Chapter 9 Corporate governance

1 Introduction of corporate governance

1.1 Definition
Corporate governance is the system by which organisations are directed and
controlled by senior officers. (Cadbury, 1992).

Corporate governance involves a set of relationships between a company‘s

management, its board, its shareholders and other stakeholders. Corporate
governance also provides the structure through which the objectives of the
company are set, and the means of attaining those objectives and
monitoring performance are determined (OECD, 2004).
1.2 Perspectives on governance
1.2.1 Agency theory
1.2.1 Agency theory
Fiduciary duty
Managers owe a fiduciary duty to shareholders. They should
always put shareholders’ interest in the first place and be
responsible for their actions.
1.2 Perspectives on governance
1.2.2 Stewardship theory
Some approaches to good governance view the management of an organisation as the stewards of
its assets, charged with their employment and deployment (部署) in ways consistent with the
overall strategy of the organisation.
1.2 Perspectives on governance
1.2.3 Stakeholder theory
Management has a duty of care, not just to the owners of the company in terms of
maximising shareholder value, but also to the wider community of interest, or
stakeholders.
 Agency
The owners are the principal and
theory
the managers are the agent.

Stewardship The management of an organisation is

theory
seen as the stewards of the assets.

Stakeholder
The management also has a duty of
theory
care to the stakeholders.
Example question 1
Jim, Mike and Dime are managers for ABC Co. Both their salary

and their bonus will be based on company performance. Which

of the following best describes the approach to governance in ABC Co?

A. Stewardship theory

B. Agency theory

C. Stakeholder theory

D. None of the above

Example question 2
Governments in many countries are encouraging improved standards of
corporate governance, focusing mainly on public companies whose securities
are listed on recognised capital markets. Why are best practices in corporate
governance of special importance to these companies?
A. Public companies are subject to a greater degree of separation between
those who manage the company and those who own it
B. Public companies are subject to less stringent regulation than other types
of commercial organisations
C. Public companies have institutional investors and have greater ethical
responsibilities to these investors than to personal investors
D. All other types of business organisations are already subject to and fully
implement high standards of corporate governance
1.3 Corporate social responsibility
Corporate social responsibility (CSR) is a self-regulating business
model that emphasis accountability of companies to not only
shareholders, but also stakeholders. By practicing CSR, companies
could be conscious of their impacts on all aspects of the society (for
example, economic, social, and environmental). The goal of CSR is to
encourage a positive impact on the stakeholders generally.

The application of CSR is highly connected to the concept of

sustainable development which suggests that organisations should
use resources in such a way that they do not compromise the
needs of future generations.
1.3.1 Stakeholder identification and analysis

In order to execute CSR better, organisations must first identify

their stakeholders and what they need.
1.3.2 Importance of CSR
• improve company’s brand: the public perception of a company is
critical to;

• customer and shareholder confidence;

• attract and retain customers and employees by enhancing good

reputation;

• help companies stand out from the competition.

However, it is noted that fulfilling social responsibility may have an

adverse effect on business:

• increased management time of CSR planning and implementation;

• reduced revenue from declining unethical contractors and extra

expenses of implanting CSR activities.
1.3.3 Strategies of implementing CSR
a. Proactive strategy: under this strategy, companies would take
full responsibility of CSR;

b. Reactive strategy: under this strategy, companies do nothing

and remain unsolved until found out by third party;

c. Defence strategy: under this strategy, companies take actions to

minimise or to avoid social obligations;

d. Accommodation strategy: under this strategy, companies take

their obligations under encouragement of interest parties or
because of government intervention.
Scandal of Enron
1.4 Approaches to corporate governance (Principle-based VS Rule-based)

