Examining The Mechanisms Of Corporate Governance Accounting Essay

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The companies are directed and managed by the system of corporate governance. It provides how the company set the objectives and achieves them, how the forthcoming risk being monitored and assessed and accordingly how performance is optimized. There is a widespread intuitive belief that higher standards of corporate governance are associated with enhanced accountability and performance. There is a powerful sense that corporate governance accountability and value creation are inextricably bound together, and that the board can make a considerable contribution to getting this right. It is the structure of the corporate governance which encourage companies to create value by entrepreneurialism, development, innovation, exploration and provide accountability and control systems commensurate with the risks involved. In attempting to ascertain the contribution of corporate governance to performance, there are problems of definition, methodology and evidence. If corporate governance as a concept refers to the system of ownership and control, and to the structure of the boards and its operations, this can be interpreted widely in terms of relations, with a range of stakeholders or narrowly in terms of compliance with the provisions of corporate governance codes.

6.2 The self-regulatory framework

The primary corporate legislation can be found in the Companies Act 20061 and the UK company law has undergone through a process of substantial review and modernisation. The method adopted by the UK for corporate governance, as per Dr Roger Barker's paper 2 of 2008 (Dr Barker is head of Corporate Governance in the institute of directors) is a good balance between self-regulation and law. The UK method of corporate governance is primarily governd by the companies Act, the combined code issued by the Financial Reporting Council (FRC), and the Listing Rules issued by the Financial Services Authority (FSA). 3

1. http://www.opsi.gov.uk/acts/acts2006/ukpga_20060046_en_1



There are articles of association 4 for each company prescribing regulations for them. The articles of association provides the contract and relationship among shareholders and contain the company rules including powers and duties of directors,5 shareholder meetings, borrowing powers, and many other aspects relating to the governance of the company.

The Company law deals in detail with the individual duties and responsibilities of the directors, but as regards to board, it hardly mentions in its collective capacity. Articles of association should be consulted in relation to all governance issues.6 Thus through various reports and codes to whom the board is accountable in the UK, there can be the development of the self-regulatory governance framework. These reports and codes primarily deal with the issues concerning the control of the boards of the companies and their directors. The focus of these reports and codes is on improving information about companies, preventing fraud, and making boards of directors more accountable to shareholders. The UK method of corporate governance revolve around the Combined Code and the "comply or explain" principle and has attained with a passage of time a position in which it is broadly "fit for purpose". 7

The starting point in a formalised manner about the governance of UK companies came in the form of the Cadbury 8 Report, 1992 when the UK witnessed the debackles of the Robert Maxwell pension fund and the Bank of Credit and Commerce International (BCCI) specially the controversy about directors' pay, which caused corporate governance to be in the public eye. The Cadbury report was on the Financial Aspects of Corporate Governance, there were also strong recommendations made for the separation of the role of the chief executive and chairman, for having a board with balanced composition of executive and non-executive directors, non-executive director's selection processes, stronger internal controls and transparency of financial reporting to which was attached a Code of Best Practice. There was more development carried out through various reworkings including work done by the Greenbury Committee which culminated in the Greenbury 9 Report, 1995 with its recommendations on executive pay, share options and a Code of Best Practice. Later a need was felt to review the previous governance recommendations and brought the Cadbury and Greenbury Reports together in a single code. Thus the task was carried out by a Committee on Corporate Governance, under the guidance and chairmanship of Sir Ronald Hampel who produced the Hampel Report, 1998, 10 containing the Combined Code on Corporate Governance. This Combined Code on Corporate Governance had a number of provisions relating to internal control. But as regards to the guidance on internal controls' it gave little information on the scope and extent. As a result the Institute of Chartered Accountants in England and Wales, supported by the Stock Exchange formulated a working body with a task to look in to the matter of

4. http://www.clickdocs.co.uk/articles-of-association.htm

5. http://www.boardworksinternational.com/board5.htm#one

6. http://www.iclg.co.uk/khadmin/Publications/pdf/2963.pdf


8. Committee on the Financial aspects of Corporate Governance, (1992). The Financial Aspects of

Corporate Governance, London, Gee (Cadbury Report)

