Governance, Risk and Ethics

2 Section A: Governance and responsibility Section B: Internal control and review Section C: Identifying and assessing risk Section D: Controlling risk Section E: Professional values and ethics Governance, risk and ethics

3 Section A: Governance and responsibility A1. The scope of governance A2. Agency relationships and theories A3. The board of directors A4. Board committees A5. Directors’ remuneration A6. Different approaches to corporate governance A8. Governance: Reporting and disclosure Designed to give you knowledge and application of:

4  Describe and compare the essentials of 'rules' and 'principles' based approaches to corporate governance. Includes discussion of 'comply or explain'. [3]  Describe and critically evaluate the reasons behind the development and use of codes of practice in corporate governance (acknowledging national differences and convergence). [3]  Explain and explore the Sarbanes-Oxley Act (2002) as an example of a rules- based approach to corporate governance. [2] Study Guide A6: Different approaches to corporate governance Learning Outcomes

5 Describe & compare essentials of 'rules‘ & 'principles' based approaches to CG & discuss the terms 'comply / explain' Rules-based approaches (RBA) Principles-based approaches (PBA) US approachUK approach resulting in the Sarbanes-Oxley laws initially driven by the Polly Peck and Coloroll collapses and the resulting Cadbury Code that emerged as the Maxwell empire collapsed Refer to Case Study in 138 Continued…

6 Compliance with rules Essentials of the rules- based approach Independence of auditors Increased accountability to shareholders Increased internal control mechanisms strictly impose governance structures and mechanisms on companies policing can be more effective  directors to be more responsible personally to their shareholders & other stakeholders  shareholders may lose trust as a result of fraud, error or excessive risk-taking  Companies are forced to put defined control mechanisms in place and auditors will be forced to police them Continued…

7 Aims to improve corporate behaviour Essentials of the principles- based approach Flexibility of codes of governance Can be applied across different legal jurisdictions Emphasises on elements of CG sets out codes of “best practices” assumes that one size does not fit all & that flexible codes allow diverse enterprises to find the best solution Aims at achievement of goals specifies the goals of good governance & not the method by which to achieve the goals Continued…

8 vs RBA Implementation of rules: compulsory Form over substance Requires exceptions & guidelines / interpretations Only rules to be complied with PBA Implementation of rules: flexible Substance over form Exceptions & guidelines / interpretations not required Leads to better system of compliance Continued…

9 Comply or explain method through which they have complied with the laid down principles Combined Code contains  method by which the company applies the principle  whether it has complied with the code principles  RBA enables users to take advantage of loopholes in the rules  PBA strengthens accountability to shareholders Continued…

10 Reasons behind the development & use of codes of practice in CG roots in a series of corporate collapses & scandals in the late 1980s & early 1990s Development of CG in UK Setting up of Cadbury Committee on Financial Aspects of CG Greenbury Report - recommendations on directors’ remuneration Cadbury & Greenbury Reports were merged to form Combined Code Turnbull Report guidance to directors on development of sound system of internal control Updated Combined Code incorporating recommendations of Higgs Report & Smith Report Publishing & maintaining Code to be done by Financial Reporting Council (FRC) UK government instructions! Refer to pages 148 to 151 Continued…

11 Cadbury report considers issues relating to financial reporting and accountability Greenbury Report looks into the set of best practices for determining and accounting for directors’ remuneration Combined Code Companies  role & remuneration of directors  relations with shareholders  accountability & audit Institutional investors  shareholder rights  communication with shareholders  disclosure of governance Turnbull Report guidance to companies, on the implementations of the internal control requirements of the Combined Code Continued…

12 Higgs report role & effectiveness of NEDs, additional recommendations to existing Combined Code Smith Report functioning of audit committees Combined Code 2003 Smith Report Higgs Report Continued…

13 Recommendations  separate chairman and chief executive  board balance ED:NED – 50:50  senior independent director to attend to shareholders’ grievances.  the board to be responsible for maintaining sound internal controls system  institutional investors are required to ignore “box ticking” and take a long-term view of the company’s performance  the design of performance-related remuneration  guidance on the liability of non-executive directors in the areas of care, skill, and diligence  provisions for the disclosure of corporate governance arrangements Continued…

14 Impetus & background of SOA Manipulation of financial reporting Dominance by board Poor external audit Non-independence of auditor Leads to lack of transparency Companies managed in self- interest of board members Financial statements not properly audited Affected objectivity Sarbanes-Oxley Act (2002) as an example of a rules-based approach to corporate governance Refer to pages 152 and 153 Continued…

15 Main contents of SOA Public Company Accounting Oversight Board (PCOB) Internal control reporting Auditor independence Corporate responsibility Whistle-blowing protection SOA compliance Audit committee Establishment of auditing, quality control, ethics, independence & other standards Prohibition from undertaking certain services To employees & auditors Evaluation of internal controls For financial reports Set up of financial accounting framework Continued…

16 RECAP  Describe and compare the essentials of 'rules' and 'principles' based approaches to corporate governance. Includes discussion of 'comply or explain'. [3]  Describe and critically evaluate the reasons behind the development and use of codes of practice in corporate governance (acknowledging national differences and convergence). [3]  Explain and explore the Sarbanes-Oxley Act (2002) as an example of a rules- based approach to corporate governance. [2]