardaccountable toindependent

provide theresources.Service usersor consumersbenefit fromcharities.

independenttrustees. Open tointerpretation andabuse in somejurisdictions,however.

Agency

Agency is defined in relation to a principal. What?! Well all this means is an owner (principal) lets somebody run her business

(manager).

The agent is doing this job on behalf of someone else.

Footballers, film stars etc all have agents. They work on behalf of the star. The star hopes that the agent is working in their best

interest and not just for their own commission

Principals and Agents

A principal appoints an agent to act on his or her behalf.

In the case of corporate governance, the principal is a shareholder and the agents are the directors.

The directors are accountable to the principals

Agency Costs

A cost to the shareholder through having to monitor the directors

Agency Relationships and TheoriesAgency Relationship

Over and above normal analysis costs

A result of comprised trust in directors

Transaction cost theory

General

Transaction costs occur when dealing with another party.

If items are made within the company itself, therefore, there are no transaction costs

Analysing these costs can be difficult because of:

Bounded rationality - our limited capacity to understand business situations

Opportunism - actions taken in an individuals best interests

Company will try to keep as many transaction as possible in-house in order to:

reduce uncertainties about dealing with suppliers

avoid high purchase prices

manage quality

Are the transaction costs (of dealing with others and not doing the thing yourself) worth it?

The 3 factors to take into account as to whether the transaction costs are worthwhile are:

Transaction Cost Theory

1. Uncertainty

Do we trust the other party enough?

The more certain we are, the lower the transaction / agency cost

2. Frequency

how often will this be needed

The less often, the lower the transaction/agency cost

3. Asset specificity

How unique is the item

The more unique the item, the more worthwhile the transaction / agency cost is

Applied to Agency theory

This can be applied to directors who may take decisions in their own interests also:

1. Uncertainty - Will they get away with it?

2. Frequency - how often will they try it?

3. Asset specificity - How much is to gain?

Board committees

Responsibilities of..

The Board of DirectorsBoard Committees

Board committees

Importance of committees

Many companies operate a series of board sub-committees responsible for supervising specific aspects of governance.

Reduces board workload

Use inherent expertise

Communicates to shareholders that directors take these issues seriously.

Communicates to stakeholders the importance of remuneration and risk.

Nominations committee

Advises on:

1. The balance between executives and NEDs

2. The appropriate number and type of NEDs on the board.

Nominations committee - Roles

The nominations committee is usually made up of NEDs.

It establishes the skills, knowledge and experience possessed by current board

Notes any gaps that will need to be filled

Looks at continuity and succession planning, especially among the most senior members of the board.

Is responsible for recommending the appointments of new directors to the board

Risk committee -Roles

Considered best practice by most corporate governance codes

Helps Investor confidence

Should be made up of NEDs

Requires good information systems to be in place

Reviews effectiveness of internal controls regarding risk

Is responsible for overseeing risk management

Remuneration Committee - Roles

Determine remunerations policy, acting on behalf of shareholders but benefitting both shareholders and the other board

members of the board

Ensure that each director is fairly but responsibly rewarded for their individual contribution in terms of levels or pay and the

components of each directors package.

It is likely that discussions of this type will take place for each individual director and will take into account issues including

market conditions, retention needs, long-term strategy and market rates for a given job.

Reports to the shareholders on the outcomes of their decisions, usually in the corporate governance section of the annual

report

Be compliant with relevant laws or codes of best practice.

Is responsible for advising on executive director remuneration policy

The board of directors

Board Of Directors

The board of directors

Roles and Responsibilities

1. Provide entrepreneurial leadership

2. Represent company view and account to the public

3. Determine the companys mission and purpose

4. Select and appoint the CEO, chairman and other board members

5. Establish appropriate internal controls

6. Ensure that the necessary financial and human resources are in place

7. Ensure that its obligations to its shareholders and other stakeholders are understood and met

8. Set the company's strategic aims

In the UK listed companies have to state in their accounts that they comply with thefollowing regulations:

1. Separate MD & chairman

2. Minimum 50% non executive directors(NEDs)

3. Independent chairperson

4. Maximum one-year notice period

5. Independent NEDs (three-year contract, no share options)

Unitary Board

This is the single board structure with sub-committees.

This is where all directors, including managing directors, departmental directors and NEDs all have equal legal and executive

status in law.

This does not mean that all are equal in terms of the organisational hierarchy, but that all are responsible and can be held

This does not mean that all are equal in terms of the organisational hierarchy, but that all are responsible and can be held

accountable for board decisions.

Advantages

1. NEDs are empowered, being accorded equal status to executive directors.

2. The presence of NEDs can bring independence, experience and expertise

3. Board accountability is enhanced as all directors are held equally accountable under a cabinet government arrangement

4. Reduced likelihood of abuse of power by a small number of senior directors

5. Often larger than a tier of a two-tier board so more viewpoints are expressed and more robustly scrutinised

6. All participants have equal legal responsibility for management of the company and strategic performance

Disadvantages

1. A NED or independent director can not be expected to both manage and monitor

2. The time requirement on NEDs may be onerous

Two-tier boards

The board is split into multi-tiers, separating the executive from directors.

These are predominantly associated with France and Germany.

This two-tier approach can take the form of a:

Management or executive board

Responsible for managing the enterprise with the CEO to coordinate activity.

Responsible for the running of the business.

Composed entirely of executive directors.

