ACCA P1 Last Minute Notes Dec 2011

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• The remuneration Committeemay also be involved in authorising expenses for senior

member of the board, e.g. the chairman.

Remuneration Package

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The role of internal audit in internal Controls and Risk Management.

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FF plc and a ‘sound’ system of internal control

Features of sound control systems

The Turnbull code employs the term ‘sound’ to indicate that it is insufficient to simply ‘have’ an internal control system. They can be effective and serve the aim of corporate governance or they can be ineffective and fail to support them.

In order to reinforce ‘soundness’ or effectiveness, systems need to possess a number of features. The Turnbull guidance described three features of a ‘sound’ internal control system.

Firstly, the principles of internal control should be embedded within the organisation’s structures, procedures and culture.

Internal control should not be seen as a stand-alone set of activities and by embedding it into the fabric of the organisation’s infrastructure, awareness of internal control issues becomes everybody’s business and this contributes to effectiveness.

Secondly, internal control systems should be capable of responding quickly to evolving risks to the business arising from factors within the company and to changes in the business environment. The speed of reaction is an important feature of almost all control systems (for example a servo system for vehicle brakes or the thermostat on a heating system). Any change in the risk profile or environment of the organisation will necessitate a change in the system and a failure or slowness to respond may increase the vulnerability (ευπάθεια) to internal or external trauma.

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Thirdly, sound internal control systems include procedures for reporting immediately to appropriate levels of management any significant control failings or weaknesses that are identified, together with details of corrective action being undertaken.

Information flows to relevant levels of management capable and empowered to act on the information are essential in internal control systems. Any failure, frustration, distortion or obfuscation of information flows can compromise the system.

For this reason, formal and relatively rigorous information channels are often instituted in organisations seeking to maximise the effectiveness of their internal control systems

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Factors to be considered by the Board when taking a decision

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� Roles of the chairman in corporate governance The chairman is the leader of the board of directors in a private or public company although other organisations are often run on similar governance lines. In this role, he or she is responsible for ensuring the board’s effectiveness as a unit, in the service of the shareholders. This means agreeing and, if necessary, setting the board’s agenda and ensuring that board meetings take place on a regular basis. The chairman represents the company to investors and other outside stakeholders/constituents. He or she is often the ‘public face’ of the organisation, especially if the organisation must account for itself in a public manner. Linked to this, the chairman’s roles include communication with shareholders. This occurs in a statutory sense in the annual report (where, in many jurisdictions, the chairman must write to shareholders each year in the form of a chairman’s statement) and at annual and extraordinary general meetings. Internally, the chairman ensures that directors receive relevant information in advance of board meetings so that all discussions and decisions are made by directors fully apprised of the situation under discussion. Finally, his or her role extends to co-ordinating the contributions of non-executive directors (NEDs) and facilitating good relationships between executive and non-executive directors. Separation of the roles of CEO and chairman

• Benefits of separation of roles The separation of the roles of chief executive and chairman was first provided for in the UK by the 1992 Cadbury provisions although it has been included in all codes since. Most relevant to the case is the terms of the ICGN clause s.11 and OECD VI (E) both of which provide for the separation of these roles. In the UK it is covered in the combined code section A2. The separation of roles offers the benefit that it frees up the chief executive to fully concentrate on the management of the organisation without the necessity to report to shareholders or otherwise become distracted from his or her executive responsibilities. The arrangement provides a position (that of chairman) that is expected to represent shareholders’ interests and that is the point of contact into the company for shareholders. Some codes also require the chairman to represent the interests of other stakeholders such as employees. Having two people rather than one at the head of a large organisation removes the risks of ‘unfettered powers’ being concentrated in a single individual and this is an important

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safeguard for investors concerned with excessive secrecy or lack of transparency and accountability. The case of Robert Maxwell is a good illustration of a single dominating executive chairman operating unchallenged and, in so doing, acting illegally. Having the two roles separated reduces the risk of a conflict of interest in a single person being responsible for company performance whilst also reporting on that performance to markets. Finally, the chairman provides a conduit for the concerns of non-executive directors who, in turn, provide an important external representation of external concerns on boards of directors.

• Accountability and separation of roles In terms of the separation of roles assisting in the accountability to shareholders, four points can be made. The chairman scrutinises (διερευνά) the chief executive’s management performance on behalf of the shareholders and will be involved in approving the design of the chief executive’s reward package. It is the responsibility of the chairman to hold the chief executive to account on shareholders’ behalfs. Shareholders have an identified person (chairman) to hold accountable for the performance of their investment. Whilst day-to-day contact will normally be with the investor relations department (or its equivalent) they can ultimately hold the chairman to account. The presence of a separate chairman ensures that a system is in place to ensure NEDs have a person to report to outside the executive structure. This encourages the freedom of expression of NEDs to the chairman and this, in turn, enables issues to be raised and acted upon when necessary. The chairman is legally accountable and, in most cases, an experienced person. He/she can be independent and more dispassionate (αµερόληπτος - objective) because he or she is not intimately involved with day-to-day management issues.

