ACCA

Paper P1

GOVERNANCE, RISK
AND ETHICS

“Challenges are what make life interesting and

overcoming them is what makes life
meaningful.”
Joshua J. Marine
 PAPER P1
GOVERNANCE, RISK AND ETHICS
STUDY TEXT
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All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval
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 Table of content

INTRODUCTION To Paper P1 ........................................................................ 3

CHAPTER 1 | Theory of Governance ............................................................. 8
CHAPTER 2 | Development of Corporate Governance ................................ 31
CHAPTER 3 | The Board of Directors .......................................................... 40
CHAPTER 4 | Directors' Remuneration ....................................................... 68
CHAPTER 5 | Relations with Shareholders and Disclosure ........................ 81
CHAPTER 6 | Corporate Governance Approaches ...................................... 94
CHAPTER 7 | Corporate Social Responsibility & Corporate Governance . 104
CHAPTER 8 | Internal Control Systems .................................................... 115
CHAPTER 9 | Audit and Compliance ......................................................... 130
CHAPTER 10 | Risk and the Risk Management Process........................... 144
CHAPTER 11 | Controlling Risk ................................................................. 155
CHAPTER 12 | Ethical Theories ................................................................ 169
CHAPTER 13 | Professional and Corporate Ethics ................................... 182
CHAPTER 14 | Ethical Decision Making .................................................... 199
CHAPTER 15 | Social and Environmental Issues ...................................... 206

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INTRODUCTION to Paper P1

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 Table of content

1. Examination Format ....................................................................................................... 5

2. Sitting the Exam ............................................................................................................. 5
3. Pass-Rates .................................................................................................................... 5
4. Syllabus ......................................................................................................................... 6

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1. Examination Format

P1 is a three-hour paper based examination, containing two sections.

Section A is compulsory, but there is a choice of 2 out of 3 questions in Section B.
For all three hour examination papers, ACCA has introduced 15 minutes reading and
planning time. This additional time is allowed at the beginning of each three-hour
examination to allow candidates to read the questions and to begin planning their answers
before they start writing in their answer books. This time should be used to ensure that all
the information and exam requirements are properly read and understood.
During reading and planning time candidates may only annotate their question paper. They
may not write anything in their answer booklets until told to do so by the invigilator.
The pass mark for all ACCA Qualification examination papers is 50%.

2. Sitting The Exam

The exam is available in Paper-Based format.

3. Pass-Rates

Pass-Rates for Paper P1

53%

52% 52%

51% 51%

50%

49%

48%

Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14

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4. Syllabus

A. Governance and responsibility

1. The scope of governance

2. Agency relationships and theories
3. The board of directors
4. Board committees
5. Directors’ remuneration
6. Different approaches to corporate governance
7. Corporate governance and corporate social responsibility
8. Governance: reporting and disclosure
9. Public sector governance

B. Internal control and review

1. Management control systems in corporate governance

2. Internal control, audit and compliance in corporate governance
3. Internal control and reporting
4. Management information in audit and internal control

C. Identifying and assessing risk

1. Risk and the risk management process

2. Categories of risk
3. Identification, assessment and measurement of risk

D. Controlling risk

1. Targeting and monitoring risk

2. Methods of controlling and reducing risk
3. Risk avoidance, retention and modelling

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E. Professional values, ethics and social responsibility

1. Ethical theories
2. Different approaches to ethics and social responsibility
3. Professions and the public interest
4. Professional practice and codes of ethics
5. Conflicts of interest and the consequences of unethical behaviour
6. Ethical characteristics of professionalism
7. Social and environmental issues in the conduct of business and of ethical behavior

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CHAPTER 1 | Theory of Governance

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 Table of content

1. Company Ownership and Control ................................................................................ 10

2. Definition of Corporate Governance ............................................................................. 11
3. Purposes and Objectives ............................................................................................. 12
4. The Key Concepts ....................................................................................................... 13
5. Areas affected by Corporate Governance .................................................................... 16
6. Different organizations, different governance ............................................................... 18
7. Internal corporate governance stakeholders ................................................................ 22
8. External corporate governance stakeholders ............................................................... 23
9. What is Agency Theory? .............................................................................................. 24
10. Key Concepts .............................................................................................................. 25
11. Principal - Agent Relationships in Corporate Governance ............................................ 26
12. Agency Accountability .................................................................................................. 28
13. Transaction Cost Theory .............................................................................................. 30
14. Stakeholder Theory...................................................................................................... 31

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1. Company Ownership and Control

Why do we need governance?

