Corporate Governance
Let’s start with some more recapping from last time:
- The gearing ratio measures what proportion of a business is funded by borrowing
- Depreciation does not count as a cash expense
- Current assets are usually only held during one operating cycle, so they are expected to be sold within a year
- The market value of a company cannot be shown on the balance sheet, as it depends on the number of shares x the share price, neither of which appear on the balance sheet.
What is corporate governance?
- The system by which businesses are controlled, or governed.
- It specifies the rights and responsibilities that apply to different people in the business, such as owners, the board, managers and shareholders.
- It makes the procedures for doing things known
Simpler explanation:
- The way suppliers of finance to a business are assured that they will get a return on their investment
Scandals
- There have been accounting scandals at big firms in the past
- This decreases the confidence that investors have
- So corporate governance is reformed to restore confidence
- In the UK we have codes of practice that outline what the best practice in difference areas of corporate governance is
- If a business chooses not to comply with the codes of practice they must say why not. Most businesses issue an annual corporate governance report
Reforms
There are 3 guiding principles in the reforms:
- Disclosure
- Accountability
- Fairness
The combined code 2008
- Every listed company needs a board of directors
- There should be a clear division of responsibilities between the chairman and the CEO
- There should be a balance between executive and non-executive members (executive means full time)
- The board should receive timely information
- Appointments to the board should be subjected to rigorous, formal and transparent procedures
- All directors should be subjected to re-election regularly
- Renumeration should be sufficient to attract, keep and motivate directors of the quality required to run the company
- There should be formal and transparent procedures for developing policy on renumeration
- The board should communicate both ways with shareholders
- Boards should use the AGM to communicate with private investors
- Shareholders have a responsibility to use their votes
- The board should publish an assessment of the company’s position and performance that is balanced and understandable
- Internal controls must be in place that protect the shareholder’s wealth
- Formal and transparent arrangements for financial reporting should be in place
- The board should undertake a formal and rigorous examination of its own performance annually
The Board of Directors
They do 3 main things:
- Decide strategic direction for the company
- Exercise control
- Maintain external relations
Exercising Control
We can split this into 4 areas:
- Carrying out the strategic plan
- Maintaining integrity of financial statements
- Evaluating and managing risk
- The way that directors are nominated and remunerated
The chairman of the board
Is expected to:
- Hold board meetings often
- Make sure the board’s agenda reflects the key issues
- Give board members relevant, reliable and timely information
- Provide enough time at meetings to discuss key issues
- Allow all directors to voice their opinions
- Guide discussions so that the focus stays on key issues
Auditing
Company law means that directors must prepare annual financial statements. This involves:
- Selecting suitable accounting policies and applying them consistently
- Making prudent and practical judgements and estimates
- Stating whether appropriate accounting standards have been used
- Applying the going concern convention when appropriate
Internal Audit
Involves a review of:
- The internal control systems, to make sure that they safeguard the company’s assets and prevent fraud
- The accounting systems to make sure they provide reliable information
- Internal processes to se whether they are efficient and provide value for money
The audit committee:
- Monitors the integrity of financial statements
- Reviews the company’s internal controls
- Makes recommendations concerning the appointment of external auditors
- Monitors the external auditor
- Establish policies about the supply of non-audit services by the external auditor
Director’s Pay
- Usually a mixture of fixed and variable pay, eg a base salary mixed with performance based awards
Performance targets should:
- Sync with the goals of the company
- Lead to a convergence of director and shareholder’s interests
- Reflect director achievement
- Be protected from financial manipulation
Share Options
- Give directors the option of buying shares in the company at an agreed price
- Usually the market price on grant date.
- See ‘Apple backdating options’ for more information
- Option must be used on an agreed date
There are several benefits by offering options:
- Aligns director and shareholder interests
- Strengthens the psychological bond between director and company
- Retains board members
- Involves no financial outlay for the company at the granting time
Problems:
- If share price falls, the incentive is lost
- This may be beyond the control of the directors
- Director might have a large proportion of their wealth in the form of equity
- Excessively focusing on share price might not be best for the company
- Option pricing has been manipulated in the past
Shareholder Involvement
- Increasingly shareholders involve themselves in challenging board decisions such as director pay
- Debatable if this makes a difference to company performance
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