Chapter-10

Q(M). Explain the purpose of an internal control system and internal controls. How might an
audit committee review the effectiveness of the company’s system of internal control?
Answer:
Internal control systems are concerned with the management of business risks. These risks can
be controlled by measures taken internally by the organization.

As per COSO (Committee of Sponsoring Organizations of the Treadway Commission) internal

control can be defined as:
‘Internal control is broadly defined as a process, effected by an entity’s board of directors,
management and other personnel, designed to provide reasonable assurance regarding the
achievement of objectives in the following categories:
1. Effectiveness and efficiency of operations.
2. Reliability of financial reporting.
3. Compliance with applicable laws and regulations.’
An internal control system has been defined as follows:
‘An internal control system consists of all the procedures, methods and measures (control
measures) instituted by the Board of Directors and executive management to ensure that
operational activities progress in a proper fashion. Organizational measures for internal control
are integrated into operations, which means that they are performed simultaneously with
working processes or performed directly before or after work is carried out’.

↗Purpose:
An internal control system is for identifying operational, financial and compliance risks, applying
controls to reduce the risk of losses from these risks and taking corrective action when losses
occur.
i. Controls to ensure the systems and procedures of the organization are operated
without disruption or disturbance
ii. Controls to ensure that assets are safeguarded. For example, there should be controls to
ensure that money received is banked and is not stolen, and that operating assets such
as equipment and computers are not damaged or lost.
iii. Controls include measures to reduce the risk of fraud.
iv. Financial controls should ensure the completeness and accuracy of accounting records,
and the timely preparation of financial information.
v. Controls should be in place to ensure compliance with key regulations, such as health
and safety regulations or, in the case of banks, anti-money laundering regulations.

↗Effectiveness of the company’s system of internal control:

The board of directors (or the audit committee) should carry out a review of the effectiveness
of the system of internal control (and risk management), at least annually. In order to review
the effectiveness of the system of internal control, there must be procedures for monitoring
and review. It is an essential part of the board’s responsibilities.
The board or audit committee needs to form its own view about the effectiveness of the
system, based on the information and assurances it receives.
The sources of information about internal control are:
a. Management: The most regular source of information for the board or audit committee
about internal control should be management reports.
b. The internal auditors: Additional reporting may be provided by the internal auditors;
and
c. The external auditors: they are hired to perform a specific internal audit investigation.
who notify management and the audit committee about weaknesses in internal controls
which discovered in their audit.

Internal controls can be classified into three main types:

o Preventive controls: These are intended to prevent an adverse risk event from occurring;
for example to prevent opportunities for fraud by employees.
o Detective controls: These are controls for detecting risk events when they occur, so that
the appropriate person is alerted and corrective measures taken.
o Corrective controls: These are measures for dealing with risk events that have occurred,
and their consequences.

Q(F): (a) What are the main elements of a system of internal control? Explain the major
internal control risks.
Internal controls are an essential part of an internal control system. The COSO Framework for
an internal control system identifies five elements to a system of internal control.

1. A control environment: A control environment describes the awareness of (and attitude

to) internal controls in the organisation, shown by the directors, management and
employees. It therefore encompasses corporate culture, management style and
employee attitudes to control procedures.
Factors in the control environment include:
– integrity and ethical values within the organisation;
– a commitment to competence in performance;
– the commitment of the board of directors and the audit committee to
monitoring management, and their independence from management; and
–human resources policies and practices, such as the company’s policies on
performance evaluation and rewarding employees for performance.

2. Risk identification and assessment: There should be a system or procedures for

identifying the risks facing the company and assessing their significance. Controls or
management initiatives should be devised to deal with significant risks. Internal control
risks can be categorised as financial risks, operational risks and compliance risks.

3. Internal Controls: Controls should be devised and implemented to eliminate, reduce or

control risks. Internal controls can be categorised as financial controls, operational
 controls and compliance controls, to deal respectively with financial risks, operational
risks and compliance risks.
4. Information and communication: there should be a system of information provision and
communication within the organisation so that individuals are aware of what is expected
of them. Communication within an internal control system also includes the existence
and use of a whistleblowing procedure.

5. Monitoring: The effectiveness of the internal control system should be monitored

regularly. Internal controls are monitored by executive management and by the external
auditors. The board of directors also has a responsibility to review the effectiveness of
the system.
↗Major internal control risks:
Internal controls focus on controls that can be established internally within the organisation.
Many of the risks that an internal control system seeks to manage are risks from errors, fraud,
breakdowns and other internal failures. Internal control risks are risks that,
o internal controls will fail to achieve their intended purpose, and
o will fail to prevent, detect or correct adverse risk events.