Supervisory board

Appoints, supervises and advises members of the management board.

A separate chairman coordinates the work and members are elected by shareholders at the AGM

Has no executive function.

It reviews the company's strategy.

Advantages of 2-tier boards

1. Clearly management and owners separation

2. Clear stakeholder involvement

3. Separate meetings means freedom of expression

4. Owners control management by power of appointment

Diversity on boards of directors

DEFINITION OF BOARD DIVERSITY

means having a range of many people that are different from each other.

factors like age, race, gender, educational background and professional qualifications of the directors to make the board less

homogenous.

In implementing policies on board diversity, both the companys chairman and thenomination committee play a significant role.

The chairman, being the leader of the board, has to facilitate new members joining the team and to encourage open

discussions and exchanges of information during formal and informal meetings.

The nomination committee should give consideration to diversity and establish a formal recruitment policy concerning

the diversity of board members with reference to the competencies required for the board, its business nature as well as its

strategies.

The committee members have to carefully analyse what the board lacks in skills and expertise and advertise board

Diversity on boards of directors

The committee members have to carefully analyse what the board lacks in skills and expertise and advertise board

positions periodically.

BENEFITS OF BOARD DIVERSITY

1. More effective decision making.

2. Better utilisation of the talent pool (not only male involved, also woman).

3. Enhancement of corporate reputation and investor relations.

Non Executive Directors (NEDs)

NEDs have no executive (managerial) responsibilities.

The key role is to reduce the conflict of interest between management (executive directors) and shareholders by providing the

balance to the board.

NEDs bring an independent viewpoint as they are not full time employees.

Roles and Responsibilities

The Higgs Report (2003) described the function of non-executive directors (NEDs) in terms of four distinct roles.

1. Strategy role

NEDs are full members and thus should contribute to strategy. They may challenge any aspect of strategy they see fit, and offer

advice

2. Scrutiny role

NEDs should hold executive directors to account for decisions taken.They should represent the shareholders interests

NEDs

3. Risk role

NEDs should ensure the company adequate internal controls and risk management systems

This is often informed by prescribed codes (such as Turnbull) but some industries, such as chemicals, have other systems in place,

some of which fall under International Organisation for Standardisation (ISO) standards.

4. People role

NEDs should oversee issues on appointments and remuneration, but might also involve contractual or disciplinary issues.

Independence

The Code states as a principle that the board should include a balance of NEDs and executives.

The board should ensure any NED is truly independent in character and judgement by:

not being an employee of the company within the last 5 years

not having a material business relationship with the company in the last 3 years

not receiving any remuneration except a directors fee

not having any family ties with the firm

not holding cross directorships with other directors

Cross directorships

When two (or more) directors sit on the boards of the other.

In most cases, each directors second board appointment is likely to be non-executive.

This can compromise the independence of the directors involved. For example, a director deciding the salary of a colleague who,

in turn, may play a part in deciding his own salary

It is for this reason the cross directorships are explicitly forbidden by many corporate governance codes

Advantages of NEDs

The main advantages of bringing NEDs onto a board are as follows:

1. Monitoring to reduce the excesses of executives.

2. External expertise

3. Perception: Company is perceived more trustworthy

4. Communication: improvement in communication between shareholders interests and the company.

5. Independent view

6. compliance with corporate governance code

Disadvantages of NEDs

1. Lack of trust can affect board operations

2. Quality: there may not be many appropriately qualified NEDs around

3. Liability: Poor remuneration and liability in law might reduce potential NEDs further

CEO - Chief executive officer

Role of CEO

1. To lead the company and to protect shareholder interests above all others

2. To develop and implement polices and strategies capable of delivering superior shareholder value

3. To assume full responsibility for all aspects of the companys operations

4. To manage the financial and physical resources of the company, monitor results, and ensure that effective operational andrisk controls are in place

5. To oversee the management team, co-ordinating the interface between the board and the other employees in the company,and assisting in the appointment of directors to the board

6. Communicating effectively with significant stakeholders including the companys shareholders, suppliers, customers andstate authorities

Role of CEO

state authorities

Roles of the chairman in corporate governance

Roles and Responsibilities

1. Provide leadership to the board

The chairman is responsible for ensuring the boards effectiveness for shareholders, by setting the agenda and ensuring meetings

occur regularly

2. The chairman represents the company to investors and other outside stakeholders/constituents.

3. Effective communication with shareholders

The public face of the organisation So, the chairmans roles include communication with shareholders.

This occurs in a statutory sense in the annual report and at annual and extraordinary general meetings.

4. Finally, the co-ordinating of NEDs and facilitating good relationships between them and executives

5. Ensuring the board receives accurate and timely information

Benefits of separation of roles of Chair & CEO

1. Frees up the chief executive to fully concentrate on the management of the organisation

2. Allows chair to represent shareholders interests

3. Removes the risks of unfettered powers in one individual

4. Reduces the risk of a conflict of interest in a single person being responsible for company performance whilst also reporting onthat performance to markets

5. Chairman provides a conduit for the concerns of non-executive directors

6. Ensures the CEO is responsible to someone named directly

7. Agrees with most best practice codes

Role of the Chairman

Importance of the chairmans statement

An important and usually voluntary item, typically at the very beginning of an annual report.

Conveys important strategic messages

Allows chairman to inform shareholders about issues Legal rights and responsibilities of Directors (Breach of responsibility

can leave director open to criminal prosecution)

Mandatory & Voluntary Disclosures

Chairman and CEO statements

Voluntary but to not include this would be unimaginable.

