THE INSTITUTE OF CHARTERED ACCOUNTANTS OF SCOTLAND

TEST OF PROFESSIONAL EXPERTISE

CONTENTS Page
CORPORATE GOVERNANCE .................................................................................. 1 9.1 INTRODUCTION ................................................................................................. 1 9.2 LEARNING OBJECTIVES ................................................................................... 1 9.3 WHAT IS CORPORATE GOVERNANCE? ......................................................... 2 9.4 GOVERNANCE SITUATIONS ............................................................................ 4 9.5 GOVERNANCE AND CONTROLS ..................................................................... 5 9.5.1 Non-executive directors .................................................................................. 8 9.5.2 Governance by exit ......................................................................................... 9 9.5.3 Risk management.......................................................................................... 11 9.5.4 The UK Corporate Governance Code ......................................................... 12 9.6 INTERNAL AUDIT ............................................................................................ 12 9.6.1 Types of Internal Audit ................................................................................. 13 9.6.2 Operational Audit ......................................................................................... 13 9.6.3 Management Audit ....................................................................................... 14 9.6.4 Value For Money Audits............................................................................... 15 9.6.5 Post Investment Reviews............................................................................... 16 9.6.6 Compliance audits ........................................................................................ 17 9.7 INTERNAL AUDIT AND CORPORATE GOVERNANCE .............................. 17 9.7.1 Independence ................................................................................................ 18 9.7.2 Audit Committees ......................................................................................... 18 9.8 EXTERNAL AUDIT ........................................................................................... 19 9.9 ALTERNATIVE BUSINESS SYSTEMS ........................................................... 20 9.9.1 Corporate Governance in Germany ............................................................. 20 9.9.2 Corporate Governance in Korea and Japan ................................................ 22 9.9.3 Future trends in Japanese corporate governance ........................................ 24 9.10 SUMMARY AND CONCLUSIONS ................................................................. 25 ICAS 11

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CORPORATE 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, but these are almost never contested. Whenever they are, the incumbent government wins by an overwhelming majority. All the information about the state of the nation which the voters receive is controlled and distributed by the government and is glossy and self-congratulatory in tone. Changes in the senior leadership do take place, normally through an orderly process of retirement in which the incumbent leaders select and groom their successors. Occasionally there is a more violent change. Sometimes this takes the form of an internal coup detat. Or it may occur as a result of the intervention of the hostile government of another state. This is not a description of Eastern Europe before perestroika and glasnost. It is a description 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, rather exaggerated in tone. Having said that, it does contain some insights which might help introduce the topic of corporate governance. The purpose of this module is to introduce some of the issues which have been raised by the whole topic of corporate governance in recent years. It looks beyond the detailed reports and pronouncements by the various committees who have contributed to the debate. It examines some of the controls which have been applied in the UK and the manner in which they have actually worked. The module concludes with a description of some of the alternative forms of governance which have been developed elsewhere in the world. While these may not appear to have much direct relevance to the UK, they do at least show that there is no particular reason why our present system of regulation could not change. The basic approach throughout this module will be to discuss and to question rather than to describe and provide factual information. This is an interesting topic and one which has enormous implications for the whole of society. It is, however, a topic which has particular relevance to the accountancy profession.

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9.2 LEARNING OBJECTIVES

By the time you complete this module, you should be able to: 1. 2. 3. Recognise the different systems of governance and business structures Evaluate and advise on different corporate governance systems and controls Exercise professional judgement in corporate governance situations

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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 issues which have been debated and written about for several decades. These issues include 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 between the different groups and individuals who are seen to have an interest in the activities of an entity. These interests are viewed as having the capacity to come into conflict.

ACTIVITY Several years ago Waterstones, a major chain of book retailers, created the worlds largest book shop in Piccadilly in the centre of London. The site they had chosen is a listed building which was previously occupied by Simpsons, a famous retailer of high quality British clothing. The store had become available because the Japanese corporation which owned DAKS Simpson, the stores parent company and the supplier of most of its merchandise, did not feel that it was sufficiently profitable. This new store affected the other bookshops already in Piccadilly including Hatchards, which is one of the oldest in the country. Even though Waterstones is a subsidiary of HMV, a major entertainment group, it is reasonable to assume that the cost was raised by borrowing. A number of groups who might have been affected by this investment are listed below. In each case: 1. 2. think about how they could be affected by Waterstones decision to purchase the store and convert it into a major book shop and decide whether their interest in the decision is one which should be taken into account by the managers of Waterstones. (a) (b) (c) the shareholders of HMV the employees of Simpsons the customers of the relatively small book stores located at university and college campuses in Central London (eg the Economist book store at the London School of Economics roughly a twenty minute walk away from Piccadilly) the bankers who will provide the finance for the purchase the author of an accountancy text book

(d) (e)

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Solution The shareholders of HMV suffer the risks and enjoy the rewards associated with the new business venture. If it is successful then the share price will increase, thereby increasing their wealth. Clearly the managers of Waterstones should have evaluated the market potential of the site and the likely costs and revenues and should not have decided to proceed unless the decision was in the best interests of the shareholders. There is, however, a theoretical possibility that they were motivated by other factors: The prospect of creating the worlds largest bookstore could have appealed to their egos. Short-term profit considerations might have affected their immediate dividend payments.

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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 relationship which affects all companies that are not owner-managed. There is always a concern that managers will act in a manner which suits their own interests, even if these are in conflict with those of the shareholders. The employees of Simpsons lost their jobs when the store closed down. Even though they were directly affected by the sale of their store, the managers of Waterstones are unlikely to feel any sense of responsibility for this. If they had not bought it then the owners would probably have sold it to someone else rather than 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 customers the benefits of the specialist local knowledge of courses and reading lists which are offered by such stores. Arguably, this should not concern the management of Waterstones. After all, if the customers of a particular store value its service then they can and should support it with their custom. It is also perfectly legitimate for a business to compete by entering a new market and offering a better product than that currently on offer. This argument is not, however, quite so clearcut. It is not necessarily in the public interest for large entities to increase their market share to the point where they can drive competitors out of business. It might be argued that the use of such a strategy would not be in the companys best interests because of the impact which it might have on public opinion. A reputation for ruthlessness may discourage customers. If that argument is accepted, it is also possible that the company considered the effects of their decision on the staff of Simpsons because of the danger of being associated with the closure of a famous UK institution (Simpsons is reputed to be the inspiration for the famous television comedy Are You Being Served?).