The risks that are managed by an internal control system can be categorized into three broad
types.
1. Financial risks: These are risks of errors or fraud in accounting systems, and in accounting
and finance activities. Errors or fraud could lead to losses for the organization, or to incorrect
financial statements.
Examples of financial risks include the risk of:
 failure to record financial transactions in the book-keeping system;
 failure to collect money owed by customers;
 failure to protect cash;
 financial transactions (such as payments) occurring without proper authorization; and
 mis-reporting (deliberate or unintentional) in the financial statements.

2. Operational risks: Operational risk is ‘the risk of losses resulting from inadequate or failed
internal processes, people and systems, or external events.
Operational risks include:
 the risk of a breakdown in a system due to machine failures or software errors;
 the risk of losing information from computer files or stolen of confidential information;
 the risk of a terrorist attack;
 losses arising from mistakes or omissions by staff; and
 inefficient or ineffective use of resources.

3.Compliance risks: These are risks that important laws or regulations will not be complied with
properly. Failure to comply with the law could result in legal action against the company and/or
fines.
These risks can occur because:
 they are badly designed, and thus not capable of achieving their purpose as a control; or
 they are well-designed, but are not applied properly, due to human error or oversight,
or deliberately ignoring or circumvention of the control (a form of operational risk
event).

An internal control system needs to have procedures for identifying weak or ineffective internal
controls. This is one of the functions of monitoring the effectiveness of the internal control
system.
Q(F): a. What is the purpose of an internal audit function? What tasks might be carried out by
an internal audit department?
Internal audit is defined as ‘an independent appraisal activity established within an organisation
as a service to it. It is a control, which functions by examining and evaluating the adequacy and
effectiveness of other controls’.
↗Purpose:
An organisation might have an internal audit unit or section, which carries out investigative
work.
i. An internal audit function should act independently and will reported to a senior
executive manager such as the finance director.
ii. Internal auditors may report to the board itself or the audit committee. FRC Guidance
suggests that the internal auditor has direct access to the board chairman and the audit
committee, and is also responsible to the audit committee.
iii. This means that the internal auditors may be in an unusual position within the company.
iv. The senior internal auditor should have some control over deciding what aspects of the
company’s systems should be investigated or audited, and also has a responsibility for
reporting to the audit committee and the chairman of the board.
↗Tasks: The possible tasks of internal audit include the following.
1. Reviewing the internal control system. Traditionally, an internal audit department has
carried out independent checks on the financial controls in an organisation, or in a
particular process or system. The checks would be to establish whether suitable financial
controls exist, and whether they are applied properly and are effective.
2. Special investigations. Internal auditors might conduct special investigations into
particular aspects of the organisation’s operations (systems and procedures), to check
the effectiveness of operational controls.
3. Examination of financial and operating information. Internal auditors might be asked to
investigate the timeliness of reporting and the accuracy of the information in reports.
4. VFM (value for money) audits. This is an investigation into an operation or activity to
establish whether it is economical, efficient and effective.
 5. Reviewing compliance by the organisation with particular laws or regulations. This is
an investigation into the effectiveness of compliance controls.
6. Risk assessment. Internal auditors might be asked to investigate aspects of risk
management, and in particular the adequacy of the mechanisms for identifying,
assessing and controlling significant risks to the organisation, from both internal and
external sources.
Q (F). b. What are the main problems with systems of whistleblowing in large companies?
Definition: Whistleblowing is the popular term used when someone who works in or for an
organisation… raises a concern about a possible fraud, crime, danger or other serious risk that
could threaten customers, colleagues, shareholders, the public or the organisation’s own
reputation
The audit committee should be responsible for review of the provisions and procedures for
whistleblowing within the company.
The objective of the audit committee should be to ensure that there are satisfactory
arrangements in place for the ‘proportionate and independent investigation’ of allegations by
whistleblowers.
A whistleblower is an employee who provides information about their company that they
reasonably believe provides evidence of:
 fraud;
 a serious violation of a law or regulation by the company or by directors, managers or
employees within the company;
 a miscarriage of justice;
 offering or taking bribes;
 price-fixing;
 a danger to public health or safety, such as dumping toxic waste in the environment or
supplying food that is unfit for consumption;
 neglect of people in care; or
 in the public sector, gross waste or misuse of public funds.
↗Problems with systems of whistleblowing:
Whistleblowing systems in large companies can face several challenges, which may impede their
effectiveness. Some of the main problems include:

1. Fear of Retaliation: Employees may be hesitant to report misconduct or unethical behavior due to fear
of retaliation from their managers or colleagues. They may worry about losing their job, facing demotion,
or being subjected to harassment or isolation if they report misconduct. This fear can prevent employees
from coming forward, even if they have valuable information.