9. Greenbury Report,1995


10. Committee on Corporate Governance, (1998). Committee on Corporate Governance: Final Report, London, Gee (Hampel Report)

internal control, which produced the Turnbull Report, 1999.11 After the scandals of the Enron and WorldCom in the US, there was a need to evaluate the role and effectiveness of non-executive directors, the Trade and Industry (DTI) took an initiative in 2002 and asked Derek Higgs for looking in to the matter. This resulted in the form of a report, known as Higgs Review, 200312 which also recommended amendments to the Combined Code. There was a coincidence that when Higgs was reporting, at the same time the Financial Reporting Council (FRC) gave a task to a body chaired by Sir Robert Smith to formulate the Combined Code guidance for audit committees. Thus revised Combined Code13 including both the Higgs Review and the guidance for audit committees was published, in July 2003 and was effective for reporting periods beginning on or after 1 November 2003. In 2003, the FRC got the responsibility to maintain the Code and now is the caretaker of the Combined Code, and wants to ensure that it remains relevant under its flag. There have been minor changes under the FRC which were incorporated in subsequent years, however, with the latest amendment being made in the code during 2006, 2008 and 200914.

At present all the reports and codes, including the Combined Code 2003, 2008 and March 2009 are being followed in the UK under the comply or explain' approach. However as regards to the obligation of how they apply the Code principles rests only with London Stock Exchange listing companies. However, there were weaknesses observed in the implementation of the Code by the Dr Barker and he pointed out that only10% of the FTSE 350 companies fully follow in all respect of the combined code and thus all those companies not fully compliant with all aspects of the combined code must explain non-compliance in their annual report. 15

These companies are required to report the way they apply the Code principles and whether the

code provisions are complied and in case they do not comply, give the explanation regarding their

departures from them, the code has had a greater and broader impact on the governance. There is

one of its continuing obligations under the Listing Rules published by the UK Listing Authority

(UKLA) 16 for reporting on the application of the code by all the quoted companies. There are

eleven principles17 that include corporate governance rules which apply to the firms regulated by

the FSA. There are Penalties for non adherence to the Listing Rules in the form of the sanction for

ignoring the Code.

11. Turnbull Report, 1999



12. Higgs Review, 2003

Department of Trade and Industry, (2003). The role and effectiveness of non-executive directors, London, DTI (Higgs Report).

13. http://www.fsa.gov.uk/pubs/ukla/lr_comcode2003.pdf

14.. http://www.frc.org.uk/corporate/reviewCombined.cfm


16. http://www.fsa.gov.uk/ukla/


6.2.1 Whether to adopt the self-regulatory or the legislatively-based corporate governance model in the UK Legislatively-based corporate governance

The US model in the mid-1990s, with legislatively-based corporate governance while emphasising on arms-length ownership, having powerful management and capital market financing was observed as offering better opportunities for new company formation and the application of new technology. This was particularly important in the fields of the IT, telecommunications and life sciences. 18 The leading management thinkers of the world praised the high levels of productivity and employment growth in the US during the 1990s. But, unfortunately many illusions concerning the US business framework were shattered with the bursting of the dot-com bubble in 2001 including many high profile scandals in various companies (e.g. Enron, WorldCom, Global Crossing). It changed the thinking of US legislators for punishing the defaulters (in particular, the Sarbanes-Oxley Act of 2002), that imposed significant costs on the US economy. According to Dr Barker, at present although, many important sectors of the world economy are being dominated by the US corporations, but the US corporate governance framework is no longer viewed as the "gold standard" that should be emulated around the world.19 Self-regulatory corporate governance

There has been a development in the UK during the last one-and-a-half decades on a distinctive framework of corporate governance with a good balance between self-regulation and law. 20

The UK method of corporate governance revolves around the combined code and the "comply or explain" principle." 21 The UK method of corporate governance is primarily governd by the companies Act, the combined code issued by the Financial Reporting Council (FRC), and the Listing Rules issued by the Financial Services Authority (FSA)22

The UK Companies Act 2006 was judged by a U.S. Country Commercial Guide published by the Department of Commerce (DoC) in 2009 as the law which simplifies and modernizes the present rules rather than make any dramatic shift in the company law regime.23

One of the writer Alex Kay, in the International Financial Law Review says that the Companies Act 2006 provides for the codification of directors' duties that used to be dictated in the past by the principles established in case law.24 As per Kay, the law has been made more consistent, certain and accessible with the incorporation of seven general duties of the director which contribute in increasing the understanding and knowledge of their duties.

