mod09 corporate governance

8/13/2019 Mod09 Corporate Governance

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THE INSTITUTE OFCHARTERED ACCOUNTANTS

OF SCOTLAND

TEST OF PROFESSIONAL EXPERTISE

CONTENTS

Page

CORPORATE GOVERNANCE .................................................................................. 19.1INTRODUCTION ................................................................................................. 19.2LEARNINGOBJECTIVES ............................................................. ...................... 19.3WHATISCORPORATEGOVERNANCE? ......................................................... 29.4GOVERNANCESITUATIONS ................................................................. ........... 49.5GOVERNANCEANDCONTROLS .......................................................... ........... 5

9.5.1 Non-executive directors ............................................................. ..................... 89.5.2 Governance by exit ......................................................... ................................ 99.5.3 Risk management ............................................................ .............................. 119.5.4 The UK Corporate Governance Code ......................................................... 12

9.6INTERNALAUDIT ............................................................................................ 129.6.1 Types of Internal Audit ............................................................. .................... 139.6.2 Operational Audit ........................................................... .............................. 139.6.3 Management Audit ................................................................... .................... 149.6.4 Value For Money Audits ........................................................... .................... 159.6.5 Post Investment Reviews................................................ ............................... 169.6.6 Compliance audits .......................................................... .............................. 17

9.7INTERNALAUDITANDCORPORATEGOVERNANCE .............................. 179.7.1 Independence .................................................................. .............................. 189.7.2 Audit Committees ......................................................................................... 18

9.8EXTERNALAUDIT ........................................................................................... 199.9ALTERNATIVEBUSINESSSYSTEMS ........................................................... 20

9.9.1 Corporate Governance in Germany ............................................................. 209.9.2 Corporate Governance in Korea and Japan ................................................ 229.9.3 Future trends in Japanese corporate governance ........................................ 24

9.10SUMMARYANDCONCLUSIONS ........................................................ ......... 25ICAS 11


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TEST OF PROFESSIONAL EXPERTISE -2011 MODULE 9

1

notesCORPORATE GOVERNANCE

9.1 INTRODUCTION

The following quote has been taken from a paper by Davis and Kay:

Imagine a system of government in which there are annual elections, butthese are almost never contested. Whenever they are, the incumbentgovernment wins by an overwhelming majority. All the information aboutthe state of the nation which the voters receive is controlled and distributedby the government and is glossy and self-congratulatory in tone. Changes inthe senior leadership do take place, normally through an orderly process ofretirement in which the incumbent leaders select and groom theirsuccessors. Occasionally there is a more violent change. Sometimes thistakes the form of an internal coup detat. Or it may occur as a result of theintervention of the hostile government of another state. This is not adescription of Eastern Europe before perestroika and glasnost. It is adescription of the system by which public companies in Britain are

controlled and governed.

This quotation is itself designed to provoke a reaction and is, therefore, ratherexaggerated in tone. Having said that, it does contain some insights which mighthelp introduce the topic of corporate governance.

The purpose of this module is to introduce some of the issues which have beenraised by the whole topic of corporate governance in recent years. It looks beyondthe detailed reports and pronouncements by the various committees who havecontributed to the debate. It examines some of the controls which have beenapplied in the UK and the manner in which they have actually worked. The

module concludes with a description of some of the alternative forms ofgovernance which have been developed elsewhere in the world. While these maynot appear to have much direct relevance to the UK, they do at least show thatthere is no particular reason why our present system of regulation could notchange.

The basic approach throughout this module will be to discuss and to questionrather than to describe and provide factual information. This is an interestingtopic and one which has enormous implications for the whole of society. It is,however, a topic which has particular relevance to the accountancy profession.

9.2 LEARNING OBJECTIVES

By the time you complete this module, you should be able to:

1. Recognise the different systems of governance and business structures

2. Evaluate and advise on different corporate governance systems andcontrols

3. Exercise professional judgement in corporate governance situations


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MODULE 9 TEST OF PROFESSIONAL EXPERTISE 2011

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notes 9.3 WHAT IS CORPORATE GOVERNANCE?

The phrase corporate governance came into common usage in the 1990s. It is,however, merely a collective term which can be used to describe a series of issueswhich have been debated and written about for several decades. These issuesinclude the:

structures processes cultures, and systems

that engender the successful and controlled operation of an organisation.

Most of the literature on corporate governance deals with relationships betweenthe different groups and individuals who are seen to have an interest in theactivities of an entity. These interests are viewed as having the capacity to comeinto conflict.

ACTIVITY

Several years ago Waterstones, a major chain of book retailers, created the worldslargest book shop in Piccadilly in the centre of London. The site they had chosenis a listed building which was previously occupied by Simpsons, a famous retailerof high quality British clothing. The store had become available because theJapanese corporation which owned DAKS Simpson, the stores parent companyand the supplier of most of its merchandise, did not feel that it was sufficientlyprofitable. This new store affected the other bookshops already in Piccadilly

including Hatchards, which is one of the oldest in the country. Even thoughWaterstones is a subsidiary of HMV, a major entertainment group, it is reasonableto assume that the cost was raised by borrowing.

A number of groups who might have been affected by this investment are listedbelow. In each case:

1. think about how they could be affected by Waterstones decision topurchase the store and convert it into a major book shop and

2. decide whether their interest in the decision is one which should be takeninto account by the managers of Waterstones.

(a) the shareholders of HMV

(b) the employees of Simpsons

(c) the customers of the relatively small book stores located atuniversity and college campuses in Central London (eg theEconomist book store at the London School of Economics -roughly a twenty minute walk away from Piccadilly)

(d) the bankers who will provide the finance for the purchase

(e) the author of an accountancy text book


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Solution

The shareholders of HMVsuffer the risks and enjoy the rewards associated withthe new business venture. If it is successful then the share price will increase,thereby increasing their wealth. Clearly the managers of Waterstones should haveevaluated the market potential of the site and the likely costs and revenues andshould not have decided to proceed unless the decision was in the best interests ofthe shareholders. There is, however, a theoretical possibility that they weremotivated by other factors:

The prospect of creating the worlds largest bookstore could have appealed totheir egos.

Short-term profit considerations might have affected their immediate dividendpayments.

Clearly, the shareholders have a legitimate interest in the running of the company.They have invested in it and are entitled to a reasonable return, commensurate

with their risk. Their problem is the well-known one of the agency relationshipwhich affects all companies that are not owner-managed. There is always a concernthat managers will act in a manner which suits their own interests, even if these arein conflict with those of the shareholders.

The employees of Simpsons lost their jobs when the store closed down. Eventhough they were directly affected by the sale of their store, the managers ofWaterstones are unlikely to feel any sense of responsibility for this. If they hadnot bought it then the owners would probably have sold it to someone else ratherthan continue to tolerate the continuing losses.