Operating and Financial Review (OFR)

This detailed report is written in non financial language.

Its narrative is forwardlooking rather than historical.

Stakeholders hoped the OFR would be a vehicle for:

1. risk disclosure

2. social and environmental reporting

Others

There are also:

Disclosures

There are also:

The accounts

Press releases

AGM

Annual General Meeting

The AGM is a formal part of a company financial year.

Purpose:

1. Present the years results

2. Discuss the outlook for the coming year

3. Present the audited accounts and

4. To have the final dividend and directors emoluments approved by shareholders.

Shareholder approval is signalled by the passing of resolutions in which shareholders vote in proportion to their holdings.

It is usual for the board to make a recommendation and then seek approval of that recommendation by shareholders.

The dividend per share, for example, is recommended by the board but only paid after approval by the shareholders at the AGM.

Institutional shareholders may employ proxy voting if they are unable to attend in person.

The chairman should arrange for the chairmen of the audit, remuneration and nomination committees to be available to answer

and for all directors to attend.

Notice of the AGM to be sent to shareholders at least 20 working days before the meeting

Extra-ordinary General Meeting

Extraordinary meetings are called when issues need to be discussed and approved that cannot wait until the next AGM.

When events necessitate substantial change or a major threat, an EGM is called.

Management may want:

a shareholder mandate for a particular strategic move, such as for a merger or acquisition.

Other major issues that might threaten shareholder value may also lead to an EGM such as a whistleblower disclosing

information that might undermine shareholders confidence in the board of directors

They also occur for many irregular events for special issues such as takeovers

The issue is basically too serious to wait for the next AGM

Proxy Voting

Ensures that shareholders unable to attend meetings can still vote

The Combined Code 2006 requires that:

After a vote has been taken the number of proxy votes should be stated in terms of:

1. number of votes for the resolution

2. number of votes against the resolution, and

3. number of votes withheld

Directors Rights and Duties

These are:

Rights

The first thing to understand is that directors do not have unlimited power. They are limited by:

Individual DirectorsDirectors Rights and Duties

The first thing to understand is that directors do not have unlimited power. They are limited by:

1. Articles of associationThese prescribe how directors operate including the need to be re-elected every 3 years

2. Shareholder resolutionThis can stop the directors acting for them

3. Provisions of lawEg health and safety or the duty of care.

4. Board decisionsBoards make decisions in the interests of shareholders not directors

Fiduciary Duties

1. Act in good faith: as long as directors motives are honest

2. Duty of skill and careThis is a legal requirement.

The amount of skill expected depends on your expertise and experience

Penalties for acting without due skill and care

Any contract made by the director may be void

Directors may be personally liable for damages if negligent

May be forced to restore company property at their own expense

Directors service contract

Directors Service Contract

This should Include:

key dates

duties

remuneration details

termination provisions (notice

constraints

other ordinary employment terms

Directors Induction & CPD

Induction

Depends on their background

It is important, for effective participation in board strategy development, not only for the board to get to know the new

director, but also for the director to build relationships with the existing board and employees below board level.

Induction Process

Highly tailored to the individual but will include the following

1. Company structure

2. Company values

3. Company strategy

4. Markets and key players

5. Day to day job details

5. Day to day job details

6. Reporting lines

7. Information about Board operations

It can be given as a presentation by other directors or as an induction pack also

Objectives of CPD

1. Maintain sufficient skills and ability

2. To communicate challenges and changes within the business environment

3. Improve board effectiveness

4. Support personal development of directors

Conflict and disclosure of interests

Key areas

Directors contracting with their own company (However, the articles may allow if disclosed)

Substantial property transactions: These need approval

Loans to directors: generally prohibited

Insider dealing/trading

Conflicts of Interest

Insider dealing/trading

Here a director uses information (not known publicly) which if publicly available would affect the share price

Trading in own shares with this knowledge is fraud

Directors are often in possession of market-sensitive information ahead of its publication and they would therefore know if

the current share price is under or over-valued given what they know about forthcoming events.

If, for example, they are made aware of a higher than expected performance, it would be classed as insider dealing to buy

company shares before that information was published.

Why is insider trading unethical and often illegal?

Directors must act primarily in the interests of shareholders.

If insider dealing is allowed, then it is likely that some decisions would have a short-term effect which would not be of the

best long-term value for shareholders.

This can become particularly important at times of takeovers where inside information could mean big profits for the

director and not necessarily in the longer term interests of the shareholder

There is also the potential damage that insider trading does to the reputation and integrity of the capital markets in general

which could put off investors who would have no such access to privileged information and who would perceive that such

market distortions might increase the risk and variability of returns beyond what they should be.

Director's Remuneration

The purpose of directors' remuneration is:

to attract and retain individuals

motivate them to achieve performance goals

Components of a rewards package

Director's Remuneration

These include:

1. Basic salary , which is paid regardless of performance;

It recognises the basic market value of a director. (Not linked to performance in the short run but year-to-year changes in it may

be linked to some performance measures)

2. Short and long-term bonuses and incentive plans which are payable based on pre-agreed performance targets being met;

3. Share schemes which may be linked to other bonus schemes and provide options to the executive to purchase predetermined numbers of shares

at a given favourable price;

4. Pension and termination benefits including a pre-agreed pension value after an agreed number of years service and anygolden parachute benefits when leaving;

5. Pension contributionsare paid by most responsible employers, but separate directors schemes may be made available at higher contribution rates than

other employees.

