UK Regulatory Framework for Corporate Governance - Dissertation Example

?UK Regulatory Framework for Corporate Governance Table of Contents Chapter 4 1 Introduction 4 1 Aims & Objectives 4 1.2 Scope of the Paper 5 2 Chapter 2 5 2.1 Literature Review 5 2.1.1 Corporate Governance Codes 5 2.1.2 Corporate Governance Developments 7 2.1.3 Role of Audit Assurance in Corporate Governance 10 2.1.4 Sarbanes-Oxley Act 10 2.1.5 Effectiveness of Corporate Governance Code 11 3 Chapter 3 12 3.1 Research Methodology & Data Collection 12 4 Chapter 4 12 4.1 Findings 12 5 Chapter 5 12 5.1 Discussion & Conclusion 12 References 14 1 Chapter 1 1.1 Introduction Corporate governance is about how the organization is controlled and administered. The essence of corporate governance lies in the separation of ownership and control. The shareholders of a firm bestow the responsibilities to control and administer the firm on the board of directors. The managers while running the company have the informational advantage, which the shareholders do not have. They have to rely on the directors’ judgement in running the company. If the information were freely available to all the firm’s stakeholders at the same time, there wouldn’t have been a need for corporate governance. Therefore, the need of corporate governance has arisen in order to facilitate an effective, prudent and entrepreneurial management, which can deliver long run success of the firm (FRC, 2010, p.1). It is a mechanism as to how the vision and values of the firm are set by the board of the firm distinguished from the regular operational management of the firm by its executives. Corporate governance defines the relationship between various stakeholders such as shareholders, directors, management, employees, creditors, suppliers, customers, government, and regulators, and ensures accountability, integrity and transparency (Mead & Sagar, 2006, p.334). 1.1.1 Aims & Objectives This paper aims to explain the effectiveness of the corporate governance framework by which UK companies are regulated. The effectiveness of the corporate governance practices has been analyzed through the understanding the development of UK’s Combined Code on corporate governance. 1.1.2 Scope of the Paper In order to achieve this paper’s aims and objectives, guidelines of FRC over the Combined Code has been carefully analyzed. The analysis of the effectiveness of corporate governance code has been done on the basis of research papers previously published in the related field. The first section of the paper reviews the literature explaining UK corporate governance code, development of the corporate governance code and practices since 1992, and link between audit assurance and corporate governance. The second section presents the research methodology. The third section presents the findings on the effectiveness of the evolved combined code of corporate governance. This followed by the discussion and conclusion. 2 Chapter 2 2.1 Literature Review 2.1.1 Corporate Governance Codes The Corporate Governance Code in UK is founded on ‘comply or explain’ approach (FRC, 2010, p.4). The approach requires that the companies should comply with the Code and if it is unable to comply with any particular aspect of the Code then it should explain in its financial disclosures. The approach is widely accepted and appreciated by the corporations. The Code does not provide rigid rules but consists of principles and provisions. Compliance with the principles and reporting the same to the shareholders is required under the Listing Rules. The principles given in the Code are as follows: Leadership: Every Company should have an effective board that is collectively responsible for the success of the company. Responsibilities of running the board and running the company’s operations should be clearly defined and divided. The powers of decision should not be fettered to single person. The chairman of the board is responsible for leading the board and for oversight of the workings of management. The non-executive board members should challenge and assist develop the proposals on strategy. Effectiveness: The board and the committees need to have balanced experience, skills, independence and knowledge about the company in order to discharge their responsibilities effectively. The procedure for appointment of the new directors to the board should be rigorous, formal and transparent. All directors should allocate sufficient time to discharge their duties towards the company and continuously develop required skills. The information must be provided to the directors on time and their re-election should be based on satisfactory performance. Accountability: The board is accountable for presenting the financial position and performance of the company in an accurate manner to the investors. The board is responsible for assessing the business risks in achievement of the company’s strategic objectives. The board should set-up an effective internal control process and maintain appropriate relationship with the external auditors. Remuneration: The levels of remuneration of directors should be sufficient to retain, attract and motivate the capable directors. Relationship with the Shareholders: There should be a mutual understanding of objectives between the shareholders, directors and management. The board, through AGM, should communicate with the investors effectively. The alternative to follow the provision is justified under particular circumstances if good corporate governance can be achieved by following the alternative. The reason for following provision should be explained clearly to the shareholders (FRC, 2010, p.4). 