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Critically Evaluate to have an international code of corporate governance (Single Code)

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� Distinguish between rules-based and principles-based approaches to internal control system compliance and discuss the benefits to an organisation of a principles-based approach

Distinguish between rules and principles This case refers to compliance with regard to internal control systems in particular but rules and principles are the two generic approaches to corporate governance and depend upon the nature of regulation. Rules-based control is when behaviour is underpinned and prescribed by statute of the country’s legislature. Compliance is therefore enforceable in law such that companies can face legal action if they fail to comply. In a principles-based jurisdiction, compliance is required under stockmarket listing rules but non-compliance is allowed based on the premise of full disclosure of all areas of non-compliance. It is believed that the market mechanism is then capable of valuing the extent of non-compliance and signalling to the company when an unacceptable level of compliance is reached.

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Benefits to an organisation There are four main benefits to the organisation of a principles-based approach. First , it avoids the need for strict compliance with inflexible legislation which, typically, fails to account for differences in size and the risk profiles of specific companies or sectors. This means (second) that compliance is less burdensome in time and expenditure for the organisation as the minutiae of general legislation can be interpreted in context rather than obeyed in detail. Third , a principles-based approach allows companies to develop their own sector and situation-specific approaches to internal control challenges. These will typically depend upon each company’s interpretation of its own internal control challenges. For example, physical controls over cash will be vital to some businesses and less relevant or not applicable to others. Fourthly , this, in turn, allows for flexibility and temporary periods of non-compliance with relevant external standards on the basis of ‘comply or explain’, a flexibility that would not be possible in a rules-based jurisdiction.

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Usefulness of Ethical Frameworks

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� Advantages of unitary board structure in general

There are arguments for and against unitary and two-tier boards. Both have their ‘place’ depending on business cultures, size of business and a range of other factors. In general, however, the following arguments can be put for unitary boards.

One of the main features of a unitary board is that all directors, including managing directors, departmental (or divisional) directors and NEDs all have equal legal and executive status in law. This does not mean that all are equal in terms of the organisational hierarchy (ιεραρχία), but that all are responsible and can be held accountable for board decisions. This has a number of benefits.

Firstly, NEDs are empowered, being accorded equal status to executive directors. NEDs can bring not only independent scrutiny to the board, but also experience and expertise that may be of invaluable help in devising strategy and the assessment of risk.

Second, board accountability is enhanced by providing a greater protection against fraud and malpractice and by holding all directors equally accountable under a ‘cabinet government’ arrangement. These first two benefits provide a major underpinning to the confidence that markets have in listed companies.

Third, unitary board arrangements reduce the likelihood of abuse of (self-serving) power by a small number of senior directors. Small ‘exclusivist’ boards such as have been evident in some corporate ‘scandals’ are discouraged by unitary board arrangements.

Fourth, the fact that the board is likely to be larger than a given tier of a two-tier board means that more viewpoints are likely to be expressed in board deliberations and discussions. In addition to enriching the intellectual strength of the board, the inclusivity of the board should mean that strategies are more robustly scrutinised before being implemented.

Critically evaluate Annette’s belief that two-tier boards are preferable in complex and turbulent environments such as at Ding Company

Critically evaluate Annette’s belief Countries differ in their employment of various types of board structure. Companies in the UK and US have tended towards unitary structures while Japanese companies and some European countries have preferred two–tier or even multi-tier boards. The distinction refers to the ways in which decision-making and responsibility is divided between directors. In a unitary structure, all of the directors have a nominally equal role in board discussions but they also jointly share responsibility (including legal responsibility) for the outcome of those discussions.

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On a two tier board, the senior board acts as a ‘kitchen cabinet’ in which decisions are concentrated whilst other directors, typically departmental managers, will be on the ‘operating board’ and brought into board discussions where the senior (upper tier) board deem it appropriate. There are some arguments in favour of the adoption of a two-tier structure in turbulent environments. As the case implies, turbulent (ταραχώδης) and dynamic environments change often and strategic leadership is partly about continually adjusting strategy to optimise the company’s fit with its environment. A smaller board can act quick and decisively in a way that larger and more cumbersome boards cannot. This is because meetings of larger numbers of people require excessive consultation, discussion and debate before a decision can be reached. When a decision needs to be taken quickly, this can be inconvenient. The meeting of a small number of people is therefore easier, cheaper and quicker to arrange because there are fewer diaries to match. As these arguments focus on both the efficiency and effectiveness of strategic decision-making, Annette has a strong case for supporting two-tier boards. The arguments against two-tier boards are as follows. In any complex situation where finely balanced judgments are made, such as making strategic decisions in turbulent environmental conditions, input from more people is likely to provide more views upon which to make the decision. Where, say, technical, detailed financial or operational details would be of benefit to the decision then a larger board would be likely to provide more feedback into the decision making process. The second reason is that decisions taken by a corporate board with little or no consultation with the operating board may not enjoy the full support of those key departmental directors who will be required to implement the decision. This, in turn, may cause friction, discord and resentment that will hinder good relations and thus impede the implementation of the strategy. Additionally, without a full understanding of operations, an inappropriate decision may be taken by the corporate board and unworkable procedures implemented. Finally, Annette is quite an autocratic personality and the two-tier board may be little more than a device to grant her excessive powers over company strategies and activities.

