IAI Actuarial Core Principles · Business Finance

Corporate governance and the regulation of companies: formula sheet

Full chapter guide

Key formulas

Total agency cost: Agency cost = monitoring cost + bonding cost + residual loss; Use this three-part split when a question asks you to define or classify agency costs. This is the standard Jensen and Meckling breakdown.
Principal-agent relationship: Principal (shareholders) → delegates decisions → Agent (managers); The conflict exists because interests differ and actions are not fully observable.
Goal congruence test: Good incentive scheme: manager's reward rises when shareholder wealth rises; Use this as a check when you evaluate any remuneration scheme.
Executive director: Executive director = board member + employee with day-to-day management role; Examples: CEO, finance director. Not independent of management.
Non-executive director: NED = board member, not an employee, not involved in day-to-day management; Roles: challenge, strategy input, monitoring, and staffing committees. A NED is not automatically independent.
Independence test: Independent = no relationship or circumstance likely to affect, or appear to affect, judgement; Check for past employment, shareholding, family ties, business links and long service.
Separation of roles: Chair ≠ Chief executive; Prevents one person holding unchecked power over the board and the business.
Committee remits: Audit → reporting, controls, auditor | Remuneration → executive pay | Nomination → board appointments and succession; Committees should be mainly or wholly independent NEDs. They advise or decide under board authority.
Payoff of a share option at exercise: Payoff per option = max(S − X, 0); S is the share price at exercise, X is the exercise price. The holder cannot lose more than the cost of the option (if any), which is why options reward risk.
Total value of options to a manager: Total payoff = Number of options × max(S − X, 0); Ignores tax and time value of money. State this assumption.
Aim of remuneration (rule): Pay linked to shareholder value → managers' interests ≈ shareholders' interests; This is a principle, not an exact equation. Alignment is only partial and depends on how pay is designed.
Comply or explain: Follow the provision, OR disclose the departure and give reasons; Principles-based. The explanation must be specific and meaningful, not a bare statement of non-compliance.
Hierarchy of rules: Company law (binding) > Listing rules (binding for listed companies) > Codes (guidance unless made binding); Use this to say which rules apply to which company.
Rules-based vs principles-based: Rules: detailed, mandatory, penalties. Principles: broad, flexible, disclosure-driven; Be ready to give one advantage and one disadvantage of each.
Audit opinion test: Accounts give a true and fair view of the company's position and results; This is the auditor's key assurance. It is not a guarantee of no fraud or of future success.
Shareholder view of the firm: Duty = maximise shareholder wealth within the law; Contrast this with the stakeholder view when you discuss CSR.
Stakeholder view of the firm: Duty = balance the interests of all affected groups; Groups include employees, customers, lenders, suppliers, society and the environment.
Companies Act 2013, section 135: Qualifying company → CSR committee + CSR policy + spend on CSR from average profits, or explain non-spend; State it in words. Check thresholds and percentages in your study material before using numbers.
Typical causes of governance failure: Dominant leader + weak board + weak controls + bad incentives + weak audit; Use this as a checklist when analysing any scandal.
Whistleblowing framework: Policy + safe channel + protection + independent follow-up; Use it to structure recommendations.

Quick revision

Corporate governance is the system by which a company is directed and controlled.
The agency problem arises because owners (principals) hire managers (agents) whose interests may differ.
Agency costs include monitoring, bonding and the loss from decisions that do not maximise shareholder value.
Typical conflicts: perks, empire building, short-term focus and avoiding risk or taking too much.
The board sets strategy, oversees management and is accountable to shareholders.
Non-executive directors bring independent judgement and help check executives.
Key committees are audit, remuneration and nomination, and each should be mainly independent.
Good pay schemes link rewards to long-term performance and are clearly disclosed.
Poorly designed bonuses can push managers towards short-term or excessive risk.
Codes often work on a comply or explain basis, while regulation is mandatory.
Ethics goes beyond the law, and weak culture is a common root of governance failures.
In answers, always name the issue, explain the harm, give a remedy and state its limit.

Common mistakes

Defining governance as day-to-day management of the company. Fix: Say governance is about direction, control and accountability. Management is about operations.
Saying directors own the company. Fix: Shareholders own the company. Directors are appointed to act on their behalf and are accountable to them.
Saying agency cost and monitoring cost are the same thing. Fix: Remember agency cost has three parts: monitoring, bonding and residual loss. Monitoring cost is only one.
Assuming performance-linked pay always solves the problem. Fix: Always give a weakness. Profit bonuses can encourage short-termism, and share options can encourage excessive risk or manipulation of results.
Assuming every non-executive director is independent. Fix: Treat NED as a status and independence as a test. A NED who was recently an employee or holds a large stake may not be independent.
Mixing up the three committees' roles. Fix: Link each to one key word: audit to accounts and controls, remuneration to pay, nomination to appointments and succession.
Saying share options always align managers with shareholders. Fix: State that options reward gains but carry no loss for the manager, so they can encourage excessive risk.
Treating a bonus as a long-term incentive. Fix: Annual bonuses are short-term and linked to a single year's targets. LTIPs and options have multi-year horizons.
Saying comply or explain means a company may ignore the code. Fix: State that the company must give a clear, reasoned explanation, and shareholders judge it.
Treating all governance codes as legally binding. Fix: Say a code is guidance unless law or listing rules make it mandatory.

Exam tips

Start every written answer with a one-line definition. It is easy credit.
Use short labelled points such as accountability, transparency and fairness, and add one explanatory sentence to each.
Distinguish clearly between roles: owners, board, management and other stakeholders.
Where the question says 'discuss', mention both the shareholder and stakeholder views.
In MCQs, watch for options that say directors own the company or that governance means maximising short-term profit only.
In written answers, always name the principal, the agent and the information gap in your first two lines.
Evaluate every remedy with a benefit and a weakness. Examiners reward balanced answers.
Learn the three-part split of agency cost. MCQs often test the difference between monitoring cost and agency cost.