18. http://www.questia.com/library/economics-and-business/corporate-governance-u-s.jsp







The assessment carried out by International Monetary Fund25 in 2003 observed that the UK is among the leading countries internationally for setting standards in the field of corporate governance including public disclosure practices basing on its ability to promote high standards of governance.

In contrast to the legislatively based corporate governance model of the United States, 26 the UK method of corporate governance which emphasize more on board engagement with shareholders

and their compliance with a voluntary combined code of best practice issued by the FRC and the Listing Rules issued by the FSA.27 The UK method of corporate governance is less costly and more flexible promoting high standards of corporate governance without stifling wealth creation.28

Dr Barker carried out the comparison of the UK and the US methods in his 2008 paper and regarding shareholders rights says that as per the company law of the UK "shareholders have comparatively extensive voting rights as compared to US shareholders, including the right to appoint and dismiss individual directors and, in certain circumstances, to call an Extraordinary General Meeting" (p. 4)29. The company law also provide various requirements as regards to the AGM,30 containing the provision of information for shareholders and having arrangements for voting on resolutions.

In the UK, the Listing Rules (which must be followed by companies) provide reinforcement to the legislative framework which are supervised by the FSA. There is also a requirement under the Listing Rules to put all major transactions to a vote by the shareholders and also require some information to be disclosed to the market. In this regard there is a formal requirement for the provision of the corporate governance statement by the companies in the annual report and explaining the way the company has applied the combined code.31

If the companies are incorporated abroad and listed in the UK, are under obligation for disclosing how their domestic governance practices differ from those given in the code. As regards to the governance of remuneration is concerned a significant reform were introduced with the directors report in 2002 which made a requirement by the legislation for shareholders advisory vote on the issue of remuneration. "It was believed at the time that this would engender significant engagement between boards and shareholders over remuneration" (p. 9) 32

25. http://www.estandardsforum.org/united-kingdom/standards/principles-of-corporate-governance








The UK method of corporate governance provide that in order to enhance economic growth, improve competitiveness, and increase the investor confidence, "Every company should be headed by an effective board, which is collectively responsible for the success of the company."33 (Main principle A.1 - Combined Code 2003) The Code adds: "the board's role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed" 34 (Supporting Principles A.1 - Combined Code 2003)

The Barker report provide that the UK companies having a unitary board which combines "a monitoring function - geared to the interests of shareholders - with a strategy-setting and business advisory role within a single institutional structure" (p. 6) 35 In order to have proper command and control in the UK board, "The roles of chairman and chief executive should not be exercised by the same individual. The division of responsibilities between the chairman and chief executive should be clearly established, set out in writing and agreed by the board." 36 (Code provision A.2.1 - Combined Code 2003)

The Barker report further added that the combined code's recommendations in the area of independence are far-reaching: "the board should include a balance of executive and non-executive directors (and in particular independent non-executive directors) such that no individual or small group of individuals can dominate the board's decision taking." 37 (Main Principle A.3 - Combined Code 2003)

The "best practice" approach adopted by the UK in corporate governance show the belief that the governance should promote both the board's ability to manage the company effectively and accountability to shareholders. This indicates the unitary board's role, which are both as the "watchman" and the "pilot" of the company.38 Cadbury Report did provide the benefits of such a dual role. The Britain's competitive position can be seen from the effectiveness by which boards discharge their responsibilities. The companies must be driven forward freely by them, but the freedom exercise must be conducted within a framework of effective accountability. This speaks of the essence of any system of good corporate governance.39








The key features of UK best practice as described by Dr Barker on corporate governance, which are derived from the Combined Code, company law, and the Listing Rules, could be summarised as follows:40

The company is to be lead by a unitary board.

