October 2009CG History in the UK - JESW - L4b 1 Audit and assurance Corporate Governance in the United Kingdom: History, context and principles Lecture 4b

October 2009CG History in the UK - JESW - L4b 2 Some history, legislation… ‘Bubble Act’ 1720 –Recognised the ‘moral hazard’ of the relationship in the principle-agent relationship –A key theme that was established and continues to today is that directors are accountable to shareholders Companies Act (CA) 1844 –Required audited balance sheet (a ‘value statement’ at year- end) to be presented to shareholders Problem: Anyone could be the auditor (usually a shareholder) CA 1856 –The CA 1844 audit provision was removed Led to many cases accusing directors of fraudulent behaviour

October 2009CG History in the UK - JESW - L4b 3 Some history, legislation… CA 1900 –Reintroduction of balance sheet audit –Auditor to be appointed by shareholders CA 1929 –P&L a/c required Shows how the company has fared over the year. CA 1948; CA 1967 –Required auditor to be qualified –Auditor to express ‘an opinion’ –A lot of disclosures to shareholders required

October 2009CG History in the UK - JESW - L4b 4 Some history, legislation… CA 1981 –Aspects of GAAP introduced into law –Directors’ report to be audited –Directors’ report to contain comment on the companies future development –Small and medium sized companies exemptions CA 1985; CA 1989; CA 2006 (Mainly consolidation) –Director’s ‘duty of competence’ (Common Law) codified Negligence where a failure of a reasonable standard of competence –IFRS for listed companies

October 2009CG History in the UK - JESW - L4b 5 Some history, legislation… The government’s role in a capitalist economy –To protect the public interest Most of the statutes have resulted from a public scandal –Usually involving fraudulent activity –Thus legislation has attempted to make directors increasingly more accountable to shareholders over time

October 2009CG History in the UK - JESW - L4b 6 Some recent history, reports… Cadbury 1992 Greenbury 1995 Hampel 1998 Turnbull 1999 Higgs 2003 Tyson 2003 Smith 2003 ‘The Code’ redrafts (the most recent in 2008)

October 2009CG History in the UK - JESW - L4b 7 Cadbury Report, 1992 Corporate governance (CG) - not a ‘new’ thing –Based on existing, implicit CG behaviour –It may thus be considered a ‘codification’ exercise of good CG practice in the UK in 1992 Public concern over several corporate failures –Particularly the Pollypeck and Maxwell Communications Corporation cases in 1991 –The rapid growth in executive remuneration and conflicts of interest between directors and shareholders The Stock Exchange and CCAB therefore initiated the Cadbury enquiry

October 2009CG History in the UK - JESW - L4b 8 Cadbury Report, 1992 (cont.) ‘The committee on the financial aspects of corporate governance’ ‘The Code of Best Practice’ (1992) –Voluntary code But for listed companies a compliance statement was required –‘Comply or explain’ – Principles rather than rules »The ‘principles v rules’ argument (UK v USA) »The following example is a true case, but in a non- financial setting (from China Daily, December 2007)

October 2009CG History in the UK - JESW - L4b 9 Rules and principles? Hospital Doctor – What will he or she do here? Woman, unconscious and unwell Rules: Next-of-kin must sign authority to operate. The husband refuses to sign

October 2009CG History in the UK - JESW - L4b 10 Rules and principles? Hospital Doctor – What will he or she do here? Underlying principles of medical profession Rules of the hospital

October 2009CG History in the UK - JESW - L4b 11 Rules and principles? In financial accounting – –Should there be strict and detailed rules trying to cover all situations (US approach) or –Limited rules with ‘overriding’ principles (true and fair / fair presentation) (UK/International approach) –In practice there is a concerted effort to bring US and UK/International accounting standards together. Do you think this is possible? What will be the effect? Back to UK CG… Homework !

October 2009CG History in the UK - JESW - L4b 12 Cadbury Report, 1992 (cont.) ‘This, more than any other initiative in corporate governance reform, has led to the shift of directors’ dialogue towards greater accountability and engagement with shareholders…’ and ‘…has generated the more significant metamorphosis of corporate responsibility toward a range of stakeholders, encouraging greater corporate social responsibility in general’ Solomon, 2007

October 2009CG History in the UK - JESW - L4b 13 Cadbury Report, 1992 (cont.) The report covered three areas –Directors It defined the composition of the board, its responsibilities, and the responsibilities of the chairman, and the audit and remuneration committees. –Auditing –Shareholders ‘Fat cats’

October 2009CG History in the UK - JESW - L4b 14 Greenbury Report, 1995 ‘Fat cats’ –Continued public concern over several incidences of exorbitant directors’ remuneration ‘Especially to departing directors and to the directors of privatised utilities, at a time when prices were rising, pay was being restrained and staff made redundant’ Steele, 1999 Particularly, British Gas, 1995 Objective to set up a Code of Practice for directors’ remuneration

October 2009CG History in the UK - JESW - L4b 15 Hampel Report, 1998 Continued public concern over corporate failures –Notably that of Barings Bank, 1995 The Hampel Committee –The intention was to ‘combine, harmonise and clarify’ the Cadbury and Greenbury recommendations and create an overall code of corporate governance Issue of a revised and extended ‘Combined Code’, 1998

October 2009CG History in the UK - JESW - L4b 16 Hampel Report, 1998 (cont.) More extensive, covering… –Board performance –Disclosure of information –Remuneration –Role of the audit committee –Training –Role of the nomination committee –Conduct of AGM’s –Role of the remuneration committee –Roles of chairman and chief executive –Directors’ contracts Key elements incorporated in the Stock Exchange Rules (1998)

October 2009CG History in the UK - JESW - L4b 17 Hampel Report, 1998 (cont.) It also underlined the voluntary, ‘principles- based’ approach as a key element Refocused the emphasis on accountability primarily to the shareholders, then to other stakeholders

October 2009CG History in the UK - JESW - L4b 18 Hampel Report, 1998 (cont.) The report covered two areas 1.Principles –Directors –Directors’ remuneration –Relations with shareholders –Accountability and audit 2.Institutional shareholder provisions The ‘Codes’ issued after Hampel’s are mainly modifications of the basic Cadbury- Greebury-Hampel model

October 2009CG History in the UK - JESW - L4b 19 Turnbull Report, 1999 So that’s it? Not quite… Public concern over risk management and control –Barings Bank, 1995 At this point we need to re-consider what risk management, systems and internal control are…