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Chapter 3 - Corporate Governance

Corporate governance is the system by which companies are directed and controlled.

OECD Principles of Corporate Governance

• The corporate governance framework should promote transparent and efficient markets.
• There should be clear division of responsibilities among different supervisory, regulatory and
enforcement authorities.
• Facilitate the exercise of shareholders’ rights.
• Ensure the equitable treatment of all shareholders, including minority and foreign
shareholders.
• Ensure that timely and accurate disclosure.
• Ensure the strategic guidance of the company.
• Ensure effective monitoring of management by the board.
• Improve governance of remuneration and incentives.
• Improve the governance of risk management.
• Improve board practices.

Principles of the UK Corporate Governance Code (for Listed UK Companies)

The following are the fundamental principle of UK Corporate Governance Code:

a) Leadership
b) Effectiveness
c) Accountability
d) Remuneration
e) Relations with shareholders

Leadership

• Every company should be headed by an effective board.

• The Board is collectively responsible for the long-term success of the company.
• There should be a clear division of responsibilities at the head of the company between the
running of the board (Chairman) and the executive responsibility for the running of the
company's business (CEO/Managing Director).
• The chairman is responsible for leadership of the board.
• The chairman should be independent (i.e. Non-executive Director)
• Chairman cannot remain in post beyond nine years
• The chairman should not be a former Chief Executive of the same company except in
exceptional circumstances.
• Non-executive directors should constructively challenge and help develop proposals on
strategy.

Effectiveness

• The board and its committees should have the appropriate balance of skills, experience,
independence and knowledge of the company.
• There should be a transparent procedure for the appointment of new directors to the board.

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• All directors should be able to allocate sufficient time to the company.

• All directors should receive induction on joining the board.
• All directors should regularly update their skills and knowledge.
• The board should be supplied with timely information.
• The board should evaluate of its own performance and that of its committees and individual
directors.
• All directors should be re-elected at regular intervals.
• Directors of FTSE 350 companies should be subject to annual re-election by shareholders.
• Directors of other companies should be subject to re-election at regular intervals not
exceeding three years.
• At least half of the board, excluding the chairman, should comprise independent non-
executive directors.
• One of the non-executive directors should be appointed as the senior independent director-
this director should be available to shareholders if they have concerns.

Accountability

• The board should maintain sound risk management and internal control systems.
• The board should maintain good relationship with the company's auditor.
• The risk assessment should cover both the principal and emerging risks.

Remuneration

• There should be a transparent procedure for developing policy on executive remuneration.

• No director should be involved in deciding his or her own remuneration.
• Executive directors' remuneration should be based on performance.
• Executive directors' remuneration should be fixed by remuneration committees.
• Remuneration committee should consist of at least three independent non-executive
directors
• Executive directors should not sit on the remuneration committee
• The chairman cannot chair the remuneration committee. However, chairman can be a
member of remuneration committee if he or she is independent.
• The remuneration committee is responsible for setting remuneration for:
a) Chairman
b) Executive directors
c) Senior management
• Level of remuneration be based on time involved and responsibilities of the role
• Non-executive directors’ salary should be fixed and should not be based on profit or
performance of the company

Nomination committee

• Board appointment (appointment of directors) should be made by nomination committee.

• Nomination committee should be made up of independent non-executive directors
• Board appointments should promote diversity of gender, social and ethnic backgrounds

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Relations with Shareholders

• The board should use the AGM to communicate with investors and encourage their
participation.
• The board must seek regular engagement of with shareholders outside of formal general
meeting.
• If 20% or more of votes go against a board recommendation, then board must consult with
shareholders to understand why this was and must report this in the annual report.

Going concern

• The board must state whether going concern is appropriate

• The board assess going concern for a period of at least 12 months from the date of approval
of financial statements.
• The board should identify any material uncertainties to the going concern

Other points

• Directors should explain in the annual report:

a) their responsibility for preparing the annual reports and accounts
b) state that they consider annual reports and annual accounts are fair, balanced and
understandable
c) state that annual report and annual accounts provide necessary information to
shareholders to assess the entity’s performance, business model and strategy
d) state that the board has carried out risk assessment and describe the principal risks and
how they are being managed
e) If 20% or more of votes go against a board recommendation, then board must consult with
shareholders to understand why this was and must report this in the annual report.