The new store may compete for much of the business of campus booksellers.These smaller shops might not be able to survive, thereby costing their customersthe benefits of the specialist local knowledge of courses and reading lists which areoffered by such stores. Arguably, this should not concern the management ofWaterstones. After all, if the customers of a particular store value its service thenthey can and should support it with their custom. It is also perfectly legitimate fora business to compete by entering a new market and offering a better product thanthat currently on offer. This argument is not, however, quite so clearcut. It is notnecessarily in the public interest for large entities to increase their market share tothe point where they can drive competitors out of business. It might be arguedthat the use of such a strategy would not be in the companys best interestsbecause of the impact which it might have on public opinion. A reputation for

ruthlessness may discourage customers. If that argument is accepted, it is alsopossible that the company considered the effects of their decision on the staff ofSimpsons because of the danger of being associated with the closure of a famousUK institution (Simpsons is reputed to be the inspiration for the famous televisioncomedy Are You Being Served?).


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notesThe bankerswould have been keen to ensure that their advance is repaid on timeand with appropriate interest. They undoubtedly protected their own interests bydemanding detailed forecasts and projections in support of the loan application.They would also have required adequate security, probably on the listed buildingitself. There would have been no need for the directors of Waterstones to worryabout the banks interests because the bank can take care of itself. There is,however, an indirect issue. If the bank had any minor reservations about theoutcome of this investment then it would have demanded a higher rate of interestor a broader security or loan covenant. This suggests that Waterstonesmanagement should have considered the banks interests, if only because thesewould have a direct impact on the conditions attached to the loan.

Finally, the poor struggling authormight not have been directly affected by thenew store in itself, but could be affected by the broader implications of thechanging book market. Concentrating the book market in the hands of a smallerbody of retailers forces publishers to deal with larger and more powerfulcustomers who can demand larger discounts against the suggested retail price.

Authors royalties are based on the net amounts received by the publisher and solarger retailers lead to smaller royalty payments. It is possible that larger storeswhich have fewer competitors will feel less pressure to stock a wide range ofbooks, thereby leaving more space to display the latest best sellers. Both factorscould discourage the creation of the new books upon which the book sellingindustry depends. It is unlikely that Waterstones would consider the authorsinterests.

You might not agree with the whole of the above analysis - indeed you shouldhave thought about each case and formed your own opinion. The main purposeof the activity was, however, to demonstrate that the boundaries of corporate

governance are wide open and rather ill-defined. Even if you disagree with someof the issues raised, you cannot deny that the debate is going on. The traditionalview of corporate governance was concerned mainly with the triangularrelationship between directors, shareholders and lenders, each of whom had adifferent set of interests, aims and objectives. (Note the monitoring role of theauditors giving assurance to those not directly involved in the business.) This hasgiven way to arguments that businesses have a broader responsibility to employeesand to society at large. Unfortunately, even that discussion is complicated by thefact that some organisations use claims that they are responsible employers orcorporate citizens as a promotional device and could, therefore, be behaving asgood citizens in order to win business and thereby increase their shareholderswealth.

9.4 GOVERNANCE SITUATIONS

While the scope of the corporate governance debate is extremely open-ended,there are a small number of specific issues which call for the exercise of judgementon the part of shareholders. Some of them are:

How should directors be paid and rewarded?

How much job security should a director have and what severance termsshould be offered?


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How much authority should the directors have and what responsibility shouldthey take for the companys smooth running?

A huge amount of attention has been paid in recent years to developing newframeworks for the regulation of business. The accountancy profession, inconjunction with a variety of other regulators and interested parties, hasparticipated fully in the workings of the Cadbury, Greenbury, Hampel andTurnbull committees. The Smith and Higgs reports led to the publication of arevised Combined Code in 2003 (see section 9.5.4). These committees have all haddifferent remits, but most deal with the development of checks and balances tomake it more difficult for company directors to take unfair advantage of theirpositions. The reports of these committees were discussed at TPS, principally inTPS Auditing & Reporting/Assurance and Business Systems, and so this modulewill not look at these directly but will deal with some of the issues that actuallyarise from their implementation.

Much of the motivation for these regulations has been from well publicised

scandals which have tended to shake the confidence of investors, employees andpoliticians in the mechanisms by which businesses have been run:

The Robert Maxwell affair highlighted the dangers associated with having anundue amount of power in the hands of one individual.

Tabloid press coverage of fat cat directors salaries in the mid 1990s raisedquestions about the legitimacy of directors deciding their own remuneration.

The collapse of Barings Bank led to an outcry because senior management hadbeen aware of the control weaknesses which permitted the manager in

question to exceed his authority and expose the bank to unacceptable risks onthe currency markets. This led to a broader concern about the need forboards to assess risks and to accept responsibility for establishing anappropriate control environment in response to these.

Corporate governance is not a discrete subject with clearly defined boundaries. Itis broadly concerned with the management of companies and encompasses a rangeof issues that include finance, psychology, ethics, human resource managementand a host of others. Taking a single concrete issue: the appointment of a newchief executive raises questions about the effect that this would have on stockmarket confidence, the suitability of different candidates for the post and theresponse of the workforce and of other senior managers to the final choice. Apart

from the internal deliberations, this appointment could also be endlessly debated inthe financial press and in analysts briefing documents and so there are alsoimportant public and investor relations issues that have to be managed as well asconsidered. Bearing that in mind, you cannot expect the whole of corporategovernance to be covered in this one module. Nor should you be surprised if youfind yourself drawing on material from other modules and even other courses.

9.5 GOVERNANCE AND CONTROLS

This section briefly describes some of the structures and safeguards that have beenput into place in order to direct the activities of these directors. It is important to

understand these safeguards, partly because they will affect the manner in whichthe business is run and partly because it is important to understand the spiritbehind the rules in order to implement them correctly.


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notesMany of the issues associated with corporate governance arise because of concernsthat directors and managers of companies might put their own interests beforethose of the shareholders. This is known as the agency problem. Traditionally, theUK system of governance has operated on the basis of accountability throughdisclosure. The shareholders (principals) have been able to monitor thestewardship of their directors (agents) by means of the annual report,supplemented by the interim financial statements and the opportunity to askquestions at the general meeting.

A great deal of time and energy has been spent researching the agency problemand numerous papers have been published on its different aspects. For example, ithas been suggested that the agency problem is particularly severe in somecompanies. The directors of such companies will have a greater incentive toreassure shareholders and lenders that the company is being managed honestly andresponsibly. This can encourage behaviour which can be measured andresearched, such as a tendency to switch to a larger and more expensive audit firm.Academic research on the agency problem often provides more questions thananswers, partly because the results of different studies are often contradictory.

