Account

Course: Accounting Theory
Corporate Governance
Prepared By: Dewan Mahboob Hossain
Definition
The meaning of Corporate Governance is influenced by different views of different authors. For example, one group described it as a system by which companies are directed and controlled (Cadbury Report, CFACG 1992), to another group, it is concerned with the structures and processes for decision making, accountability, control and behavior at the governing body (Public Accounts and Estimates Committee, 2002), to someone corporate governance is about finding ways to ensure effective decision making (Pound, 1995).
Definition (contd.)
But
it should be noted that the term corporate governance is a separate term than management. The term management is highly related to the day-to-day management of a companys operations. Corporate Governance oversights this task of management under a harmonized structure.
Definition (contd.)
Vittal (2000) states that corporate governance calls for three factors: 1. Transparency in decision-making 2. Accountability which follows from transparency because responsibilities could be fixed easily for actions taken or not taken, and 3. The accountability is for the safeguarding of the interests of the stakeholders and the investors in the organization.
Definition (contd.)
Corporate governance is probably the widest control mechanism used for efficient utilization of corporate resources. It can be defined as an organizational control device, which is a hybrid of internal and external control mechanisms with a view to efficient utilization of corporate resources. It is the network among various corporate players such as, shareholders, managers, employees, lenders, government, suppliers, and consumers for increasing the value of the firm.
OECD Principles
1.
To have a clear idea about corporate governance system the principles laid out by Organization of Economic Cooperation and Development (OECD) can be considered in this regard: Protecting the rights of shareholders: This includes the right to secure ownership, full disclosures, voting rights, participation in all kind of activities in general shareholder meeting, to be informed on fundamental corporate changes, to have access to efficiency and transparency in markets for corporate control. Bosch Committee (1995) suggested that shareholders should see themselves as owners, not just investors.
OECD Principles (Contd.)

2. Equitable treatment of shareholders: Here OECD is concerned to protect the rights of the minority shareholders. Corporate governance framework should ensure the fair treatment of all shareholders including minority and foreign shareholders. Insider trading and abusive selfdealing is explicitly prohibited. Members of the board should disclose any material interests in transactions or matters influencing the organization.

3. Role of stakeholders: OECD recognizes that in addition to shareholders there are other stakeholders such as banks, bond holders, regulatory authorities, suppliers and employees who are very important in the way in which companies perform and make decisions. Corporate governance framework should recognize the rights of stakeholders as established by law and encourage active cooperation between organizations and stakeholders.

4. Ensuring disclosure and transparency: The OECD suggests for provision for disclosing and communicating all material facts (financial and non-financial). The corporate governance framework should ensure timely and accurate disclosures on all matters regarding the organization. Annual audits by independent auditors are also required in this context.

5. Clarifying responsibilities of the board: The OECD is much concerned about a boards responsibilities for protecting the company, its shareholders and stakeholders. The corporate governance framework should ensure the effective monitoring of management by the board and the boards accountability to the organization and shareholders.
The Role of Shareholders
1. 2.
Shareholders consist of: Individual shareholders and Institutional shareholders. They monitor the activities of management through direct negotiations with the management, proxy contests and various guidelines.
The Role of Shareholders (contd.)

According to Cadbury report (1992): The shareholders as owners of the company elect the directors to run the business on their behalf and hold them accountable for its progress. (they) have delegated many of their responsibilities as owners to the directors who act as their stewards. It is for the shareholders to challenge the directors if they appear to be failing in their stewardship as they should use this power. While they cannot be involved in the direction of management of their company, they can insist on high standard of governance.
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2.
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In Australia, a working group chaired by Henry Bosch (the Bosch Committee) put forward some guidelines in which the followings are identified as some of the rights and obligations of shareholders: Shareholders should make themselves as informed as possible of the activities of the company; Shareholders should see themselves as owners, not just investors. Their responsibility as shareholders increases with the size of their shareholdings. Shareholders should have made a sufficient analysis to vote in an informed manner on all issues raised in general meeting.