2. Lack of secrecy and Confidentiality: Whistleblowers may be concerned about the confidentiality of
their reports and fear that their identity will be revealed, leading to negative consequences. Even if
confidentiality is promised, employees may still worry about the risk of being identified through indirect
means or leaks.

3. Lack of Trust in the System: Employees may lack confidence in the whistleblowing system due to past
experiences or perceptions of management's response to whistleblowers. If they believe that their
concerns will not be taken seriously or that the system is biased, they are less likely to report misconduct.

4. Inadequate Policies and Procedures: If the whistleblowing policies and procedures are unclear or
inconsistently applied, employees may be unsure about how to report misconduct or what protections
they are entitled to. This lack of clarity can lead to confusion and discourage employees from using the
system.

5. Inadequate Investigation and Follow-up: If reports of misconduct are not promptly and thoroughly
investigated, or if whistleblowers do not receive feedback on the outcome of their reports, it can
undermine confidence in the system. Employees may feel that their reports are ignored or that no action
is taken, leading to disillusionment and decreased reporting.

6. Cultural Barriers: In some corporate cultures, there may be a perception that reporting misconduct is
disloyal or detrimental to the company's reputation. This can create a culture of silence where employees
feel pressured to remain silent about wrongdoing rather than risk their careers or relationships with
colleagues.

7. Complex Reporting Channels: If the whistleblowing reporting channels are overly complicated or
difficult to access, employees may be deterred from reporting misconduct. It's essential for reporting
mechanisms to be user-friendly and accessible to all employees, regardless of their role or location within
the organization.

Lack of Support and Protection: Whistleblowers may not receive adequate support or protection from
retaliation, despite legal protections in place. This can leave employees feeling vulnerable and
discouraged from speaking up.

Perception of Futility: Employees may perceive whistleblowing as futile if they believe that reports will
not lead to meaningful action or change within the organization. This can result in underreporting of
issues or reliance on external whistleblowing channels.

Addressing these problems requires a holistic approach that involves creating a supportive environment
for whistleblowers, implementing clear and effective policies and procedures, ensuring confidentiality
and protection from retaliation, conducting thorough investigations, and fostering a culture of
accountability and integrity within the organization.

Companies therefore need to establish a whistleblowing system that:

 encourages employees to report illegal or unethical behavior; but
 discourages malicious and unfounded allegations

A company might state its policy on whistleblowing in the following terms.

 Whistleblowing is appropriate if the employee does it in good faith and is not being
malicious, and there is no other way to resolve the problem.
  The company will not tolerate any discrimination by employees or management in the
company against an individual who has reported in good faith their concerns about
illegal or unethical behavior.
 Disciplinary action will be taken against any employee who knowingly makes a false
report of illegal or improper behavior by someone else (malicious reporting should not
be tolerated).

Whistleblowing procedures:
The Code of Practice states that an internal whistleblowing procedure will be effective only if it
has the confidence of the employees, who are its intended users. Confidence in the system will
be obtained only if the employer is genuinely committed to the procedure.

The Code of Practice suggests that features of an internal whistleblowing policy and procedure
should include the following provisions.
i. The internal whistleblowing procedures should be documented and a copy should
be given to every employee.
ii. It should set out the key aspects of the procedure, such as the person to whom
employees should report their suspicions or concerns. This might be the company
secretary or internal audit.
iii. It should contain a statement that the employer takes malpractice or misconduct
seriously, and is committed to a culture of openness in which employees can report
legitimate concerns without fear of penalty or punishment.
iv. It should give examples of the type of misconduct for which employees should use
the procedure and set out the level of proof that there should be in an allegation.
v. The document should set out the procedures by which an allegation will be
investigated.
vi. It should make clear that false or malicious allegations will result in disciplinary
action against the individual making them.
vii. It should make clear that no employee will be victimised for raising a genuine
concern. victimization for raising a qualified disclosure should be a disciplinary
offence.
viii. An external whistleblowing route should be offered, as well as an internal reporting
procedure.
ix. There should be an undertaking that, whistleblowers will be informed about the
outcome of their allegations and the action that has been taken.
x. Whistleblowers should be promised confidentiality, as far as this is possible.
 Chapter-7:

