Corporate Governance Sector in UK

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Table of Contents

Introduction
General Background
Corporate Governance Failure
Case Study – Tesco 2013 Report
Findings
Recommendations
Evaluation of UK system
Conclusion
Reference List

Introduction

Corporate governance is the relationship between the daily running of an organization and its ownership. It entails the processes, procedures, decisions, and controls that define the effective running of an organization vis-à-vis the ownership. In UK, the effectiveness with which corporations operate has been an arduous journey, which is still in growth. This paper will look into the forces that led to these changes including the Enron Scandal.

The paper will also describe findings with reference to the Tesco PLC (2013) case. Finally, the author will conclude on the effectiveness of the UK corporate governance sector. London Stock Exchange is the custodian of governance rules in UK. LSE manages the agency relationship between owners of a company (shareholders) and the day-to-day controllers of operations for profit making purposes.

General Background

The UK corporate governance sector has had numerous changes and the reports have had a key role to play in these changes. Changes have occurred primarily based on the need to remunerate corporate chiefs fairly, the need for careful investment of shareholders’ money continually, and the need to improve shareholders’ returns.

Although these are the basics, other factors come into play because of the changing economic times buoyed by technological advancement, a shifting social-corporate relationship, and competition. The following reports are an indication of the metamorphosis of the corporate governance and recommendations accrued over time.

Cardbury Report 1992

The report, commissioned in the wake of numerous UK scandals, aimed at instilling integrity, transparency, and accountability in the entire decision-making processes in an organization. Corporate governance in UK lies upon that bedrock. It established auditor independence, encouraged information flow to the shareholders, and established a structure in which an organization could run independently (Chapman, Hopwood & Shields 2006).

Greenbury Report 1995

The report greatly discussed remuneration in the wake of public outcry regarding excessive salaries and allowances paid to directors and top management. The report recommended establishment of a Remuneration Committee, salary disclosures to shareholders, company remuneration policy, and service contracts. The report also advocated that the power to do all that vest in shareholders (Ahrens & Chapman 2007).

Hampel Report 1997

The report was because of a recommendation contained in the Cardbury Report that a body be mandated with development and enforcement of Codes of Conduct in Governance. With the cooperation of LSE and snippets drawn from Greenbury Report as well, The Combined Code (Principles of Good Governance and Code of Best Practice) was created.

These codes had a holistic outlook on organization including remunerations, internal audit controls, directors’ roles, terms, and appointments (Financial Reporting Council 2010). Braithwaite, Cary & Levi‐Faur (2007) delve into the question of regulation concerning prevention financial scandals and improvement of corporate governance.

They conclude that the state has to be quite alert to the changes in the global arena to curtail loopholes occasioned by such changes. For instance, when Enron happened, there were regulations but they had been passed by events, which gave way to the scandal. Hence, The Combined Code, though a noble idea may not be solution after all. Integrity and accountability are the main drivers of corporate governance (Braithwaite, Cary & Levi‐Faur 2007)

Turnbull Report 1999

First, the report stressed the need for internal auditing. If an organization does not have one, the report suggested that the board carry out the function on annual basis. Secondly, the report focused on risk and its control. It recommended a holistic look towards risk and a holistic and inclusive way of handling it. Additionally, the urge to risk shareholders’ money carelessly was discouraged (Marlene & Aston 2011).

Smith and Higgs Reports 2003

In the wake of Enron and WorldCom, US scandals, the world financial regulation sector went on a frenzy to strengthen regulations to prevent such scandals. This was the basis for establishment of Smith and Higgs Committee. It advocated for empowerment of Audit Committees. The report streamlined the roles and usefulness of non-executive directors as part of checks and balances. It gave direction concerning members’ remuneration and their relationship with the board (Marlene & Aston 2011).

FRC (Financial Regulatory Council – UK) was established based on this report. According to Financial Reporting Council (2010), the UK Corporate Governance Code proposes a “comply or explain” approach. A company either adheres to set out principles or adopts a system more appropriate to its operations as long it can explain. The system is quite crucial in ensuring firms do not feel restricted in their operations in UK. It encourages competition, innovation, and economic growth (Bornholt 2013).

Turnbull Report (Part 2)

The report extended the topic of risk, the number executive committees, and executive committee members. Conclusively, the report was a holistic review of all the reports with the aim of a streamlined UK financial system (Marlene & Aston 2011). Flint disregarded calls to copy the stricter Sarbanes-Oxley Act 2002 of US, which was passed in the wake of Enron and WorldCom (Masdoor, 2011).