4. Shareholders in companies listed on stock exchanges (other than employee shareholders) should not involve themselves in the companys day to day operations. 5. Shareholders should take a positive interest in the composition of board of directors specially in case of appointment of the non-executive directors. 6. Shareholders should take a positive interest in the structure of boards and, in particular, the appointment of appropriate committees of the Board specially the audit committee.

7. Shareholders in listed companies should take a positive interest in the performance of the board and should exercise their votes in the election of directors in an informed manner. 8. Shareholders should take a positive interest in the auditors report and the competence of the auditors and where appropriate, be prepared to ask questions of the auditor. 9. Shareholders should not seek to receive price sensitive information which is not available to the market generally.
The Directors
All companies must have directors. The board of directors or governing body gives direction and exercises judgment in setting the entitys objectives and monitoring their implementation. The board of a large public corporation cannot manage the corporations day to day business. That function must be left to the corporate executives.
The functions of the board according to Bosch Report

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4. 5.
Taking steps designed to protect the companys financial position and its ability to meet its debts and other obligations when they fall due. Adopting a strategic plan for the company, including general and specific goals and compare actual results with the plan; Adopting an annual budget for the financial performance of the company and monitoring results on a regular basis; Adopting clearly defined delegations of authority from the board to the CEO; Agreeing performance indicators with the management.
The functions of the board according to Bosch Report (contd.)

6. Ensuring that systems are in place which facilitate the effective monitoring and management of the principal risks to which the company is exposed. 7. Determining that the company has instituted adequate reporting systems and internal control. 8. Establishing and monitoring policies directed to ensure that the company complies with the law and conforms with the highest standards of financial and ethical behavior. 9. Determining that the company accounts are in conformity with accounting standards and are true and fair. 10. Determining that satisfactory arrangements are in place for auditing the companys financial affairs and the scope of external audit is adequate.
The functions of the board according to Bosch Report (contd.)

11. Selecting and recommending auditors to shareholders at general meetings; 12. Selecting and if necessary, replacing the chief executive, setting an appropriate remuneration package, giving guidance on the appointment and remuneration of other senior management. 13. Ensuring that the company has in place a policy that enables it to communicate effectively with its shareholders, other stakeholders and the public generally; 14. Adopting formal processes for the selection of new directors and recommending them in consideration in general meetings with adequate information to allow shareholders to make informed decisions; 15. Reviewing its own processes and effectiveness and the balance of competence on the board.
Categories of Directors
Two categories of directors are generally recognized: 1. Executive directors who are employees, usually senior managers such as managing directors and finance directors. In addition to their responsibilities as managers, executive directors have all the same responsibilities as other members of the board. Therefore, it is important that they are of sufficient stature and security of employment to express disagreement, if necessary, with other board members. 2. Non-executive directors who are not employees but bring special qualifications, experience, expertise and independent perspective to the board.
Categories of Directors (contd.)

The main functions of non-executive directors are: a. To bring independent view to the boards deliberations; b. To help the board (and the chairman) provide the company with effective leadership; c. To foster the continuing effectiveness of executive directors and management.
Categories of Directors (contd.)

The Cadbury Report recommended that the board of directors should include non-executive directors of sufficient caliber and number. On the composition of sub-committees of the board, it indicated that all boards would require a minimum of three non-executive directors. Further it recommended that the majority of nonexecutive directors should be independent of management and free from any business or other relationship which could materially interfere with the exercise of their independent judgment.
How the Directors should act?

According to the Articles of Association of the Australian Institute of Company Directors, the following are the code of conducts of the directors: 1. A director must act honestly, in good faith and in the best interest of the company; 2. A director has a duty to use due care and diligence in fulfilling the functions of the office and exercising powers attached to that office. 3. A director must use the power of the office for a proper purpose, in the best interest of the company as a whole. 4. A director must recognize that the primary responsibility is to the companys shareholders as a whole but should, where appropriate, have regard for the interests of all stakeholders of the company.
How the Directors should act? (contd.)

