Corporate Governance
1 What is corporate governance?
Corporate governance is the system by which companies are directed and controlled. It is concerned with how the board runs the company, how the board itself is monitored, and how the interests of the shareholders (and wider stakeholders) are protected.
The need for it arises from the agency relationship at the heart of every company: the shareholders own the business, but the directors run it on their behalf. The directors therefore act as agents of the shareholders – and, like any agents, they may be tempted to act in their own interests rather than those of their principals. Corporate governance provides the structures, processes and controls that give shareholders confidence that:
the business is being run competently and honestly
its assets are being safeguarded
the systems and controls in place are appropriate, regularly monitored, and corrected when problems are found
the information reported to shareholders – above all the financial statements – can be relied upon
This recording is sound on the ground it reaches, but it is the largest recording gap in Chapters 1–4. Three parts of the chapter are notes-only.
The board: its role, the three committees, and the whole application of governance to financial reporting are taught only in these notes.
Codes and legislation: the UK Corporate Governance Code, “comply or explain” and Sarbanes-Oxley are never named on the recording.
The scandals: the recording’s list stops in 2015; these notes carry it forward.
2 Why corporate governance matters – the scandals
Corporate governance rose to prominence because of a series of major corporate scandals, each of which happened under a board that failed to direct and control the company properly:
Enron (US, 2001) – enormous debts were hidden through off balance sheet finance; executives misled the board and the audit committee, and when the debts finally surfaced the company collapsed
WorldCom (US, 2002) – revenue was inflated and revenue expenditure was recorded as capital expenditure, so reported profits were fictitious; the company imploded when the fraud came to light
The Co-operative Bank (UK, 2013) – the bank's chairman lacked any relevant banking qualifications or experience and was involved in public scandals; the bank ran into severe financial difficulty and had to be rescued
Volkswagen (Germany, 2015) – emissions test results were deliberately falsified, misleading customers and regulators and exposing the group to fines and legal claims around the world
Carillion (UK, 2018) and Wirecard (Germany, 2020) – more recent reminders: aggressive accounting concealed a deteriorating position at Carillion until it collapsed, while Wirecard reported cash balances that simply did not exist
In every case the root cause was inappropriate corporate governance: boards that did not challenge the executives, controls that did not operate, and reporting that could not be trusted.
3 The principles of good corporate governance
Whatever form the local rules take, good corporate governance rests on four principles:
Principle | Meaning |
Transparency | Open and clear disclosure of relevant information to shareholders and other stakeholders – no concealment of what is really happening |
Independence | The board directs and controls the business free from undue influence – including independent judgement within the board itself, so executives can be challenged |
Accountability | Those who make decisions are answerable for them – to the board, and ultimately to the shareholders |
Integrity | Honesty and straightforward dealing in the conduct of the business and in its reporting |
Link to Chapter 2
Corporate governance and professional ethics reinforce one another. WorldCom was simultaneously a governance failure (an unchallenged, dominant management) and an ethical failure (individual accountants lacking integrity and objectivity). Good governance structures make it easier for individuals to behave ethically – and harder for the unethical to go unnoticed.
4 The role of the board
The board of directors has overall responsibility for ensuring that the executives create value for the company's stakeholders and safeguard its assets. Its role includes:
setting the company's strategy and risk appetite
appointing, supervising and, where necessary, removing senior management
ensuring that an effective system of internal control and risk management operates
ensuring the integrity of the company's financial reporting
reporting to the shareholders on its stewardship of the company
Governance codes typically expect the board to be structured so that no single individual dominates:
Chair and chief executive – the roles of chair (who leads the board) and chief executive (who leads the business) should be held by different people
Executive directors – full-time managers of the business who sit on the board
Non-executive directors (NEDs) – outsiders who bring independent judgement, challenge the executives, and staff the board's committees; codes generally expect a substantial proportion of the board to be independent NEDs
Much of the board's detailed work is delegated to committees staffed mainly by non-executive directors:
Committee | Role |
Audit committee | Oversees financial reporting and the internal control system; monitors the internal audit function; oversees the relationship with the external auditors and their independence |
Remuneration committee | Sets the pay of executive directors, so that directors do not set their own remuneration |
Nomination committee | Leads the process for board appointments, ensuring directors have the right skills, experience and independence – exactly what was missing at the Co-operative Bank |
5 Corporate governance and financial reporting
For F1, the most important application of corporate governance is to financial reporting. The board's stewardship of the company is reported to shareholders primarily through the financial statements, so governance principles apply directly to them:
Responsibility – the directors (not the auditors) are responsible for preparing financial statements that comply with accounting standards and give a true and fair view of the company's performance and position
Sound internal control – reliable financial reporting depends on the board maintaining an effective system of internal control over the recording of transactions
Independent oversight – the audit committee reviews significant accounting judgements, challenges management's estimates, and safeguards the independence of the external audit
Fair, balanced and understandable reporting – governance codes require the annual report as a whole to present a fair, balanced and understandable assessment of the company's position and prospects, including an honest assessment of whether the business is a going concern
Key point
Good corporate governance is what makes regulated financial reporting credible: the directors prepare the financial statements, so the users' confidence depends on how the directors themselves are directed and controlled.
6 Approaches to corporate governance regulation
Just as accounting standards may be principles-based or rules-based (Chapter 1), so may corporate governance regulation:
6.1 Principles-based codes
focus on objectives and outcomes rather than detailed prescription
can be applied across different legal jurisdictions
can address areas where hard rules cannot easily be written (such as board culture and behaviour)
put the emphasis on investors making up their own minds about whether governance is adequate
The UK takes this approach. The UK Corporate Governance Code is a voluntary code, built on principles of openness, integrity and accountability, that applies to listed companies on a 'comply or explain' basis: a company must either comply with each provision of the Code or explain to its shareholders why it has not. It is then for the shareholders to judge whether the explanation is acceptable.
6.2 Rules-based regimes
emphasise measurable, enforceable requirements
suit jurisdictions where the letter of the law is stressed and enforcement is through the courts
leave little room for judgement – a requirement is either met or breached
The US takes this approach. Following Enron and WorldCom, the Sarbanes-Oxley Act 2002 wrote governance requirements into legislation – for example, chief executives and chief financial officers must personally certify the accuracy of the financial statements, and companies must report on the effectiveness of their internal controls over financial reporting. Breach of the rules is a legal offence, not a matter for explanation.
UK | US | |
Approach | Principles-based | Rules-based |
Instrument | UK Corporate Governance Code (voluntary code) | Sarbanes-Oxley Act 2002 (legislation) |
Enforcement | 'Comply or explain' – judged by shareholders | Legal compliance – enforced by regulators and courts |
Corporate governance is the system by which companies are directed and controlled, needed because directors act as agents of the shareholders. Scandals such as Enron, WorldCom, the Co-operative Bank and Volkswagen were failures of governance. Good governance rests on transparency, independence, accountability and integrity; it is delivered by a balanced board (separate chair and chief executive, independent NEDs, audit, remuneration and nomination committees) and applies directly to financial reporting through the directors' responsibility for the financial statements and the audit committee's oversight. Regulation may be principles-based ('comply or explain', as in the UK Code) or rules-based (as in the US Sarbanes-Oxley Act).
7 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Corporate Governance
22 questionsAnswer the questions one at a time. Your progress is saved so you can leave and come back.
Open chapter practice