Financial reporting and corporate governance:

The annual report and accounts is an important document for corporate governance because it
is a means by which the directors are made accountable to the shareholders, and provides a
channel of communication from directors to shareholders. The report and accounts enable the
shareholders to assess how well the company has been governed and managed. It should
therefore be:
 clear and understandable to a reader with reasonable financial awareness; and
 reliable and ‘believable’.

There are two widely expressed concerns about the annual report and accounts of companies.
o Whether the accounts are reliable, and can be ‘trusted’ for making decisions about the
company;
o Whether the annual report is clear and helps the reader to understand the
performance, position and future prospects of the company.

The reliability of the annual report and accounts depends on several factors, including:
 The honesty of the company in preparing them: if allowed to do so by accounting
regulations, companies might indulge in window dressing their financial performance or
financial position through the use of accounting policies (methods) that hide the true
position of the company.
 The care of directors to prepare financial statements to give a ‘true and fair view’ and
that everything of relevance has been properly reported.
 The opinion of the external auditors, which the shareholders should be able to rely on as
an objective and professional opinion.

If financial statements are produced in a way that is intended deliberately to mislead

shareholders, the persons responsible would be guilty of fraud, which is a crime. Misleading
financial statements, however, could only be issued if the:
 audit committee is satisfied with their preparation;
 external auditors provide a ‘clean’ audit report; and
 the board of directors approves the financial statements.
Misleading financial statements:
Q (M). In what ways might financial statements be misleading to shareholders and other
investors?
There are several ways, however, in which published financial statements could be misleading.
i. There could be a fraudulent misrepresentation of the affairs of the company, where
the company’s management deliberately presents a false picture of the financial
position and performance.
ii. The company might use accounting policies whereby it presents its reported position
and profits more favorably than would be the case if more conservative accounting
policies were used.
iii. The financial statements could be complex and difficult for investors to understand.
It is a relatively easy matter for accountants, to present financial statements in a way
that readers will find difficult to understand properly.
Occasionally, some companies may want to report strong growth in revenues and profits, or
even to improve the look of the balance sheet by ‘hiding’ debts or other liabilities.
Improving the reported financial position, shows the board of directors in a favorable light
and helps to boost the share price. Individual directors could therefore stand to benefit
from higher annual bonuses and more valuable share options.
Financial reporting: directors’ duties and responsibilities
Legal duties of directors for financial reporting:
The directors of a company have certain legal duties with regard to financial reporting.
1. Companies must prepare an annual report and accounts and consolidated accounts for
the group in the case of a parent company. The accounts must be approved by the
board and signed on behalf of the board by a director.
2. Directors have a duty to prepare a directors’ report, which must also be approved by the
board and signed on its behalf by a director or the company secretary. The directors’
report must contain a strategic report.
3. The directors have a duty to prepare a directors’ remuneration report, must be
approved by the board and signed on its behalf by a director or the company secretary.
4. The accounts and reports of a public company must be laid before the shareholders in a
general meeting and the shareholders of the company must be invited to approve the
company’s remuneration policy and approve the directors’ remuneration report.
5. The directors must file the annual accounts, director’s report, the auditor’s report and
director’s remuneration report with the Registrar of Companies annually.
 Responsibilities of the directors for financial reporting:
The directors are responsible for the financial statements: they prepare the financial
statements and have the primary responsibility for the reliability of the information they
provide.
i. Management and the directors are therefore responsible for identifying and
correcting any errors or misrepresentations in the financial statements.
ii. The responsibility of the external auditors is to obtain reasonable assurance, in their
professional opinion, that the financial statements are free from material error or
misstatement.
iii. They present a professional opinion to the shareholders, not to the directors of the
company, and the directors should not rely on the opinion of the external auditors in
reaching their own view
As per UK Corporate Governance Code the directors should explain in the annual report
their responsibility for preparing the annual report and financial statements. They should
also state that they consider the annual report and accounts, taken as a whole:
o to be fair, balanced and understandable; and
o to provide the information necessary for shareholders to assess the company’s
performance, business model and strategy.

