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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to review and monitor the effectiveness of the audit process
to develop and monitor a policy for the use of the external auditor to perform
non-audit work for the company.
As a part of these responsibilities, the audit committee should: ‘review
arrangements by which staff of the company may, in confidence, raise concerns
about possible improprieties in matters of financial reporting or other matters. The
audit committee’s objective should be to ensure that arrangements are in place for
the proportionate and independent investigation of such matters and for
appropriate follow-up action.’ In other words, the audit committee is responsible for
making sure that there is an effective system to allow ‘whistleblowers’ to report
their concerns about possible wrongdoing without fear of retaliation from their
bosses.
The audit committee should prepare a report to shareholders about its work, for
inclusion in the annual report and accounts.
The Singapore Code of Corporate Governance contains similar guidelines about the
role and responsibilities of the audit committee. However, in the following respects,
it is more specific than the UK Code:
The audit committee should review ‘the scope and results of the audit and its
cost-effectiveness’.
When the auditors provide a large amount of non-audit services to the company,
the audit committee should ‘keep the nature and extent of such services under
review, seeking to balance the maintenance of objectivity and value for money’.
The audit committee should also review annually the independence of the
external auditors.
Oversight, assessment and review
Recommendations about the role of the audit committee were first proposed in the
UK in the Smith Report, a report on audit committees published at about the same
time as the Higgs Report in 2003. The provisions in the UK Combined Code were
based on the recommendations in the Smith Report.
Extracts from the Smith Report were subsequently included as an appendix to the
Combined Code, called the Smith Guidance. Some of the comments in this
Guidance were:
The functions of the audit committee are concerned with ‘oversight’,
‘assessment’ and ‘review’ of functions performed by executive management and
the external auditors. It is not the responsibility of the audit committee to
perform those functions. For example, the finance director is responsible for
preparing the financial statements, and the role of the audit committee is to
oversee, assess and review this process. Similarly, the auditors perform the
audit, but the audit committee is responsible for assessment and review.
However, the oversight function of the committee might sometimes lead to more
detailed work. For example, the audit committee might be dissatisfied with an
explanation of management or the auditors about a particular matter. To resolve
the problem, the committee might then need to seek other professional advice.
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The audit committee reports to the board, and the board reaches decisions based
on the recommendations of the audit committee. However, if the board and the
audit committee disagree about a particular matter, the audit committee should
have the right to report the disagreement to the shareholders.
Example
The Smith Guidance went into some detail about the role of the audit committee in
the annual audit cycle. It is useful to look at some of the suggestions in the Guidance,
to get an idea of what the audit committee might actually do.
At the beginning of the annual audit, the audit committee should check that
appropriate plans for the audit are in place. It should check that the work plan
for the audit is consistent with the size and scope of the audit engagement. It
should also check that the audit team will be of the right size and will have a
suitable range of skills and experience for the work.
At some stage in the audit cycle, the audit committee should meet with the
external auditors to discuss the results of the audit and the findings of the
auditors. As a part of this review, the committee should discuss any particular
problems or disagreements that occurred during the audit (and whether these
have been resolved). The committee should also ask about any important
accounting judgements that have been made in preparing the financial
statements. They should also ask the auditors about the errors that they found
during the audit.
There should be a review of the audit after it has been completed. The audit
committee should consider the audit plan and whether the auditors met the
requirements of the plan. The committee should also consider whether the
auditors were strong-minded in their dealings with the company’s management.
It should also obtain the views of the finance director about the conduct of the
audit by the auditors.
2.5 Composition of the audit committee
An audit committee should make its judgements and recommendations
independent of influence from executive management. However, the opinion about
the composition of the audit committee varies between countries.
The UK Combined Code states that the audit committee should consist entirely
of independent non-executive directors. In large listed companies there should
be at least three members of the committee (and in smaller listed companies at
least two).
The Singapore Code of Corporate Governance states that the audit committee
should consist of at least three members, all of them non-executive directors.
However, only a majority of the committee, including the committee chairman,
needs to be independent.
In order to perform their functions properly, the members of the audit committee
should have some understanding of finance and accounting. However, it would be
unreasonable to expect that all the audit committee members should be qualified
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accountants. There are differences of opinion about how much experience or
understanding of finance and accounting the audit committee members should
have.