• The board has a responsibility to engage with the workforce by:

a) Appointing a director from the workforce
b) Creating a formal workforce advisory panel
c) Appointing a designated non-executive director (for addressing worker grievances)
d) There should be a way for the workforce to raise concern in confidence and anonymously
(whistleblower policy)

Guidance on Risk Management, Internal Control and Related Financial and Business Reporting

The entity should:

• Have a defined process for the effectiveness of internal control

• Review regular reports on internal control
• Consider key risks and how they are managed
• Check the adequacy of action taken to remedy weakness and incidents
• Consider adequacy of monitoring
• Conduct annual assessment of risks and effectiveness of internal control
• Make a statement on this process in the annual report

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Independence for a non-executive director

Independence for a non-executive can be compromised by the following:

a) Employment with the company or in the group in the last 5 years

b) Material business relationship with the company within the last 3 years
c) Remuneration beyond the basic fess agreed for the role
d) Close family ties with any of the company’s advisors, directors or senior employees
e) Representing a significant shareholder
f) Serving longer than nine years on the board

Auditor’s Responsibility

• Auditors are required to report on whether listed companies comply with specific provisions
within the UK Corporate Governance Code.
• Auditors have to report:
a) Directors' responsibility for preparing the annual report and accounts explained in report
b) Effectiveness of the risk management and internal control systems
c) Audit committee of at least three non-executive directors set up (or at least two non-
executive directors for smaller companies)
d) Audit committee terms of reference is set out in writing
e) Audit committee monitors and reviews effectiveness of internal audit activities
f) If external audit provides non-audit services, then the annual report sets out how
independence is maintained.

Audit Committee

• An audit committee can help a company maintain objectivity with regard to financial reporting
and the audit of financial statements.
• Audit committee is a sub-committee of the board of directors usually containing a number of
non-executive directors.
• The role and function of the audit committee should be set out in written terms of reference.
• The chairman should not be a member of the audit committee.
• At least one member should have recent and relevant financial experience.
• Provide advice on whether the annual reports and annual accounts are fair, balanced and
understandable.
• Provide necessary information to shareholders to assess the entity’s performance, business
model and strategy.

Role & Responsibility of audit Committee

• Monitor the integrity of the financial statements

• Reviewing significant financial reporting issues
• Review the company's internal financial controls
• Monitor and review the effectiveness of the company's internal audit function
• Make recommendations to the board
• Conducting the tender process and make recommendation to the board on appointment,
reappointment and removal of the external auditor

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• Approve the remuneration of the external auditors

• Approve terms of engagement of the external auditors (ISA 210)
• To review and monitor the external auditor's independence
• Review and monitor effectiveness of external audit process
• The audit committee should monitor and review the effectiveness of the internal audit
activities.
• Where there is no internal audit function, the audit committee should consider annually
whether there is a need for an internal audit function.
• If the audit committee decides there is no need for an internal audit function (department),
the reasons should be explained in the annual report.
• Developing and implementing policy on provision of non-audit services by external auditor
• Prior approval of non-audit service services by the external auditor

Advantages of having Audit Committee

• Improve the quality of financial reporting

• Create a climate of discipline and control
• Reduce the opportunity for fraud
• Provides independent judgment
• Strengthens the position of Internal Audit department by providing independence from
management
• Increase public confidence about the credibility and objectivity of financial statements

Drawbacks of Audit Committees

• The executive directors may not understand the purpose of an audit committee.
• There may be difficulty in selecting sufficient non-executive directors with the necessary
competence in auditing matters.
• Costs may be increased.
• The formalized reporting procedures may dissuade the auditors from raising matters of
judgement and limit them of reporting only matters of fact.

Question Practice

OT Revision Cases – Education Hub [2 Questions]

December 2016 (CBE) [Revision Class]

March/June 2016 [Revision Class]

March/June 2023 [Practice Platform]

September/December 2022 [Practice Platform]

Suggested Extra Practice

Activity 2 [Education Hub, 3.2.5]

Quizzes [Education Hub]

Suggested Extra Reading [Only for knowledge purpose, not from an exam point of view]

All the ten “Exhibit”s in Eduction Hub

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