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The bankers would have been keen to ensure that their advance is repaid on time and with appropriate interest. They undoubtedly protected their own interests by demanding detailed forecasts and projections in support of the loan application. They would also have required adequate security, probably on the listed building itself. There would have been no need for the directors of Waterstones to worry about 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 the outcome of this investment then it would have demanded a higher rate of interest or a broader security or loan covenant. This suggests that Waterstones management should have considered the banks interests, if only because these would have a direct impact on the conditions attached to the loan. Finally, the poor struggling author might not have been directly affected by the new store in itself, but could be affected by the broader implications of the changing book market. Concentrating the book market in the hands of a smaller body of retailers forces publishers to deal with larger and more powerful customers who can demand larger discounts against the suggested retail price. Authors royalties are based on the net amounts received by the publisher and so larger retailers lead to smaller royalty payments. It is possible that larger stores which have fewer competitors will feel less pressure to stock a wide range of books, thereby leaving more space to display the latest best sellers. Both factors could discourage the creation of the new books upon which the book selling industry depends. It is unlikely that Waterstones would consider the authors interests. You might not agree with the whole of the above analysis - indeed you should have thought about each case and formed your own opinion. The main purpose of the activity was, however, to demonstrate that the boundaries of corporate governance are wide open and rather ill-defined. Even if you disagree with some of the issues raised, you cannot deny that the debate is going on. The traditional view of corporate governance was concerned mainly with the triangular relationship between directors, shareholders and lenders, each of whom had a different set of interests, aims and objectives. (Note the monitoring role of the auditors giving assurance to those not directly involved in the business.) This has given way to arguments that businesses have a broader responsibility to employees and to society at large. Unfortunately, even that discussion is complicated by the fact that some organisations use claims that they are responsible employers or corporate citizens as a promotional device and could, therefore, be behaving as good citizens in order to win business and thereby increase their shareholders wealth.

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 judgement on 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 terms should be offered?

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

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A huge amount of attention has been paid in recent years to developing new frameworks for the regulation of business. The accountancy profession, in conjunction with a variety of other regulators and interested parties, has participated fully in the workings of the Cadbury, Greenbury, Hampel and Turnbull committees. The Smith and Higgs reports led to the publication of a revised Combined Code in 2003 (see section 9.5.4). These committees have all had different remits, but most deal with the development of checks and balances to make it more difficult for company directors to take unfair advantage of their positions. The reports of these committees were discussed at TPS, principally in TPS Auditing & Reporting/Assurance and Business Systems, and so this module will not look at these directly but will deal with some of the issues that actually arise 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 and politicians in the mechanisms by which businesses have been run: The Robert Maxwell affair highlighted the dangers associated with having an undue amount of power in the hands of one individual. Tabloid press coverage of fat cat directors salaries in the mid 1990s raised questions about the legitimacy of directors deciding their own remuneration. The collapse of Barings Bank led to an outcry because senior management had been aware of the control weaknesses which permitted the manager in question to exceed his authority and expose the bank to unacceptable risks on the currency markets. This led to a broader concern about the need for boards to assess risks and to accept responsibility for establishing an appropriate control environment in response to these.

Corporate governance is not a discrete subject with clearly defined boundaries. It is broadly concerned with the management of companies and encompasses a range of issues that include finance, psychology, ethics, human resource management and a host of others. Taking a single concrete issue: the appointment of a new chief executive raises questions about the effect that this would have on stock market confidence, the suitability of different candidates for the post and the response of the workforce and of other senior managers to the final choice. Apart from the internal deliberations, this appointment could also be endlessly debated in the financial press and in analysts briefing documents and so there are also important public and investor relations issues that have to be managed as well as considered. Bearing that in mind, you cannot expect the whole of corporate governance to be covered in this one module. Nor should you be surprised if you find 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 been put 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 which the business is run and partly because it is important to understand the spirit behind the rules in order to implement them correctly.
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Many of the issues associated with corporate governance arise because of concerns that directors and managers of companies might put their own interests before those of the shareholders. This is known as the agency problem. Traditionally, the UK system of governance has operated on the basis of accountability through disclosure. The shareholders (principals) have been able to monitor the stewardship of their directors (agents) by means of the annual report, supplemented by the interim financial statements and the opportunity to ask questions at the general meeting. A great deal of time and energy has been spent researching the agency problem and numerous papers have been published on its different aspects. For example, it has been suggested that the agency problem is particularly severe in some companies. The directors of such companies will have a greater incentive to reassure shareholders and lenders that the company is being managed honestly and responsibly. This can encourage behaviour which can be measured and researched, such as a tendency to switch to a larger and more expensive audit firm. Academic research on the agency problem often provides more questions than answers, partly because the results of different studies are often contradictory.

ACTIVITY A series of papers was published on the topic of auditor resignations. These examine the effectiveness of the auditors duty to report to the shareholders and creditors on any circumstances associated with the resignation. An analysis of several hundred resignation statements suggested that only a tiny proportion of cases led to anything other than a nil response. A second paper examined the audit fees charged by replacement auditors following a resignation. The tendency for 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 reportable facts when they left. A third paper suggested that, despite the auditors assurances that there are no reportable facts, the share price tends to fall in response to the announcement of the resignation. (a) Describe the relationship between the shareholders and auditors in terms of agency and explain why a resigning auditor might not be motivated to act in the best interests of the shareholders. Try to suggest how the first and second papers might appear to demonstrate that auditors do, in fact, act in their own interests rather than those of the shareholders. It might be argued that the auditor does not have to make any explicit statement about the reasons for resignation because the third paper demonstrates that the market can infer these. Do you agree?