UK USA
Principle-based Rule-based
Guidelines (best practice) Rules
Comply or explain (not compulsory) Must comply (compulsory)
1.5 Main principle of UK corporate governance code
A) Leadership
Every company should be headed by an effective board which is
collectively responsible for the long-term success of the company to
ensure no one individual should have unfettered powers of decision.
a)The chairman is responsible for leadership of the board and
ensuring its effectiveness on all aspects of its role.
b)Non-executive directors should constructively challenge and help
develop proposals on strategy.
1.5 Main principle of UK corporate governance code
B) Effectiveness
The board and its committees should have the appropriate balance of skills,
experience, independence and knowledge of the company to enable them to
discharge their respective duties and responsibilities effectively.
1.5 Main principle of UK corporate governance code
C) Accountability
The board should establish arrangements to ensure that the
information presented is fair, balanced and understandable,
internal control and risk management system is sound
and relationship with auditors is appropriate.
1.5 Main principle of UK corporate governance code
D) Remuneration
Executive directors’ remuneration should be designed to promote
the long-term success of the company. Performance-related
elements should be transparent and ensure no director involved in
deciding his or her own remuneration.
1.5 Main principle of UK corporate governance code
E) Relations with shareholders
There should be a dialogue with shareholders based on the mutual
understanding of objectives. The board should use general meetings to
communicate with investors and to encourage their participation.
1.6 Corporate governance report
(a)Review of structure and responsibilities of the board of directors
(b)Role of auditors and recommendations to the accountancy
profession
(c)Rights and responsibilities of shareholders
(d)Director’s responsibility for preparing accounts.
(e)The oper a t i n g a n d f i n a n c i a l r e v i e w ( O F R ) : I t p r o v i d e s
stakeholders a thorough analysis of the company from the perspective
of the management.
2 Best practice in corporate governance
2.1 Board of directors
2.1.1 Role of the board
Every company should be headed by an effective board which is
collectively responsible for the long-term success of the company, the
main role of the board is to:
a) set out the company’s strategic aims;
b) ensure necessary financial and human resources are in place;
c) set the company’s values and standards;
d) establish effective controls and risk management practices.
All directors need to act and make decisions in the best interest of the
company.
2.1 Board of directors
2.1.2 Required qualities of board of directors:
a) The board should have appropriate balance of skills,
experience, independence and knowledge of the company to
e n a b l e t h e m t o d i s c h a rg e t h e i r r e s p e c t i v e d u t i e s o n
responsibilities effectively.
b) Appropriate combination of executives and non-executive
directors (and in particular independent non-executive
directors ) s uch that no individual (or s m all group of
individuals) can dominate the board’s decisions.
c) All directors need to allocate sufficient time to the company.
2.1 Board of directors
2.1.3 Structure of the board
The board needs to be organised in appropriate size and
structure in order to make itself more effective.
A) Executive directors (EDs) are full-time employees of the
company and they work for the company in a senior
position. The chief executive officer (CEO) and the finance
director (in the US, chief financial officer) are nearly always
executive directors. Executive directors are usually recruited
by the board of directors.
2.1 Board of directors
B) Non-executive directors (NEDs) are not employees of the company

so they do not participate in the day-to-day operation. The main aim of

involving NEDs is to provide a balancing influence and help to minimise
conflicts of interest. The Higgs Report (2003), summarised their roles as:

a) Strategy: to propose or challenge strategies

b) Performance: to scrutinise the performance of the executive directors
c) Risk: to provide an external perspective on risk management
d) People: to deal with people issues, such as remuneration and
nomination decisions
2.1 Board of directors
2.1.3 Structure of the board
In general, NEDs are beneficial in providing external knowledge
and independent judgment on important matters, which is called
dual nature. Thus, NEDs could act as comfort factors for
stakeholders. However, the quality of the NEDs should be evaluated
prudently before being appointed. Lacking inside consideration of
the operation or independence would diminish its effectiveness.
Extension - Safeguards of the independence of NEDs

• NEDs should have no business, financial or other

connection with the company
• NEDs should not take part in share option schemes apart
from fixed fees and small amount of shareholdings
• NED’s appointment should be limited for a specified period
and approval is needed for reappointment
• NEDs could take independent advice and have independent
reporting access

It is highly recommended as best practice that a public company

should have more non-executive directors than executive directors.
Example question 3

To encourage executive directors to operate in the best

interests of the shareholders, they could:
A. Be given a high basic salary
B. Receive share options based on both individual and
company’s performance
C. Be entitled to large payment upon resignation or
termination
D. Be asked to attend AGMs
2.1 Board of directors
2.1.4 Responsibilities of main roles in board of directors
There should be a clearly accepted division of responsibilities at the head of a
company, which will ensure a balance of power and authority, such that “no one
individual has unfettered power of decision making.”
2.1 Board of directors
2.1.4 Responsibilities of main roles in board of directors
A) Role of Chairman
The chairman is the leader of the board of directors. Chairman is
responsible for:
a) Setting agenda of the board and ensure its effectiveness in all aspects;
b) deciding the scope of each board meeting and ensure all matters have
been fully discussed;
c) ensuring effective communication with shareholders;
d) facilitating contribution of NEDs and constructive relations between
EDs and NEDs.
2.1 Board of directors
2.1.4 Responsibilities of main roles in board of directors
B) Role of CEO
CEO is the leader of the executives and is responsible for the day-to-day
management of the organisation.