There is clear division of powers at the top of the company. In order to run the board the chairman is responsible, while CEO is responsible for running the company.

There have to be a balance of executive and independent NEDs. In larger companies, at least half of the board members should be independent NEDs. Smaller companies (e.g. outside the FTSE 350) should have at least two independent directors.

Transparent and formal procedures for the appointment of the directors, duly ratified by shareholders.

Evaluation at regular interval of the effectiveness of the board and its committees.

Setting the executive remuneration by formal and transparent procedures on the recommendations of a remuneration committee made up of independent directors and an advisory vote for shareholders.

A significant proportion of executive remuneration linked to performance.

Board would be responsible for disclosing a balanced assessment about the position of the company (including through the balance sheet), and incorporating a sound system of internal control. These responsibilities are conducted by a transparent and formal procedure including an audit committee made up of independent directors having the necessary financial experience.

The board and shareholders have to maintain close relationship, so that the board understands the shareholders opinions and concerns.

In order to allow shareholders to express their opinions on individual items there has to be separate resolutions on all substantial issues at general meetings.

The present economic catastrophe is considered to be the result of the inadequacy of corporate governance. Financial Times columnist John Plender in his article writes that "the credit bubble was not just a simple market failure, but a failure of business leadership, corporate governance and risk management, exacerbated by flawed incentive structures within banks"41.

Similar remaks were given by a report published by the International Corporate Governance Network (ICGN) it revealed that the cause of the current financial crisis is due to poor corporate governance because company boards could not visualize the market and failed to understand and manage the forthcoming risk and tolerated perverse incentives. 42


41. Financial Times, 22 August 2008.

42. quoted by P Skypala, 'Time to reward good corporate governance', The Financial Times, 17 November 2008, at p 6 Ftfm

Thus a long-term solution is required for the UK but to carry over a long-term solution, short-term measures bridge the transitional period. We must not forget the underlying strengths of

various aspects of the broader UK corporate governance framework. The UK has the distinctive nature of the corporate governance model which has emerged from various analysis as broadly "fit for purpose".43

The main aspect of the UK adopted approach is that most of these principles of best practice are not defined by company law, but arise from the combined code. Thus, they are based on a form of "soft law", which are non-binding code of conduct to be monitored and enforced by shareholders. This shows that not all aspects of corporate governance behaviour should (or can) be defined by the inflexible requirements of formal legislation. Such a soft law approach provides a practical advantage to the companies allowing them to have a degree of flexibility in their choice of corporate governance processes. Whereas regulators would face difficulty in allowing exceptions because they must be seen applying rules consistently. However shareholders in these environments can be more pragmatic.44 They could deviate from the defined codes of conduct if they are persuaded that they are justifiable in specific instances. So this flexibility is going to exert a positive impact on company performance, because governance requirement differ from every company, as it depend on factors such as ownership structure, size, and the nature of individual business activities being conducted. 45

Shareholders have the right to participate and be given an opportunity to be equipped with sufficient information on decisions about fundamental corporate changes, such as authorization of additional shares, amendments to constitutional documents, major acquisitions or dispositions, and closure of businesses. In this manner, the shareholders to have appropriate and relevant information in order to make an informed judgement on a firm's governance choices for the "comply or explain" principle46 to function effectively as provided in the combined code. (paragraph 5)

The combined code has also emphasised the companies to follow the Comply-or-Explain85 rule to report on their corporate governance practices annually and account for deviation from the code's recommendations. The directors' are accountable to the company as a whole under the 2006 Act; which has strengthened the rights of the shareholder, particularaly the minority; and requiring a business review for encouraging transparency and improve shareholders' ability for assessing the progress.47






The companies are also required for ensuring shareholder's effective participation in key corporate governance decisions on the nomination, election and removal of members of the board as well as external auditors and give shareholders the opportunity to express their views on remuneration policies for top managers and board members. 48 The 2008 Barker paper indicates that the shareholders in extreme cases resort to "legally-underpinned" shareholders rights if informal negotiations with the board are not adequate. 49(enforceable through the courts).