(b)

(c)

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Solution (a) The shareholders are unable to check the truth and fairness of the financial statements for themselves and so they are forced to appoint the auditors to carry out this task on their behalf. In that sense, the auditor is acting as an agent on behalf of the shareholders. There will always be a possibility that any agent will not act in the best interests of the principal and that is as true of auditing as any other activity. The auditors most obvious economic incentive is to collect as many fees as possible at the least cost. Minimising cost might involve reducing the amount of evidence collected or taking steps to avoid risking the audit firms reputation, either of which may not be in the best interests of the shareholders. It is difficult to see why an auditor would wish to resign. Doing so involves the loss of future revenues from that client and so it is unlikely that the auditor would resign without a good reason. An auditor might resign as a formal act of protest in order to highlight some problem with the company. This does not appear to happen often in practice because virtually all of the reported statements are nil returns. Resignation might also provide the auditor with a means of escaping from a difficult situation such as the existence of doubts about the integrity of management. The fact that incoming auditors tend to charge more than they would normally in the aftermath of a resignation suggests that such audits are regarded as high-risk. This evaluation is being made by a firm which will probably have had an opportunity to explore the reasons for the departure of the previous firm and who will also have had some experience of resigning from other appointments. Taking the findings from both of these papers together suggests that auditors sometimes may resign to avoid bringing some matter to the attention of the shareholders. An interesting example of an audit resignation was Coopers & Lybrands resignation as auditors of computer software firm Eidos in August 1998. C&L gave as reason certain inadequacies in the companys corporate governance practices and those included the failure to review the effectiveness of financial controls. The audit work had been worth 130,000 in the previous year. The whole episode was part of the reason for a short-term slide in Eidos share price. This resignation did not, however, mean that Eidos could not get an international 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 the failures were exceptional and due to rapid growth by the company and that the problems would be rectified as soon as practically possible. The fact that the share price reacts indicates that shareholders have a simple mechanism for dealing with any major uncertainty about the management of their company, namely that they can sell their shares. Unfortunately, this is not a satisfactory alternative to full and clear disclosure of all relevant facts. Only those shareholders who have the means to monitor all company filings and announcements will be able to sell quickly in response to the resignation.

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(b)

(c)

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The response to this activity suggests that some of the codified safeguards in the UK system of corporate governance, such as the disclosure requirements imposed on resigning auditors, may not be effective. Others, such as the cultural and institutional frameworks which make it relatively easy to sell shares if the shareholders have doubts about management, are not codified but do provide an effective remedy for doubts. It would appear that it is necessary to look beyond the letter and even the spirit of the rules and regulations in order to form a judgement about the effectiveness of a set of procedures.

9.5.1 Non-executive directors

The Cadbury Committee argued that the appointment of suitable non-executive directors was a particularly important way in which a company could reassure its members and other stakeholders that the company was being managed responsibly.

ACTIVITY For each of the following assertions about nonexecutive directors, circle the response which best describes your opinion. 1. 2. 3. 4. Non-executive directors are always independent of the company. Non-executive directors are always independent of the executive directors. Non-executive directors will always be able to monitor the activities of the executive directors. Non-executive directors will always have an overwhelming motivation to stand against any dishonesty. Agree/Disagree Agree/Disagree Agree/Disagree Agree/Disagree

Solution None of these assertions lend themselves to an absolutely categorical response. All do, however, require a certain amount of scepticism. 1. There is no guarantee that non-executives will be linked to the company through their directorships and nothing else. Indeed, Cadbury introduced the concept of independent non-executives. Some non-executive directors 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 covenant and so on. Some of the so-called independent non-executives may have been drawn from the ranks of friends and business contacts of the executive directors. There is also a possibility that the appointments will be relatively lucrative and that the nonexecutives will be loath to upset their colleagues on the board without good reason. Surveys have shown that some non-executives have very little contact with the company, beyond attending a board meeting every few months. In such cases, their knowledge of the company will be drawn from the minutes, reports and other documents prepared by the other board members.

2.

3.

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In theory the non-executive directors will wish to maintain and protect their reputations for honesty and integrity. In practice, they may feel that the markets cannot distinguish honest nonexecutives any more easily than it can honest executive directors. Given that many nonexecutive directors will wish to have a string of such appointments, they may feel that creating a fuss about some problem with the company will actually create an impression that they are obstructive.

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The concerns outlined above are somewhat pessimistic and do not reflect the situation in all boards. However, the fact remains that the system may not always enable or encourage non-executive directors to fulfil the purpose of their appointment. A weak group of non-executives would actually be worse than useless because they could lull shareholders into a false sense of security. In practice, non-executive directors are being asked to spend increasing amounts of time on governance issues, with a corresponding increase in their overall commitment to the company. Typically, a non-executive director will devote 1521 days per annum to the task. In 2003 the average fee for holding such a position was reported as 20,950 for a small company rising to 34,250 for a large company. Despite the rewards, it appears difficult to identify suitable candidates. Traditionally, appointments have been given to current or retired executive directors from other companies. Some companies make use of executive search agencies to locate suitable candidates, although this can prove costly. Other companies are turning to local contacts, such as solicitors and other professionals, whose backgrounds may actually make them more suitable for the governance role than executives.

