Corporate Governance, the system by which companies are directed


Good corporate governance structures encourage companies to create value (through entrepreneurism, innovation, development and exploration) and provide accountability and control systems commensurate with the risks involved (ASX Principles, 2003).

The introduction of the Corporate Law Economic Reform Program (CLERP 9) in 2002 brought about changes to laws governing corporations to try reflect changes in the business environment. CLERP 9 also focused on the independence of auditors due to the collapse of high profile companies such as HIH and One.Tel. More specifically, it requires top 500 ASX-listed companies to have an audit committee, and top 300 ASX-listed companies to have an independent audit committee. It is the role of the independent directors in these committees to 'monitor policies and decisions made by executive directors as they have no relationship with the company that would, or could be perceived to, materially affect their decision making' (Leo et al. 2009). On the other hand, in some cases independent directors may not contribute to effective corporate governance (Rosenstein & Wyatt, 1997).

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The change under CLERP 9 regarding the existence of independent directors in an audit committee seems to lead to better enhanced corporate governance. One of the reasons towards this benefit is the non-existence of conflict of interest and the absence of directors personal interest which affect their decision making while being a member of the audit committee. In other words, an independent director, unlike executive directors have their interests aligned with the shareholders interest. This shows that in any circumstances whatsoever, an independent director in an audit committee would never be involved in any fraudulent. If the majority of the board are genuinely independent they have the power to implement board decisions, even contrary to the wishes of management or a major shareholder, if the need arises. The independent board majority is a key mechanism to assure shareholders that their company will be run competently in its own best interests and consequently in the best interests of all shareholders

Furthermore, independent directors are essential to an audit committee because they have a role in decreasing selfish behaviour of executive directors, also known as agency theory. An example of such action is in the case Re Darby [1911] 1 KB 95 where a fraudulent company was created to steal money away from investors. Independent directors perform this role by reviewing financial reports, analysing the audit function of the company and overseeing managerial operations to ensure that the company's performance is consistent with maximising shareholder value and efficient use of resources. Because these directors have a separate relationship to the company compared to executive directors they have a good opportunity to question policies used and challenge strategies put in place. As a result, 'financial reports are relevant and reliable, company objectives are followed, any risks can be monitored and assessed and performance can be optimised' (Considine et al. 2008), thus tying in with the corporate governance definition by the ASX Corporate Governance Council.

Some effective governance structures for the control and supervision of managers include the board of directors, who are predominantly outsiders with no personal relationship with the company (Donaldson, 1990). Independent directors in the audit committee keep an eye on the management's acts reflecting in the financial statements .This is to ensure that management is working in the best interests of shareholders and the firm. Due to managers pursuing their own interests, boards are involved in monitoring managerial decision-making and performance, 'particularly through independent non-executive directors' (Roberts et al. 2005). Keil and Nicholson (2003b) present the view that agency theory was widely adopted in the 1970s and 1980s due to the 'excesses' of the period. That is, managers were making decisions on a grand scale, takeovers of companies were very common and managers were paying themselves hefty salary packages even in situations where the business was not performing so well.

In addition, setting an appropriate charter for independent directors is an essential part of the committee's operations. It sets the company's industry and objectives, but more importantly it sets out the audit committee's roles and responsibilities. Some examples of these duties include:

Internal and external reporting;

Oversight of risk management services;

Internal and external audit;

Internal control framework including policies and procedures;

Compliance with applicable laws and regulations;

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Oversight of activities to control and prevent fraud (Australian Institute of Company Directors, 2008).

If a solid charter is created, it gives effective guidance when selecting members for the independent audit committee because potential conflicts of interest can be discovered before they affect the operations of the committee. Thus, when individuals with the required key qualities are selected using the committee's charter, they will be able to discharge their responsibilities with a high level of integrity and professionalism. Furthermore, these qualities will help independent directors challenge managerial decisions and question motives and strategies that they have put in place. As a result of setting an appropriate charter independent directors can 'successfully monitor management, thus contributing to the way corporations are managed and governed' (Leo et al. 2009).