The UK Code also requires that the directors should include in their annual report an
explanation of the:
i. basis on which the company generates or preserves value over the longer term (its
‘business model’); and
ii. strategy for delivering the objectives of the company.

The directors should also report, in both the half-yearly and the annual financial statements:
1. whether they consider it appropriate for the company to adopt the going concern basis
of accounting, when preparing the financial statements, and also
2. identify any material uncertainties about the company’s ability to do so over a period of
at least 12 months from the date of their approval of the financial statements.
Q. (M) What are the responsibilities of the external auditors with regard to the financial
statements of a company?
Investors, creditors and other stakeholders in a company rely on the information contained in
the annual report and accounts, which are audited each year by a firm of independent auditors.
The purpose of an independent audit is to make sure, that the financial statements are
objective and can be relied on.
After completing their annual audit, the auditors are required to prepare a report to the
shareholders of the company which has two main purposes:
i. to give an expert and independent opinion on the financial statements whether it
give a true and fair view of the financial position of the company as at the end of the
financial year covered by the report, and of its financial performance during the
year; and
ii. to give an expert and independent opinion on the financial statements whether
comply with the relevant laws.

 The purpose of the external audit:

The main purpose of the audit report is to give reassurance to the users of a company’s
financial that the information in the statements is believable and that the financial statements
present a ‘true and fair view’ of the company’s financial position and performance.

 Responsibility for detecting errors and fraud:

It is not the primary responsibility of the external auditors to detect fraud. The auditors will
assess the risk or possibility that fraud or error might have caused the financial statements to
be materially misleading.
The auditors should therefore design audit procedures that will provide reasonable reassurance
that material fraud or error has not been occurred, and that the financial statements give a
‘true and fair view’ of the company’s financial position and performance.

The external audit might also act as a deterrent to fraud, because the auditors will check out of
control procedures, documents and transactions in the course of their audit work. They might
discover fraud during the course of their audit work, in which case it would be their
responsibility to report the matter to the directors.

 Criminal liability of auditors for recklessness:

Negligence or breach of duty is a criminal offence and punishable by a fine for auditors in
connection with the auditors’ report:
 In an audit report knowingly or recklessly include any matter that is misleading, false or
deceptive;
  In an audit report knowingly or recklessly omit a statement that is required by certain
specified sections of the act.

Q. What are the five categories of threats to auditor independence?

The audit profession has identified potential threats to auditor independence. Auditors are
required to be aware of these threats, and to take measures to eliminate them or reduce them
to an insignificant level.

1. Self-interest threat: an auditor or audit firm is earning a large amount of fee income
from the audit. Auditors’ judgement might be affected by a desire to protect this income
stream.
For example, if the audit firm earns a large proportion of its revenue from a client
company, it may be unwilling to annoy that client by challenging the figures and
assumptions used by management to prepare the company’s financial statements.

2. Self-review Threat: This can arise when the audit firm does non-audit work for the
company, and the annual audit involves checking the work done by the firm’s own
employees. The auditors may not be as critical of the work, or prepared to challenge it,
because this would raise questions about the professional competence of the audit firm.

3. Advocacy threat: This can arise if the audit firm is asked to give its formal support to the
company by providing public statements on particular issues or supporting the company
in a legal case. Acting as advocate for a company means taking sides, and this implies a
loss of independence.

4. Familiarity threat: A threat to independence occurs when an auditor is familiar with a

company/directors/senior managers, or becomes familiar with them through a working
association over time. Familiarity leads to trust to the other person says, without
carrying out an investigation into its accuracy or honesty.

5. Intimidation threat: An auditor may feel threatened by the directors or senior

management of a company.

For example, a company CEO or finance director may act aggressively and in a bullying
manner towards audit staff, so that the auditors are browbeaten into accepting what
the ‘bully’ is telling them. Both real and imagined threats can affect the auditor’s
independence. A company may also threaten to take away the audit or stop giving the
firm non-audit work unless the auditor accepts the opinions of management.
 Role and responsibilities of the audit committee:
The UK Code lists the role and responsibilities of an audit committee. they are as
follows:

i. To monitor the integrity of the company’s financial statements and any formal
announcements relating to the company’s financial performance. In doing so, it
should review ‘significant financial judgements’ that these statements and
announcements contain.
ii. To make recommendations to the board in relation to the appointment,
reappointment or removal of the company’s external auditors, to put to the
shareholders for approval in a general meeting of the company.
iii. To approve the remuneration and terms of engagement of the external auditors
(after they have been negotiated with the auditors by management).
iv. To review and monitor the independence of the external auditors, and also the
objectivity and effectiveness of the audit process, taking into account relevant
professional and regulatory requirements.
v. To develop and implement the company’s policy on using the external auditors to
provide non-audit services. This should take into account any relevant external
ethical guidance on the subject. The committee should report to the board,
identifying actions or improvements that are needed and recommending the steps
to be taken.
vi. To report to the board on how it has discharged its responsibilities.
Financial reporting and the role of the audit committee:
It is the responsibility of management to prepare complete and accurate financial statements. It
is the responsibility of the audit committee to review the significant financial reporting issues
and made judgements in connection with these statements.
o The audit committee should consider significant accounting policies to prepare the
statements, any changes to them, and any significant estimates or judgements on which
the statements have been based.
o Management should inform the committee about the methods they have used to
account
for significant or unusual transactions, where the accounting treatment is open to
different approaches.
o Taking the external auditors’ views into consideration, the committee should consider
whether the company has adopted appropriate accounting policies and made
appropriate estimates and judgements.
 o The committee should also consider the clarity and completeness of the disclosures in
the financial statements.

Chapter-8: Relations with shareholders

Q. (M) What are the power and rights of shareholders? Explain the responsibilities of
institutional shareholders with a view to improving corporate governance.

Answer:
↗Power and rights of shareholders: Shareholders do not involve directly in the management
of the companies but may occasionally express their views about corporate strategy to the
chairman or board of the directors since the board of directors and management of the
company make the strategic and operational decisions.

Shareholders have certain rights in law and under the constitution (articles of association) of
their company.
 they have a right to receive the annual report and accounts,
 the right to vote at general meetings,
 the right to a share of the profits of the company.

The powers of shareholders to exercise their rights are limited, and are mainly restricted to:
 voting powers at general meetings; and
 taking legal action in cases where the directors have acted illegally.

i. Pre-emption rights: shareholders have the first right of refusal and offered the right to
buy new shares in proportion to their existing shareholding while a company issues new
shares for cash.
ii. Right to approve long-term incentive schemes: shareholders may be given the right to
approve any new or amended long-term incentive scheme for the company.
iii. Election and re-election of directors and auditors: The articles of association of a public
company should provide for the directors to retire by rotation. A simple majority is
required for election of a new director or re-election of a director.
iv. Approval of remuneration policy: Shareholders have the right to a binding vote at least
every three years on the company’s remuneration policy.
v. Other voting rights: shareholders have a right to,
 call a general meeting of the company, and call for a vote on a resolution
 propose a resolution to be voted on at the AGM
 call an extraordinary general meeting (EGM) if together they hold at least 5% of
the voting share capital.
  include a matter in the business of the AGM of the company if together the hold
at least 5% of the voting share capital.

↗Institutional shareholder responsibilities:

Institutional investors should be responsible for improving the dialogue and conveying the
concerns of shareholders to the board. Institutional shareholders express active concern about
corporate governance in the companies in which they invest

The interests of institutional investors in good corporate governance can be explained as

follows.

 Investors expect a return on their investment. Most evidence suggests that well-
governed companies deliver reasonable returns over the long term.

 Institutional investors also have legal responsibilities (fiduciary duties) to the individuals
on whose behalf they invest. For pension funds, these individuals are the beneficiaries
of the funds. In fulfilling their responsibilities, institutions should try to ensure that they
make a decent return on investment, and promoting good corporate governance is one
way of trying to do this.

 Shareholder activism: Corporate governance would be improved if shareholders were

more active in making their views known to their company, and using their votes against
the board of directors if the company failed to respond in a satisfactory way to their
concerns.

The term ‘shareholder activism’ refers to activities by institutional investors to influence

governance and strategy decisions in companies, involving dialogue and discussion. This
further action will often involve withholding a vote at an AGM, or voting against a
resolution at a general meeting, including votes against the re-election of certain
directors.

Q. Board responsibility to maintain a dialogue with institutional shareholders:

There should be a dialogue with shareholders based on the mutual understanding of objectives.
The board as a whole has responsibility for ensuring that a satisfactory dialogue with
shareholders takes place.
Dialogue with institutional shareholders calls not just for regular formal announcements by a
company, but also for regular, informal contact with the larger shareholders in the company.
UK Code states as supporting principles that:

 the chairman should ensure that all the directors are made aware of the issues and
concerns of the company’s major shareholders; and
 the board should keep in touch with shareholder opinion in the most practical and
efficient ways, whatever these may be.