ACTIVITY

A series of papers was published on the topic of auditor resignations. Theseexamine the effectiveness of the auditors duty to report to the shareholders andcreditors on any circumstances associated with the resignation. An analysis ofseveral hundred resignation statements suggested that only a tiny proportion ofcases led to anything other than a nil response. A second paper examined theaudit fees charged by replacement auditors following a resignation. The tendencyfor incoming auditors to lowball in order to win new business did not occur

when the outgoing firm resigned, even if it stated that there were no reportablefacts when they left. A third paper suggested that, despite the auditors assurancesthat there are no reportable facts, the share price tends to fall in response to theannouncement of the resignation.

(a) Describe the relationship between the shareholders and auditors in termsof agency and explain why a resigning auditor might not be motivated toact in the best interests of the shareholders.

(b) Try to suggest how the first and second papers might appear todemonstrate that auditors do, in fact, act in their own interests rather than

those of the shareholders.

(c) It might be argued that the auditor does not have to make any explicitstatement about the reasons for resignation because the third paperdemonstrates that the market can infer these. Do you agree?


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notesSolution

(a) The shareholders are unable to check the truth and fairness of thefinancial statements for themselves and so they are forced to appoint theauditors to carry out this task on their behalf. In that sense, the auditor isacting as an agent on behalf of the shareholders. There will always be apossibility that any agent will not act in the best interests of the principaland that is as true of auditing as any other activity. The auditors mostobvious economic incentive is to collect as many fees as possible at theleast cost. Minimising cost might involve reducing the amount ofevidence collected or taking steps to avoid risking the audit firmsreputation, either of which may not be in the best interests of theshareholders.

(b) It is difficult to see why an auditor would wish to resign. Doing soinvolves the loss of future revenues from that client and so it is unlikelythat the auditor would resign without a good reason. An auditor mightresign as a formal act of protest in order to highlight some problem with

the company. This does not appear to happen often in practice becausevirtually all of the reported statements are nil returns. Resignation mightalso provide the auditor with a means of escaping from a difficult situationsuch as the existence of doubts about the integrity of management. Thefact that incoming auditors tend to charge more than they would normallyin the aftermath of a resignation suggests that such audits are regarded ashigh-risk. This evaluation is being made by a firm which will probablyhave had an opportunity to explore the reasons for the departure of theprevious firm and who will also have had some experience of resigningfrom other appointments. Taking the findings from both of these paperstogether suggests that auditors sometimes may resign to avoid bringing

some matter to the attention of the shareholders.

(c) An interesting example of an audit resignation was Coopers & Lybrandsresignation as auditors of computer software firm Eidos in August 1998.C&L gave as reason certain inadequacies in the companys corporategovernance practices and those included the failure to review theeffectiveness of financial controls. The audit work had been worth130,000 in the previous year. The whole episode was part of the reasonfor a short-term slide in Eidos share price.

This resignation did not, however, mean that Eidos could not get aninternational firm to audit its accounts as KPMG stepped in to that role.

KPMG stated that they discussed the issues with Eidos directors,financial and legal advisers and C&L. They stated that they believed thefailures were exceptional and due to rapid growth by the company andthat the problems would be rectified as soon as practically possible.

The fact that the share price reacts indicates that shareholders have asimple mechanism for dealing with any major uncertainty about themanagement of their company, namely that they can sell their shares.Unfortunately, this is not a satisfactory alternative to full and cleardisclosure of all relevant facts. Only those shareholders who have themeans to monitor all company filings and announcements will be able to

sell quickly in response to the resignation.


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notesThe response to this activity suggests that some of the codified safeguards in theUK system of corporate governance, such as the disclosure requirements imposedon resigning auditors, may not be effective. Others, such as the cultural andinstitutional frameworks which make it relatively easy to sell shares if theshareholders have doubts about management, are not codified but do provide aneffective remedy for doubts. It would appear that it is necessary to look beyondthe letter and even the spirit of the rules and regulations in order to form ajudgement about the effectiveness of a set of procedures.

9.5.1 Non-executive directorsThe Cadbury Committee argued that the appointment of suitable non-executivedirectors was a particularly important way in which a company could reassure itsmembers and other stakeholders that the company was being managedresponsibly.

ACTIVITY

For each of the following assertions about nonexecutive directors, circle theresponse which best describes your opinion.

1. Non-executive directors are always independent of thecompany.

Agree/Disagree

2. Non-executive directors are always independent of theexecutive directors.

Agree/Disagree

3. Non-executive directors will always be able to monitorthe activities of the executive directors.

Agree/Disagree

4. Non-executive directors will always have anoverwhelming motivation to stand against any

dishonesty.

Agree/Disagree

Solution

None of these assertions lend themselves to an absolutely categorical response. Alldo, however, require a certain amount of scepticism.

1. There is no guarantee that non-executives will be linked to the companythrough their directorships and nothing else. Indeed, Cadbury introducedthe concept of independent non-executives. Some non-executivedirectors will owe their place on the board to a shareholding, others will

have been appointed by a bank or other lender as part of a debt covenantand so on.

2. Some of the so-called independent non-executives may have been drawnfrom the ranks of friends and business contacts of the executive directors.There is also a possibility that the appointments will be relatively lucrativeand that the nonexecutives will be loath to upset their colleagues on theboard without good reason.

3. Surveys have shown that some non-executives have very little contact withthe company, beyond attending a board meeting every few months. Insuch cases, their knowledge of the company will be drawn from the

minutes, reports and other documents prepared by the other boardmembers.


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notes

4. In theory the non-executive directors will wish to maintain and protecttheir reputations for honesty and integrity. In practice, they may feel thatthe markets cannot distinguish honest nonexecutives any more easilythan it can honest executive directors. Given that many nonexecutivedirectors will wish to have a string of such appointments, they may feelthat creating a fuss about some problem with the company will actuallycreate an impression that they are obstructive.

The concerns outlined above are somewhat pessimistic and do not reflect thesituation in all boards. However, the fact remains that the system may not alwaysenable or encourage non-executive directors to fulfil the purpose of theirappointment. A weak group of non-executives would actually be worse thanuseless because they could lull shareholders into a false sense of security.

In practice, non-executive directors are being asked to spend increasing amountsof time on governance issues, with a corresponding increase in their overallcommitment to the company. Typically, a non-executive director will devote 15-

21 days per annum to the task. In 2003 the average fee for holding such a positionwas reported as 20,950 for a small company rising to 34,250 for a largecompany.

Despite the rewards, it appears difficult to identify suitable candidates.Traditionally, appointments have been given to current or retired executivedirectors from other companies. Some companies make use of executive searchagencies to locate suitable candidates, although this can prove costly. Othercompanies are turning to local contacts, such as solicitors and other professionals,whose backgrounds may actually make them more suitable for the governance rolethan executives.