The UK Combined Code states that the board of directors should satisfy itself
that ‘at least one member of the audit committee has recent and relevant
financial experience.’ The Smith Guidance states that it is desirable that this
person (who is likely to be the audit committee chairman) should have a
professional accountancy qualification from one of the professional bodies. The
amount of financial understanding required from the other audit committee
members will depend on the nature of the company and its business.
The guidelines in the Singapore Code of Corporate Governance state that the
members of the audit committee should be ‘appropriately qualified’ to carry out
their responsibilities, but at least two of the committee members should have
‘accounting or related financial management expertise or experience’.
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The remuneration committee
Remuneration as a corporate governance issue
The need for a remuneration committee
Main duties of a remuneration committee
Composition of the remuneration committee
Continuing problems with the remuneration of executive directors
3 The remuneration committee
3.1 Remuneration as a corporate governance issue
The remuneration of executive directors and senior managers is an important issue
in corporate governance. It is at the heart of the conflict of interest between
management and shareholders.
It might be argued that executive directors and other senior managers, as full-
time employees of their company, are primarily concerned about their personal
remuneration. They will put concern for their personal remuneration ahead of
concern for the wealth of the company’s shareholders.
Directors might attempt to increase their remuneration, without necessarily
doing anything to justify the increase.
Higher rewards for managers, without any improvements in the company’s
performance, mean lower profits for the company.
However, the conflict of interest between management and shareholders might
be resolved if the remuneration of directors could include incentives. If directors
are rewarded for achieving performance targets that are consistent with the best
interests of the company’s shareholders, the conflict of interests could be
reduced. Directors and shareholders would both benefit.
The issues involved in using incentives to reduce the conflict of interest, and link the
remuneration of directors to performance targets that are in the best interests of
shareholders, will be considered in more detail in a later chapter.
Origins of the controversy about directors’ remuneration
The remuneration of executive directors is seen as a major corporate governance
problem in some countries but not in others. The controversy began in the UK
during the 1990s, when the government privatised state-owned businesses and a
number of utility companies were created in energy production, and electricity,
water and gas supply.
The senior directors appointed to the new companies were the same individuals
who had managed the businesses when they were state-owned. For doing much the
same job as before, these individuals were given a very large increase in
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remuneration. They were criticised by the press as ‘fat cats’, who were being paid
far more than they were worth.
Directors’ remuneration became a cause of anger in the press some years later when
several high-profile directors of major companies were dismissed, or threatened
with dismissal. Because of the terms of their employment contract, these directors
were entitled on dismissal to very large termination payments. These termination
payments were described in the press as ‘rewards for failure’.
Criticisms of excessive directors’ remuneration have also been expressed by
institutional investors, who consider that the remuneration of directors should be
linked much more closely to company performance. There has been an increasing
willingness by institutional shareholders to express their displeasure with
remuneration for directors by voting against the board at general meetings of the
company. In the UK, shareholders are able to use their votes by:
voting against the re-election of directors, or
voting against the directors remuneration report: quoted companies in the UK
are required to include a directors remuneration report in their annual report
and accounts, and shareholders are able to vote on the report, indicating their
approval or disapproval.
Institutional investors have been concerned about the apparent lack of concern
about directors’ remuneration. There have been some reported cases where
shareholder action appears to have had some effect.
Example: United Business Media
At the annual general meeting of the media group United Business Media in 2005,
the shareholders voted against the directors remuneration report. 76% of
shareholders voted against the directors’ remuneration report at the AGM and
another 11% abstained. This was a remarkable majority.
The shareholders were objecting to the ‘ex gratia’ payment of a £250,000 bonus to
Lord Hollick, the departing chief executive. There was some uncertainty about
whether the payment was for helping to ensure a successful handover to the
incoming chief executive, or for the role Lord Hollick had played in the sale of NOP
World, a polling subsidiary. Shareholders felt that whatever the payment was for, it
was not justified.
Following the vote, Lord Hollick agreed to waive the bonus. UBM announced that it
would not make similar ex gratia payments to directors in the future.