The UK Code states a number of practical requirements for maintaining dialogue.

 The chairman should ensure that the views of the shareholders are communicated to
the board as a whole.
 The chairman should discuss strategy and governance with the major shareholders.
 NEDs should be given the opportunity to attend existing meetings with major
shareholders.
 If requested to attend meetings with major shareholders, NEDs should expect to attend
them.
 The Senior Independent Director (SID) should attend enough meetings with a range of
major shareholders to listen to their views, in order to develop a ‘balanced
understanding’ of their concerns and views.

Q. Constructive use of the AGM and other general meetings:

The UK Corporate Governance Code states that: ‘The board should use general meetings to
communicate with investors and to encourage their participation.’ The provisions in this part
of the UK Code are concerned mainly with:
 encouraging attendance by shareholders at the AGM and other general meetings;
 giving shareholders an opportunity to ask questions and to hear about the company
during the meeting; and
 giving shareholders the opportunity to use their vote and greater openness in voting
procedures at general meetings.

The Code provisions are as follows:

1. Encouraging attendance: The company should arrange for the notice of the AGM and
the related papers to be sent to the shareholders at least 20 working days before the
meeting.
2. Giving shareholders an opportunity to ask questions: The board chairman should
ensure the attendance of chairman of audit, nomination and remuneration committees
and all directors to answer questions at the AGM.
3. Voting procedures: At the AGM, there should be a separate resolution for each
substantially separate issue. Each issue will then be voted on separately.
 4. Proxy voting forms should include a ‘vote withheld’ box: In addition to the ‘for’ and
‘against’ boxes for each resolution. The ‘vote withheld’ box allows shareholders to
indicate their displeasure about a company’s proposals.
5. Disclosure of information about proxy votes: By announcing the number of votes
including proxy votes, companies will give some recognition to the views of
shareholders unable to attend the meeting, and will not be able to pass controversial
resolutions.

Q. Explain the responsibilities of institutional shareholders with a view to improving

corporate governance
Institutional shareholders, such as pension funds, mutual funds, insurance companies, and
hedge funds, play a significant role in corporate governance by virtue of their large ownership
stakes in publicly traded companies. Their responsibilities in improving corporate governance
include:
1. Active Ownership: Institutional shareholders are expected to actively engage with the
companies in which they invest. This involves exercising their voting rights at annual
general meetings and extraordinary general meetings on matters such as electing
directors, approving mergers or acquisitions, and approving executive compensation
packages. They should also engage in dialogue with company management and board
members on strategic matters, performance concerns, and governance issues.
2. Monitoring: Institutional shareholders are responsible for monitoring the performance
of the companies in their portfolios. This includes evaluating financial performance,
assessing management's strategy and execution, and ensuring that the company
operates ethically and in accordance with relevant laws and regulations.
3. Corporate Governance Oversight: Institutional shareholders should advocate for good
corporate governance practices within the companies they invest in. This involves
pushing for the establishment of independent and diverse boards of directors, ensuring
proper board oversight of management, advocating for transparency and disclosure,
and promoting the adoption of best practices in areas such as risk management,
executive compensation, and board structure.
4. Risk Management: Institutional shareholders are responsible for assessing and
managing risks associated with their investments. This includes evaluating the risks
posed by environmental, social, and governance (ESG) factors, such as climate change,
 labor practices, and corporate culture, and ensuring that companies have appropriate
strategies in place to mitigate these risks.
5. Long-Term Value Creation: Institutional shareholders should prioritize long-term value
creation over short-term profits. This involves supporting management's efforts to
invest in research and development, innovation, employee development, and
sustainable business practices that contribute to the company's long-term success.
6. Stewardship Reporting: Institutional shareholders are increasingly expected to publicly
disclose their stewardship activities, including how they engage with companies, their
voting decisions, and the rationale behind their investment decisions. This transparency
helps to hold institutional shareholders accountable and encourages greater alignment
between their interests and those of their beneficiaries or clients.
By fulfilling these responsibilities, institutional shareholders can contribute to the improvement
of corporate governance practices, which in turn can enhance shareholder value, mitigate risks,
and promote the long-term sustainability of companies.