9.5.2 Governance by exitThe last few pages have discussed some of the provisions which have beendesigned with the explicit intention of providing good corporate governance.While these would undoubtedly serve their purpose there is no guarantee that theywould be fully effective. Market forces will, however, tend to deter such self-seeking behaviour. While this might not be enough to guarantee that the companywill be well managed, it will at least tend to compensate for any shortcomings.

There is also a strong secondary market in shares which makes it easy to move intoor out of a particular company and shareholders tend to have very little loyalty toany given company or its management. Finally, there is a long tradition of

contested takeover bids. Taken together, these factors mean that anyone who hassufficient capital could acquire a controlling interest in a company which appearsto be offering a poor rate of return. If that persons opinion about the quality ofthe current management team is correct then the appointment of a newmanagement team will improve the companys profitability and increase the shareprice by enough to cover the costs incurred in the course of the takeover.

The possibility of a takeover should be enough to encourage management toperform to the best of their ability. In addition, they will have to ensure that thestock market perceives the company as being well managed in order to deter eithermisinformed or speculative bids. Even if the directors do manage to fend off a

takeover, they will be forced to invest both time and resources in mounting adefence.


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ACTIVITY

It has been argued that the takeover mechanism can lead to dysfunctionalbehaviour on the part of both potential bidders and targets. Go through thefollowing list of criticisms and decide whether each is most likely to apply to thebidding company or the one which is the subject of the offer.

1. Directors may adopt a short-term outlook. Bidder/Target2. Directors may have unbalanced investment

portfolios.Bidder/Target

3. Directors may have vested interests in evaluatingthe transaction.

Bidder/Target

Solution

1. The threat of takeover might encourage all company directors to take ashort-term outlook in order to reduce the risk of their company becominga potential target. If they cut back on expenditure on areas such asmaintenance, asset replacements and so on they will avoid the temporarydecrease in profitability or return on capital employed associated withthese. Doing so may, of course, reduce the long term profitability of thecompany, although that might be regarded as a price worth paying in orderto protect their immediate security.

2. The directors of the biddingcompany will almost certainly have differentlevels of exposure to problems with the company than their shareholderswill. Any sensible shareholder will invest in a portfolio of investments so

that a problem with one is likely to be compensated by strength inanother. The directors do not have this same capacity to diversify. Theyare likely to regard their company salary and benefits package as their mainsource of income. Share options may mean that company shares will forma major portion of their other financial resources. Thus the directorsmight be tempted to take over other businesses in order to spread therisks of their stake in the company failing. Doing so may be of littlebenefit to the shareholders because they can easily diversify for themselvessimply by holding shares in a range of different companies.

3. The directors of the targetcompany may be motivated by the fact that a

successful bid is likely to leave them unemployed. They may defend thebid even if the bidder has offered a fair amount because of the threat totheir personal livelihoods. This imposes an opportunity cost on theshareholders, assuming that they would have received more than themarket price. Furthermore, their company will have to spend a great dealon professional services, advertising, printing and so on in order to fightoff the bid.

There are other costs associated with takeovers. For example, some takeovers areonly commercially feasible because the bidder intends to reduce the pay andconditions of the target companys work force. This ruthlessness has the effect ofshifting wealth from the employees to the bidders shareholders without actually

creating any additional value for the economy or for society as a whole.


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notesThere have also been a number of studies which tend to suggest that the benefitspredicted by the bidding companys directors can be extremely difficult to realiseonce the bid succeeds. Effectively, this means that it is often against the interestsof the bidding shareholders to proceed with a bid.

The threat of takeover might have the effect of providing the shareholders withsome reassurance that the directors will act to maximise their wealth, but even thismechanism can lead to dysfunctional behaviour. There may, however, be atendency to overstate the importance of matters such as salary and job security tosenior managers. A survey of directors attitudes suggested that job satisfactionand the opportunity to work in a challenging environment were far moreimportant than the factors which motivate employees at lesser levels. While therewill always be doubts about the responses to any questionnaire or interview-basedsurvey, one comment suggested that the responses may indeed have been honest.An executive director who had been appointed to a 300,000 per annum post tookout a mortgage of 300,000. He did not regard the job itself as particularly secure,but felt confident that his mortgage would be paid off by the company as part ofany severance package and so he had very little to lose from borrowing heavily.

9.5.3 Risk managementMuch of the emphasis in corporate governance is moving to the development ofprocedures to manage risks. The Turnbull Committee has produced guidance fordirectors on implementation of the internal control aspects of the CombinedCode. The following quotes from the Code summarise the key aspects of the newguidance:

The board should maintain a sound system of internal control to safeguardshareholders investment and the companys assets.

The directors should, at least annually, conduct a review of the effectiveness ofthe groups system of internal controls and should report to shareholders that theyhave done so. The review should cover all controls, including financial,operational and compliance controls and risk management. In addition, theboard should regularly receive and review reports on internal control. Thus, thetraditional emphasis on the accounting and financial controls which have beenregarded as paramount in the past will make way for a much broader concern forall business risks and controls. The boards responsibilities are also likely to bebroadened by an explicit statement that the whole board is responsible. It is notacceptable to delegate these duties to the audit committee, although it may be thata small sub-committee of the board will actually undertake much of the detailedmonitoring and review work.

The risks faced by senior managers could go beyond the threat of being sued fordamages. In October 2000 a high-speed train left the track at Hatfield, killing fourpassengers and seriously injuring a further 30. The subsequent investigation intothe tragedy revealed that senior managers in Railtrack and their primary contractorwere aware that the track was in poor condition and that the tragedy could havebeen averted by imposing a speed restriction until the line could be repaired.British Transport Police has passed a report to the Crown Prosecution Serviceindicating that manslaughter charges could be brought against five seniormanagers. The Crown Prosecution Service has also indicated that it could considercorporate manslaughter charges against the companies. If such an action was

taken then the companies could face an unlimited fine while any managers foundguilty could be jailed.


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notes9.5.4 The UK Corporate Governance CodeThe Combined Code 2008 was replaced by the UK Corporate Governance CodeJune 2010. The new code applies to accounting periods beginning on or after 29June 2010. The code was developed from refinement of earlier versions andincludes main principles and provisions, as well as supporting principles.

The board should follow the principles of the code. The detailed provisions are aguide as to how this may be achieved but this will not be relevant to all companies.This structure was intended to allow greater flexibility in the implementation of thenew code. It also allows the board to follow fundamental principles rather thanticking off a list of rules which will not necessarily guarantee that the desiredoutcome is achieved.

The Code contains 18 main principles and 52 provisions for companies and theseare structured under the following sections:

CompaniesA. Leadership

B. EffectivenessC. AccountabilityD. RemunerationE. Relations with Shareholders

A separate Code has been developed to set out good practice for investors onengagement with their investee companies. This is called The UK StewardshipCode.

