Corporate governance

YouTube videoLoad YouTube video

1 Why corporate governance is needed

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

The problem is that although the shareholders own companies and are known as the ‘principals’, the day-to-day management and direction of companies is given to the Board of Directors. The directors are the ‘agents’ of the shareholders and should act in the best interests of the shareholders. In large companies many shareholders are relatively passive and the Board of Directors is given more or less free rein to make whatever decisions they wish.

Auditing was instituted so that at least once a year, when the financial statements were presented to the members of the company, the auditors would examine the financial statements and give their opinion to the members of the company as to whether the financial statements were true and fair. Without that assurance the members of the company really would have little idea as to whether or not the financial statements were worth relying on. The auditors therefore examine the financial statements and this adds credibility to those statements so that the shareholders have a much better idea of the performance of the directors and the company.

Note that shareholders appoint the independent auditors, they also appoint the directors. The problem is, however, that once directors were appointed, shareholders often didn’t take much further interest in what the directors were doing. Scandals such as Enron, Worldcom in the early 2000’s, and perhaps banking problems in 2008, showed that this hands-off approach was entirely inadequate and therefore additional safeguards have been instituted to try to ensure that directors act in the best interests of the members of the company.

1.1 What corporate governance is for

The syllabus asks for the role and key objectives of corporate governance. Put at its shortest, a governance system exists to close the gap the diagram above opens up. Its objectives are:

• To align the directors' interests with the members' — the agency problem, and the reason remuneration, appointment and removal are governed at all.

• To make the board accountable for the company's performance and conduct, to people outside the boardroom.

• To secure reliable disclosure — timely, accurate information on which an owner or a lender can actually decide.

• To control risk so that the company is not exposed to more than the owners knowingly accepted.

• To sustain trust in the market itself, which is what makes capital available to every company, not just this one.

1.2 Objectivity and independence

Two words do most of the work in every governance code, and it is worth being precise about them because they are not the same thing.

The distinction matters because governance cannot inspect a state of mind. It can only remove the circumstances that would make objectivity doubtful — which is the same move the CIMA Code makes when it addresses a threat by eliminating the circumstance creating it.

2 Governance, ethics and the law

Ethical directors should always seek to act in the best interests of their shareholders, but often did not. Sometimes this was deliberate so that directors could enrich themselves at the expense of the shareholders. Sometimes it was accidental such as not understanding the risks and returns that shareholders were happy with. Therefore, to encourage better (and more ethical) corporate governance, most advanced economies have introduced corporate governance rules, laws and guidelines. Some countries have taken a rules- or procedural-based approach and some a principles- or framework-based approach (these concepts were discussed in the previous chapter). Some countries have enshrined corporate governance in their laws whilst others rely on their stock exchange enforcing the rules. Both routes are compared in §2.2 below.

2.1 Three ways of making a board behave

The syllabus asks how corporate governance interacts with business ethics and company law. They are three different mechanisms pointed at the same target, and they bite in different ways:

The three overlap far more than they conflict. A director who enriches himself at the members' expense has breached his legal duty, departed from the code, and behaved unethically, and the same set of facts supports all three findings. Governance is largely the business of turning the third into the first two so that something can actually be done about it.

2.2 Rules-based and principles-based governance

Countries have taken two broad approaches, and the distinction is examined more often than almost anything else in this chapter.

The UK Corporate Governance Code's own contents — the sections it is organised into, the role of non-executive directors, the board's committees — are chapter 4's subject, not this one's.

3 The G20/OECD Principles of Corporate Governance

3.1 Purpose, definition and status

Purpose. The Principles are an international benchmark. They set out what a country's corporate governance framework should achieve, so that governments, regulators and stock exchanges around the world have a common starting point, and so that investors can compare one market with another.

Definition. They are a set of high-level principles addressed to policy makers, not a rulebook addressed to companies. Each is written as what the corporate governance framework should do — not what a particular board must do.

Status — and this is the part students most often get wrong. The Principles are not law anywhere. They are non-binding. It is then for individual countries to implement them through their own laws or codes, which is exactly why the United States arrived at Sarbanes-Oxley and the United Kingdom at the UK Corporate Governance Code from the same starting point. Their authority comes from adoption rather than from enforcement: they are an OECD instrument, endorsed by the G20, and they are one of the Financial Stability Board's key standards for sound financial systems.

The current text is the G20/OECD Principles of Corporate Governance 2023, adopted by the OECD Council at ministerial level in June 2023 and endorsed by G20 leaders in September 2023. It has six chapters.

3.2 The six chapters

Each chapter opens with a single sentence — the chapeau — which is what you should be able to reproduce. The right-hand column is what it means in practice.

4 IFAC’s drivers of sustainable organisational success

IFAC published an International Good Practice Guidance, Evaluating and Improving Governance in Organizations (IFAC, 2009). It analyses, with illustrative case studies, how professional accountants in business support their organisations in integrating governance into the key drivers of organisational success. It identifies eight drivers:

4.1 Customer and shareholder focus

• Understanding and satisfying customer or service-user needs.

• Aligning all parts of an organisation to these needs.

A customer and stakeholder focus involves ensuring that the organisation as a whole, not merely the front-line staff, puts an understanding of customers and key stakeholder groups first. Similarly, in the public and not-for-profit sectors, sustainable performance is strongly linked to meeting stakeholder expectations and the quality of service delivery to their customers, clients, and society.

Irrespective of an organisation’s size, structure, or sector, a customer and stakeholder focus can be aided by:

1. practising good customer and stakeholder relationship management;

2. maintaining a customer and stakeholder relations or engagement program;

3. ensuring that all functions, including finance and accounting, are geared to supporting customer- and stakeholder-focused decisions.