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Example: Misys
In 2005, UK company Misys proposed to make a payment of shares to each of two
senior executive directors. The reason for the payment was to persuade the two
executives not to leave the company. The board considered that without the
payment, they might otherwise leave the company unless they were appointed to
the vacant role of chief executive. The board decided to hold a binding vote on the
share award at the annual general meeting (AGM) of the company, to be held in
September.
The proposed award met strong resistance from institutional investors, who argued
that ‘retention rewards’ should have no part in succession planning.
The company, faced with the prospect of possible defeat at the AGM, withdrew the
proposed share award in the week before the AGM.
3.2 The need for a remuneration committee
The remuneration of executive directors and senior management is such a
contentious issue that it should be dealt with carefully.
The need for a remuneration committee was first recommended in the UK by the
Greenbury Committee in 1995, which published a report into directors’
remuneration. The Greenbury Report reached the following conclusions.
Putting together a remuneration package for senior executives is a key issue in
corporate governance.
The system for negotiating and agreeing a remuneration package is open to
abuse if executive directors can decide or influence their own remuneration
arrangements.
It is not practicable for shareholders to be involved in the negotiation of
remuneration packages, and shareholders should not be able to make decisions
about the remuneration of individual directors. However, they are entitled to
extensive information about directors’ remuneration.
Remuneration for executive directors and other senior executives should
therefore be decided by a remuneration committee of the board.
These recommendations were accepted. The UK Combined Code includes the
following principles about remuneration.
Levels of remuneration should be sufficient to attract, retain and motivate
directors of the quality required to run the company successfully, but a company
should not pay more than is necessary for this purpose.
There should be a formal and transparent procedure for developing policy on
executive remuneration and for fixing the remuneration packages of individual
directors.
No director should be involved in deciding his or her own remuneration.
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The UK Code therefore states that a company should establish a remuneration
committee. The committee should:
be given delegated responsibility by the board to set the remuneration levels for
all executive directors and the chairman, and
recommend and monitor the level and structure of remuneration for senior
management. (The board should decide the definition of ‘senior management’
but it will normally include the first layer of management below board level.)
3.3 Main duties of a remuneration committee
The duties of a remuneration committee should be decided by the board of
directors. However, the Higgs Guidance suggested that the following duties should
be included:
The committee should agree with the main board a policy for the remuneration
of the chairman, CEO, other executive directors and any other designated senior
management.
Where there is a performance-related pay scheme, the committee should decide
the targets for performance.
The committee should decide the pension arrangements for each executive
director.
The committee should approve the design of any new share incentive plan.
In negotiating service contracts with directors, the committee should ensure that
severance payments in the event of dismissal are fair, but that ‘failure’ is not
rewarded.
Within the framework of the agreed remuneration policy, the committee should
negotiate and agree the remuneration of each individual executive director.
To provide advice and assistance, the remuneration committee should be able to
hire the services of remuneration consultants. The committee should also make a
report to the shareholders each year, for inclusion in the annual report and accounts.
Advice from executive colleagues
Although no one should be able to decide or influence their own remuneration, this
does not prevent a remuneration committee from taking advice from executive
colleagues on the board and other senior executives. Executives may be able to
provide helpful information about what managers might expect to earn, and what
specific performance targets might be appropriate for incentive schemes.
However, when it takes advice from executive colleagues, the remuneration
committee should take care to recognise and avoid conflicts of interest (UK
Combined Code).
The remuneration committee should also talk to the finance director about the
potential impact of a proposed remuneration scheme on the company’s reported
profits. The committee needs to be aware that the company should not pay more in
remuneration than it can sensibly afford, given its financial situation.
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3.4 Composition of the remuneration committee
As with the composition of the audit committee, views about the composition of the
remuneration committee vary between countries. However, the general view is
accepted that individuals should not be allowed to decide or influence their own
remuneration.
In the UK, the Combined Code states that in large companies, the remuneration
committee should consist of at least three members, and all members should be
independent non-executive directors. (In smaller listed companies, the
remuneration committee should consist of at least two independent NEDs.)
The Singapore Code of Corporate Governance does not specify the size of the
remuneration committee. However, the committee should consist entirely of
non-executive directors, the majority of whom should be independent. ‘This is to
minimise the risk of any potential conflict of interest.’