5. A director must not make improper use of information acquired as a director; 6. A director must not take improper advantage of the position of director; 7. A director must not allow personal interests, or the interests of any associated person, to conflict with the interest of the company. 8. A director has an obligation to be independent in judgment and actions and to take all reasonable steps to be satisfied as to the soundness of all decisions taken by the board. 9. Confidential information received by a director in the course of the exercise of directorial duties remains the property of the company from which it was obtained and it is improper to disclose it, or allow it to be disclosed, unless that disclosure it authorized by that company, or the person from whom the information is provided, or is required by law. 10. A director should not engage in conduct likely to bring discredit upon the company.
Independent/ non-executive Directors

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The Australian Investment Managers Association defines an independent director as a director who: is not a member of management; is not a substantial shareholder of the company or an officer of or otherwise associated directly or indirectly with a substantial shareholder of the company; has not within the least three years been employed in an executive capacity by the company or any other group member or been a director after ceasing to hold any such employment; is not a principal or a professional adviser to a company or another group member;
Independent/ non-executive Directors (contd.)

5. is not a significant supplier or customer of the company; 6. has no significant contractual relationship with the company; 7. Is free from any interest or any business or other relationship which could, or could reasonably be perceived to, materially interfere with the directors ability to act with a view to the best interests of the company.
The Chairman
The role of the chair in leading the board of directors, including determining the board agenda and obtaining contributions from other board members in the boards deliberations, is crucial to ensure that the board works effectively. The Cadbury committee recommended that due to the importance and nature of chairmans role, it should, in principle, be separate from Chief Executive Officer (CEO). A strong independent chairperson provides a check and counterbalance to the power of CEO. The Bosch Committee indicated that the combination of the roles of chairperson and CEO constitute a concentration of power that could give rise to conflicts. Therefore, the roles should be separated.
Sub-committees of the board
The effectiveness of the board, and particularly of non-executive directors, is likely to be enhanced by the establishment of effective subcommittees. Generally, three sub-committees are recommended in corporate governance practices and they are : audit committee, remuneration committee and nomination committee. Membership of these board sub-committees is generally confined to directors and ideally they should be governed by a charter which documents their responsibilities.
Sub-committees of the board (contd.)

Further, they should report back results of their separate meetings to the full board on a regular basis. The use of sub-committees gives nonexecutive directors a well defined area in which they are expected to contribute. It is expected that, the sub-committees should be comprised of majority of the nonexecutive directors.
Audit Committee

An audit committee is an important component of corporate governance. An audit committee is a sub-committee of the board of directors, comprising a majority of independent/non-executive members of the governing body of an entity and represents owners rather than management. Among other functions, it is usually assigned the duty of oversight of the financial reporting and auditing process. The auditors major dealing with the governing body will be through audit committee, although the auditor will usually meet with the full governing body at least once per year.
Composition of Audit Committee
Two predominant schools of thoughts:
The first school maintains that the audit committee should be entirely composed of non-executive directors who have no management responsibilities or affiliations. It is claimed that this is the only way to ensure the complete independence of the committee in its evaluation of management and audit representation. The NYSE requires the highest possible standard which is that all listed companies have an audit committee composed totally of independent directors.
Composition of Audit Committee (contd.)

The second school claims that at the very least there should be one management representative on the committee. It would provide a more balanced perspective to the problems under committee investigation. The problem with this kind of structure is the potentially adverse effect that the management representative may have on the committees independence.
Objectives and responsibilities of audit committee

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4. 5. 6.
To enhance the ability of governing body to fulfill its legal responsibilities; To add to the credibility and objectivity of financial reports; To oversee the application of appropriate accounting policies and procedures including appropriate disclosures; To establish and monitor corporate policies to prohibit unethical, questionable or illegal activities; To establish and monitor effective internal and management control; To provide a communication link between management, auditors and the governing body.
Benefits of audit committees

An audit committee may: 1. Form part of an effective corporate governance structure; 2. Strengthen the internal control structure and ensure the maintenance of appropriate accounting records; 3. Support the independence of internal and external auditors; 4. Provide direct communication channel between management, auditor and the board; 5. Improve the quality of financial disclosures and the effectiveness of the audit function by providing independent review of these functions.
Benefits of audit committees (contd.)

