ACCA P1 Governance, Risk and Ethics - 2011 - Study text - Emile Woolf Publishing
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Paper P1: Governance, risk and ethics
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The directors’ report in the annual report and accounts should state how the
performance evaluation of the board as a whole, its committees and its individual
directors has been conducted.
Singapore Code of Corporate Governance on performance evaluation
The requirement for annual performance evaluation was introduced into the UK
Code in 2003. The UK Code is not unique in requiring performance evaluation. The
Singapore Code of Corporate Governance includes similar requirements, although
the responsibility for carrying out the review is given to the Nominations
Committee of the board, not the board chairman. The Code includes the following
guidelines:
The Nominations Committee should decide how the performance of the board
should be evaluated and should suggest objective criteria for assessment.
The performance evaluation of the board should also consider the changes in the
company’s share price over a five-year period.
There should also be evaluation of the performance of individual directors.
The use of external consultants for performance evaluation
In most UK listed companies, the annual performance review is carried out by the
chairman, with the assistance of the company secretary.
The chairman might use the services of specialist external consultants. The Higgs
Guidance comments that ‘the use of an external third party to conduct the
evaluation will bring objectivity to the process.’
However, companies may combine performance evaluation by the chairman
personally with the use of external consultants, for example by alternating the use of
external consultants in one year with internal review by the chairman the next year.
5.4 Assessments of performance
Assessing the performance of the board as a whole
Questions that might be asked to assess the performance of the board as a whole
include the following:
How well has the board performed against specific objectives or performance
targets that were set?
What has been the contribution of the board to the development of strategy?
What has been the contribution of the board to ensuring effective risk
management?
Is the composition of the board and its committees suitable? Is there a suitable
balance of knowledge, experience and skills?
How well (or badly) did the board respond to any crisis that occurred during the
year?
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There should also be an evaluation of the procedures of the board and its
committees, to ensure that they use effective working practices. This should include
an assessment of the length and frequency of board meetings, whether important
issues were given the full amount of time and consideration that they needed, and
what the meetings have achieved.
Assessing the performance of individual non-executive directors
Questions that might be asked to assess the performance of individual non-
executive directors include the following:
Has the attendance of the NED at meetings been satisfactory? Was he (or she)
properly prepared for the meetings?
Doe she show a willingness to spend time and effort with the company?
What has been the quality and value of his contributions to meetings?
What has he contributed to the development of (1) strategy and (2) risk
management?
How successfully have they brought their knowledge and skills to the
discussions and decision-making of the board?
How has he refreshed his knowledge and skills during the year?
Does he give in too easily to the opinions of other directors?
How good (or bad) are his relationships with other board members?
Does he communicate effectively with anyone in management other than the
executive directors on the board?
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Governance,riskandethics
CHAPTER
4
Board committees
Contents
1 The need for board committees
2 The audit committee
3 The remuneration committee
4 The nominations committee
5 The risk committee
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The need for board committees
The nature of a board committee
The main board committees
The reasons for having board committees
1 The need for board committees
1.1 The nature of a board committee
A board committee is a committee set up by the board, and consisting of selected
directors, which is given responsibility for monitoring a particular aspect of the
company’s affairs for which the board has reserved the power of decision-making.
A committee is not given decision-making powers. Its role is to monitor an aspect of
the company’s affairs, and:
report back to the board, and
make recommendations to the board.
The full board of directors should make a decision based on the committee’s
recommendations. When the full board rejects a recommendation from a committee,
it should be a very good reason for doing so.
A board committee will meet with sufficient frequency to enable it to carry out its
responsibilities. It is important to remember, however, that a board committee is
not a substitute for executive management and a board committee does not have
executive powers. A committee might monitor activities of executive managers, but
it does not take over the job of running the company from the management.
1.2 The main board committees
Within a system of corporate governance, a company might have at least three or
possibly four major committees. These are:
a remuneration committee, whose responsibility is to consider and negotiate the
remuneration of executive directors and senior managers
an audit committee, whose responsibility is to monitor financial reporting and
auditing within the company
a nominations committee, whose responsibility is to identify and recommend
individuals for appointment to the board of directors
a risk management committee, where the responsibility for the review of risk
management has not been delegated to the audit committee.
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1.3 The reasons for having board committees
There are two main reasons for having board committees.