However, the Company Law provide that shareholders possesses comparatively extensive voting rights as compared to the US shareholders, including the right for appointment and dismissal of individual directors and, calling EGM in certain special circumstances.50 Requirements with regards to AGM , including the provision of information to shareholders arrangements for voting on resolutions are also laid out in Company Law. The Listing Rules provide further rights to Shareholders - major transactions being put to vote or disclosure of information to the market. The new Companies Law, introduces a new procedure for shareholders to bring proceeding, on behalf of the company, against a director for negligence, default, breach of duty or breach of trust, enabling minority shareholders to bring action against those in control.

Thus, there is emphasis on a voluntary corporate governance code by the UK with a lighter regulatory touch as compared to US systems based entirely on "hard law." 51 The UK voluntary corporate governance behaviour provides an opportunity and incentive for shareholders to engage with the boards in a constructive dialogue on non-statutory aspects of corporate governance. The Advantages and the strength of the UK model - Self-regulatory corporate governance

In the US the government regulation has been playing a pivotal role in US corporate governance (as a source of protecting small private investors, which have historically formed a major component of US corporate ownership). In contrast, the key strength of the UK approach to corporate governance lies in its ability to provide high standards of corporate governance with relatively low associated costs while placing greater reliance over institutional shareholders for enforcing high standards of corporate behaviour.52

The Combined Code measures although voluntary in nature have been successful in driving significant changes in governance behaviour. For example, there were very few companies with split role of Chairman and CEO prior to 1992. But today this division exist among 94% of FTSE 350 companies. 53






53. http://www.grant-thornton.co.uk/pdf/Corporate-Governance-Review-2008.pdf

NEDs and board committees have increased in numbers and could influence and play a major governance role. As a result, the UK outperforms the US and most other countries in terms of governance standards.32 The reports published in 2005, by the FTSE ISS Corporate Governance Index and Governance Metrics International both have placed the UK at the top of the list of countries by average corporate governance score. 54

The compliance costs incurred in the UK as compared to the US are considerable lower, in particular ever since the introduction of the Sarbanes-Oxley Act in 2002. The requirements of Sarbanes-Oxley Act are very costly specially relating to internal control structures. This have raised the implementation costs for US corporations to an exuberant level, according to the American Enterprise Institute - quantifies the cumulative cost to the US economy at $1.4 trillion.55(P. 5) This made the foreign companies to migrate to London and other financial centres and started avoiding New York as a location for a dual listing 56(P. 5) This contrasts with the situation immediately prior to Sarbanes-Oxley, when New York captured 90% of foreign listings. 57(P. 5)

Moreover, this has been an established fact from many reports and the practical application of 26 out of 27 EU Member States to adopt UK-style corporate governance codes is an indication of its success. 58 The UK model of self-regulatory corporate governance, while keeping a balance between self-regulation and law 59is in good shape until the companies fully compliance with the code while making improvement to the existing system failing which the responsibility for corporate governance enforcement would be transferred from shareholders to regulators. This would reduce the flexibility of the UK model, and impose significant additional compliance costs on UK companies.

Thus it is of utmost importance to focus on internationally coordinated reforms of the global financial architecture and not against the UK self-regulatory model ("soft law") 60 i.e. a non-binding code of conduct to be monitored and enforced by shareholders. The UK model of corporate governance is finding increasing favour amongst policy makers around the world for its ability to promote high standards of governance and is a source of competitive advantage for the UK economy.61









6.4 Conclusion

The public accountability and democracy should form the basis of a new social settlement with companies, in order to ensure that they are run for the benefit of people but not for the short-term interests of professional advisers, capital markets or the CEOs. These arrangements will need to be extended by reforming the basis and providing education so that there is learning for the public regarding ethical conduct, social responsibility, and the dubious pleasures of speculation care for the community, compassion, and the environment, instead of greed, maximization of profits, financial engineering, consumer binges and the ever quicker and ever bigger buck. Companies at all will come to recognize that the corporate governance is a matter of strategic goal rather than just the regularity compliance and accountability.