9.5.2 Governance by exit

The last few pages have discussed some of the provisions which have been designed with the explicit intention of providing good corporate governance. While these would undoubtedly serve their purpose there is no guarantee that they would be fully effective. Market forces will, however, tend to deter such selfseeking behaviour. While this might not be enough to guarantee that the company will 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 into or out of a particular company and shareholders tend to have very little loyalty to any given company or its management. Finally, there is a long tradition of contested takeover bids. Taken together, these factors mean that anyone who has sufficient capital could acquire a controlling interest in a company which appears to be offering a poor rate of return. If that persons opinion about the quality of the current management team is correct then the appointment of a new management team will improve the companys profitability and increase the share price by enough to cover the costs incurred in the course of the takeover. The possibility of a takeover should be enough to encourage management to perform to the best of their ability. In addition, they will have to ensure that the stock market perceives the company as being well managed in order to deter either misinformed 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 a defence.

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ACTIVITY It has been argued that the takeover mechanism can lead to dysfunctional behaviour on the part of both potential bidders and targets. Go through the following list of criticisms and decide whether each is most likely to apply to the bidding company or the one which is the subject of the offer. 1. 2. 3. Directors may adopt a short-term outlook. Bidder/Target Directors may have unbalanced investment Bidder/Target portfolios. Directors may have vested interests in evaluating Bidder/Target the transaction.

Solution 1. The threat of takeover might encourage all company directors to take a short-term outlook in order to reduce the risk of their company becoming a potential target. If they cut back on expenditure on areas such as maintenance, asset replacements and so on they will avoid the temporary decrease in profitability or return on capital employed associated with these. Doing so may, of course, reduce the long term profitability of the company, although that might be regarded as a price worth paying in order to protect their immediate security. The directors of the bidding company will almost certainly have different levels of exposure to problems with the company than their shareholders will. Any sensible shareholder will invest in a portfolio of investments so that a problem with one is likely to be compensated by strength in another. The directors do not have this same capacity to diversify. They are likely to regard their company salary and benefits package as their main source of income. Share options may mean that company shares will form a major portion of their other financial resources. Thus the directors might be tempted to take over other businesses in order to spread the risks of their stake in the company failing. Doing so may be of little benefit to the shareholders because they can easily diversify for themselves simply by holding shares in a range of different companies. The directors of the target company may be motivated by the fact that a successful bid is likely to leave them unemployed. They may defend the bid even if the bidder has offered a fair amount because of the threat to their personal livelihoods. This imposes an opportunity cost on the shareholders, assuming that they would have received more than the market price. Furthermore, their company will have to spend a great deal on professional services, advertising, printing and so on in order to fight off the bid.

2.

3.

There are other costs associated with takeovers. For example, some takeovers are only commercially feasible because the bidder intends to reduce the pay and conditions of the target companys work force. This ruthlessness has the effect of shifting 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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There have also been a number of studies which tend to suggest that the benefits predicted by the bidding companys directors can be extremely difficult to realise once the bid succeeds. Effectively, this means that it is often against the interests of the bidding shareholders to proceed with a bid. The threat of takeover might have the effect of providing the shareholders with some reassurance that the directors will act to maximise their wealth, but even this mechanism can lead to dysfunctional behaviour. There may, however, be a tendency to overstate the importance of matters such as salary and job security to senior managers. A survey of directors attitudes suggested that job satisfaction and the opportunity to work in a challenging environment were far more important than the factors which motivate employees at lesser levels. While there will always be doubts about the responses to any questionnaire or interview-based survey, 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 took out 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 of any severance package and so he had very little to lose from borrowing heavily.

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9.5.3 Risk management

Much of the emphasis in corporate governance is moving to the development of procedures to manage risks. The Turnbull Committee has produced guidance for directors on implementation of the internal control aspects of the Combined Code. The following quotes from the Code summarise the key aspects of the new guidance: The board should maintain a sound system of internal control to safeguard shareholders investment and the companys assets. The directors should, at least annually, conduct a review of the effectiveness of the groups system of internal controls and should report to shareholders that they have done so. The review should cover all controls, including financial, operational and compliance controls and risk management. In addition, the board should regularly receive and review reports on internal control. Thus, the traditional emphasis on the accounting and financial controls which have been regarded as paramount in the past will make way for a much broader concern for all business risks and controls. The boards responsibilities are also likely to be broadened by an explicit statement that the whole board is responsible. It is not acceptable to delegate these duties to the audit committee, although it may be that a small sub-committee of the board will actually undertake much of the detailed monitoring and review work. The risks faced by senior managers could go beyond the threat of being sued for damages. In October 2000 a high-speed train left the track at Hatfield, killing four passengers and seriously injuring a further 30. The subsequent investigation into the tragedy revealed that senior managers in Railtrack and their primary contractor were aware that the track was in poor condition and that the tragedy could have been averted by imposing a speed restriction until the line could be repaired. British Transport Police has passed a report to the Crown Prosecution Service indicating that manslaughter charges could be brought against five senior managers. The Crown Prosecution Service has also indicated that it could consider corporate manslaughter charges against the companies. If such an action was taken then the companies could face an unlimited fine while any managers found guilty could be jailed.

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The Combined Code 2008 was replaced by the UK Corporate Governance Code June 2010. The new code applies to accounting periods beginning on or after 29 June 2010. The code was developed from refinement of earlier versions and includes main principles and provisions, as well as supporting principles. The board should follow the principles of the code. The detailed provisions are a guide 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 the new code. It also allows the board to follow fundamental principles rather than ticking off a list of rules which will not necessarily guarantee that the desired outcome is achieved. The Code contains 18 main principles and 52 provisions for companies and these are structured under the following sections: Companies A. Leadership B. Effectiveness C. Accountability D. Remuneration E. Relations with Shareholders A separate Code has been developed to set out good practice for investors on engagement with their investee companies. This is called The UK Stewardship Code. A copy of the UK Corporate Governance Code 2010 is included as an appendix in TPE Module 11, along with details of the key changes and new provisions in this code.