A copy of the UK Corporate Governance Code 2010 is included as an appendix inTPE Module 11, along with details of the key changes and new provisions in thiscode.

9.6 INTERNAL AUDIT

The controls that were discussed in section 9.5 were concerned with controlsassociated with the structure of the board and ensuring that the executive directorsdid not think that they could run the business without regard to the interests of theshareholders and other stakeholders. The internal audit function is moreconcerned with the actions of lower level managers and staff in ensuring that theyfollow the boards instructions. By doing so, this should mean that all staff areworking towards furthering the shareholders interests rather than their own. This

section will describe the operation of the internal audit function. Section 9.7 willbuild on this by linking internal audit more directly to corporate governance.

Internal audit has progressed significantly in recent years and continues to developto meet the ever changing needs of business and management. Internal audit isperceived, in progressive organisations, as a source of advice and guidance thatassists executives in their responsibilities for the management of business risk. Ithelps management to ensure that the whole system of controls, financial andotherwise, is adequate and effective in reducing risk to acceptable levels. Thisassists the organisation in conducting its business in an orderly and efficientmanner. Internal auditors provide management with recommendations andguidance on solutions to problems.


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notes9.6.1 Types of Internal AuditRisks and systems of control vary according to business needs and it is notpracticable to generalise on the scope of work that should be covered by internalaudit. Indeed it is the Board of an organisation that will ultimately determine thescope of work of its internal audit function. The scope will be primarily concernedwith contributing in some way to the achievement of the management objectives.These terms will vary considerably from one organisation to another. A recentsurvey conducted by the Audit Faculty of the Institute of Chartered Accountantsof England and Wales, revealed a wide range of work being undertaken by internalaudit departments both in the private and public sectors. The highest proportionof internal audit effort is devoted to audits of operations and business processes,followed by financial audits, IT systems reviews, fraud and special investigationsand regulatory compliance work. Internal audit investigations can take the form of:

Operational audits, Management audits, Value for Money (VFM) audits, Post Investment Reviews (PIRs), and

Compliance audits

9.6.2 Operational AuditOperational auditis a service provided to operational management which givesassurance that operational objectives are valid, control information is reliable andthat activities are effective, efficient and economic. It is the audit of control in thefunctional areas of a business as distinct from the controls that are exercised withinthe accounting and financial departments of the business. These functional areasmight be marketing, sales, distribution, production, and so on, depending on thenature of the business.

Operational audit is not a universal panacea for all management problems. A firstessential is a strong commitment by the management to whom the service is beingprovided. Effective results depend upon good collaboration between theoperational auditor and the user of the service. Ideally the user managementshould identify the areas needing operational audit examination and initiate therequest for the service.

The key to effective operational audit is in developing a programme of audit testswhich will enable the auditor to make a positive contribution to managementperformance. The following is an example of how an operational audit of themarketing function can be used to contribute positively to achieving managementobjectives.

Example: an operational audit of marketing

The audit objective should be to assist in enhancing the quality of marketingjudgements and the effectiveness of their application. Auditing skills can beapplied to evaluate the information bases and the rationale used in formingmarketing judgements but the auditor must take care to stop short of secondguessing the experts. In this way there can be considerable potential for the auditof marketing activity to contribute positively to operational effectiveness in thepursuit of corporate objectives.


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notesThe audit tests should be designed to analyse information validity and applicationeffectiveness for the marketing judgement, typically in six key areas:

Market research and demand forecasting; Market development; Product development; Distribution planning; Sales pricing; and Sales promotion.

Taking market research as an example, the auditor might confirm the validity ofthe information base and the rationale for its interpretation interpreting by askingthe following questions:

What market research has been done? Consider alternative sources ofinformation. Is there any information lacking?

Is the rationale sound for the projections adopted? Consider the relevance of

the statistical techniques used.

How do the projections match with track record trends?

Have all functions of the business been fully consulted? Have the forecastsbeen fully accepted and adopted?

Are the forecasts feasible in terms of the potential resources and capacity ofthe business?

9.6.3 Management Audit

The distinction between management audit and operational audit is not alwaysclear, however management audit is concerned with the objective and independentappraisal of the effectiveness of managers and corporate structures in theachievement of company objectives and policies. It is the audit of procedures bywhich the management of the organisation control the resources available toachieve business requirements, whereas we have seen above that operational auditis concerned with the audit of control in functional areas of the business such aswarehousing, distribution, marketing etc.

An example of a key management audit would be manpower and successionplanning. Nothing is ever static in business and the general ability of anorganisation to pre-empt anticipated change and adequately plan for its

consequences can be a fundamental matter of survival. Any company will need toensure that the workforce is capable of meeting both the current and foreseeabledemands. In a dynamic employment situation, staff will be promoted and moveinto other areas of the organisation and there should be mechanisms in place toensure that other employees are suitably groomed and waiting in the wings tomove into the vacated positions.

Management audit therefore reviews the underlying fundamental policies andprocedures within an organisation which are just as critical to its successfuloperation as the efficient performance of its functional departments.


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notes9.6.4 Value For Money AuditsValue for money audit is, very broadly, a function provided by internal audit withthe aim of identifying and recommending to management ways in which they maymaximise its return on resources employed. It frequently makes extensive use ofperformance indicators in the form of ratios and other statistics (averageturnaround time, ratio of stock held to turnover) to give an indication of value formoney, especially when trends are explored in these performance indicators overtime, or variations in performance are identified and explored between differentoperating units.

The term value for money is often applied to public sector spending in the UKwhere there is an implied obligation on public bodies to ensure that they obtainand provide services on the most economic grounds. However, VFM auditing isnot limited to the public sector. Much of the methodology which has beendeveloped is applied in the private sector.

It is now generally accepted that VFM auditing consists of three interdependentelements:

Economy: which is concerned with obtaining the appropriate quantity and qualityof resources (physical, financial and human) at lowest cost.

Efficiency: which is concerned with the relationship between goods or servicesproduced and the resources used to produce them.

Effectiveness: which is concerned with how well an activity is achieving its policyobjectives or other related intended effects.

Auditors may prefer to concentrate on economy and efficiency because these are

much easier to measure than effectiveness. This is particularly true in areas such ashealth and education where the outputs are extremely difficult to quantify.

VFM audits can take the form of selective investigations of signs of possibleextravagance, inefficiency, ineffectiveness or weakness in control. For example,why a building project overran its costs or timetable or failed to meet therequirements for which it was designed. On a smaller scale, ad hoc investigationsof value for money can produce useful improvements in systems and can fostercost consciousness throughout the organisation.

It is a feature of VFM audit that the auditor often finds it useful to draw uponexamples where similar bodies (or operating units) have been successful in securing

arrangements for economy, efficiency and effectiveness in particular activities. Hetakes such examples of good practice and examines how far they can be applied tothe body or operating unit under audit.