The Act was largely based on a national control. Flint was more interested in an independent approach whereby the firm had freedom to make risky decisions and to carry out internal audit. Asie (2011) notes that this was a brilliant move because compared to US economy, the UK economy did not suffer “aftershocks” occasioned by fear of state pressure in matters corporate.

Corporate Governance Failure

Enron

The following are reasons that led to the fall of Enron:

Guaranteeing price to be paid

Enron entered into a contract with its customers, Kaiser, guaranteeing them that they would never pay more than $2.50 for every thousand cubic feet. Additionally, if the prices were to increase, Enron was to supply the oil at the stated price.

Enron would also manipulate the market prices upwards, benefiting from the difference (Ghosh & Varshney 2013). Such decisions like assuming huge risks were not very necessary for the firm since this was not its primary business. Locking prices was an aggressive way of making money (Palepu 2003).

Revenue recognition

The company accountants adopted a method of recognizing revenues on accrual basis. Accrual basis allowed the company to recognize revenues from twenty-year contracts in the first year (Bornholt 2013), which led to reporting high revenues for the company. The executives wanted to report high earnings to meet Wall Street projections, which the company was unable to meet by following the traditional accounting procedures (Elton, Gruber & Brown 2006).

WorldCom – Unreported expenses

Enron used to avoid reporting all the relevant expenses to overstate their profits and their auditors overlook such details. For example, expenses in transactions with WorldCom telecommunications (Klein 2003). The telecommunications company was also culpable for not reporting revenues and omission of financial expenses. WorldCom used to report its earning without charging the financial expenses incurred during the financial year, which led to reporting of huge profits than it was the case (Zekany 2004).

Parmalat

A company has high quality earnings if the cash is from aspects of the company business, which includes decrease in production costs or increase in sales rather than external forces (Bodie, Kane & Marcus 2008). For Parmalat, most of its earnings and cash flow were attributable to external forces such as sale of stocks in the financial markets. Therefore, Parmalat’s earnings and cash flows were of low quality (Davila & Foster 2005).

Case Study – Tesco 2013 Report

The governance structure at Tesco is starts with the Chairman who is the Board of Directors. Under the chair are four strategic committees tasked with various responsibilities. The committees are nominations, remuneration, corporate social responsibility, and audit committee.

The committees probe into those specific matters for the Board and reports timely. The board delegates its responsibility to the Group CEO. The CEO at Tesco has various executive committees whose chairs report to him. Tesco also has non-executive directors whose work is to assess the performance and the work of the board and the CEO. It includes a group of experienced individuals especially in the corporate world.

The board chairperson reiterates the need for the governance structure to reflect modern challenges. For example, the CSR committee was created to recognize the importance of giving back to society and to use global resources responsibly. A company that fails to recognize this need risks the wrath of its clientele.

Although the board influences major policy decisions, Tesco has internal and external board evaluation structures. Externally, for example in 2012, Tesco used Egon Zehnder. This ensures that the Board and a few directors cannot take autocratic control of the company was the finding of Cardbury Report.

The Tesco report points out major corporate governance issues such as auditing, risk management analysis, number of executives among others. The report indicates a norm where the members of the executive report to shareholders over duration of time the goings on in the organization.

Additionally, the report points out the fact that agency relationships are subject to law (Schreyögg & Busse 2006). UK for instance requires that shareholders know about the risks associated with their investments, the remuneration and number of executives. Additionally, the shareholders determine whom to elect in the board of directors and other executive functions.

To mitigate risk for example, it is crucial that the external auditors of the firm should not work as the consultants of their client to prevent the auditors from auditing their own work. Additionally, it avoids conflict of interest, as was with the case with Arthur Andersen and Enron whereby Andersen provided both consulting services and audit.

GAAP required that there should be separation of certain and uncertain projections and auditors are required to attest on the former only. The Tesco Report clearly indicates that the auditors are chosen independently and do not have any affiliations to the company.

Findings

The culture adopted by the earlier UK corporate governance set-up encouraged development of environment perfect for fraud (Reilly & Brown 2007). The management allowed the employees to use any means they think would enable the firm to make money (Brealey & Allen 2003).

The end justified the means used and the management supported the actions taken by employees (Perold 2004). Board members adopted ideas despite knowing they were fraudulent ways of making money. Senior executives were under pressure from boards to meet set targets.