Importantly, a committee comprised of independent directors' assists with a company's corporate governance by 'identifying mistakes made by executives be they fraudulent or simply careless' (Lee, 2006). Independent directors do not have the same understanding of the company's goals as executive directors, so they must rely on information provided by management. Unfortunately, management may act fraudulently in order to protect their own interests. Consequently, financial reports and information received may be misleading, incomplete or some important items purposely withheld as management tries to cover up its mistakes. It is through the independent directors' duty of care and diligence that allows them to review management behaviour and more importantly through the case of AWA Ltd v Daniels (1992) 7 ASCR 759 at 868 that a director is entitled to rely without verification on the judgement, information and advice of officers, unless the circumstances clearly show it is unreasonable to do so. An example where independent directors were not given reliable information, but did not exercise duty of care and diligence is in the case of One.Tel. The executive finance director saw that the company was going to miss its profit target by $52 million, he processed a few suspicious accounting adjustments to meet this, and did not inform the independent directors of what had occurred. For an audit committee comprised of independent directors, it is imperative that any and all mistakes are discovered and amended correctly to ensure that the company's system of management is performing ethically.

Another reason leading to effective corporate governance is the continuing control of the company while in liquidation or any crucial circumstances. It is generally accepted that the board of independent directors is the first and best line of defence against corporate fraud. In other words, independent directors in an audit committee have no relation and share in the company and hence they are not liable to any other party including shareholders .This makes independent directors calm, constant and focused on trying to stable company's statements and the company itself in hard times. Wheatley (2006) stated that 'in times of crisis independent directors should play a crucial role. We would expect independent directors to continue to act as directors at the time of crisis'. This role of independent directors helps to keep the company and its statements up to date and organised in a comparable form to other companies in the market. This way of managing, monitoring and keeping up of record and information with the market leads to effective corporate governance.

On the other hand, studies conducted by Rosenstein and Wyatt (1997) show that scandals and corporate collapses have occurred even with an independent audit committee and with good corporate governance mechanisms in place. In addition, it is stated that:

The independent director is conceived of as having no direct or indirect connection with the corporation other than the position they hold on the board and a shareholding of less than 5% (ASX Corporate Governance Council, 2003).

This means that an independent director cannot have a material connection with the corporation. While this is true, the corporation is allowed to decide what constitutes a material connection. However, when looking into the situation of large companies making millions of dollars in profits, as long as they have a shareholding of less than 5% they are considered as an independent director (Hall & Le Mine, 2006). This seems funny, because it skews the perception of an independent director. Anyone who purchases goods or services, in the millions of dollars scale, would naturally be interested and biased in their interactions with the corporation.

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Furthermore, Hall et al.(2006) make a note that 'Most commentators and regulators see the primary task of corporate governance as addressing the possibility that management will neglect their duties or act in their own interest. This suggests that there can be a creation of inner circles within corporations and couple with socialisation can severely undermine the independence of external directors. In addition, studies conducted by Wan (2004) show that there isn't a link between today's definition of good corporate governance, where independent directors play a vital role, and corporate governance. Even though there is evidence to suggest that with the appointment of independent directors, share prices increases initially, the independent director has no lasting positive effect on share price. Some reasons may include; independent directors lacking relevant experience, and aside from following their legal obligations of due care and skill, might lack a direct interest in the company's performance (and the incentive that incentive brings), because of the fact that they have no attachment to the company.

In conclusion, corporate governance has been an important issue in Australia's business environment. CLERP 9 brought significant changes to corporate governance laws and with those changes was the focus on independent auditors to fulfill their role to monitor management and question their motives. Because of independent directors having no relationship with their company, meaning they have no self-interest while on the board, they are in the best position to ensure that the company has the right policies and performs ethically, all contributing to the notion of effective corporate governance.