F1 CORPORATE GOVERNANCE: THE BOARD OF DIRECTORS AND STANDING COMMITTEES(1)

 

The syllabus for Paper F1/FAB, Accountant in Business, requires candidates to understand the meaning of corporate governance and the role of the board of directors in establishing and maintaining good standards of governance.

Specifically, the Study Guide refers to the separation of ownership and control, the role of non-executive directors and two of the standing committees commonly established by public companies. This article provides an introduction to corporate governance and some of the basic concepts that underpin it, and explains the roles of the board, the different types of company director and standing committees.

 

WHAT IS CORPORATE GOVERNANCE?

The simplest and most concise definition of corporate governance was provided by the Cadbury Report in 1992, which stated: Corporate governance is the system by which companies are directed and controlled.

 

Though simplistic, this definition provides an understanding of the nature of corporate governance and the vital role that leaders of organisations have to play in establishing effective practices. For most companies, those leaders are the directors, who decide the long-term strategy of the company in order to serve the best interests of the owners (members or shareholders) and, more broadly, stakeholders, such as customers, suppliers, providers of long-term finance, the community and regulators.

It is important to recognise that effective corporate governance relies to some extent on compliance with laws, but being fully compliant does not necessarily mean that a company is adopting sound corporate governance practices. Significantly, the Cadbury Report was published in the UK shortly after the collapse of Maxwell Communications plc, a large publishing company. Many of the actions that brought about the collapse, such as the concentration of power in the hands of one individual and the company borrowing from its pension fund in order to achieve leveraged growth, were legal at the time.

 

The Organisation for Economic Co-operation and Development published its ‘Principles of Corporate Governance’ in 2004. These are:

 

·           Rights of shareholders: The corporate governance framework should protect shareholders and facilitate their rights in the company. Companies should generate investment returns for the risk capital put up by the shareholders.

·           Equitable treatment of shareholders: All shareholders should be treated equitably (fairly), including those who constitute a minority, individuals and foreign shareholders.

 

 

·           Shareholders should have redress when their rights are contravened or where an individual shareholder or group of shareholders is oppressed by the majority.

·           Stakeholders: The corporate governance framework should recognise the legal rights of stakeholders and facilitate cooperation with them in order to create wealth, employment and sustainable enterprises.

·           Disclosure and transparency: Companies should make relevant, timely disclosures on matters affecting financial performance, management and ownership of the business.

·           Board of directors: The board of directors should set the direction of the company and monitor management in order that the company will achieve its objectives. The corporate governance framework should underpin the board’s accountability to the company and its members.

 

TO WHOM IS CORPORATE GOVERNANCE RELEVANT?

Corporate governance is important in all but the smallest organisations. Limited companies have a primary duty to their shareholders, but also to other stakeholders as described above. Not-for-profit organisations must also be directed and controlled appropriately, as the decisions and actions of a few individuals can affect many individuals, groups and organisations that have little or no influence over them. Public sector organisations have a duty to serve the State but must act in a manner that treats stakeholders fairly.

 

Most of the attention given to corporate governance is directed towards public limited companies whose securities are traded in recognised capital markets. The reason for this is that such organisations have hundreds or even thousands of shareholders whose wealth and income can be enhanced or compromised by the decisions of senior management. This is often referred to as the agency problem. Potential and existing shareholders take investment decisions based on information that is historical and subjective, usually with little knowledge of the direction that the company will take in the future. They therefore place trust in those who take decisions to achieve the right balance between return and risk, to put appropriate systems of control in place, to provide timely and accurate information, to manage risk wisely, and to act ethically at all times.

 

The agency problem becomes most evident when companies fail. In order to make profits, it is necessary to take risks, and sometimes risks that are taken with the best intentions – and are supported by the most robust business plans – result in loss or even the demise of the company. Sometimes corporate failure is brought about by inappropriate behaviours of directors and other senior managers.

 

As already mentioned, in the UK, corporate governance first came into the spotlight with the publication of the Cadbury Report, shortly after two large companies (Maxwell Communications plc and Polly Peck International plc) collapsed. Ten years later, in the US, the Sarbanes-Oxley Act was passed as a response to the collapse of Enron Corporation and WorldCom. All of these cases involved companies that had been

highly successful and run by a few very powerful individuals, and all involved some degree of criminal activity on their part.

 

The recent credit crisis has brought about renewed concern about corporate governance, specifically in the financial sector. Although the roots of the crisis were mainly financial and originated with adverse conditions in the wholesale money markets, subsequent investigations and reports have called into question the policies, processes and prevailing cultures in many banking and finance-related organisations.

 

APPROACHES TO CORPORATE GOVERNANCE

Most countries adopt a principles-based approach to corporate governance. This involves establishing a comprehensive set of best practices to which listed companies should adhere. If it is considered to be in the best interests of the company not to follow one or more of these standards, the company should disclose this to its shareholders, along with the reasons for not doing so. This does not necessarily mean that a principles-based approach is a soft option, however, as it may be a condition of membership of the stock exchange that companies strictly follow this ‘comply or explain’ requirement.

 

Some countries prefer a rules-based approach through which the desired corporate governance standards are enshrined in law and are therefore mandatory. The best example of this is the US, where the Sarbanes-Oxley Act lays down detailed legal requirements.

 

THE ROLE OF THE BOARD OF DIRECTORS

Nearly all companies are managed by a board of directors, appointed or elected by the shareholders to run the company on their behalf. In most countries, the directors are subject to periodic (often annual) re-election by the shareholders. This would appear to give the shareholders ultimate power, but in most sectors it is recognised that performance can only be judged over the medium to long-term. Shareholders therefore have to place trust in those who act on their behalf. It is rare but not unknown for shareholders to lose patience with the board and remove its members en masse.

 

The role of the board of directors was summarised by the King Report (a South African report on corporate governance) as:

 

·           to define the purpose of the company

·           to define the values by which the company will perform its daily duties

·           to identify the stakeholders relevant to the company

·           to develop a strategy combining these factors

·           to ensure implementation of this strategy.

 

The purpose and values of a company are often set down in its constitutional documents, reflecting the objectives of its founders. However, it is sometimes appropriate for the board to consider whether it is in the best interests of those served

by the company to modify this or even change it completely. For example, NCR Corporation is a US producer of automated teller machines and point-of-sale systems, but its origins lay in mechanical accounting machines (NCR represents National Cash Register). As cash registers would quickly become obsolete with the emergence of microchip technology, the company had to adapt very rapidly. Whitbread plc originated as a brewer in the 18th century in the UK, but in the 1990s redefined its mission and objectives completely. It is now a hospitality and leisure provider (its brands include Premier Inn and Costa coffee) and has abandoned brewing completely.

 

The directors must take a long-term perspective of the road that the company must travel. Management writer William Ouchi attributes the enduring success of many Japanese companies to their ability to avoid short-term ‘knee-jerk’ reactions to immediate issues in favour of consensus over the best direction to take in the long-term.

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