Benchmarking has become a common assessment tool for management. There area number of government bodies and trade organisations who maintain databasesof information on different industry sectors. These sources, along with internalperformance data, are often used to benchmark.

ACTIVITY

Consider a distribution company. What objectives would you expect a VFM auditto achieve in relation to the distribution process?


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notesIn PIRs the auditors impartial view will be particularly valuable in making anobjective assessment of the effect of various elements of the changes which willhave occurred, as not all of them will have been anticipated. The auditor will needto consider all relevant changes in the business, the environment and the economysince the project plan was prepared and endeavour to evaluate how these haveinfluenced performance.

9.6.6 Compliance auditsCompliance audits have been deliberately left to the end to stress the positivecontribution that internal audit can make to the overall management process.There is, however, still a role for the more mundane ticking and bashingapproach to audit. One of the ways in which the board discharges itsresponsibilities is by the creation of systems of internal control. These comprisean overall control environment as well as detailed control procedures. Internalcontrol can have the following objectives:

the reliability and integrity of financial and operating information; compliance with policies, plans, procedures, laws and regulations;

the safeguarding of assets; and the economical and efficient use of resources.

None of these objectives will be met unless the system actually operates as itshould. One of the ways in which the board can satisfy itself that the system isoperating properly is by asking the internal audit department to conductcompliance tests on the operation of the systems.

Compliance audits are frequently conducted on a cyclical basis, with the auditorworking through a programme over a period of years. As with an external audit,the internal audit department might use a variation of the risk-based approach to

identify areas which require greater emphasis. The very visibility of a complianceaudit is an important element of the overall control environment. If the boarddemonstrates its commitment to the operation of control procedures by sendingstaff to check on their operation then staff will be encouraged to adhere to themanual.

A compliance audit need not focus on the financial controls that are most relevantto external audit. The internal auditor could, for example, review safetyprocedures to ensure that the companys policies on, say, training of new staff,servicing of safety equipment and so on are being adhered to.

9.7 INTERNAL AUDIT AND CORPORATE GOVERNANCE

Internal auditing is an important part of the whole process of corporategovernance. It underpins several key relationships. Internal audit provides:

the executive directors with some assurance that other managers and staff areputting the policies and procedures established by the board into effect;

the non executive directors with confidence in the financial records and othermanagement reports (eg health and safety) that they rely on in their overallsupervision of the business; and

the shareholders with evidence that the board takes the need for controls,checks and balances seriously in the overall management of the business.


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notesCorporate governance issues face the board with an almost insurmountable set ofchallenges. One of the ways in which they can discharge their responsibilities is bycreating an effective internal audit department which is tasked with checking ongovernance procedures on behalf of the directors. The principal task of internalaudit is normally perceived as assisting with corporate governance and managerialaccountability.

9.7.1 IndependenceInternal auditors must be independent of the activities they examine.Independence is a state of mind achieved through organisational status andprofessional objectivity and should enable internal auditors to render the impartialand unbiased judgements essential to the proper conduct of their work.

The Head of Internal Audit should be appointed by the Chairman (or othersuitable independent senior executive). He or she should have no executivepowers outside the internal audit function. Because of concern for internal auditindependence, the Treadway Commission (1987) discouraged the situation wherethe internal audit function reports to the senior officer directly responsible for

preparing the accounts. The head of internal audit should report directly to theAudit Committee, usually via its non executive chairman. There should be nopreconditions of access to the board, particularly to non-executive directors, set bythe executive directors or other senior management. In practical terms the Headof Internal Audit must also have a strong day to day working relationship withexecutive management and may also report to an executive director such as theChief Executive.

9.7.2 Audit CommitteesMost quoted companies have an audit committee, normally comprisingpredominantly non-executive directors but with the Finance Director and

representatives of the external and internal auditor in attendance as appropriate.

The ambit of the audit committee goes beyond reacting to the outputs of thevarious accounting and control systems (eg reports, draft financial statements andso on). The audit committee should also consider whether the systems andcontrols that input the information (eg accounting systems, stock controls etc.) areadequate. The audit committee should be concerned with control informationbased on which the board make business judgements is it correct, timely and ofthe required quality?

The audit committee is a formally constituted subcommittee of the main board.This structure enables the entire board to be confident that the financial reporting

process and internal control systems are subject to scrutiny by designated boardmembers. It also provides internal and external auditors with a voice at boardlevel.

ACTIVITY

An audit committee provides the opportunity for internal auditors to reportdirectly to board members and thus improve communication between the boardand the internal audit function. What are the main benefits of this structure?


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notesSolutionAn audit committee provides a forum in which a subset of directors can considerthe scope and results of internal audit work and filter matters for consideration bythe main board. This facility should give the following benefits:

It will raise the status of the Internal Audit Function. It may encourage internal auditors to enhance the quality of their work. It will pressure management into acting on the recommendations made. It will raise internal audits status among the companys managers who will be

aware that the internal auditors have this line of communication. It provides an independent outlet for the Head of Internal Audit in situations

of conflict with executive management.

The increased emphasis on, and awareness of, corporate governance and relatedpublic reporting has brought the role of internal audit into sharper focus.Organisations are increasingly looking to their internal auditors to guide and assistall levels of management, from the Board down, in their quest for an effectivecontrol framework appropriate to their business.

Internal audit has evolved so that it should be the expert adviser helpingmanagement with business risk assessment and control to ensure that the wholesystem of controls, financial and otherwise, established by the management isadequate and effective in reducing the risks faced by the organisation to acceptablelevels. This assists the Board and all levels of management to meet theirresponsibilities for ensuring that the business is conducted in an orderly andefficient manner, in the way that executive management require it to be undertakenboth as to policy and practice.

Internal auditors value and effectiveness are linked not only to their attunement tomanagements philosophy and direction, but to their understanding of risk and itsmanagement, and their direct knowledge of operating systems. As an independentappraisal function working within an organisation, internal audit provides aproactive value-added assurance service which helps directly in the achievement ofthe entitys goals and business objectives, as well as assisting senior management inmeeting their responsibilities. Internal audit can therefore make a real contributionto an organisation, and greatly assist the Board in discharging its responsibilities.

9.8 EXTERNAL AUDIT

The external auditor also has a role to play in the whole process of corporategovernance. While most of this module has been concerned with the development

of checks and balances within the organisation, the provision of credible, unbiasedaccounting information to shareholders and external readers also helps develop asense of openness and transparency. The whole process of financial reporting andthe publication of audited financial statements is, therefore, yet another facet ofcorporate governance. External auditors provide shareholders with confidencethat the financial statements are a credible source of information upon which tobase stewardship decisions. This, in turn, provides further support for therelationship between the board and the shareholders.