6. Act as a forum for the resolution of disagreements between management and the auditors. 7. Improve the effectiveness of internal and external auditors by providing a coordinating approach for audit planning. 8. Keep the governing body fully informed about accounting and auditing issues; 9. Increase the effectiveness of non-executive directors; 10. Provide evidence that members of the governing body have exercised due care in fulfilling their statutory responsibilities;
Limitations of audit committee

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4. 5.
The audit committee, being only a sub-committee of the governing body, may not have the power to enforce its recommendations; Financial report users may have unrealistic expectations of audit committees; The establishment of an audit committee may cause conflict within the governing body, particularly between executive and non-executive directors; The audit committee may be ineffective due to lack of competent non-executive members; Committee members may be selected because of their association with the CEO or chairman of the governing body, thus reducing perceived independence.
Limitations of audit committee (contd.)

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7. 8.
The presence of management in the audit committee may inhibit open discussion and affect the independence of the committee. The maintenance of an audit committee is time consuming and costly; The responsibilities of audit committee may interrupt on those of management, creating an atmosphere of conflict and distrust.
Characteristics of effective audit committees

1. 2. 3. 4. 5. 6. 7.
They are perceived to be independent and actually exercise independence in their dealings with management and auditors; They are composed of experienced and competent non-executive directors; They are established by a resolution of the full board of the governing body; They have a limited number of members; They are given explicit objectives and terms of references which are subject to regular review; They should arrange necessary meetings at the request of the auditors or management; They should circulate agendas and minutes to relevant parties.
Remuneration committees

Remuneration committees are set up to review terms and conditions relating to the employment of senior management. Clearly this is an area where the interests of the shareholders conflict with those of management. Remuneration committees will also review the design of employee incentive schemes such as bonus schemes and stock option plans. This has been a controversial area specially in the eyes of small shareholders. Under agency theory, it is argued that in order to increase shareholders value, it is necessary to align the interests of management with the interests of shareholders. One way of achieving this is through the design of appropriate remuneration committee.
Remuneration committees (contd.)
Remuneration committees provide a mechanism for the views of management and shareholders to be considered by non-executive directors and therefore assist in the development of appropriate remuneration structure. Perceived excess executive remuneration has been a continuing source of conflict between shareholders and managers. According to The Australian Investment Managers Association (1997), remuneration committees should be composed primarily of non-executive members. But they did not say that all the members here should be non-executive. In contrast, UK-based Institutional Shareholders Committee has recommended that remuneration committees comprise only independent non-executive directors.
Nomination Committees
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2.
Nomination Committees generally have two main roles: To establish the skills required of a replacement or additional director and to approach potential candidates. To review, on a regular basis, the performance of the board as a whole and the contribution of individual members to the board.
Corporate governance is related to the management process. Internal control is also related to many aspects of the management process. Effective controls, coupled with good management practices, can ensure that an organization promptly identifies business risks, and mitigates and limits any negative consequences that may result from such risks. An effective internal control structure is central to efficient risk management. Ineffective controls result in an ineffective management process.
Corporate Governance and Internal Control
Importance of Internal control
The Cadbury Report (1992) argued that an effective internal structure is the key aspect of the efficient management of a company. The Toronto Guidelines identify managing risk as one of the principal responsibilities of the board. Thus the board needs to understand the principal risks of all aspects of the business in which the entity is engaged and must recognize that business decisions require the incurrence and management of risks. The board must then achieve a proper balance between the risks incurred and the potential returns to the shareholders.
The nature of Internal Control: The COSO framework The fact that internal controls are diverse and pervasive was recognized in the USA by National Commission on Fraudulent Financial Reporting (the Treadway Commission, 1987). This commission had a committee called the Committee of Sponsoring Organizations (COSO). It released a fourvolume report entitled Internal ControlIntegrated Framework.
The nature of Internal Control: The COSO framework (contd.)
The COSO report defines internal control as: ..a process, effected by an entitys board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: Effectiveness and efficiency of operations; Reliability of financial reporting; and Compliance with applicable laws and regulations.
The nature of Internal Control: The COSO framework (contd.)
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Internal control, as defined by COSO, is directed toward the achievement of entity objectives relating to: Effectiveness and efficiency of operations: Related to performance, profitability and productivity. And also related to safeguarding resources. Reliability of financial reporting: Related to the preparation and dissemination of reliable financial information, safeguarding entity assets and records. Compliance: With applicable laws and regulations to which the entity is subject.
Components of Internal Control
1.
To achieve these three objectives, there should be the following internal control components: Control environment: Setting the tone of the organization. Influencing the control consciousness of its people. Control environment factors include: integrity, ethical values and competence of the entitys people; managements philosophy and operating style; the way management assigns authority and responsibility and organizes and develops its people; and the intentions and directions provided by the BOD.
Components of Internal Control (contd.)