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� Explain how a family (or insider-dominated) business differs from a public listed company and, using evidence from the case, explore the governance issues of a family or insider-dominated business.

Difference A family or insider-dominated business is one in which the controlling shareholding is held by a small number of dominant individuals. In many cases, these individuals will also work for the business making them owner-managers. When the insiders belong to a nuclear or extended family it is common to refer to the business as a family firm. In a listed company, the shares are dispersed between many shareholders, the shares are publicly traded and managers are unlikely to be substantial shareholders themselves (although they may own shares as a part of their reward packages).

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Explore the governance issues

• The agency issues are quite different in the two types of business. There are usually lower agency costs associated with insider-dominated businesses (family business) owing to there being fewer agency trust issues.

• Less monitoring is usually necessary because the owners are often also the managers.

Principals (majority shareholders) are able to directly impose own values and principles (business or ethical) directly on the business without the mediating effect of a board. In the case of ‘Healthy and happy’, Ken and Steffi have been the majority owners for all of its 40 years and as long as they trust each other, director monitoring costs should be very low. This is complicated by the new knowledge that there are trustworthiness questions over Ivan. Short and long-term decision-making issues and the pursuit of motives other than short-term profits. A smaller base of shareholders are more likely to be flexible over when profits are realised and so the expectations of the rates and timings of returns are likely to be longer. This gives management more strategic flexibility especially if, as is the case at ‘Happy and healthy’ the purpose of the business is simply to leave it in a good state to pass on to Ivan when Ken and Steffi retire. Ken and Steffi are motivated by factors other than the pursuit of short-term profit, such as promotion of healthy food, good service to customers, etc. ‘Gene pool’ and succession issues are common issues in family businesses. It is common for a business to be started off by a committed and talented entrepreneur but then to hand it on to progeny who are less equipped or less willing to develop the business as the founder did. When the insiders are unwilling or unable to buy in outside management talent then this issue is highlighted. There are clearly doubts over Ivan’s commitment to the business if he has started up a competing business with his wife and this may mean an unfortunate outcome for ‘Happy and healthy’. In addition, there are important differences in the formality of nominations, appointments and rewards. In larger companies these matters are dealt with by a formal committee structure whereas they are likely to be more informal in family businesses. ‘Feuds’ and conflict resolution can be major governance issues in an insider-dominated business.

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Whereas a larger bureaucratic (γραφειοκρατικός) business is capable of ‘professionalising’ conflict (including staff departures and disciplinary actions) this is less likely to be the case in insider-dominated businesses. Family relationships can suffer and this can intensify stress and ultimately lead to the deterioration of family relationships as well as business performance. Ivan’s actions are likely to be relevant here as his transfer of inventory to Barong Company is likely to place a severe strain on the Potter family relationships. � Explain the content of a director’s induction programme and assess the

advantages of such a programme for Sam (a new director ( financial controller).

Director’s induction programme The overall purpose of induction is to minimise the amount of time taken for the new director to become effective in his or her new job. There are four major aspects of a director’s induction.

1) To convey to the new starter, the organisation’s norms (κανόνες), values and culture. This is especially important when the new employee is from a different type of culture.

Because Sam moved from a different country to join Ding Company, he had to adjust to a new national culture as well as a new corporate culture. There is evidence from the case that he misunderstood some of the cultural norms in that it was alleged that he made what he considered normal but what was perceived as an inappropriate remark to a young female employee. An induction programme including content on culture and norms may have prevented this situation from occurring.

2) To communicate practical procedural duties to the new director including company policies relevant to a new employee.

In Sam’s case this would involve his orientation with his place in the structure, his reporting lines (up and down), the way in which work is organised in the department and practical matters. In the case scenario, Sam made a simple error in the positioning of his office furniture. Again, this is an entirely avoidable situation had the induction programme provided him with appropriate content on company policy in this area.

3) To convey an understanding of the nature of the company, its operations, strategy, key stakeholders and external relationships.

For a new director, an early understanding of strategy is essential and a sound knowledge of how the company ‘works’ will also ensure that he or she adapts more quickly to the new role. In the case of a financial controller such as Sam, key external relationships will be with the company’s auditors and banks. ` If Sam is involved in reporting, the auditor relationship will be important and if he is involved in financing, the banks and other capital providers will be more important.

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4) To establish and develop the new director’s relationships with colleagues, especially those with whom he or she will interact on a regular basis.

The importance of building good relationships early on in a director’s job is very important as early misunderstandings can be costly in terms of the time needed to repair the relationship. It is likely that Sam and Annette will need to work together to repair an unfortunate start to their working relationship as it seems that one of her first dealings with him was to point out his early misunderstandings (which were arguably due to her failure to provide him with an appropriate induction programme).