Accountants can help to identify, understand and monitor groups of customers and stakeholders to provide appropriate decision-oriented information.

4.2 Effective leadership and strategy

• Providing ethical and strategic leadership focused on sustainable value creation.

• Facilitating key performance drivers, including strong corporate values, ethical culture, organisational structures and processes.

Professional accountants in business often participate in the key areas of strategic leadership: strategy (what do we want to achieve?); values and attitudes (what do we stand for?); and the business model (how do we organise to create, deliver, and capture sustainable organisational success?).

This involves:

(a) participating in strategy and planning, providing information and analysis for strategic decision making and maintaining strategic control and financial navigation to ensure execution of strategy; and

(b) evaluating strategic options that align with the organisation’s risk management strategy and policies on internal control and recommending optimal strategies. It also requires setting the right tone at the top in the organisation.

4.3 Integrated governance, risk and control

• Deploying effective governance structures and processes with integrated risk management and internal control.

• Balancing performance and conformance in governance.

Professional accountants in business can create awareness among their colleagues regarding the importance of integrating governance, risk management, and internal control. Effective risk management enables an organisation to exploit opportunities and take on additional risk while staying in control and, therefore, increasing its sustainable success. With an integrated, enterprise-wide approach to risk management and internal control, professional accountants in business also encourage the idea that risks are viewed and managed in a more holistic way so that individual risks are not assessed and dealt with in isolation.

Professional accountants in business are also frequently engaged in the improvement of documentation and communication of governance, risk management, and internal control systems.

4.4 Innovation and adaptability

• Innovating processes and products to improve reputation and performance.

• Adapting the organisation to changing circumstances.

Professional accountants can be involved in supporting each of the key stages of innovation development, including innovation and opportunity selection, concept and design definitions, product and service realisation, and required production and service support.

4.5 Financial management

• Ensuring financial leadership and strategy support sustainable value creation.

• Implementing good practices in areas such as tax and treasury, cost and profitability improvement, and working capital management.

Financial management is at the core of what many professional accountants do in organisations, such as: provision, analysis, and interpretation of financial and non-financial information to the governing body and managers, supporting them in understanding the financial health of the organisation and progress in delivering financial objectives, and providing the information and analysis needed for organisational objective setting, strategy formulation, execution, and control.

4.6 People and talent management

• Enabling people and talent management as a strategic function.

• Applying talent management to the finance function so it better serves the needs of the whole organisation.

Professional accountants should serve as promoters of integrity, transparency, and expertise. They also deploy people and talent management strategies and policies that are focused on determining core competencies, engaging new employees, and retaining critical staff through robust career development—both for the finance function and the wider organisation. This enables the organisation to continuously meet its changing needs.

4.7 Operational excellence

• Aligning resource allocation with strategic objectives and the drivers of shareholder and stakeholder value

• Supporting decision making with timely and insightful performance analysis.

Professional accountants in business also often use and advise on management approaches such as the application of advanced management accounting tools, such as process analysis, strategic and operational cost management, and throughput accounting, to make their organisations more successful and more adaptive to changing circumstances.

4.8 Effective and transparent communication

• Engaging shareholders effectively to ensure that they receive relevant communications.

• Preparing high quality business reporting to support stakeholder understanding and decision-making.

Accountants contribute to this last driver directly, since much of what an organisation communicates about its performance is prepared by the finance function. Chapter 7 takes it further: reporting is no longer only financial, and the triple bottom line asks a company to report on its social and environmental performance as well.

5 CIMA’s proposals for better reporting of corporate governance

CIMA take the view that good corporate governance is essential to create trust and engagement between companies and their investors, so contributing to the long-term success of the business. However, even where a company has good corporate governance, reporting is often formulaic and relies on standard, ‘boiler plated’ paragraphs brought together for the sake of claiming that communication of governance issues has taken place – even though it might be very poor. CIMA has therefore come up with practical proposals to bring corporate governance reporting ‘to life’.

CIMA published these as Simple practical proposals for better reporting of corporate governance. There are five, and they are the answer to Example 2 at the end of this chapter.

The proposals are:

5.1 Tone from the top

The chairman’s view on what good governance means to him [or her] and his [or her] company.

• How the chairman has met the challenge of leading the board and ensuring its effectiveness.

• The culture of the board and whether it is open and welcoming to effective debate and contribution from all members, including non-executive directors.

• Whether the governance culture is aligned with the company’s policies and procedures, and reinforced by a measurement and incentive system.

• A quick reference guide to governance activities during the year and where more information may be found.

5.2 How the board works as a team

• Showing how the company’s board is properly composed and balanced, with skill sets that complement one another.

• That a range of views will be expressed in the spirit of constructive challenge, and that the boardroom environment allows for this.

5.3 The key actions of the board and its committees

• What issues the board has focused its attention on.

• Whether the board has been focusing on the right things.

• How the company’s governance processes interact with the year’s key corporate events and significant governance changes since the previous year.

5.4 Board effectiveness

• That there is a rigorous process in place to assess how effectively the board and its committees are working.

• A balanced assessment of the effectiveness of the board and an understanding of the actions being taken to address any underperformance.

• That the right issues are being discussed and that issues are kept on the agenda until resolved.

• That the assessment of board and committee effectiveness is part of the linkage through from strategy and risk to performance and reward.

• That matters are being addressed in a forward-looking way, so that effectiveness will improve in the future.

5.5 Communication and engagement with shareholders

The company’s story needs to be told consistently to a broad audience. It must meet the needs of:

• Fund managers, who need to understand the business model and its shorter term returns.

• Ultimate owners such as pension funds and insurance companies, who need confidence in management, and a longer term perspective.

• Those responsible for voting, in-house or outsourced, who need compliance data.

6 Chapter questions

Work each one before reading the answer.

7 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.