Delegation of Control
Shareholders Directors

VS
Ownership Control

Objectives Objectives

Companies that are trading on the stock exchange require a substantial investment in
equity to fund them and therefore have a large numbers of shareholders.

Shareholders delegate the control to professional managers to run the company.

This separation of ownership and control leads to a potential conflict of interests between
directors and shareholders.

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2. Definition of Corporate Governance

DEFINITION

Corporate Governance is the system by which companies are directed and controlled
in the interests of shareholders and other stakeholders.

In more detail: governance is the relationship between the directors, the shareholders
and other stakeholders. It also provides the structure through which the objectives of
the company are set, the means of achieving them and monitoring performance.

Governance is an issue for all companies not just large quoted companies as well as non for
profit organizations and governmental organizations.

The case for Corporate Governance:

- CG increases accountability and therefore maximizes sustainable wealth creation

- Applying CG allows for better management which in turn results in better financial
performance

Providing a case for governance is important in order to ensure the support of the
management in an organization.

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3. Purposes and Objectives

Purposes: Objectives:

Primary: Monitor the parties that Primary: To improve corporate

control the resources owned by performance and accountability
investors in creating long term
shareholder value

Other:

- Suitable balance of power on the Other:

board - Control the controllers
- Executive directors are fairly - Increase transparency and
remunerated confidence
- Make the board is responsible - Ensure the company is run in a
for monitoring and managing risk legal and ethical manner

- Ensure independency of - Build in control from top to down

auditors

- Address issues like ethics and

Corporate Social Responsibility
(CSR)

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4. The Key Concepts

Why is the moral stance of an individual important in governance? Because the foundation to
governance is the action of the individual and these actions are guided by a person’s moral
stance.

- CG outlines a set of codes that provide managers with principle to guide their behavior
appropriately. It is the individual’s ethical stance that translates this into action.

- The demonstration of higher levels of ethical behavior improves the perception of the
accounting profession

- The existence of moral virtue provides trust in the agency relationship.

Characteristics of an appropriate moral stance:

 Fairness
- Equality in dealing with internal stakeholders.
- Even–handedness in dealing with external stakeholders.
- Ability to reach a fair judgment in an ethical situation.

 Openness / Transparency
This implies corporate disclosure to shareholders which includes disclosing information in
the Financial Statements, in the narrative statements or even voluntary disclosure.

The reason for this is to mitigate the agency problem (the potential conflict between the owner
and the manager). Without effective disclosure the managers will have far more knowledge
about the business than the owners and they will be in a position to abuse this power.
Additional to the effective disclosure rules, there should be internal controls that will ensure
that the information disclosed is reliable.

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  Independence
Non-Executive Directors (NEDs) must be independent from personal influence from the
managers. The board must be independent from operational involvement and directors must
be independent from personal conflicts of interest.

 Honesty / Probity
This relates to not only telling the truth but to also not misleading. Not only there must be
honesty in financial reporting but there also must be the perception/ability to prove honesty.

 Responsibility
There must be a willingness to accept liability for the outcome of decisions and clarity in
the responsibilities. The Board must act responsibly in relation to all tasks delegated to them
by all stakeholders. The issues regarding to whom they are responsible and to what extent
are still under debate.

 Accountability
This is about the organization being answerable for the consequences of their actions.
There must be clarity in the communications as well as a development of risk management.
One of the biggest debates is the extent of accountability managers have towards other
stakeholders.

 Reputation
Reputation is about developing a good personal and business name through moral virtues,
developing a moral stance for the organization and for the profession. The concern for the
company’s reputation is purely for commercial reasons as the price of the company’s shares
depend on its reputation. Hence the reputation of a company is its most valuable asset!

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  Judgment
The members of the board must have the ability to reach and communicate meaningful
conclusions, to weigh numerous issues and give them consideration.