6. Other benefits in kind such as cars, health insurance, use of company property, etc.

Balanced package

This is needed for the following reasons:

A reduction of agency costs

These are the costs the principals incur in monitoring the actions of agents acting on their behalf.

The main way of doing this is to ensure that executive reward packages are aligned with the interests of principals

(shareholders) so that directors are rewarded for meeting targets that further the interests of shareholders.

A reward package that only rewards accomplishments in line with shareholder value substantially decreases agency costs

and when a shareholder might own shares in many companies, such a self-policing agency mechanism is clearly of benefit.

Typically, such reward packages involve a bonus element based on specific financial targets in line with enhanced company(and hence shareholder) value.

There are 3 main methods

Director's removal

There are 3 main methods

Retire by Rotation

At AGM, every 3 years

Longest serving director retires first

Means a nice phased retirement of directors

Directors can be replaced in an orderly manner

Termination

1. Death

2. Resignation

3. Not seeking re-election (see above)

4. Bankruptcy

5. Disciplinary procedures

Disqualification

The reasons can be:

Wrongful trading - allowing the company to trade while knowing its insolvent

Not keeping proper accounting records

Failing to prepare & file accounts. 3+ defaults in filing documents in 5 years

Failing to send tax returns and pay tax

Corporate Social Responsibility (CSR)

CSR is a concept whereby organisations consider the interests of society by taking responsibility for the impact of their activities

on wider stakeholders.

Milton Friedman

Only humans have moral responsibilitiesnot companies

Enlightened Self Interest

By looking after society also, society will respond and look after your company

Carrolls view on CSR

1. Economic

Economic responsibilty towards shareholders, employees etc -eg Maximise EPS, be consistently profitable

Eg.

Stakeholders

Corporate Social ReponsibilityCSR Introduction

Eg.

Shareholders demand a good return

Employees want fair employment

Customers seek good quality products

2. Legal

Legal responsibility to operate within the laws of society e.g.. Health and safety

Laws codify society's moral views

3. Ethical

Ethical responsibility to act fairly e.g..Do not put profits before ethical norms

4. Philanthropic

Philanthropic responsibility to give to charities, sponsor art events etc

Social responsiveness of a company

1. Reaction (deny all responsibility to society)

2. Defence (Accept responsibility but do the minimum)

3. Accommodation (Do what is demanded of them)

4. Proaction (Go beyond the norm)

Understanding the Influence of each Stakeholder (MENDELOW)

This framework is used to attempt to understand the influence that each stakeholder has over an organisations strategy.

The idea is to establish which stakeholders have the most influence by estimating each stakeholders individual power over and

interest in the organisations affairs.

The stakeholders with the highest combination of power and interest are likely to be those with the most actual influence over

objectives.

Definition and categoriesThe Mendelow Framework

objectives.

The Mendelow Framework

Power

Is the stakeholders ability to influence objectives

Interest

is how much the stakeholders care

Influence

= Power x Interest

However it is very hard to effectively measuring each stakeholders power and interest.

The map is not static; changing events can mean that stakeholders can move around the map

Mendelow Framework - explanation

1. A) Low power, low Interest - Minimal effort

These can be largely ignored, although this does not take into account any moral or ethical considerations.

It is simply the stance to take if strategic positioning is the most important objective

2. B) Low power, high interest - Keep informed

Can increase their overall influence by forming coalitions with other stakeholders in order to exert a greater pressure and thereby

make themselves more powerful.

The management strategy for dealing with these stakeholders is to keep informed

3. C) High power, low interest - Keep satisfied

All these stakeholders need to do to become influential is to re-awaken their interest.

This will move them across to the right and into the high influence sector, and so the management strategy for these stakeholders

is to keep satisfied.

4. D) High power, high interest - Key players

Those with the highest influence.

The question here is how many competing stakeholders reside in that quadrant of the map.

If there is only one (eg management) then there is unlikely to be any conflict in a given decision-making situation.

If there are several and they disagree on the way forward, there are likely to be difficulties in decision making and strategic

direction

Stakeholders Definitions and Influence

Stakeholders Definitions and Influence

Definition

Freeman,1984 defined a stakeholder as:

Any group or individual who can affect or [be] affected by the achievement of an organisations objectives.

This definition shows important bi-directionality of stakeholders - that they can be affected by - and can affect - an

organisation.

Small v large companies stakeholders

Compare, for example, the different complexities of a small organisation, such as a corner shop with a large international

organisation as a major university.

The stakeholders can be:

1. shareholders

2. management

3. employees

4. trade unions

5. customers

6. suppliers

7. communities

Stakeholder Theory

Business are now so large and pervasive they are accountable to more than just direct shareholders; they are also accountable to

other stakeholders

STAKEHOLDER CLAIMS

A stakeholder makes demands of an organisation.

Some shareholders want to influence what the organisation does (those stakeholders who want to affect) and the others are

concerned with the way they are affected by the organisation.

Some stakeholders may not even know that they have a claim against an organisation, this brings us to the issue of..

Direct stakeholder claims

Direct stakeholder claims are made by those with their own voice.

These claims are usually unambiguous, and are made directly between the stakeholder and the organisation.

