Corporate governance and financial reporting
This chapter explains corporate governance: the framework used to direct and control companies. A key idea is the separation of ownership from management. We’ll also look at directors’ responsibilities as stewards of shareholders’ interests, especially their role in ensuring financial reporting is reliable and has integrity.
Learning objectives
By the end of this chapter, you should be able to:
- Explain what is meant by governance, specifically in the context of the preparation of financial statements
- Describe the duties and responsibilities of directors in the preparation of the financial statements
Corporate governance
Corporate governance is especially important where ownership is separated from management. In many companies, the people who own the company (shareholders) are not the same people who manage it day to day.
The board of directors is charged with the responsibility for governing the company, including overseeing the preparation of the financial statements. In exam questions and auditing language, the directors are often called “those charged with governance.”
Directors are often described as agents of the shareholders. That means they are expected to make decisions in shareholders’ best interests and to be accountable for how they use the company’s resources.
This relationship between directors and shareholders is commonly referred to as the principal-agent relationship. Shareholders (principals) delegate authority to directors (agents) to manage the company on their behalf. This delegation creates a risk that directors may act in their own interests rather than those of shareholders (i.e., the agency problem) - for example, a director whose bonus depends on reported profit might be tempted to pick overly optimistic estimates. Independent audits and disclosure requirements help limit that risk.
Regulatory framework of corporate governance
Company law and corporate governance codes, together with international standards such as IFRS, define directors’ duties and set reporting benchmarks that hold directors accountable to shareholders and other stakeholders.
General responsibilities of the directors
Company law in most jurisdictions requires directors to:
- Exercise reasonable care, skill, and diligence in performing their duties, using their experience and knowledge appropriately
- Act in good faith and in the best interests of the company, avoiding conflicts of interest and not misusing their position
- Ensure compliance with relevant laws, regulations, and statutory requirements, including timely filing of documents
- Participate actively in company management through regular board meeting attendance and decision-making
- Ensure proper corporate governance practices are followed and monitor company operations effectively
- Meet specific financial reporting duties (see the next section)
These responsibilities reflect the directors’ role as stewards of the company, accountable to shareholders and other stakeholders. Corporate governance is often judged by how well the board balances stakeholder interests while supporting the company’s long-term success.
These responsibilities are not just administrative. They carry legal weight. Directors who fail to meet these duties may face personal liability, disqualification, or (in serious cases such as fraudulent reporting) criminal prosecution.
Directors’ responsibilities in financial reporting
Within the governance framework, directors have specific duties related to the preparation of financial statements. Their primary duty is to ensure the financial statements present a true and fair view of the company’s financial position and performance. Specifically, they have the responsibility to:
- Maintain accurate accounting records documenting all financial transactions.
- Ensure financial statements are prepared following appropriate reporting frameworks like IFRS. By doing so, they are to select appropriate accounting policies, apply them consistently, and make reasonable judgements and estimates.
- Establish controls to prevent material misstatements and create processes that ensure accuracy in financial reporting.
- Establish systems to detect and prevent fraud.
Example: Which duty has been breached?
A director discards several months of invoices and bank statements instead of filing them, so the company has no record of some transactions it made. Which duty has been breached?
Answer: The duty to maintain accurate accounting records documenting all financial transactions.
In many jurisdictions, directors are also required to sign a directors’ responsibility statement, included in the annual report, which contains the audited financial statements alongside other reports such as the directors’ report. This statement formally acknowledges that the directors have fulfilled their obligations in preparing the financial statements in accordance with applicable financial reporting standards, have maintained appropriate accounting records, and that the financial statements give a true and fair view. This formal acknowledgement reinforces directors’ accountability and provides users of financial statements, such as investors, lenders, and regulators, with assurance that the reported figures have been subject to appropriate oversight.