The board can use a committee to delegate time-consuming and detailed work to
some of the board members. Committees can help the board to use its resources
and the time of its members more efficiently.
The board can delegate to a committee aspects of its work where there is an
actual or a possible conflict of interests between executive directors
(management) and the interests of the company and its shareholders. However,
to avoid a conflict of interests, board committees should consist wholly or
largely of independent directors. This means independent non-executive
directors.
− A remuneration committee of independent non-executive directors
negotiates and recommends remuneration packages for executive directors
or senior managers. The committee members do not have a personal interest
in the remuneration structure for senior executives, because they are not
remunerated in the same way as executives. They receive a fixed annual fee.
− An audit committee of indendent non-executive directors can monitor
financial reporting and auditing, to satisfy themeselves that these are carried
out to a satisfactory standard, and that executive management are not
‘hiding’ information or presenting a misleading picture of the company’s
financial affairs. The work of the audit committee therefore provides a check
on the work of executive managers, such as the finance director. The
committee can also monitor the effectiveness of the auditors, to satisfy
themselves that the auditors carry out their work to a suitable standard.
− Similarly, the work of a risk committee of the board should be to satisfy itself
that executive management have a suitable system of risk management and
internal control in place, and that these systems function effectively. This is
another check on executive management.
− A nominations committee makes recommendations about new appointments
to the board. The views of executive directors are important in this aspect of
the board’s work, particularly when a vacancy for a new executive director
occurs. However, independent non-executives should have some influence in
the nominations process, to make sure that new appointments to the board
will not be selected ‘yes men’ and supporters of the CEO or chairman.
Through the work of the board committees, independent non-executive directors
therefore have a very important role to play in providing good corporate
governance.
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The audit committee
Corporate governance and financial reporting: the responsibility of the board
The need for an audit committee
Independence of the external auditors
Role and functions of the audit committee
Composition of the audit committee
2 The audit committee
2.1 Corporate governance and financial reporting: the responsibility of the
board
The board of directors of a company is accountable to the shareholders. An
important aspect of accountability is the legal requirement to present an annual
report and accounts.
Published financial statements should also be understandable to shareholders. The
UK Combined Code states that the board should present ‘a balanced and
understandable assessment of the company’s position and prospects.’ In addition, it
requires the directors to explain in their annual report their responsibility for the
preparation of the financial statements.
Typically, the annual report of a UK listed company might include a statement from
the directors as follows:
‘The directors are required by law to prepare financial statements for each
accounting period that give a true and fair view.
The directors confirm that appropriate accounting policies have been used and
applied consistently, and reasonable and prudent judgements and estimates have
been made in the preparation of the accounts. The directors also confirm that
applicable accounting standards have been followed, any material departures being
disclosed and explained, and that the financial statements have been prepared on
the going concern basis.
The directors are responsible for ensuring proper accounting records are kept which
disclose with reasonable accuracy at any time the financial position of the company
and the group. They are also responsible for taking steps to safeguard the assets of
the company and the group and to prevent and detect fraud and other
irregularities.’
Having made such a statement of responsibilities, directors should expect to be
liable for any failure in carrying out their responsibilities with due care.
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Example
The collapse of US corporation Enron has already been mentioned. However, it is
also interesting for the attitude of the board to the financial reporting methods that
were used.
In October 2000, about one year before the company collapsed, the finance
committee of the board was informed that the company had about $60 billion of
assets, of which nearly one half were held in ‘unconsolidated affiliates’ – in other
words, ‘off balance sheet’.
The board was informed in 2000 that one of these affiliates, LJM, had made $2
million profits in just six months. This was a huge amount of money, even for a
company the size of Enron. The board apparently did not question the figure.
It could therefore be argued that the directors of Enron failed to fulfil their
responsibility for ensuring the reliability of the financial statements.
2.2 The need for an audit committee
Many directors on company boards have only limited understanding of accounting
and financial reporting, but the board is nevertheless responsible for the reliability
of the financial statements.
In the past, the board has relied on the advice and assurances that it receives from:
executive management, and in particular the CEO and finance director, and
the external auditors.
The history of corporate governance has shown that when a corporate scandal
occurs:
misleading financial statements have been used to disguise the wrongdoing and
misdemeanours
senior executives (the CEO and/or finance director) are to blame for the
misleading accounts, and
the company’s auditors failed to spot the problem:
− possibly because they were misled by the company’s executives, or
− possibly because the quality of the audit was not as good as it should have
been, or
− possibly because the auditors were willing to accept assurances from
executive management when they should perhaps have asked more
questions.