It is for this reason that the board is expected to have an extensive knowledge of the business
and its environment.

 Integrity
Integrity depicts someone of high moral character who sticks to his principles no matter what
the pressure placed on him. The highlight is on the personal honesty and integrity of the
preparers of accounts. The reason being is that the integrity of reports depends on the integrity
of those who prepare and present them. Ethical codes don’t cover all situations and therefore
depend for their effectiveness on the qualities of the accountant. Additionally, the aim of
corporate governance is to inspire confidence in the market and this depends upon the public
perception of competence and integrity.

 Innovation
Occurs when a firm “transforms knowledge and ideas into new products, processes and
systems for the benefit of the firm and its stakeholders.
In the context of C.G, this relates to innovation and experimentation in reporting, moving with
this way away from rigid compliance and at the same time it improves the
communication of its individual value creation story for its providers of financial capital
Innovation can also improve a company’s reporting performance for the benefit of its
investors and consumers.

 Skepticism
It is an attitude which includes a questioning mind, being alert to conditions indicating
possible misstatement due to fraud or error and critical assessment of evidence.

In C.G, this is applicable for NEDs to apply skepticism so as to achieve their roles (strategy,
scrutiny, people and risk) effectively.

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5. Areas affected by Corporate Governance

BOARD OF DIRECTORS AND BOARD

COMMITTEES

DUTIES AND REMUNERATION &

COMPOSITION
FUNCTIONS REWARDS

REPORTING NED'S

RISK MANAGEMENT EXECUTIVE

& INTERNAL CONTROL DIRECTORS

SHAREHOLDERS

RIGHTS & RESPONSIBILITIES

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In more detail:

- Duties of directors and functions

 The board should meet regularly.
 There should be a clear list of responsibilities.
 There must be a formal procedure for their appointment.
 Performance evaluation of the board and the directors.
 Directors must submit themselves for re-election.
 Key and strategic decisions must be reserved for the board.

- Reliability of financial reporting and external auditing

 The reports should provide a balanced assessment of the company’s position
 Formal consideration on how to apply Financial Reporting and internal control
procedures
 An appropriate, independent, relationship must be maintained with the auditors
 The accounts must include the directors’ responsibility in preparing the accounts, a
going concern statement, and a statement on how CG principles have been applied.
 Auditor’s statements

- Risk Management and Internal Control

 The directors must maintain a sound system of internal control. Why? To safeguard
the shareholders’ interests.
 Joint and collective responsibility
 Management reviews the effectiveness of the Internal Controls
 The risks facing the business must be regularly evaluated

- Board Composition
 There must be a balance of executive and independent NEDs so that no group will
dominate the decision making.
 Half of the members of the board (excluding the chair) must be independent
 NEDs should make up the remuneration and audit committees and the majority of
the nomination committee.
 Board effectiveness must be judged according to: time available, personal
competence, quality of info, boardroom culture.

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 - Rights and responsibilities of shareholders
The company must

- give enough notice to shareholders of meetings

- have regular dialogues with shareholders
- use Annual General Meeting constructively

The institutional shareholder must

- use their votes

- have regular dialogues with the company
- pay attention to the relevant factors drawn to their attention

6. Different organizations, different governance

KEY POINT

Only publicly listed companies (PLC’s) are required by the stock exchange to
follow corporate governance principles. The scope of governance for private and
not-for-profit organizations is much reduced when compared to a listed company.
However, many of the governance principles are applicable to other entities.

The not-for-profit sector (and the public sector) has voluntary best practice guidelines for
governance that cover many of the same topics that are included in the Combined Code
such as board composition, accountability, risk management, transparency etc.
The focus however of these codes varies. For example the key governance focus for non-
for-profit organizations is to demonstrate that the money is being spent in an appropriate
manner.

 Public Sector Governance:

In most economies there are three types of organisation:
- Private Sector: exists to make a profit
- Charities: are charitable or benevolent
- Public sector: delivers goods/services which are not provided by “for profit”
entities.

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 Government organisations can exist at three levels:
- National Government: Subdivided into central government departments and they are
supported by permanent government employees (Civil Servants) who are employed
in order to provide advice to the Minister in charge and assist in the implementation
of governance policy.