C) Role of Company secretary (Chief administrative officer, CAO)

a) Filing the following documents (financial statements, director’s reports,
auditor’s report);
b) Organising board meetings of shareholders and taking formal minutes;
c) Establishing and maintaining a registered office for official communication.
Example question 4
Who should sign the minutes of a committee meeting to confirm they
are a true and accurate record of meeting?
A. Chief executive
B. Any two members
C. Secretary
D. Chairman
Example question 5
It is important to promote proper and complete dialogue between the company
registration body and a company. It is also important to ensure that essential
administrative requirements laid down by the company registration body come
to the attention of the board.
Which TWO positions should be responsible for the above events?
A. Director
B. Chairman
C. Chief executive officer
D. Company secretary
Extension
a) Chairman是否一定要是NED？

b) Chairman和CEO可否是同一个人？

c) 好的公司治理需要chairman/ED/NED三者的动态制衡
2.2 Committee
2.2.1 Remuneration committee

Composition of members: entirely constituted by non-executive directors

Functions: take responsibility for setting the organisation’s policy regarding executive directors’
remunerations and specific pay structures for each director
2.2 Committee
2.2.2 Audit committee

Composition of members:

a) entirely constituted by INDEPENDENT non-executive directors

b) at least one member to have significant, recent and relevant financial experience
2.2 Committee
2.2.2 Audit committee
Functions:
a) to monitor the integrity of the financial statements of the company；
b) to review the company’s internal financial control system；
c) to monitor and review the effectiveness of the company’s internal
audit function;
d) to make recommendations to the board in relation to the appointment
of the external auditor and to approve the remuneration and terms of
engagement of the external auditor;
e) to monitor and review the external auditor’s independence,
objectivity and effectiveness.
Extension
a) Nomination committee

b) Risk committee
2.3 Public oversight
Public oversight is also one kind of measure to facilitate corporate
governance. In retrospect, the establishment of public oversight can be
traced to the Sarbanes-Oxley Act 2002 in the US. In this Act, the Public
Company Accounting Oversight Board (PCAOB) was firstly introduced.

It is found later that the principle of public oversight is vital and

applicable to other countries, e.g. the UK, both in improving audit
quality and emphasising the importance of compliance with standards
in a company’s control environment.
Example question 6
Which two of the followings are principles of a public oversight board?
A. To review internal controls
B. To improve audit quality
C. To approve the appointment of board members
D. To emphasize the importance of compliance with standards in a company's
control environment.
Example question 7
Example question 8
2.4 External auditor
2.4.1 External audit
External auditors are those qualified accountants from auditing firms
which are independent from client companies. As independent third
parties, they have a periodic purpose to express an opinion on clients’
financial statements. Such opinion is up to whether the accounting
records and financial statements are prepared, in all material aspects, in
accordance with applicable accounting standards.
2.4 External auditor
2.4.1 External audit
After the examination, if the accounts and financial statements are prepared
in accordance with applicable accounting standards, auditors will issue an
unqualified audit report . If the auditor disagrees with the preparation of
accounts which are important and cannot persuade the management to
change the accounts, then a qualified report will be issued. In brief,
external audits provide assurance to shareholders about the reliability of the
financial statements prepared by company’s management.
2.4 External auditor
2.4.1 External audit
Additionally, for the listed companies, the external audit
is compulsory and must be conducted annually.
However, for some companies which are not on the list,
they may conduct the external audit if the shareholders and
other stakeholders requires.
Example question 9
What is the primary responsibility of the external auditor?

A To verify all the financial transactions and supporting

documentation of the client

B To ensure that the client’s financial statements are reasonably

accurate and free from bias

C To report all financial irregularities to the shareholders of the client

D To ensure that all the client’s financial statements are prepared and
submitted to the relevant authorities on time