9.5.4 The UK Corporate Governance Code

9.6 INTERNAL AUDIT

The controls that were discussed in section 9.5 were concerned with controls associated with the structure of the board and ensuring that the executive directors did not think that they could run the business without regard to the interests of the shareholders and other stakeholders. The internal audit function is more concerned with the actions of lower level managers and staff in ensuring that they follow the boards instructions. By doing so, this should mean that all staff are working towards furthering the shareholders interests rather than their own. This section will describe the operation of the internal audit function. Section 9.7 will build on this by linking internal audit more directly to corporate governance. Internal audit has progressed significantly in recent years and continues to develop to meet the ever changing needs of business and management. Internal audit is perceived, in progressive organisations, as a source of advice and guidance that assists executives in their responsibilities for the management of business risk. It helps management to ensure that the whole system of controls, financial and otherwise, is adequate and effective in reducing risk to acceptable levels. This assists the organisation in conducting its business in an orderly and efficient manner. Internal auditors provide management with recommendations and guidance on solutions to problems.

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9.6.1 Types of Internal Audit

Risks and systems of control vary according to business needs and it is not practicable to generalise on the scope of work that should be covered by internal audit. Indeed it is the Board of an organisation that will ultimately determine the scope of work of its internal audit function. The scope will be primarily concerned with contributing in some way to the achievement of the management objectives. These terms will vary considerably from one organisation to another. A recent survey conducted by the Audit Faculty of the Institute of Chartered Accountants of England and Wales, revealed a wide range of work being undertaken by internal audit departments both in the private and public sectors. The highest proportion of internal audit effort is devoted to audits of operations and business processes, followed by financial audits, IT systems reviews, fraud and special investigations and 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

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9.6.2 Operational Audit

Operational audit is a service provided to operational management which gives assurance that operational objectives are valid, control information is reliable and that activities are effective, efficient and economic. It is the audit of control in the functional areas of a business as distinct from the controls that are exercised within the accounting and financial departments of the business. These functional areas might be marketing, sales, distribution, production, and so on, depending on the nature of the business. Operational audit is not a universal panacea for all management problems. A first essential is a strong commitment by the management to whom the service is being provided. Effective results depend upon good collaboration between the operational auditor and the user of the service. Ideally the user management should identify the areas needing operational audit examination and initiate the request for the service. The key to effective operational audit is in developing a programme of audit tests which will enable the auditor to make a positive contribution to management performance. The following is an example of how an operational audit of the marketing function can be used to contribute positively to achieving management objectives. Example: an operational audit of marketing The audit objective should be to assist in enhancing the quality of marketing judgements and the effectiveness of their application. Auditing skills can be applied to evaluate the information bases and the rationale used in forming marketing judgements but the auditor must take care to stop short of second guessing the experts. In this way there can be considerable potential for the audit of marketing activity to contribute positively to operational effectiveness in the pursuit of corporate objectives.

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The audit tests should be designed to analyse information validity and application effectiveness 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 of the information base and the rationale for its interpretation interpreting by asking the following questions: What market research has been done? Consider alternative sources of information. 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 forecasts been fully accepted and adopted? Are the forecasts feasible in terms of the potential resources and capacity of the business?

9.6.3 Management Audit

The distinction between management audit and operational audit is not always clear, however management audit is concerned with the objective and independent appraisal of the effectiveness of managers and corporate structures in the achievement of company objectives and policies. It is the audit of procedures by which the management of the organisation control the resources available to achieve business requirements, whereas we have seen above that operational audit is concerned with the audit of control in functional areas of the business such as warehousing, distribution, marketing etc. An example of a key management audit would be manpower and succession planning. Nothing is ever static in business and the general ability of an organisation to pre-empt anticipated change and adequately plan for its consequences can be a fundamental matter of survival. Any company will need to ensure that the workforce is capable of meeting both the current and foreseeable demands. In a dynamic employment situation, staff will be promoted and move into other areas of the organisation and there should be mechanisms in place to ensure that other employees are suitably groomed and waiting in the wings to move into the vacated positions. Management audit therefore reviews the underlying fundamental policies and procedures within an organisation which are just as critical to its successful operation as the efficient performance of its functional departments.

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9.6.4 Value For Money Audits

Value for money audit is, very broadly, a function provided by internal audit with the aim of identifying and recommending to management ways in which they may maximise its return on resources employed. It frequently makes extensive use of performance indicators in the form of ratios and other statistics (average turnaround time, ratio of stock held to turnover) to give an indication of value for money, especially when trends are explored in these performance indicators over time, or variations in performance are identified and explored between different operating units. The term value for money is often applied to public sector spending in the UK where there is an implied obligation on public bodies to ensure that they obtain and provide services on the most economic grounds. However, VFM auditing is not limited to the public sector. Much of the methodology which has been developed is applied in the private sector. It is now generally accepted that VFM auditing consists of three interdependent elements: Economy: which is concerned with obtaining the appropriate quantity and quality of resources (physical, financial and human) at lowest cost. Efficiency: which is concerned with the relationship between goods or services produced and the resources used to produce them. Effectiveness: which is concerned with how well an activity is achieving its policy objectives 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 as health and education where the outputs are extremely difficult to quantify. VFM audits can take the form of selective investigations of signs of possible extravagance, inefficiency, ineffectiveness or weakness in control. For example, why a building project overran its costs or timetable or failed to meet the requirements for which it was designed. On a smaller scale, ad hoc investigations of value for money can produce useful improvements in systems and can foster cost consciousness throughout the organisation. It is a feature of VFM audit that the auditor often finds it useful to draw upon examples where similar bodies (or operating units) have been successful in securing arrangements for economy, efficiency and effectiveness in particular activities. He takes such examples of good practice and examines how far they can be applied to the body or operating unit under audit. Benchmarking has become a common assessment tool for management. There are a number of government bodies and trade organisations who maintain databases of information on different industry sectors. These sources, along with internal performance data, are often used to benchmark.