Stakeholders making direct claims will typically include:

1. trade unions

2. shareholders

3. employees

4. customers

5. suppliers

6. in some instances, local communities

Indirect stakeholder claims

Indirect claims are made by those stakeholders unable to make the claim directly because they are, for some reason,

inarticulate or voiceless.

This does not invalidate their claim however.

Typical reasons for this include the stakeholder being:

(apparently) powerless (eg an individual customer of a very large organisation)

not existing yet (eg future generations)

having no voice (eg the natural environment), or

being remote from the organisation (eg producer groups in distant countries).

The claim of an indirect stakeholder must be interpreted by someone else in order to be expressed, and it is this interpretation

that makes indirect representation problematic.

How do you interpret, for example, the needs of the environment or future generations?

The example is an environmental pressure group

HOW TO CATEGORISE STAKEHOLDERS

Internal and external stakeholders

1. Internal stakeholders

Will typically include employees and management

2. External stakeholders

Will include customers, competitors, suppliers, and so on.

Some will be more difficult to categorise, such as trade unions that may have elements of both internal and external membership

Narrow and wide stakeholders

1. Narrow stakeholders

Most affected by the organisations policies and will usually include shareholders, management, employees, suppliers, and

customers who are dependent upon the organisations output.

2. Wider stakeholders

Categories of Stakeholder

2. Wider stakeholders

Less affected and may typically include government, less-dependent customers and the wider (non local) community

An organisation may have a higher degree of responsibility and accountability to its narrower stakeholders.

Primary and secondary stakeholders

1. Primary stakeholder

Without whom the corporation cannot survive

Do influence the organisation

2. Secondary stakeholders

Those that the organisation does not directly depend upon for its immediate survival

Do not influence the organisation

Active and passive stakeholders

1. Active stakeholders

Those who seek to participate in the organisations activities.

Management and employees obviously fall into this active category, but so may some parties from outside an organisation, such

as regulators and environmental pressure groups

2. Passive stakeholders

Are those who do not normally seek to participate in an organisations policy making.

This is not to say that passive stakeholders are any less interested or less powerful, but they do not seek to take an active part in

the organisations strategy.

Will normally include most shareholders, government, and local communities.

Voluntary and involuntary stakeholders

1. Voluntary stakeholders

Voluntary stakeholders are those that engage with an organisation of their own choice and free will. They are ultimately (in the

long term) able to detach and discontinue their stakeholding if they choose.

They will include employees with transferable skills (who could work elsewhere), most customers, suppliers, and shareholders.

They will include employees with transferable skills (who could work elsewhere), most customers, suppliers, and shareholders.

2. Involuntary stakeholders

Involuntary stakeholders have their stakeholding imposed and are unable to detach or withdraw of their own volition.

Do not choose to be stakeholders but are so nevertheless

Includes local communities, the natural environment, future generations, and most competitors.

Legitimate and illegitimate stakeholders

Legitimacy depends on your viewpoint (one persons terrorist, for example, is anothers freedom fighter).

1. Legitimate

Those with an active economic relationship with an organisation will almost always be considered legitimate.

For example suppliers, customers

2. Illegitimate

Those that make claims without such a link, or that have no mandate to make a claim, will be considered illegitimate by some.

This means that there is no possible case for taking their views into account when making decisions.

Recognised and unrecognised (by the organisation) stakeholders

The categorisation by recognition follows on from the debate over legitimacy. If an organisation considers a stakeholders claim

to be illegitimate, it is likely that its claim will not be recognised.

This means the stakeholders claim will not be taken into account when the organisation makes decisions.

Known about and unknown stakeholders

It is very difficult to recognise whether the claims of unknown stakeholders (eg nameless sea creatures, undiscovered species,

communities in close proximity to overseas suppliers, etc) are considered legitimate or not.

It may be a moral duty for organisations to seek out all possible stakeholders before a decision is taken and this can sometimes

result in the adoption of minimum impact policies.

For example, even though the exact identity of a nameless sea creature is not known, it might still be logical to assume that low

emissions can normally be better for such creatures than high emissions.

Stakeholder Theory

Proponents of shareholder theory

The agents (directors) have a moral and legal duty to only take account of principals claims when setting objectives and

making decisions.

A business is a citizen of society, enjoying its protection, support and benefits so it has a duty to recognise a plurality of

claims

INSTRUMENTAL AND NORMATIVE

MOTIVATIONS OF STAKEHOLDER THEORY

Some people are concerned about others opinions, while other people seem to have little regard for others concerns.

Why is this so?

1. The instrumental view of stakeholdersThat organisations take stakeholder opinions into account only insofar as they are consistent with profit maximisation

So, a business acknowledges stakeholders only because to do so is the best way of achieving other business objectives.

If the loyalty of an important primary stakeholder group is threatened, it is likely that the organisation will recognise the

groups claim

It is therefore said that stakeholders are used instrumentally in the pursuit of other objectives.

2. The normative view of stakeholdersDescribes not what is, but what should be, deriving from the philosophy of the German ethical thinker Immanuel Kant (1724

1804).

Kants argued civil duties were important in maintaining and increasing overall good in society. We each have a moral duty to

each other in respect of taking account of each others concerns and opinions.

TheoryStakeholder Theory

each other in respect of taking account of each others concerns and opinions.

The normative view argues that organisations should accommodate stakeholder concerns because by doing so the

organisation observes its moral duty to each stakeholder.

The normative view sees stakeholders as ends in themselves and not just instrumental to the achievement of other ends.

