Financial Reporting - Corporate Governance

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