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ACTIVITY Consider a distribution company. What objectives would you expect a VFM audit to achieve in relation to the distribution process?
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Solution Management would want to receive assurance that it was achieving the three Es as follows: Economy Vehicles have been purchased/leased for the lowest cost. The sizes of vehicles owned are suitable for the required deliveries. Appropriate manning levels are in place to minimise wage levels. Efficiency Sufficient vehicles are owned to deliver all goods. Appropriate manning levels are in place to cover the various levels of deliveries at different times. Percentage of vehicle usage is maximised. Cost per vehicle is minimised. Percentage of idle time for vehicles is minimised. The cost per delivery is minimised. Effectiveness Goods are delivered in good condition, on time to the consumer; There are minimal customer complaints; Benchmarking against similar company or other operating units in the same company prove favourable. In carrying out a VFM audit, the auditors primary aim is to assist management by reviewing a bodys objectives, strategy, organisation and performance and then suggesting whether there is scope for beneficial cost effective change and if so, how such change might be brought about.

9.6.5 Post Investment Reviews

Post Investment Reviews (PIRs) are an important management function which internal audit will either complete themselves or as part of a cross functional team. The main purpose of reviews is to learn from past experience so as to improve the quality of future decisions. Analysing the reasons for success can be as helpful as identifying why a project has fallen short of expectations. There may be important administrative and control issues arising from such a review. This can lead to the subsequent improvement and refinement of relevant procedures so that future projects can be more effectively managed. The appropriate timing for a performance review is normally after a full financial year of operation. PIRs should cover the following: The original justification and key assumptions. What actually happened, identifying the differences from the original proposal? Comparison of the actual financial returns with those forecast in the proposal. Any significant changes in the project. A summary of the benefits the project has contributed to the organisation. This should reflect both quantitative and qualitative data.

Internal audit can make significant contributions to PIRs by validating the information collected on performance and interpreting the comparison made with the original projections in the project plan in the light of all the changes which have occurred in the interval between. An important objective of these studies will be to assist management to improve the quality of investment decision making.

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In PIRs the auditors impartial view will be particularly valuable in making an objective assessment of the effect of various elements of the changes which will have occurred, as not all of them will have been anticipated. The auditor will need to consider all relevant changes in the business, the environment and the economy since the project plan was prepared and endeavour to evaluate how these have influenced performance.

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9.6.6 Compliance audits

Compliance audits have been deliberately left to the end to stress the positive contribution that internal audit can make to the overall management process. There is, however, still a role for the more mundane ticking and bashing approach to audit. One of the ways in which the board discharges its responsibilities is by the creation of systems of internal control. These comprise an overall control environment as well as detailed control procedures. Internal control 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 it should. One of the ways in which the board can satisfy itself that the system is operating properly is by asking the internal audit department to conduct compliance tests on the operation of the systems. Compliance audits are frequently conducted on a cyclical basis, with the auditor working 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 compliance audit is an important element of the overall control environment. If the board demonstrates its commitment to the operation of control procedures by sending staff to check on their operation then staff will be encouraged to adhere to the manual. A compliance audit need not focus on the financial controls that are most relevant to external audit. The internal auditor could, for example, review safety procedures 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 corporate governance. It underpins several key relationships. Internal audit provides: the executive directors with some assurance that other managers and staff are putting the policies and procedures established by the board into effect; the non executive directors with confidence in the financial records and other management reports (eg health and safety) that they rely on in their overall supervision 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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Corporate governance issues face the board with an almost insurmountable set of challenges. One of the ways in which they can discharge their responsibilities is by creating an effective internal audit department which is tasked with checking on governance procedures on behalf of the directors. The principal task of internal audit is normally perceived as assisting with corporate governance and managerial accountability.

9.7.1 Independence

Internal auditors must be independent of the activities they examine. Independence is a state of mind achieved through organisational status and professional objectivity and should enable internal auditors to render the impartial and unbiased judgements essential to the proper conduct of their work. The Head of Internal Audit should be appointed by the Chairman (or other suitable independent senior executive). He or she should have no executive powers outside the internal audit function. Because of concern for internal audit independence, the Treadway Commission (1987) discouraged the situation where the internal audit function reports to the senior officer directly responsible for preparing the accounts. The head of internal audit should report directly to the Audit Committee, usually via its non executive chairman. There should be no preconditions of access to the board, particularly to non-executive directors, set by the executive directors or other senior management. In practical terms the Head of Internal Audit must also have a strong day to day working relationship with executive management and may also report to an executive director such as the Chief Executive.

9.7.2 Audit Committees

Most quoted companies have an audit committee, normally comprising predominantly 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 the various accounting and control systems (eg reports, draft financial statements and so on). The audit committee should also consider whether the systems and controls that input the information (eg accounting systems, stock controls etc.) are adequate. The audit committee should be concerned with control information based on which the board make business judgements is it correct, timely and of the 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 board members. It also provides internal and external auditors with a voice at board level.

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

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Solution An audit committee provides a forum in which a subset of directors can consider the scope and results of internal audit work and filter matters for consideration by the 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.

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The increased emphasis on, and awareness of, corporate governance and related public reporting has brought the role of internal audit into sharper focus. Organisations are increasingly looking to their internal auditors to guide and assist all levels of management, from the Board down, in their quest for an effective control framework appropriate to their business. Internal audit has evolved so that it should be the expert adviser helping management with business risk assessment and control to ensure that the whole system of controls, financial and otherwise, established by the management is adequate and effective in reducing the risks faced by the organisation to acceptable levels. This assists the Board and all levels of management to meet their responsibilities for ensuring that the business is conducted in an orderly and efficient manner, in the way that executive management require it to be undertaken both as to policy and practice. Internal auditors value and effectiveness are linked not only to their attunement to managements philosophy and direction, but to their understanding of risk and its management, and their direct knowledge of operating systems. As an independent appraisal function working within an organisation, internal audit provides a proactive value-added assurance service which helps directly in the achievement of the entitys goals and business objectives, as well as assisting senior management in meeting their responsibilities. Internal audit can therefore make a real contribution to 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 corporate governance. While most of this module has been concerned with the development of checks and balances within the organisation, the provision of credible, unbiased accounting information to shareholders and external readers also helps develop a sense of openness and transparency. The whole process of financial reporting and the publication of audited financial statements is, therefore, yet another facet of corporate governance. External auditors provide shareholders with confidence that the financial statements are a credible source of information upon which to base stewardship decisions. This, in turn, provides further support for the relationship between the board and the shareholders. Arguably, internal and external auditors have a relatively minor role to play in the whole 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 has compliant non-executives. The auditor is nevertheless an important supporting player who will make such behaviour more difficult to conceal.
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9.9 ALTERNATIVE BUSINESS SYSTEMS