General objectives of internal control

To ensure the orderly and efficient conduct of business in respect of systems being in place and fully implemented.

To safeguard the assets of the business. Assets include tangibles and intangibles

To prevent and detect fraud

To ensure the c ompleteness and a ccuracy of accounting records.

To ensure the t imely preparation of financial information

Internal controls can be at the strategic or operational level.

At the strategic level, controls are aimed at ensuring that the organisation does the right things;

at the operational level, controls are aimed at ensuring that the organisation does things right.

Internal Control and Review

Internal ControlObjectives of Internal Control

Internal Control Failure

Typical causes of internal control failure are:

1. Poor judgement in decision-making

2. Human error

3. Control processes being deliberately circumvented

4. Management overriding controls

5. The occurrence of unforeseeable circumstances

Internal Controls Importance

Importance of internal control

1. Underpins investor confidence

2. Risks would not be known about and managed without adequate internal control

3. Helps to manage quality

4. Provides management with information on internal operations and compliance

5. Helps expose and improve underperforming internal operations

6. Provides information for internal and external reporting

Internal Control Failure

Internal Controls Importance

However, internal control systems are only as good as the people using them.

No system is infallible

Responsibility for internal control is not simply an executive management role.

Though they should set the tone

All employees have some responsibility for monitoring and maintaining internal controls

Effective systems of Internal Control

These are:

Principles of internal control embedded within the organisations structures, procedures and culture.

Capable of responding quickly to evolving risks.

Any change in the risk profile or environment of the organisation will necessitate a change in the system

Include procedures for reporting failures immediately to appropriate levels of management

Internal control and reporting

Effective Systems of Internal Control

Internal Control and Reporting

The United States Securities and Exchange Commission (SEC) guidelines are to disclose in theannual report as follows:

A statement of managements responsibility for establishing and maintaining adequate internal control over financial

reporting for the company.

This will always include the nature and extent of involvement by the chairman and chief executive, but may also specify

the other members of the board involved in the internal controls over financial reporting.

The purpose is for shareholders to be clear about who is accountable for the controls.

A statement identifying the framework used by management to evaluate the effectiveness of this internal control.

Managements assessment of the effectiveness of this internal control as at the end of the companys most recent fiscal

year.

This may involve reporting on rates of compliance, failures, costs, resources committed and outputs (if measurable)

achieved.

Internal Audit - What and When

Internal Audit

What is Internal audit?

Internal audit is a management control, where all other controls are reviewed

Sometimes it is a statutory requirement

Codes of corporate governance strongly suggest it

The department is normally under the control of a chief internal auditor who reports to the audit committee.

When is internal audit needed?

Internal AuditInternal Audit - What and When

1. Large, diverse and complex organisation

2. Large number of employees

3. Cost benefit analysis required

4. Changes in organisational structure

5. Changes in key risks

6. Problems with existing internal control

7. Increased number of unexplained events

IA and Effective Internal Controls

Role of internal audit in ensuring effective internal controls

Internal audit underpins the effectiveness of internal controls by performing several key tasks:

1. Reviews and reports on controls

The controls put in place for the key risks that the company faces in its operations are reviewed.

This will involve ensuring that the control (i.e. mitigation measure) is capable of controlling the risk should it materialise.

This is the traditional view of internal audit. A key part of this role is to review the design and effectiveness of internal

controls.

2. Follow up Visits

IA and Effective Internal Controls

Many organisations also require internal audit staff to conduct follow-up visits to ensure that any weaknesses or failures

have been addressed since their report was first submitted.

This ensures that staff take the visit seriously and must implement the findings.

3. Examine Information

Internal audit may also involve an examination of financial and operating information to ensure its accuracy, timelinessand adequacy.

In the production of internal management reports, for example, internal audit may be involved in ensuring that the

information in the report is correctly measured and accurate.

Internal audit needs to be aware of the implications of providing incomplete or partial information for decision-making.

4. Compliance to standards checks (Internal variance analysis)

It will typically undertake reviews of operations for compliance against standards.

Standard performance measures will have an allowed variance or tolerance and internal audit will measure actual

performance against this standard.

Internal compliance is essential in all internal control systems.

Examples might include safety performance, cost performance or the measurement of a key environmental emission

against a target amount (which would then be used as part of a key internal environmental control).

5. Compliance with regulations

Internal audit is used to review internal systems and controls for compliance with relevant regulations and externally-

imposed targets.

Often assumed to be of more importance in rules-based jurisdictions such as the United States, many industries have

upper and lower limits on key indicators and it is the role of internal audit to measure against these and report as

necessary.

In financial services, banking, oil and gas, etc, legal compliance targets are often placed on companies and compliancedata is required periodically by governments.

Audit Committee & Internal Control

Audit CommitteeAudit Committee & Internal Control

Who is in the Audit Committee?

Entirely NEDs (at least three in larger companies), of whom at least one has had recent and relevant financial experience

What is its Key roles?

1. Oversight

2. Assessment

3. Review

of other functions and systems in the company.

What is the Most important areas for attention regarding IC?

Monitoring the adequacy of internal controls involves analysing the controls already in place to establish whether they are

capable of mitigating risks

To check for compliance with relevant regulation and codes

Playing a more supervisory role if necessary, for example reviewing major expenses and transactions for reasonableness

Checking for fraud

Audit Committee & External Audit

Audit committee must oversee the relationship between external auditors and the company

Audit Committee and External Audit

Key roles

So the role is to OVERSEE the external audit relationship, I want you to therefore visualise windscreen wipers when you think of

audit committee and external audit.