2. Risk Assessment: Every company faces a variety of risks from its internal and external environment. Risk assessment is the identification and analysis of relevant risks to achievement of the objectives, forming a basis for how the risks should be managed. Because economic, industry, regulatory and operating environment will continue to change, mechanisms are needed to identify and deal with specific kinds of risks associated with the change.

3. Control activities: These are policies and procedures that help ensure management directives are carried out. They help ensure that necessary actions are taken to address risks to achievement of entitys objectives. Control activities occur throughout the organization, at all levels and in all functions. They include a range of diversified activities such as approvals, authorizations, verifications, reconciliations, reviews of operating performance, security of assets and segregations of duties.
4. Information and communication: Pertinent information must identified, captured and communicated in a form and timeframe that enables people to carry out their responsibilities. Information systems produce reports containing operational, financial, and compliance-related information, that make it possible to run and control the business. They deal not only with internally generated data, but also information about external events, activities and conditions necessary to informed decision making. All personnel must receive a clear message from top management that control responsibilities must be taken seriously. They must understand their own role in the internal control system, as well as how their individual activities relate to the works of others.

5. Monitoring: Internal control systems need to be monitored- a process that assesses the quality of systems performance over time. This is accomplished through ongoing monitoring activities, separate evaluations or a combination of the two. Internal control deficiencies should be reported upstream, with serious matters reported to top management and the board.
Role of the Auditors
Auditors are perceived as upholders of the integrity of financial reporting in public interest. Therefore, auditors are vitally interested in corporate governance related issues. The Cadbury Report emphasizes the importance of financial reports. To ensure this, direct contact between the auditors, the non-executive directors and the board as a whole is important. The external auditor, as an independent party with a detailed knowledge about the entitys financial affairs, is able to provided substantial inputs to the audit committee. The external auditor should also assist the audit committee by informing it of any developments such as legislative changes or new accounting standards.
Role of the Auditors (contd.)
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The external auditors roles and responsibilities in relation to effective interaction with an effective audit committee include the following: Ensuring that information regarding the planning of audit (e.g., scope, materiality etc.) is communicated to the audit committees on time; Communicating to the committee the responsibilities of auditors according to auditing standards and legal mandates. Communicating to the committee matters which, in auditors judgment, represent significant deficiencies in the design or operation of the internal control structure.
Role of the Auditors (contd.)