You might be forgiven for believing that the UK system of regulation is commonly used throughout the world. The US system is surprisingly close to the UKs and so a comparison might tend to suggest that all countries are the same. Nothing could, however, be further from the truth. There are several alternative models which incorporate concepts which are radically different to the Anglo-American approach. This final section discusses some of these because they might give some fresh ideas which could be fed into the UK debate. The impact of culture is often underestimated because accountants tend to see their craft as technical and do not allow for the effects of different legal, political and 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 these countries 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, the code law countries (such as France and Germany) have much more prescriptive rules and these tend to be set by government, with very little direct involvement from other organisations.

9.9.1 Corporate Governance in Germany

Germany is a major industrial nation and is home to a host of major multinational companies. In common with most of Continental Europe it has a code law system. This is reflected in the highly detailed and prescriptive rules contained in the Corporate Governance Rules for Quoted German Companies, published by the German Panel on Corporate Governance and updated in 2000. These go right down to the requirement to treat each individual shareholder fairly, requiring that all receive the same accounting information simultaneously, and the banning of the pursuit of personal interests by management board members whenever they face a conflict of interest.

ACTIVITY The following is a brief summary of some of the feature of corporate governance in Germany. Read through it, underline the features which stand out as being different from the UK and think about how these might affect the manner in which German businesses are managed. Incorporated companies have a two-tier board structure. The supervisory board 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 their stake in the business as long term and tend to take an active role in supervision.

The stock exchange is not particularly large or important.

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Solution Broadly, the German system differs from the UKs in terms of the greater range of stakeholders who are involved in the management process. The fact that only a small proportion of any given companys shares is likely to be traded on the stock exchange means that short-term market forces are far less important. It is common for shareholdings to be concentrated in the hands of banks and large institutional investors who will expect to be kept informed of any developments in return for their long-term support. The concentration of voting power in the hands of the banks means that hostile takeovers are almost unheard of in Germany. The two-tier board is another major difference which appears to have no direct parallel in the UK, although this is common practice throughout much of the remainder of the EU. The executive board (Vorstand) is broadly similar to the board of directors of a UK company while the supervisory board (Aufsichtsrat) is made up of representatives of the shareholders and the employees. Half of the supervisory board is elected by employees in companies with more than 2,000 staff and one third if the company has fewer. In practice, the supervisory boards tend not to meet very often and may not receive a great deal of information. This is partly because the shareholders representatives are often nominated by members of the executive board and these individuals may be keen to avoid rocking the boat at meetings which are also attended by representatives of the employees. Having said that, the power of the supervisory boards was demonstrated in 1998 when the shareholders favoured candidate for the post of CEO of BMW was rejected by the employee representatives on the supervisory board, thereby forcing the candidate to stand down. The importance of banks arises because there are relatively few large joint-stock companies (AGs, broadly equivalent to UK PLCs) relative to the size of the German economy. Smaller, private limited companies (GmbHs) are far more numerous and these tend to be owner-managed or have a close, tight-knit shareholding. There is a general reluctance on the part of many German entrepreneurs to share control with outsiders and to open their companies up to the greater scrutiny implied by quoted status. Despite their relative lack of importance this module will concentrate on the AGs because they might have some lessons which could be relevant to the quoted companies in the UK. The influence of banks arises partly because they are major equity investors in German companies. They also tend to hold shares on behalf of private and corporate investors and exercise full voting rights over these. Banks might have 80% of the votes at a typical general meeting. The banks often make substantial loans in addition to holding shares. German companies tend to make far greater use of debt than their British counterparts. This will often mean that a bank has a significant stake in both the debt and equity of any given company and will, therefore, have an enormous incentive to work for that companys long-term prosperity. This offers a stark contrast with the stereotypical picture of a British bank, where the relationship is often seen as a tentative one where the bank will avoid risks and may have little incentive to work for the companys long-term good. 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 influence through the general meeting. The banks tend to be supportive of management, to the extent that there have been only a tiny handful of contested takeovers in recent decades.