Visualise the committee as windscreen wipers - helping the external auditors to see things more clearly.

This will help you understand their key role in this respect:

W ork plan of auditors is reviewed

I independence is maintained

P rep are for the audit

E engagement terms approved

R ecommend and review audits and their work

S election process involvement

Audit Committee & Internal Audit

As part of the overseeing internal controls the audit committee must also oversee the internal audit function

This time I want you to appreciate the difference between how an audit committee would deal with an external auditor

compared to an internal one.

To make that distinction clear for your memory - understand that the internal audit department work for the same company as

Audit Committee and Internal Audit

To make that distinction clear for your memory - understand that the internal audit department work for the same company as

the committee.

They share the same goals therefore. In fact picture the internal auditor as one man only.

After all the head of IA is in fact appointed by the audit committee.

Remember though that he works for the same company as the audit committee.

So they like him. In fact they often say We are Him!.

This will help you memorise those key roles..

Key roles

W ork plan reviewed

E ffectiveness assessed

A ccountable for the Internal Controls

R ecommendations are actioned

E fficiency of IA ensured

H ead of IA appointed

I ndependence preserved

M onitor IA

Identifying Risks

Risk

Process and IndentifactionIdentifying Risk

Management must be aware of potential risks

They change as the business changes

So this stage is particularly important for those in turbulent environments

Uncertainty can come from any of the political, economic, natural, socio-demographic or technological contexts in which the

organisation operates.

Categories of risk

1. Strategic risks

Refers to the positioning of the company in its environment.

Typically affect the whole of an organisation and so are managed at board level

2. Operational risks

Refers to potential losses arising from the normal business operations.

Are managed at risk management level and can be managed and mitigated by internal controls.

3. Financial risks

= are those arising from a range of financial measures.

The most common financial risks are those arising from financial structure (gearing), interest rate risk, liquidity

4. Business risks

The risk that the business won't meet its objectives.

If the company operates in a rapidly changing industry, it probably faces significant business risk.

5. Reputation risk

Any kind of deterioration in the way in which the organisation is perceived

When the disappointed stakeholder has contractual power over the organisation, the cost of the reputation risk may be material.

6. Market risk

Those arising from any of the markets that a company operates in, such as where the business gets its inputs, where it sells its

products and where it gets its finance/capital

Market risk reflects interest rate risk, currency risk, and other price risks

7. Entrepreneurial risk

The risk associated with any new business venture

In Ansoff terms, it is expressed the unknowns of the market reception

It also refers to the skills of the entrepreneurs themselves.

Entrepreneurial risk is necessary because it is from taking these risks that business opportunities arise.

8. Credit risk

Credit risk is the possibility of losses due to non-payment by creditors.

9. Legal, or litigation risk

arises from the possibility of legal action being taken against an organisation

10. Technology risk

arises from the possibility that technological change will occur

11. Environmental risk

arises from changes to the environment over which an organisation has no direct control,

e.g. global warming, or occurrences for which the organisation might be responsible,

e.g. oil spillages and other pollution.

12. Business probity risk

related to the governance and ethics of the organisation.

13. Derivatives risk

due to the use of underperforming financial instruments

14. Fiscal risks

risk that the new taxes and limits on expenses allowable for taxation purposes will change.

Risk and the risk management process

4 step process:

1. Identify Risk

Make list of potential risks continually

Risk Management Process

Make list of potential risks continually

2. Analyse Risk

Prioritise according to threat/liklihood

3. Plan for Risk

Avoid or make contingency plans (TARA)

4. Monitor Risk

Assess risks continually

Why do all this?

To ensure best use is made of opportunities

Risks are opportunities to be siezed

Can help enhance shareholder value

Related and correlated

Related risks

These are risks that vary because of the presence of another risk.

This means they do not exist independently and they are likely to rise and fall in importance along with the related one.

Risk correlation is a particular example of related risk.

Related risks

Positively Correlated

Risks are positively correlated if one will fall with the reduction of the other and increase with the rise of the other.

Negatively correlated

They would be negatively correlated if one rose as the other fell.

Example

Often environmental and reputation risks are positively correlated - the more attention spent on how the business

interacts with the environment means their environmental risk is lower and also their reputation risk

Risk AnalysisRisk Analysis

Risk Analysis

Use a Risk map like the one below

This helps management analyse risks according to their probability / likelihood of happening, and the potential threat they carry

Board Evaluation of risk

Depends on:

Risk appetite of company

Maximum risk a business can take (capacity)

Risk that cant be managed (residual risk)

Risk Exposure Assessment

Risk assessment can be broken down into 5 steps:

1. Identify risks facing the company - through consultation with stakeholders

2. Decide on acceptable risk - and the loss of return/ extra costs associated with reduced risks

3. Assess the likelihood of the risk occurring - management attention obviously on the higher probability risks

4. Look at how impact of these risks can be minimised - through consultation with affected parties

5. Understand the costs involved in the internal controls set up to manage these risks - and weighed against the benefits

Risk Analysis

Risk Attitudes

Risk Attitudes / Appetite

The overall risk strategy determines the overall approach to risk.

1. Risk Appetite

This determines how risks will be managed.

Some will be risk averse and some will be risk seekers, younger companies often need to be risk seekers and more established

companies risk averse

2. Risk Capacity

Risk capacity indicates how much risk the organisation can accept.

