CIMA F1 Syllabus A. Regulatory Environment Of Financial Reporting - Approaches to Corporate Governance - Notes ^{2 / 7}

These are:

1. Rules based (adopted in USA)

2. Principle based (adopted in the UK)

Rules-based system

In the rules-based system, companies adhere to the rules or pay penalties.

• ADVANTAGES

  1. Clarity

  2. Standardisation

  3. Penalties are a deterrent against bad CG

  4. Easier compliance with the rules, as they are unambiguous, and can be evidenced

• DISADVANTAGES

  1. Can create just a "box-ticking" approach

  2. Not suitable to all possible situations.

  3. Creates unnecessary administration burden on some companies

  4. One size does not necessarily fit all.

  5. Expensive

How to address the problem of over-familiarity of the audit firm with the client?

• Rotation of lead audit partner every five years

Principles-based System (Comply or explain)

In the principles system, companies adhere to the spirit of the “rule”, or explain why it hasn’t. 

This does not mean the company has a choice not to adhere. 

It just means it can TEMPORARILY explain why it has not. 

The punishment for this non-adherence will be judged by investors.

• ADVANTAGES

  1. Not so rigid, allows for different circumstances.

  2. Allows companies to go beyond the minimum required.

  3. Less of an admin burden.

  4. Can develop own specific CG and Internal controls (For example physical controls over cash will be vital to some businesses and less relevant or not applicable to others.

• DISADVANTAGES

  1. The principles are so broad that they are of very little use as a guide to best corporate government practice

  2. Not easier compliance as with the rules, as they are ambiguous, and can not be evidenced

Principles v Rules More Detail

• Principles

  The principle of ‘comply or explain’ means that companies have to take seriously the general principles of relevant corporate governance codes.

  Compliance is required under stock market listing rules but non-compliance is allowed based on the premise of full disclosure of all areas of non-compliance.

  So basically it is then up to the market (share price) to judge how good/bad the non-compliance is

  In most cases nowadays, comply or explain disclosures in the UK describe minor or temporary non-compliance.

• Rules

  Rules-based control is when behaviour is underpinned and prescribed by statute of the country’s legislature. 

  Compliance is therefore enforceable in law such that companies can face legal action if they fail to comply.

  US-listed companies are required to comply in detail with Sarbox provisions.

  Sarbox compliance can also prove very expensive.