- Sub-national Government: Counties can be organized into regional local

authorities, which are managed by elected representatives and supported by
permanent officials (similar to the Civil Servants) mentioned above. These local
authorities take control of specific functions which are supposed to be better
controlled by local people as these people have knowledge regarding the
demographic needs.

- Supranational Government: National Governments come together for a specific

purpose (e.g. European Union). The ultimate purpose is to foster a collective
opinion on high level international issues

 Stakeholders and the Public Sector:

- The complexity of the stakeholder relationship and their claims are much more
complicated issues in the public sector as the taxpayers’ funds in many cases are
used for services which are of no benefit for the taxpayers.

- This raises the question of agent and principal in the Public Sector.

- In the public sector the principals are not shareholders but, are those who fund
and/or use the activity. Therefore, public sector organisations carry out their roles
on behalf of those who fund the service and the users of the service.

- In cases where the funders and the service users are not the same people,
disagreements arise on how much is spent and on what service

 Public Sector VS Private Sector:

- Public sector organisations have different objectives than the private sector.

- Private companies tend to seek to optimize their competitive strategy and

advantages whereas, public sector organisations tend to be concerned with social
purposes and in delivering their services effectively, efficiently and to achieve
value for money.

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- This is known as the three E’s.

 Economy: deliver the service on time and within the budget

 Effectiveness: deliver the service for which the organisation was created to provide

 Efficiency: gain an acceptable return on the money invested

 Other forms of organisations:

- In addition to the private and public sector, there is also the “third sector”.
- It includes organisations which are created for the delivery of services that cannot be
delivered by the other two categories.

 Non-governmental Organisations (NGOs):

 Task oriented and driven by people with a common interest providing a variety of
services and humanitarian functions (e.g. Red Cross)
 There are usually privately funded, managed by executive and non-executive
board.
 They are answerable to a board of trustees, which is in place to ensure that the
NGOs are operated in line with their stated purpose.

 Governance arrangements in the Public Sector

- Accountability is achieved through a system of reporting and oversight
- This includes those in charge of the service delivery to report to an external
body which may be a board of governors or trustees.
- This body should act in the best interests of the providers of finance in
order to ensure that the service is delivered on time and for the benefit of the
users. It can include executives and non-executives (similar to private sector)

- The roles of the oversight bodies include:

 To ensure that the service provided is in compliance with the

government rules

 To ensure that the performance targets are met

 To set and monitor performance against budgets

 To oversee new appointments

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  To monitor management performance

 To remove underperforming managers

 To report to higher authorities

 Changing policy objectives

- There is a debate about the extent, operation and need of the public sector
organisation something which has raised the argument regarding the process
of privatization (i.e a previously publicly funded organisation to be provided
by the private sector by making it a publicly listed company and encouraging
people to buy shares.

 In favour of privatization:
- More efficiency in delivery through profit driven performance measures
- Increased competition leading to increased value for money to the customer
- Better quality management
- Improved governance

 Against privatization:
- Profit is not the motive for strategic services (e.g. health)
- Increased competition will lead to detrimental change
- Key services should remain under state control in order to ensure effective
delivery

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7. Internal corporate governance stakeholders

The internal stakeholders have an operational role in the company, a role in Corporate
Governance, and an interest in the company.

STAKEHOLDERS OPERATIONAL ROLE CORPORATE INTERESTS

GOVERNANCE ROLE

Directors Strategy and Company Control of the Company Pay, bonus,

actions status, power

Company Compliance with law Advise board on Pay, bonus,

Secretary Keep members Corporate Governance status, stability,
informed of their duties issues development,
work conditions

Junior Managers Run operations. Identify & evaluate risks, As above

Implement policies monitor, report

Employees Carry out orders Comply with internal As above

controls. Report breaches

Unions Protect employee Act against breaches of Power, status

interests governance

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8. External corporate governance stakeholders

The external stakeholder has a role to play in influencing the Co and its own interest in it.