4. Informing audit committee of any major issues which were discussed with the management in connection with the appointment of the auditors; 5. Informing the audit committee of any serious difficulties encountered in the performance of the audit; 6. Informing the audit committee about any significant errors, problems of weaknesses revealed by the audit or areas of significant disagreement with the management, the corrective actions taken and their current status. 7. Asking the audit committee if there are any other matters of which the auditor should be aware. 8. Documenting in the working papers significant matters communicated to the audit committee. 9. Responding in an appropriate manner to reasonable audit committee questions. Mahboob Hossain Prepared By: Dewan
Internal Auditors Responsibilities
The role of internal auditors may vary between different situations and companies: it could include financial, compliance or performance audit. An effective internal audit function should evaluate and monitor the adequacy and effectiveness of the internal control structure. An internal audit program may assist in risk assessment and management. It is important for the internal auditors to have direct access to the audit committee.
Internal Auditors Responsibilities (contd.)

1. 2.
The audit committee should: Monitor the scope of the work of internal audit; and Review the reports issued.
This can be achieved by having the head of the internal audit function attend meetings with the audit committee.
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3. 4. 5.
The audit committee can play an important role in ensuring that the internal audit function is effective by addressing such issues as: The level of resources allocated to the internal audit; The scope of the authority of internal audit; The appropriateness of the internal audit program and reporting line; The quality and timeliness of its reports; The extent to which management reacts to the matters raised by internal audit.

The
audit committee can also provide an effective means of formalizing and coordinating the working relationship between internal and external auditors.

1.
2. 3.
Internal auditors should provide the audit committee with the following: A copy of formal audit plan, including internal audits objectives, work schedules, staffing requirements, budget and description of any limitations placed on internal audits scope of work. Details of the internal audit staff structure, including staff skills, experience and qualifications. Activity reports highlighting significant findings and recommendations, particularly in relation to the entitys risk management, and identifying any lack of action by management.

4. Major variances from the internal audit departments work schedules and budgets; 5. Advice on the coordination of internal audit plan with the external audit plan; 6. Activity reports on any major frauds or conflict of interest. 7. Any other information requested by the audit committee.

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Course: Accounting Theory

Prepared By: Dewan Mahboob Hossain

OECD Principles (Contd.)

OECD Principles (Contd.)

OECD Principles (Contd.)

OECD Principles (Contd.)

The Role of Shareholders

The Role of Shareholders (contd.)

The Role of Shareholders (contd.)

The Role of Shareholders (contd.)

The Role of Shareholders (contd.)

Prepared By: Dewan Mahboob Hossain

The functions of the board according to Bosch Report

The functions of the board according to Bosch Report (contd.)

The functions of the board according to Bosch Report (contd.)

Categories of Directors (contd.)

Categories of Directors (contd.)

How the Directors should act?

How the Directors should act? (contd.)

Prepared By: Dewan Mahboob Hossain

Independent/ non-executive Directors

Independent/ non-executive Directors (contd.)

Sub-committees of the board

Sub-committees of the board (contd.)

Prepared By: Dewan Mahboob Hossain

Composition of Audit Committee

Two predominant schools of thoughts:

Composition of Audit Committee (contd.)

Objectives and responsibilities of audit committee

Benefits of audit committees

Benefits of audit committees (contd.)

Limitations of audit committee

Limitations of audit committee (contd.)

Prepared By: Dewan Mahboob Hossain

Characteristics of effective audit committees

Remuneration committees (contd.)

Prepared By: Dewan Mahboob Hossain

Corporate Governance and Internal Control

Importance of Internal control

Prepared By: Dewan Mahboob Hossain

The nature of Internal Control: The COSO framework (contd.)

The nature of Internal Control: The COSO framework (contd.)

Components of Internal Control

Components of Internal Control (contd.)

Components of Internal Control (contd.)

Components of Internal Control (contd.)

Components of Internal Control (contd.)

Role of the Auditors

Role of the Auditors (contd.)

Role of the Auditors (contd.)

Internal Auditors Responsibilities

Internal Auditors Responsibilities (contd.)

Internal Auditors Responsibilities (contd.)

Internal Auditors Responsibilities (contd.)

Internal Auditors Responsibilities (contd.)

Internal Auditors Responsibilities (contd.)

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