- Information
- AI Chat
Independence as a concept in corporate governance ACCA Global
Association of Chartered Certified Accountants - ACCA (PAC150)
INTEC Education College
Recommended for you
Students also viewed
Preview text
Home / Students / Study support resources / Strategic Business Leader (SBL) / Technical articles
Back to
Technical articles
Passing Strategic Professional exams
Strategic Business Leader – 10 things to learn from the September 2018 sitting
How to approach Strategic Business Leader
Independence as a concept in corporate governance
This article explores the theory of independence, and
discusses why it’s vital in many contexts relating to
corporate governance and professional behaviour.
Introduction Degrees of independence Independence and non-executive directors Measures to increase NED independence
Independence as a concept in corporate governance
Menu
Introduction
The concept of independence occurs at several points in the Strategic Business Leader (SBL) syllabus.
In corporate governance, independence is important in a number of contexts. It is vital that external auditors are independent of their clients, that internal auditors are independent of the colleagues they are auditing, and that non-executive directors have a degree of independence from their executive colleagues on a board. But what do we mean by ‘independence’ as a concept?
Independence is a quality that can be possessed by individuals and is an essential component of professionalism and professional behaviour. It refers to the avoidance of being unduly influenced by a vested interest and to being free from any constraints that would prevent a correct course of action being taken. It is an ability to ‘stand apart’ from inappropriate influences and to be free of managerial capture, to be able to make the correct and uncontaminated decision on a given issue.
If, for example, an auditor is a longstanding friend of a client, the auditor may not be sufficiently independent of the client. Given that it is an auditor’s job to act on behalf of shareholders and not the client, the friendship with the client may compromise the auditor’s ability to effectively represent the interests of the shareholders. The auditor may not be as thorough as he ought to be, or he may be influenced to give the benefit of a doubt to the client when he should not be doing so.
The same could apply to non-executive directors (NEDs). In some countries, NEDs are referred to as independent directors to emphasise this very point. NEDs are appointed by shareholders in order to represent their interests on company boards. The primary fiduciary duty that NEDs owe is, therefore, to the company’s shareholders. This means that they mustn’t allow themselves to be captured or unduly influenced by the vested interests of other members of the company such as executive directors, trade unions or middle management.
Degrees of independence
A common problem in many organisational situations is ensuring independence where it could represent an ethical threat if absent. In real-life situations, friendships and networks
Looking in a bit more detail at the roles of NEDs in particular, what are the specific benefits of NED independence? We have already discussed the fact that the primary fiduciary duty of a NED is to the company’s shareholders. In order to increase NED independence, some shareholders prefer to bring new NEDs in from outside the industry in which the company competes. This is because a number of independence-threatening informal networks can build up within an industry over the years as staff move between competitor companies and as they collaborate in industry ‘umbrella’ bodies from time to time.
There is a debate about the pros and cons of appointing NEDs that have some industry experience compared to appointing NEDs from outside the industry in which the company in question competes. Previous industry involvement brings with it a higher technical knowledge of issues in that industry (which might be important), a network of contacts and an awareness of what the strategic issues are within the industry. While these might be of some benefit to a NED’s contribution, the prior industry involvement might also reduce the NED’s ability to be objective and uncontaminated by previously held views: in other words, they can make the NED less independent.
Accordingly, it is sometimes easier to demonstrate independence when NEDs are appointed from outside the industry. In addition to the benefits of the ‘new broom’ effect of bringing a fresh pair of eyes to a given problem, a lack of previous material business relationships will usually mean that a NED will not have any previous alliances or prejudices that will affect his or her independence.
In practice, many companies employ a mix of NEDs, and it is often this blend of talents and areas of expertise that is what makes a non-executive board effective. Technical input can be given by some NEDs, while wider political or regulatory insights might be provided by others. In large and highly visible companies, NEDs able to bring a social or political perspective to board deliberations can be strategically important. They may have retired senior government ministers or former chairmen of other large companies on their boards to give these insights. The fact that such people usually have no previous material business relationship with the company is seen as important in ensuring that they are materially independent.
Back to top
Measures to increase NED independence
In order to enhance the independence of non-executive directors, a number of provisions are made in company law and in corporate governance codes. The nature of these provisions and their enforceability in law also varies with jurisdiction.
First, it is usually the case that NEDs should have – and have had – no business, financial or other connections with the company during the past few years (again, the period varies by country). This means that, for example, the NED should not have been a shareholder, an auditor, an employee, a supplier or a significant customer.
Second, cross-directorships are usually banned. This is when an executive director of Company A serves as a NED in Company B and, at the same time, an executive director of Company B serves as a NED at Company A. Such a relationship is considered to make the two boards too intimately involved with each other and potentially reduces the quality of the scrutiny that the two NEDs involved in the cross-directorship can bring.
Third, restrictions or total bans on share options for NEDs are often imposed. These are intended to help ensure that NEDs are able to stand slightly apart from the executive board and offer advice and scrutiny that are unhampered by vested interests such as short- termism on the company’s share price.
Fourth, NED contracts sometimes allow them to seek confidential external advice (perhaps legal advice) on matters on which they are unhappy, uncomfortable or uncertain. This should be at the company’s expense and helps the NED to gain outside, objective advice on the issue he or she is concerned about. Finally, NEDs are usually time-limited appointments (typically three years) and the number of terms that a NED can serve is also often limited, perhaps to two consecutive terms.
In conclusion, then, independence is an essential quality in a number of situations in corporate governance and in professional behaviour. Independence is sometimes enhanced and underpinned by regulation and legislation, but over and above that, it is expected of every professional person and of every professional accountant.
Adapted and updated for SBL from an article originally written by a member of the P examining team
Back to top
Independence as a concept in corporate governance ACCA Global
Course: Association of Chartered Certified Accountants - ACCA (PAC150)
University: INTEC Education College