Arguably, internal and external auditors have a relatively minor role to play in thewhole system of corporate governance. It is unlikely that audit will be effective if,

for example, a company is being mismanaged by an aggressive board which hascompliant non-executives. The auditor is nevertheless an important supportingplayer who will make such behaviour more difficult to conceal.


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notes 9.9 ALTERNATIVE BUSINESS SYSTEMS

You might be forgiven for believing that the UK system of regulation is commonlyused throughout the world. The US system is surprisingly close to the UKs andso a comparison might tend to suggest that all countries are the same. Nothingcould, however, be further from the truth. There are several alternative modelswhich incorporate concepts which are radically different to the Anglo-Americanapproach. This final section discusses some of these because they might give somefresh ideas which could be fed into the UK debate.

The impact of culture is often underestimated because accountants tend to seetheir craft as technical and do not allow for the effects of different legal, politicaland financial settings on the development of statutory and professional regulations.A good example of this arises with differences between the two main legal systems:common law and code law. In common law countries (such as the UK and USA)the system is based on qualities such as fairness and precedent. In general thesecountries tend to have more flexibility in the setting and enforcement of rules and,amongst many other things, this means that their professional accountancy bodies

have a fair amount of influence over the standard setting process. By contrast, thecode law countries (such as France and Germany) have much more prescriptiverules and these tend to be set by government, with very little direct involvementfrom other organisations.

9.9.1 Corporate Governance in GermanyGermany is a major industrial nation and is home to a host of major multinationalcompanies. In common with most of Continental Europe it has a code lawsystem. This is reflected in the highly detailed and prescriptive rules contained inthe Corporate Governance Rules for Quoted German Companies, published bythe German Panel on Corporate Governance and updated in 2000. These go right

down to the requirement to treat each individual shareholder fairly, requiring thatall receive the same accounting information simultaneously, and the banning of thepursuit of personal interests by management board members whenever they face aconflict of interest.

ACTIVITY

The following is a brief summary of some of the feature of corporate governancein Germany. Read through it, underline the features which stand out as beingdifferent from the UK and think about how these might affect the manner inwhich German businesses are managed.

Incorporated companies have a two-tier board structure. The supervisoryboard includes representatives of various stakeholders, including employees.The executive board has a very similar role to the board of a UK company.

Banks are important providers of finance, both as shareholders and as lenders.Gearing levels are high compared to those of the UK. The banks regard theirstake in the business as long term and tend to take an active role insupervision.

The stock exchange is not particularly large or important.


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notesSolution

Broadly, the German system differs from the UKs in terms of the greater range ofstakeholders who are involved in the management process. The fact that only asmall proportion of any given companys shares is likely to be traded on the stockexchange means that short-term market forces are far less important. It iscommon for shareholdings to be concentrated in the hands of banks and largeinstitutional investors who will expect to be kept informed of any developments inreturn for their long-term support. The concentration of voting power in thehands of the banks means that hostile takeovers are almost unheard of inGermany.

The two-tier board is another major difference which appears to have no directparallel in the UK, although this is common practice throughout much of theremainder of the EU. The executive board (Vorstand) is broadly similar to theboard of directors of a UK company while the supervisory board (Aufsichtsrat) ismade up of representatives of the shareholders and the employees. Half of thesupervisory board is elected by employees in companies with more than 2,000 staffand one third if the company has fewer.

In practice, the supervisory boards tend not to meet very often and may notreceive a great deal of information. This is partly because the shareholdersrepresentatives are often nominated by members of the executive board and theseindividuals may be keen to avoid rocking the boat at meetings which are alsoattended by representatives of the employees. Having said that, the power of thesupervisory boards was demonstrated in 1998 when the shareholders favouredcandidate for the post of CEO of BMW was rejected by the employeerepresentatives on the supervisory board, thereby forcing the candidate to standdown.

The importance of banks arises because there are relatively few large joint-stockcompanies (AGs, broadly equivalent to UK PLCs) relative to the size of theGerman economy. Smaller, private limited companies (GmbHs) are far morenumerous and these tend to be owner-managed or have a close, tight-knitshareholding. There is a general reluctance on the part of many Germanentrepreneurs to share control with outsiders and to open their companies up tothe greater scrutiny implied by quoted status. Despite their relative lack ofimportance this module will concentrate on the AGs because they might havesome lessons which could be relevant to the quoted companies in the UK.The influence of banks arises partly because they are major equity investors inGerman companies. They also tend to hold shares on behalf of private andcorporate investors and exercise full voting rights over these. Banks might have

80% of the votes at a typical general meeting. The banks often make substantialloans in addition to holding shares. German companies tend to make far greateruse of debt than their British counterparts. This will often mean that a bank has asignificant stake in both the debt and equity of any given company and will,therefore, have an enormous incentive to work for that companys long-termprosperity. This offers a stark contrast with the stereotypical picture of a Britishbank, where the relationship is often seen as a tentative one where the bank willavoid risks and may have little incentive to work for the companys long-termgood.

The proportion of the votes managed by the banks means that there is very little

point in attempting to exercise any type of shareholder or stakeholder influencethrough the general meeting. The banks tend to be supportive of management, tothe extent that there have been only a tiny handful of contested takeovers in recentdecades.


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notes

ACTIVITY

The fact that company managers tend to enjoy the support of their principalshareholders, who also tend to be their bankers, may have both advantages anddisadvantages for the company. Try to identify two possible benefits and twopossible drawbacks of this aspect of business culture.

Solution

One major advantage is that managers can concentrate on the long-termprofitability of the company. They do not have to worry about, say, reducingshort-term profits by investing in research and development which is likely to bearfruit in the longer term. Studies of the investment behaviour of British andGerman companies suggest that the latter do invest more heavily.

A second advantage is that the companys principal banker will have a strongincentive to support it through any short-term cash problems. Indeed, the bankwill be kept abreast of any and all developments in the normal course of thecompanys budgeting and management control activities.

On the other hand, the fact that the banks are likely to support the incumbentmanagement team might tend to reduce the boards incentive to perform to thevery best of their ability. It might also tend to make the company less accountableto society as a whole. For example, German disclosure requirements tend to beless onerous than those of the UK. Furthermore, there is very little point inaggrieved minority shareholders attempting to use the annual general meeting tobring about any substantive change in the company.

While there are major differences between German and Anglo-US business

practices, these are beginning to diminish over time. German companies arebeginning to move towards equity finance and are seeking listings often on theLondon and New York stock exchanges. At the same time, the major Germancommercial banks: Deutsche, Dresdnerand Commerzbank, have been expanding theirhorizons in order to become global players. This has made them less inclinedtowards taking on further long-term equity stakes. For example, most of theexpansion in the former Eastern Germany has been financed by the Land, orpublic, banks.