2.1.2 Corporate Governance Developments The development of corporate governance in UK was driven by corporate collapse and scandals such as Coloroll, Maxwell publishing group, Poly Peck, BCCI and Marconi (OECD, 2004, p.19). The UK’s 1998 combined code was a result of findings of three major codes provided by the 1992 Cadbury Report, the 1995 Greenbury Report and the 1997 Hampel Report (Solomon, 2007, p.56). The historical development of the Combined Code of corporate governance is given in the following sections. Cadbury Report 1992 Due to investors’ loss of confidence in financial reporting by UK companies resulting from numerous scandals, FRC along with the London Stock Exchange and accountancy profession established a committee in 1991 on the corporate governance. Sir Adrian Cadbury headed the committee. The scandals of BCCI and Maxwell after the set-up of the committee lead to more wide scope of investigations by committee and recommendations included role and functions of the board, composition and establishment of various committees, importance and contribution of non-executive directors, and reporting and control mechanisms. Greenbury Report 1995 The motivation behind setting up of this committee was the remuneration size and inconsistent, incomplete disclosures of the directors. The committee’s recommendations included enhancing the directors’ performance and strengthening their accountability through remuneration committee comprised of independent non-executive directors and adoption of performance measures, with the interests of shareholders and directors closely aligned. Hampel Report 1997 Hampel committee was set-up to review the implementation of the recommendations given by Cadbury committee and Greenbury committee. The committee concluded that the board is responsible for maintaining relations with the company’s stakeholders but accountable to shareholders only (Mallin, 2007, p.25). It emphasized the role of institutional investors in proxy voting and making decisions. The Combined Code was formed in 1998 drawing the recommendations of the three committees. Turnbull Report 1999 (Turnbull 1) This committee was set-up by ICAEW and chaired by Nigel Turnbull. The committee provided guidance on the internal control mechanism required under the Combined Code. Smith & Higgs Report 2003 Smith Review appointed by FRC was to provide the clearly defined role of audit committee in corporate governance whereas the Higgs review reported on the functions and effectiveness of non-executive board directors. Financial Reporting Council (FRC) Combined Code 2003 The FRC Combined Code 2003 was a revised version of 1998 Combined Code, which incorporated the recommendations of Smith, and Higgs reviews. The result was the requirement of at least half of the board of a large listed firm to consist of independent non-executive directors (Mallin, 2007, p.27). The role of the directors was more clearly defined. FRC Combined Code 2006 Amendment The updated version of the Combined Code included changes such as allowing the company chairman to be a part of remuneration committee. If he has to chair the committee then he will be made independent. The second change was to allow ‘vote withheld’ during proxy voting indicating the wish of the shareholder to withhold his/her vote. The third change was to recommend the companies to provide the details of proxies on its website (Mallin, 2007, p.27). The UK Government proposed reforms in the Company Law Reform Bill in 2005, to encourage the shareholder engagement, investment culture and to ensure better regulation. The concerned areas were company’s AGM and codification of directors’ responsibilities and duties. Presently FRC has five bodies i.e. Accounting Standards Board, POBA, Auditing Practices Board, FRRP and AIDB (Mallin, 2007, p.29). These bodies are responsible for maintenance of effective Combined Code, ensuring guidance on internal control, influencing the global corporate governance framework and encouraging professionalism in board’s workings. 2.1.3 Role of Audit Assurance in Corporate Governance An external auditor’s role is to verify the quality of the financial statements prepared by the corporate management and disclosed to the shareholders. This provides confidence to the shareholders regarding the disclosures (Lee, 2007, p.27). In UK, Auditing Practices Board issues the standards and guidelines for external auditors (Gray & Manson, 2007, p.117). The UK Combined Code recognizes the importance of internal control and risk management and therefore, under the principle of accountability, it describes the role and responsibilities of audit committee and auditors. There are various provisions such as inclusion of at least three non-executive independent directors in the audit committee and at least one member should have relevant financial experience (FRC, 2010, p.19). 