The encouragement and incentives given to employees by corporate managements allowed the highly educated employees of different companies to become notorious financial criminals. For example, investment banks such as Citibank allowed Enron to use special accounts to borrow money and trade the treasury bonds making huge profits. Enron reported these as cash flow from operations.

Recommendations

There are three factors necessary for fraud to occur. That is Pressure, Opportunity, and Rationalization. Employees in the earlier corporate set up were always under pressure to meet targets from the board and senior management. They (employees) would always reconcile their behavior with accepted standards, which would rationalize the financials. The corporations had weak internal control procedures, which created an opportunity for fraud.

Therefore, the culture of the companies fit the fraud triangle of Pressure, Opportunity, and Rationalization. Prevention of fraud should ensure the triangle is never complete. It is imperative to review corporate laws constantly through sustained focus on the changing business environment. The changes proposed were effected as a result scandals and use of loopholes in laws. Hence, as the world financial structure and general outlook changes, the corporate set up should reflect similar changes.

Evaluation of UK system

The corporate governance in UK is at its optimal level having developed over the last decade. Since the 2003 report by turnbill, which was effected into the financial legal system, there have been no major corporate governance issues. The agency relationship is at its best and both shareholders and the corporate executives enjoy cordial relations (Lutchen 2004). However, there are shareholders who still feel corporate executives hold too much sway in their investments and earn too much in allowances.

An accounting information system should incorporate other things apart from data analysis (Fama & French 2004). An individual manager is responsible for a small docket for responsible for daily decisions. This means that he has to have a system that supplements his decisions or the process of his decision-making. Therefore, before development, the project must incorporate each supervisors and managers capability to continue making critical unit decisions (Asie, 2011).

The following checks and balances are incorporated in the system. First, there is a separate chief executive and chairperson (Grembergen & De Haes 2010). For example, as of 2013, the CEO of Tesco was Philip Clarke and the chairperson was Sir Richard Broadbent. Additionally, the executive branches of the board have different committees.

The board has executive and non-executive directors whose roles are independent and somewhat counter check. The remuneration committees ensure that there is fair remuneration. To conclude the executive branch, the executive members have an annual evaluation, and there is complete transparency in appointments (Financial Reporting Council 2010).

A good corporate governance structure in a country is essential for the growth and development of an economy (Rodrigues & Santiago 2011). Following the infamous Enron scandal, the markets in UK fell drastically and the UK economy suffered for a long time.

Lately, after the fall of Lehman Brothers in US and the subsequent meltdown of a number of Wall Street companies, global economy suffered (Hovey & Naughton 2007). In its wake, the US administration instituted tougher regulations on the governance of corporations to curtail future meltdowns (Lichocik & Sadowski 2013).

In the early 1990 and late 1980s, UK and other world markets such as US and Mexican stock markets would experience dreadful scandals that started in boardrooms.

The UK government had a fair share of these scandals that projected a picture of dirty boardrooms. The government commissioned the Adrian Cardbury in 1992 to assess the situation and come up with recommendations. In his report, he noted the need for a regulatory framework that gives entrepreneurs the freedom to invest whilst putting brakes on careless investment (Das, Markowitz & Scheid 2010).

He suggested a raft of checks and balances. In the current day UK, following a raft of such similar reports, there are many regulations directed at corporate governance (Erturk 2004). There are listing rules, UK corporate governance Code of 2003, the UK Stewardship Code of 2010, and the UK companies’ act of 2006. All these regulations have undergone several changes according to the changes in markets both internally and globally (Financial Reporting Council 2010).

Conclusion

The corporate governance set up in UK has undergone great metamorphosis. The changes were prompted by scandals and identification of loopholes that senior management was likely to exploit. Additionally, some changes occurred because of the need to curtail redundancy and create effectiveness in the running of an organization (Wilkin & Chenhall 2010). In this regard, corporate governance is not at its perfection.

Globalization and technological advancements are the major drivers of the change, currently and in future (Radón 2012). Additionally, as companies set up global centers, different laws inform corporate governance in different countries. Hence, companies and/or organizations with a global outlook need to familiarize with these changes. Governments have to keep tabs of the loopholes that corporations are likely to exploit and seal them off with laws (Levich 2001).

Reference List

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Asie, D 2011, ‘Corporate governance: an informative glimpse’, International Journal of Governance, vol. 1, no. 2, pp. 206-214.

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Brealey, M & Allen, J 2003, Principles of Corporate Finance, McGraw Hill, London.

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