Accountability of directors
The law imposes a duty on directors to report annually, both to the shareholders and, to some extent, to the world at large, on the performance of the company’s trading and on its financial position. Each year, directors are required to prepare (or to have prepared on their behalf) a report for the shareholders. The minimum contents of the report are prescribed by International Financial Reporting (Accounting) Standards, which have the weight of UK law. In practice this minimum content is often exceeded. The report consists principally of an income statement (or a profit and loss account), a balance sheet and a cash flow statement. These financial statements are subject to audit by an independent firm of accountants, whose main role is to express an opinion on the truth and fairness of the view shown by the financial statements. The auditors’ expression of opinion is attached to the annual report. A copy of the report (containing the financial statements) must be sent to each shareholder. A copy must also be sent to the Registrar of Companies for insertion on the company’s file in Cardiff. This file must be available to be inspected by anyone wishing to do so. Virtually all major companies place a copy of their annual report on their website. In addition, large companies also send hard copies of the report to financial analysts and journalists. They will usually comply with a request from any private individual for a hard copy. The annual report is a major, but not the only, source of information for interested parties, including existing and prospective shareholders, on the progress of the company. Companies whose shares are listed on the LSE are required by its rules to publish summarised financial statements each half-year (also usually available on the companies’ websites). In practice, most large companies, from time to time, issue information over and above that which is contained in the annual and half-yearly reports.
Corporate governance and the role of directors
In recent years, the issue of corporate governance has generated much debate. The term is used to describe the ways in which companies are directed and controlled. The issue of corporate governance is important because, with larger companies, those who own the company (that is, the shareholders) are usually divorced from the day-to-day control of the business. The shareholders employ the directors to manage the company for them. Given this position, it may seem reasonable to assume that the best interests of shareholders will guide the directors’ decisions. However, in practice this does not always occur. The directors may be more concerned with pursuing their own interests, such as increasing their pay and ‘perks’ (such as expensive motor cars, overseas visits and so on) and improving their job security and status. As a result, a conflict can occur between the interests of shareholders and the interests of directors.
Where directors pursue their own interests at the expense of the shareholders, there is clearly a problem for the shareholders. However, it may also be a problem for society as a whole. If shareholders feel that their funds are likely to be mismanaged, they will be reluctant to invest. A shortage of funds will mean fewer investments can be made and the costs of funds will increase as businesses compete for what funds are available. Thus, a lack of concern for shareholders can have a profound effect on the performance of individual companies and, with this, the health of the economy. To avoid these problems, most competitive market economies have a framework of rules to help monitor and control the behaviour of directors.
These rules are usually based around three guiding principles:
- Disclosure. This lies at the heart of good corporate governance. An OECD report (see the reference at the end of the book for details) summed up the benefits of disclosure as follows: Adequate and timely information about corporate performance enables investors to make informed buy-and-sell decisions and thereby helps the market reflect the value of a corporation under present management. If the market determines that present management is not performing, a decrease in stock [share] price will sanction management’s failure and open the way to management change. (OECD 1998)
- Accountability. This involves defining the roles and duties of the directors and establishing an adequate monitoring process. In the UK, company law requires that the directors of a business act in the best interests of the shareholders. This means, among other things, that they must not try to use their position and knowledge to make gains at the expense of the shareholders. The law also requires larger companies to have their annual financial statements independently audited. The purpose of an independent audit is to lend credibility to the financial statements prepared by the directors.
- Fairness. Directors should not be able to benefit from access to ‘inside’ information that is not available to shareholders. As a result, both the law and the LSE place restrictions on the ability of directors to buy and sell the shares of the business. One example of these restrictions is that the directors cannot buy or sell shares immediately before the announcement of the annual trading results of the business or before the announcement of a significant event such as a planned merger or the loss of the chief executive.
Strengthening the framework of rules
The number of rules designed to safeguard shareholders has increased considerably over the years. This has been in response to weaknesses in corporate governance procedures, which have been exposed through well-publicised business failures and frauds, excessive pay increases to directors and evidence that some financial reports were being ‘massaged’ so as to mislead shareholders. Some believe, however, that the shareholders must shoulder some of the blame for any weaknesses. Not all shareholders in large companies are private individuals owning just a few shares each. In fact, ownership, by market value, of the shares listed on the LSE is dominated by investing institutions such as insurance businesses, banks, pension funds and so on. Of the LSE-listed shares that are owned by UK investors, about 79 per cent are owned by the ‘institutions’. Table 1.1 shows the breakdown by percentages of LSE listed share ownership among UK investors.