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ACTIVITY The fact that company managers tend to enjoy the support of their principal shareholders, who also tend to be their bankers, may have both advantages and disadvantages for the company. Try to identify two possible benefits and two possible drawbacks of this aspect of business culture. Solution One major advantage is that managers can concentrate on the long-term profitability of the company. They do not have to worry about, say, reducing short-term profits by investing in research and development which is likely to bear fruit in the longer term. Studies of the investment behaviour of British and German companies suggest that the latter do invest more heavily. A second advantage is that the companys principal banker will have a strong incentive to support it through any short-term cash problems. Indeed, the bank will be kept abreast of any and all developments in the normal course of the companys budgeting and management control activities. On the other hand, the fact that the banks are likely to support the incumbent management team might tend to reduce the boards incentive to perform to the very best of their ability. It might also tend to make the company less accountable to society as a whole. For example, German disclosure requirements tend to be less onerous than those of the UK. Furthermore, there is very little point in aggrieved minority shareholders attempting to use the annual general meeting to bring 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 are beginning to move towards equity finance and are seeking listings often on the London and New York stock exchanges. At the same time, the major German commercial banks: Deutsche, Dresdner and Commerzbank, have been expanding their horizons in order to become global players. This has made them less inclined towards taking on further long-term equity stakes. For example, most of the expansion in the former Eastern Germany has been financed by the Land, or public, banks. Korea has a family oriented society. This means that much of the entrepreneurial activity takes place in small-scale family-run businesses. The size of these enterprises is effectively limited by the fact that owners are keen to reserve senior managerial posts for immediate family members. The state has, however, encouraged the creation of a small number of very large industrial conglomerates in the interests of economic efficiency. As with our discussion of Germany, this section will concentrate on the larger organisations so that we can draw comparisons with the UK situation. Korean companies are not large, but that fact conceals one of the distinguishing characteristics of Asian businesses. Most large businesses are part of a network organisation known as a chaebol. These networks are created by an interlocking arrangement of companies holding shares in one another. The familiar holding company/subsidiary company relationship does not really exist but, despite this, the chaebol can 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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The Korean government used a number of different strategies to create these businesses. The banks are all state owned and, in the interests of promoting growth, a number of favoured institutions received loans at rates which were negative once inflation was taken into account. These businesses were also given a certain amount of protection from both domestic and foreign competition while they were being established. Finally, pressure was brought to bear on a number of wealthy business owners to make sure that they committed themselves to establishing businesses in sectors identified by the state as having some strategic importance. One implication of the states involvement has been that Korean companies can compete successfully in capital intensive sectors such as electronics and car production. Large scale chaebol organisations can be created very quickly in order to enjoy the benefits of economies of scale and scope. The disadvantage of this is that 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 be argued 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 has led 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 its reputation. In 1999 the Daewoo chaebol collapsed shortly after having claimed to have net assets of $10.7bn. A subsequent audit commissioned by the groups creditors uncovered net liabilities of $22.2bn, making this the worlds largest ever accountancy 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 of the close ties between group members is that they encourage a lack of openness and accountability. The Korean government was inspired to create the chaebol by the success of the Japanese keiretsu (chaebol and keiretsu are represented by the same Chinese characters). There are, however, some significant differences between the two. The most notable of these is the fact that the keiretsu tend to be structured around an internal, commercial bank which is a member business of the keiretsu. There is no formal government policy pushing towards the development of these organisations. The other differences are partly due to cultural differences between the two countries: Japanese society can be characterised as less family oriented and there is no particular tendency to retain family ties within organisations. Japanese companies tend to be far more co-operative than their Korean equivalents. This manifests itself in a willingness amongst Japanese businesses to support one another rather than to seek competitive advantage when one of them has a problem.

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There is one common stereotype of Japanese managers which does not really bear close analysis. Japanese companies have a reputation for providing life-long employment for staff and for providing a very rigid career progression for managers. This is only true of the very largest companies. There is a vast number of smaller companies, many of which act as sub-contractors to the keiretsu, which cannot afford such a paternalistic environment. There is intense competition for entry to the very largest companies because these offer better salaries as well as considerably more security. Those who are unsuccessful are unlikely to spend the whole of their working lives with the same employer. Those who do obtain a starting position with one of the keiretsu are unlikely to move to another organisation, although there is a great deal of scope for internal mobility within the organisation itself. The structure of the keiretsu themselves offers both advantages and disadvantages. They tend to be well diversified organisations, with a bank at the core. This means that there is scope for mutual support and even possible synergies between group members. The tightly knit nature of these holdings was highlighted in 1990 when the American takeover entrepreneur T. Boone Pickens owned 26.43 percent of the Japanese company Koito, and was its largest shareholder. Despite this, he could not force management to give him a seat on the board. Together, nineteen Japanese firms owned a majority of Koitos stock, and all supported management. There is, however, a corresponding problem in that any difficulties which affect the keiretsu as a whole may be rather more difficult to deal with because of the introspective nature of these organisations. Furthermore, the keiretsu are rather diffuse organisations. This can make it difficult for them to seek outside support, particularly from non-Japanese sources. One reason for this is that the various affiliates who are not actually members (eg some suppliers and distributors) trade in ways which create enormous off-balance sheet balances. In very broad terms, the managers of Asian companies are likely to owe a joint allegiance: they will be accountable to their shareholders and also to the other companies in their business grouping. These loyalties are not really in conflict with one another because the chaebol/keiretsu are created by a series of interlocking shareholdings and so at least the larger members of the group will also be shareholders. In any case, the purpose of the arrangement is to create opportunities for long term prosperity and stability. Supporting a fellow member might involve some costs, but those may be compensated by the fact that the group will rally round if the company ever finds itself in difficulty. As was the case with Germany, the preceding analysis highlights the commonly held outsiders views of Japanese business practice. There is, however, a trend towards the US system which, in a sense, started with the US occupation at the end of the Second World War. The occupying powers attempted to break up the forerunners to the keiretsu, the zaibatsu, by issuing shares to employees and other stakeholders. This led to the creation of the keiretsu when most of these new shareholders sold their equity to large block shareholders. This created a financial system which appeared relatively stable until the crisis brought about by the Japanese banking crisis at the end of the 1990s. This highlighted inefficiencies in the banking system that had been tolerated in the past. It also accelerated the tendency away from debt towards equity and the wealth available through the global equity markets.

9.9.3 Future trends in Japanese corporate governance

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9.10 SUMMARY AND CONCLUSIONS

This module has discussed the highly topical issue of corporate governance. It has examined some of the situations in which governance issues arise, described some of the forms that governance structures might take and has discussed some of the risks and associated controls that might be raised by a discussion of governance. This is a wide ranging topic and one where no two individuals could be expected to agree on every point. Indeed, a great deal depends on ones moral and ethical stance. While this means that it is difficult to determine the most appropriate course of action, it also makes the area an interesting one for study. The easiest way to prepare for a question on governance issues is to be aware of the broad principles underlying the various pronouncements in the UK Corporate Governance Code and associated guidance. Knowing why the code recommends a particular course of action is probably more useful than attempting to memorise every detailed requirement. It is also useful to keep abreast of real cases. The best source of these is the company news section of the Financial Times or Big 4 publications.

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