STAKEHOLDER ROLE INTERESTS

Auditors Independent review Fees, reputation, relationship

Regulators Implementing and monitoring Compliance & effectiveness

regulations

Stock Exchange Implementing and maintaining Compliance, taxes, employment,

the laws imports, exports

Institutional Influence the strategy Value of shares, dividends, security

Investors

Institutional Investors and Corporate Governance

 Due to their size they can exert influence on the strategy

 The Institutional Shareholders Committee (2002) issued guidelines that place

obligations upon institutional shareholders to develop a policy on Corporate
Governance and put pressure on PLC’s where they have investments to apply it

SUPPLEMENTARY READING

Wikipedia: Institutional Investors

http://en.wikipedia.org/wiki/Institutional_investor

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9. What is Agency Theory?

The agency theory examines the duties and conflicts that occur between parties that
have an agency relationship.

DEFINITION

The agency relationship is a contract under which one or more persons (the
principals) engage another person (the agent) to perform a service on their behalf
that involves delegating some decision-making authority to him.

The agency relationship in an organization is the result of the separation of ownership and
control:

 The owners of the company are the shareholders; however their powers are actually
restricted.
 The organization is run by its directors that are responsible for the day to day
operations and for yielding a return to the shareholders
 The directors are less risk averse as they are managing someone else’s capital (in
particular the investor’s investment).
 The goals of the shareholders (wealth maximizations) conflict to the personal
objectives of the managers.
 The managers are looking for short-term results rather than long-term shareholder
wealth

10. Key Concepts

 Agent
The agent is employed by the principal to carry out a task on their behalf
 Principal
The principal is the person employing the agent to carry out a task for them
 Agency
The relationship between the principal and the agent

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  Agency Costs
Costs incurred by the principals to monitor the agent’s behavior because of lack of trust in
the good faith of agents

 Accountability
By accepting to undertake a task on the principal’s behalf, the agent becomes accountable to
the principal. Accountability means that the agent is answerable under the contract to the
principal and must account for the resources of his principal and the money he has gained
working on the principal’s behalf.

KEY POINT

TWO problems arise out of this:

- How does the principal enforce this accountability? (The agency problem)
- What happens if the agent is accountable to parties other than his principal?
(The stakeholder view)

 Fiduciary duty
It is a duty imposed upon certain persons because of the position of trust and confidence
which they hold. It requires full disclosure of information held by the fiduciary, a strict duty
to account for any profits received under this relation and a duty to avoid conflict of
interests.

11. Principal – Agent Relationships in Corporate Governance

For the agency relationship to work the directors in an organization should have incentives
and the shareholders should be monitoring them. Corporate Governance is concerned with
ways to monitor the directors. By doing so, there are additional costs to the organization:

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11.1 The Cost of Agency Relationships

 Residual Loss
This is when the directors use the company’s assets for themselves for example buying
expensive cars and private planes. This is a loss to the shareholders.

 Agency Cost

This is the cost of monitoring the agent:

- incentive schemes and remuneration packages
- cost of management providing report data regarding the effectiveness of internal
controls and risk management analysis
- cost of organizing meetings with shareholders
- cost of directors accepting higher risks than the shareholders would like

The agency cost arises from the attempts of the principal to monitor the activities of the agent
and it may be in terms of money spent, resources used or time taken. There will also be
costs involved in setting up methods of control. These costs are not only incurred by the
shareholders: the directors spend a lot of their time and resources in proving that they are
maximizing shareholder value.

11.2 How Can the Problem be Resolved?

The only way the agency problem is resolved is by aligning the interests of the directors with
those of the organization. How is it achieved?
- Profit-related pay
- Rewarding managers with shares
- Executive Share Option Plans

Other ways of resolving the agency problem:

- Meetings between directors and institutional investors
- Investors voting at the Annual General Meeting
- Directors proposing resolutions for vote regarding important investment decisions
- Investors selling off their shares

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11.3 The principal – agent Relationships in Corporate Governance

There are two types of relationships that fall under the agency relationship in an organization:

Shareholders Shareholders
& &
Directors Auditors

Shareholders & Auditors:

- The auditor acts as an agent to the shareholders when performing an audit as it is a
relationship of trust and confidence.
- Auditors however have their own interests and motives to consider.
- Auditor independence from the Board is very important for the shareholders; however
an audit necessitates a close working relationship with the Board.
This close relationship has led the shareholders to question the perceived and actual
independence of auditors. As a result tougher controls and standards are now
introduced.