The overall strategy of an organisation will therefore be affected by risk strategy, risk appetite and risk capacity.

Risk is a good thing because

Makes a business more competitive

Prevents just following the leader

Comes with rewards

ALARP

(As low as reasonable practicable)

A risk is more acceptable when it is low (and less acceptable when it is high).

Risks cannot be completely eliminated, so each risk is managed so as to be as low as is reasonably practicable because we

can never say that a risk has a zero value.

Risk Attitudes

For example, It would be financially and operationally impracticable to completely eliminate health and safety risks

This does not mean becoming complacent, so we maintain a number of controls that should reduce the probability of the

risks materialising,

Risk Planning and Control strategies

TARA

There are four strategies for managing risk and these can be undertaken in sequence. It is sometimes called the TARA framework.

1. Transfer

This means passing the risk on to another party which, in practice means an insurer or a business partner such as a supplier or a

customer

2. Avoid

This means asking whether or not the organisation needs to engage in the activity where the risk is.

If it is decided that the risk cannot be transferred nor avoided, it might be asked whether or not something can be done to reduce

the risk.

3. Reduce

This means diversifying the risk or re-engineering a process to bring about the reduction.

It can also include Risk sharing.

This involves finding a party that is willing to enter into a partnership so that the risks of a venture might be spread

4. Retain

This means believing there to be no other feasible option. Such retention should be accepted when the risk and return

characteristics are clearly known

Risk Planning and ControlRisk Control

Embedded risk

It is important to embed awareness at all levels to reduce the costs of risk

In practical terms, embedding means introducing a taken-for-grantedness of risk awareness into the culture of an organisation

Culture, defined in Handys terms as the way we do things round here underpins all risk management activity as it defines

attitudes, actions and beliefs.

How?

Introduce risk controls into the process of work and the environment in which it takes place.

So that people assume such measures to be non-negotiable components of their work experience.

Risk management becomes unquestioned, taken for granted, built into the corporate mission and culture and may be used

as part of the reward system.

Risk management committee

Embedded Risk

Risk MonitoringRisk Manager

Risk management committee Role

1. To agree the risk management

2. Review risk reports from affected department

Provide board guidance on emerging risks

Work with the audit committee on designing and monitoring internal controls

3. Monitor overall exposure and specific risks. Strategic risk monitoring could occur frequently

4. Assess the effectiveness of risk management systems

Roles of a risk manager

1. Providing overall leadership, vision and direction, involving the establishment of risk management (RM) policies

2. Seeking opportunities for improvement of systems.

3. Developing and promoting RM competences

Arguments against Risk management

1. Cost

2. Disruption to normal organisational practices

3. STOP errors - where a practice has been stopped when it should have been allowed to proceed

4. Slowing the seizing of new business opportunities

Internal and external risk audit

Risk AuditsRisk Audit

Risk audit and assessment is a systematic way of understanding risks

Features

1. Complicated

It can be a complicated and involved process. Some organisations employ teams of people to monitor and report on risks.

2. Voluntary

Risk audit is not a mandatory requirement for all organisations but, importantly, in some highly regulated industries (such as

banking and financial services), a form of ongoing risk assessment and audit is compulsory

Process

1. Identify risk

Management must be aware of potential risks

They change as the business changes

So this stage is particularly important for those in turbulent environments

Uncertainty can come from any of the political, economic, natural, socio-demographic or technological contexts in which the

organisation operates.

2. Assess risks

The probability and the impact of the risk needs assessing

( sometimes not possible to gain enough information about a risk to gain an accurate picture of its impact and/or probability)

This strategy is often, from share portfolio management to terrorism prevention.

Businesses then come up with strategies to deal with the risks (TARA) but thats for a different part of the syllabus

In a risk audit, the auditor now reviews the organisations responses to each identified and assessed risk.

3. Review controls over risk

Here, the controls used are reviewed

For example, insurance cover or diversification of the portfolio

In the case of accepted risks, a review is made of things such as evacuation, clean-up and so on,

4. Report on inadequate controls

Finally, a report is produced and submitted, in most cases, to the Board

Management will want to know about the key risks; the quality of existing assessment and the effectiveness of controls currently

in place.

Any ineffective controls would be the subject of urgent management attention.

Internal Risk Audit

Advantages

Those conducting the audit will be familiar with the systems, environment and culture.

So an internal auditor should be able to carry out a highly context-specific risk audit.

The audit assessments will therefore use appropriate technical language and in a management specified form

Disadvantages

Impaired independence and overfamiliarity

External Risk Audit

Advantages

Reduces the independence and familiarity threats.

Higher degree of confidence for investors and regulators.

A fresh pair of eyes to the task

Best practice and current developments often used

Ethics

ProfessionalProfessions and the Public Interest

Professions and the public interest

Profession

Has two essential and defining characteristics:

1. A body of theory

2. Knowledge which guides its practice and commitment to the public interest

Professionalism

Professionalism may be interpreted more as a state of mind while the profession provides the rules that members of that

profession must follow.

Over time, the profession appears to be taking more of a proactive than a reactive approach. This means seeking out the public

interest and positively contributing towards it

The Public Interest

Providing information that society as a whole should be aware of in many cases public interest disclosure is used to establish

that disclosure is needed although there is no law to confirm this action

A professional accountant

Society accords professional status to those that both possess a high level of technical knowledge in a given area