2.1.4 Sarbanes-Oxley Act In U.S., the weaknesses of accounting and audit practices, as exposed by failure of Enron and WorldCom, were addressed by introduction of Sarbanes-Oxley Act in 2002. The Act was applicable to all U.S. and non-U.S. companies that have equity and debt securities registered under Exchange Act. It referred to the accountability of directors, corporate executives, auditors, attorneys, accountants, and regulators towards the interests of investors. The Act contained following provisions: Corporate Responsibility: This includes increased responsibility of audit committee and auditor oversight. The prior approval from the committee was required to seek non-audit services from external auditor. The CEOs and CFOs were accountable for the accuracy of the interim as well as annual reports. Auditor Independence: The Act established standards to determine auditor’s independence and created PCAOB to oversee the same. Other Provisions: It emphasized the independence of analysts and increased disclosures of conflict of interests by them (Lander, 2005, pp.1-3). 2.1.5 Effectiveness of Corporate Governance Code In an empirical study of UK’s large listed companies for the impact of corporate governance and agency costs, it was found that changes in board structure in post-Cadbury time period has not affected the agency costs, which affirms the objective of value-maximisation. However, the inclusion of nominations committee has increased agency costs whereas the increase in board’s ownership decreases costs (McKnight & Weir, 2009, p.139-155). FRC presently has responsibilities for two codes based on ‘comply or explain’ approach. The 2010 revised UK Combined Code on corporate governance for listed companies and the Stewardship Code for shareholders introduced in 2010. In an annual survey of FTSE 350 firms’ compliance with the Code, it was revealed that only 50% fully complied with the Code and of the remaining companies 80% complied but left one or two of the Code’s provisions. Regarding the board’s responsibility for risk assessment, FRC concluded from its discussions with the companies’ directors, risk officers, auditors, and investors, that the boards are making efforts in managing risks. The latest data suggests that FTSE 350 companies have not changed their board compositions since 2009, which means that there is an average of 3 executive directors on the board. The study conducted by Grant Thornton also suggested that 70% of FTSE 350 provided informative explanations in their reports whereas only a small number of companies breached the Listing Rules regarding the explanation of non-compliance (FRC, 2011, p.11-15). 3 Chapter 3 3.1 Research Methodology & Data Collection The validity of a paper is determined by proper selection of research methods considering the research topic. The corporate governance framework in UK has been researched using the secondary data from the online journals, books and relevant articles. In order to analyze the data, qualitative research technique has been used. 4 Chapter 4 4.1 Findings The developments of the Combined Code on corporate governance and the recently introduced Stewardship Code show that the corporate governance process has strengthened over time. The results from the survey and studies conducted by FRC reveals that a significant number of companies are complying with the corporate governance provisions based on the ‘comply or explain’ approach. However, there are still a considerably smaller number of companies that have failed to comply with the provisions or explain such non-compliance. 5 Chapter 5 5.1 Discussion & Conclusion From the findings on the corporate governance framework in UK and its effectiveness, it can be concluded that the revised Combined Code 2010 since the Cadbury Committee recommendations, has developed considerably while maintaining the initial ‘comply or explain’ approach. However, the effectiveness of the recent revisions to the Code will take time to become visible. Overall, the process of revising the corporate governance framework is an on-going process. References FRC. (2010). The UK Corporate Governance Code. [Pdf]. Available at: http://www.frc.org.uk/documents/pagemanager/Corporate_Governance/UK%20Corp%20Gov%20Code%20June%202010.pdf. [Accessed on January 30, 2012]. FRC. (2011). Developments in Corporate Governance 2011: The Impact and Implementation of the UK Corporate Governance and Stewardship Codes. [Pdf]. Available at: http://www.frc.org.uk/images/uploaded/documents/Developments%20in%20Corporate%20Governance%2020116.pdf. [Accessed on January 31, 2012]. Gray, I. & Manson, S. (2007). The Audit Process: Principles, Practice and Cases 4th ed. Cengage Learning EMEA. Lander, G.P. (2005). What is Sarbanes-Oxley? India: Tata McGraw-Hill Education. Lee, T.A. (2007). Financial Reporting and Corporate Governance. John Wiley and Sons. Mallin, C.A. (2007). Corporate governance 2nd ed. Oxford University Press. McKnight, P.J. & Weir, C. (2009). Agency costs, corporate governance mechanisms and ownership structure in large UK publicly quoted companies: A panel data analysis, The Quarterly Review of Economics and Finance, 49, pp.139-158. [Pdf]. Available at: http://philsfinance.com/QREF%20McKnight.pdf. [Accessed on January 30, 2012]. Mead, L. & Sagar, D. (2006). CIMA Learning System Fundamentals of Ethics, Corporate Governance and Business Law. Butterworth-Heinemann. OECD. (2004). Corporate governance: a survey of OECD countries. OECD Publishing. Solomon, J. (2007). Corporate governance and accountability 2nd ed. John Wiley and Sons. Read More