An audit committee can provide a check on the risks of misleading reporting, by
providing an additional line of communication to the auditors and by ensuring that
the auditors remain independent from executive managers and perform the audit
effectively.
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2.3 Independence of the external auditors
This text does not explore in detail the role of the external auditors. However, a
critical aspect of good corporate governance is the need for the board to ensure that
the external auditors carry out their audit work properly, so that the board of
directors is able to rely on the conclusions and recommendations they provide at the
end of the audit.
One of the requirements for the auditors is that they should perform their audit
work with independence. In this sense, independence means freedom from the
influence of the company’s executive management.
There are at least two ways in which the independence of the auditors might be at
risk.
Familiarity of the audit firm or audit partner with the company. When the
same audit partner is responsible for the audit of a particular client company
every year for a long period of time, he or she is likely to become very familiar
with the company and its management. As this familiarity grows, the audit
partner will probably become more willing to accept assurances from
management and rely on the accuracy of the information they provide. This
obviously can be a very serious problem when the assurances given by
management are false and the information is incorrect or incomplete.
Non-audit work and a reliance of the audit firm on the company for a large
amount of fee income. An audit firm receives an audit fee each year. In addition,
it is common for the audit firm to obtain a substantial amount of fee income
from non-audit work, such as providing tax advice and advice on information
systems, and carrying out investigations for the company. If an audit firm
obtains a large amount of its income from one corporate client, it will probably
be reluctant to disagree with the company’s management on issues relating to
the preparation of the financial statements (such as the size of estimates and the
application of accounting policies).
The audit firm Arthur Andersen collapsed in 2002 as a result of the Enron scandal.
Andersens were the auditors of Enron, and it was found that the firm, in particular
its office in Houston Texas, was not independent of the company. The publicity
given to Andersens led to a general loss of confidence in the audit firm, which was
dissolved.
The problem of familiarity of the auditors with an audit client can be reduced by
either:
rotation of the audit firm, so that the same audit firm does not carry out the
audit of any company for more than a maximum number of years, or
rotation of the audit partner, so that the same audit partner is not responsible
for the audit of any company for more than a maximum number of years.
Rotation of audit partners has become a regulatory requirement in some countries
(including the UK), as a means of dealing with this problem.
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The task of monitoring the independence of the audit firm on the company for fee
income should be the responsibility of the board of directors. It is generally-
accepted good corporate governance practice that this responsibility should be
delegated by the board to its audit committee.
Example
In 2006 auditors PricewaterhouseCoopers were fined by the Accountants’ Joint
Disciplinary Scheme (JDS) for failures by Coopers & Lybrand in connection with the
collapse of the engineering company TransTec in 1999.
The JDS found that Coopers & Lybrand had placed too much reliance on what they
were told by the company’s management, and as a result their audit procedures had
been inadequate. Several senior executives of TransTec had colluded to conceal
some key information from the company’s board of directors and the auditors,
about debit notes issued to the company by car manufacturers Ford. The auditors
had not spotted the fraud, although they had been misled by management.
The JDS concluded that the audit firm had ‘failed to carry out adequate audit
procedures in relation to the debit notes, including investigating conflicting
explanations as to what the debit notes were…. In the 1998 audit they did not
clearly express their own concerns and so did not find fault with the management.’
2.4 Role and functions of the audit committee
Codes of corporate governance suggest what the role and functions of the audit
committee should be. The UK Combined Code states as a principle of governance
that the board should establish formal arrangements for:
considering how they should apply the financial reporting and internal control
principles, and
maintaining an appropriate relationship with the company’s auditors.
It should do this by establishing an audit committee. The Code states that the role
and responsibilities of the audit committee should include:
to monitor the integrity of the company’s financial statements and any other
formal statements relating to the company’s financial performance
to review the company’s internal financial controls
to review the company’s internal control and risk management systems (unless
this responsibility is given to a separate risk committee or retained by the full
board itself)
to monitor and review the effectiveness of the company’s internal audit function
to make recommendations to the board about the appointment, re-appointment
or removal of the audit firm as auditors of the company (for the board to make a
recommendation to the shareholders)
approve the remuneration and terms of engagement of the external auditors
to review and monitor the independence and objectivity of the company’s
external auditors