9.9.2 Corporate Governance in Korea and JapanKorea has a family oriented society. This means that much of the entrepreneurial

activity takes place in small-scale family-run businesses. The size of theseenterprises is effectively limited by the fact that owners are keen to reserve seniormanagerial posts for immediate family members. The state has, however,encouraged the creation of a small number of very large industrial conglomeratesin the interests of economic efficiency. As with our discussion of Germany, thissection will concentrate on the larger organisations so that we can drawcomparisons with the UK situation.

Korean companies are not large, but that fact conceals one of the distinguishingcharacteristics of Asian businesses. Most large businesses are part of a networkorganisation known as a chaebol. These networks are created by an interlockingarrangement of companies holding shares in one another. The familiar holding

company/subsidiary company relationship does not really exist but, despite this,the chaebolcan be huge. The three largest (Samsung, Hyundai and Lucky-Goldstar)produce more than one third of Koreas gross domestic product between them.


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notes

The Korean government used a number of different strategies to create thesebusinesses. The banks are all state owned and, in the interests of promotinggrowth, a number of favoured institutions received loans at rates which werenegative once inflation was taken into account. These businesses were also given acertain amount of protection from both domestic and foreign competition whilethey were being established. Finally, pressure was brought to bear on a number ofwealthy business owners to make sure that they committed themselves toestablishing businesses in sectors identified by the state as having some strategicimportance.

One implication of the states involvement has been that Korean companies cancompete successfully in capital intensive sectors such as electronics and carproduction. Large scale chaebolorganisations can be created very quickly in orderto enjoy the benefits of economies of scale and scope. The disadvantage of this isthat some of the industries are not particularly attractive in themselves. There is,for example, over-capacity in the global shipbuilding industry and so it can beargued that many of the initiatives which have been imposed from outside have

not been in the long-term interests of the companies at large.

A second problem has been that the tendency to retain control within families hasled to resistance to the appointment of professional managers in senior positions.This may have impeded efficiency to some extent.

The apparent stability created by these structures does not always live up to itsreputation. In 1999 the Daewoo chaebolcollapsed shortly after having claimed tohave net assets of $10.7bn. A subsequent audit commissioned by the groupscreditors uncovered net liabilities of $22.2bn, making this the worlds largest everaccountancy fraud. Former Daewoo executives were fined a total $19bn and

sentenced to up to seven years in prison for their part in this affair. The danger ofthe close ties between group members is that they encourage a lack of opennessand accountability.

The Korean government was inspired to create the chaebolby the success of theJapanese keiretsu (chaebol and keiretsu are represented by the same Chinesecharacters). There are, however, some significant differences between the two.The most notable of these is the fact that the keiretsutend to be structured aroundan internal, commercial bank which is a member business of the keiretsu. There isno formal government policy pushing towards the development of theseorganisations. The other differences are partly due to cultural differences betweenthe two countries:

Japanese society can be characterised as less family oriented and there is noparticular tendency to retain family ties within organisations.

Japanese companies tend to be far more co-operative than their Koreanequivalents. This manifests itself in a willingness amongst Japanese businessesto support one another rather than to seek competitive advantage when one ofthem has a problem.


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notesThere is one common stereotype of Japanese managers which does not really bearclose analysis. Japanese companies have a reputation for providing life-longemployment for staff and for providing a very rigid career progression formanagers. This is only true of the very largest companies. There is a vast numberof smaller companies, many of which act as sub-contractors to the keiretsu, whichcannot afford such a paternalistic environment. There is intense competition forentry to the very largest companies because these offer better salaries as well asconsiderably more security. Those who are unsuccessful are unlikely to spend thewhole of their working lives with the same employer. Those who do obtain astarting position with one of the keiretsu are unlikely to move to anotherorganisation, although there is a great deal of scope for internal mobility within theorganisation itself.

The structure of the keiretsuthemselves offers both advantages and disadvantages.They tend to be well diversified organisations, with a bank at the core. This meansthat there is scope for mutual support and even possible synergies between groupmembers. The tightly knit nature of these holdings was highlighted in 1990 whenthe American takeover entrepreneur T. Boone Pickens owned 26.43 percent of the

Japanese company Koito, and was its largest shareholder. Despite this, he couldnot force management to give him a seat on the board. Together, nineteenJapanese firms owned a majority of Koitos stock, and all supported management.There is, however, a corresponding problem in that any difficulties which affectthe keiretsu as a whole may be rather more difficult to deal with because of theintrospective nature of these organisations. Furthermore, the keiretsu are ratherdiffuse organisations. This can make it difficult for them to seek outside support,particularly from non-Japanese sources. One reason for this is that the variousaffiliates who are not actually members (eg some suppliers and distributors) tradein ways which create enormous off-balance sheet balances.

In very broad terms, the managers of Asian companies are likely to owe a jointallegiance: they will be accountable to their shareholders and also to the othercompanies in their business grouping. These loyalties are not really in conflict withone another because the chaebol/keiretsu are created by a series of interlockingshareholdings and so at least the larger members of the group will also beshareholders. In any case, the purpose of the arrangement is to createopportunities for long term prosperity and stability. Supporting a fellow membermight involve some costs, but those may be compensated by the fact that thegroup will rally round if the company ever finds itself in difficulty.

9.9.3 Future trends in Japanese corporate governanceAs was the case with Germany, the preceding analysis highlights the commonly

held outsiders views of Japanese business practice. There is, however, a trendtowards the US system which, in a sense, started with the US occupation at the endof the Second World War. The occupying powers attempted to break up theforerunners to the keiretsu, the zaibatsu, by issuing shares to employees and otherstakeholders. This led to the creation of the keiretsu when most of these newshareholders sold their equity to large block shareholders. This created a financialsystem which appeared relatively stable until the crisis brought about by theJapanese banking crisis at the end of the 1990s. This highlighted inefficiencies inthe banking system that had been tolerated in the past. It also accelerated thetendency away from debt towards equity and the wealth available through theglobal equity markets.


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notes9.10 SUMMARY AND CONCLUSIONS

This module has discussed the highly topical issue of corporategovernance. It has examined some of the situations in whichgovernance issues arise, described some of the forms thatgovernance structures might take and has discussed some of the

risks and associated controls that might be raised by a discussionof governance.

This is a wide ranging topic and one where no two individualscould be expected to agree on every point. Indeed, a great dealdepends on ones moral and ethical stance. While this means thatit is difficult to determine the most appropriate course of action, italso makes the area an interesting one for study.

The easiest way to prepare for a question on governance issues isto be aware of the broad principles underlying the variouspronouncements in the UK Corporate Governance Code andassociated guidance. Knowing why the code recommends aparticular course of action is probably more useful than attemptingto memorise every detailed requirement. It is also useful to keepabreast of real cases. The best source of these is the companynews section of the Financial Times or Big 4 publications.


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mod09 corporate governance

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