3.5 Continuing problems with the remuneration of executive directors
In the UK, since remuneration became a significant issue for corporate governance,
the remuneration of executive directors in public companies has risen at a much
faster rate than pay rises generally for the working population.
Remuneration committees have been criticised for making wrong judgements, or
overlooking aspects of remuneration, and as a result remuneration has been higher
than it should be.
The main reason for the problem appears to be ‘benchmarking’. This is a method of
deciding the level of remuneration by making comparisons with remuneration
levels in other public companies.
Problems with using benchmarks
A problem with looking at what other companies are paying their directors is that
when most companies do this, there is a tendency for remuneration levels to rise.
Other companies are typically divided into four quarters (quartiles): companies
paying the highest remuneration are placed in the upper quartile and companies
paying the least are put in the lowest quartile.
The remuneration committee of a company in the FTSE 250 index might decide that
its executive directors should be paid on a similar level to executives in companies
in the second quartile, and negotiate remuneration on that basis. However, since
very few companies will set a policy of being in the lowest quartile of companies in
the benchmark group, there will be a tendency for remuneration levels to rise
continuously as each company re-sets remuneration levels that put it in the middle
level or in the upper quartile.
The UK Combined Code recognises that benchmarking is likely to result in higher
remuneration. It therefore states that comparisons should be used with caution ‘in
view of the risk of an upward ratchet of remuneration levels with no corresponding
improvement in performance.’
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International benchmarks
For large companies, there is the additional problem of international comparisons. It
may be argued in order to attract the best executive talent it is necessary to offer
remuneration packages comparable to those paid to executives in global
competitors. Global competitors will often include US corporations, where executive
remuneration is high. For global companies in other countries, this could be an
‘excuse’ for increasing executive pay to very high levels.
Example
Occasionally, a remuneration committee might overlook entirely an aspect of
executive remuneration, and as a result executive rewards might be higher than they
should be.
In August 2006, the Association of British Insurers (ABI) in the UK sent a letter to
each of the FTSE 350 companies asking remuneration committees to look at the
pension arrangements in the service contracts of senior executives.
The letter was prompted by the publication of details of the pension arrangements
for four senior executives at the energy company Scottish Power, which the ABI
criticised because it considered them excessive and they were not performance-
based.
The four Scottish Power executives all retired (before their ‘normal’ retirement age)
with very large increases in their pension funds. For example, the pension of the
CEO doubled on termination of his contract, from £3.4 million to £6.8 million. In
addition, his contract allowed him to retire early on exactly the same pension he
would have received if he had stayed in his job until normal retirement age. The
company argued in its own defence that it was contractually obliged to make the
payments.
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The nominations committee
Appointments to the board as a corporate governance issue
The need for a nominations committee
Main duties of a nominations committee
Composition of the nominations committee
The nominations committee and appointment of a new chairman
4 The nominations committee
4.1 Appointments to the board as a corporate governance issue
When new appointments are made to the board of directors, it is obviously
important that the individual selected should be someone with suitable skills and
experience. The board as a whole should also consist of individuals who collectively
have an appropriate breadth of skills and experience to bring to the discussions and
decision-making of the board.
To ensure that there is a suitable balance of power on the board, the system for
nominating and selecting new directors should not put the choice into the hands of
one individual or a small group of individuals.
However, executive directors should have a voice in new appointments to the
board.
When the appointment of a new executive director is considered, the executive
directors are probably in a better position than NEDs to assess the qualities of
internal and external candidates for the position.
The executive directors should be aware of the skills and experience that they
lack, and so can offer suggestions about the type of non-executive that they
would like to add to the board.
Decisions about nominations to the board might occur quite frequently with non-
executive directors. Whereas executive directors are normally expected to retain
their position on the board as long as they have their job with the company, non-
executives might be expected to retire when their current fixed term of appointment
reaches an end. When a current NED retires, he or she will probably be replaced
with someone else.
Succession planning
In addition to selecting new directors for the board, the process of nomination also
involves succession planning. Succession planning means planning in advance for
the eventual replacement of key members of the board when they eventually retire
(or in the event that they are dismissed).