12. Agency Accountability

Accountability relates to the need to:

- act in shareholders’ interests

- to provide good information
- to operate within a defined legal structure

There are a number of codes of conduct that directors can follow to satisfy the accountability
requirements under their fiduciary duty such as the UK Combined Code of Corporate
Governance, the Organization for Economic Co-operation and Development code on ethics,
ACCA code and the International Federation of Accountants code.

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Compliance with the Combined Code is voluntary (as it is not governed by the law) however
the fear of damage to reputation arising from governance weaknesses and the threat of
delisting from the stock exchange makes non-compliance not an option.

Other accountabilities (agency relationships) that exist within a company:

- managers to directors (accountable for running of operations)

- employees to managers (accountable for quality of products)
- management to creditors (accountable for payment of invoices on time)

KEY POINT

To summarize:

Agency is very important in CG as the directors are acting as agents for the
owners. CG frameworks aim to ensure that the directors fulfill their
responsibilities as agents by requiring disclosure and suggesting they be
rewarded on the basis of performance.

13. Transaction Cost Theory

When dealing with another party, the following transaction costs occur:
- Search and information costs: finding a supplier
- Bargaining and decision costs: buying a component
- Policing and enforcement costs: Monitoring quality

When components are produced internally these costs disappear. Internalizing transactions
reduces business risk concerning prices and quality.

Analyzing these costs can be difficult because of:

- Restricted rationality: limited capacity to understand the business situation. This
limits the factors we consider when making the decision.
- Opportunism: actions taken in an individual’s best interest. This creates mistrust
between the parties.

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 The factors that dictate the impact to an organization of transaction costs are the following:
 Frequency – how often the transaction is made will have an effect on the amount
of transaction costs incurred by the organization
 Uncertainty – long term, close personal relationships relations and lack of trust
might increase transaction costs
 Asset specificity – if the component is unique for organizational needs,
transaction costs might increase for the company

The same analysis can be used to consider the motivation of the director in deciding the above.
The director’s analysis of the costs is limited again by the bounded rationality and opportunistic
behavior.
Following are the factors of bounded rationality and opportunism on the part of directors that
can be used to view the motivation behind any decision:
 Frequency – whether company culture accepts specific transactions
 Certainty – or otherwise chance of being caught doing something unethical
 Asset Specificity – amount the manager will gain personally from a transaction

Agency Theory vs. Transaction Cost Theory

The two theories both examine agency, with Agency Theory focusing on the parties involved
and Transaction Cost theory focusing on specific transactions.

14. Stakeholder Theory

Under the stakeholder theory, it is argued that the stakeholder provides the company with a
contribution and expects their own interests to be satisfied. It proposes corporate
accountability to a broad range of stakeholders. The reasoning of this is that:

Modern corporations have been seen as so powerful socially, economically and politically that
unstrained use of their power will inevitably damage other people’s rights.
Examples:
- long-term unemployment may result in the local workforce by closing a major factory
- Imposition of unequal contracts on suppliers and customers by using high purchasing
power
- Exercising undesirable influence over the government
There is an argument about whose interests should be taken into account.

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Stakeholder Theory v Agency Theory

 The stakeholder theory may be the evolution of the agency theory as there is an
increasing awareness of improved customer perception, employee motivation, supplier
stability etc. therefore it has increasingly become a requirement for the directors to
consider other stakeholders.
 The agency theory is a narrow form of stakeholder theory
 Both theories must uphold an implicit moral minimum that includes the fundamental
rights.
 Both theories involve an implicit and explicit contract and the purpose is to try to align
the conflicting interests. Both theories are policed by governance structures.

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CHAPTER 2 | Developments of Corporate
Governance

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 Table of content

1. Influences on Corporate Governance........................................................................... 35

2. Development of Corporate Governance Codes ............................................................ 36
3. The UK Corporate Governance Code .......................................................................... 40
4. Reasons for Developing the Codes .............................................................................. 41
5. Problems with Developing the Codes........................................................................... 41

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1. Influences on Corporate Governance

Governance theory concludes that there are two major factors affecting organizational
operation:

 Agency theory leads to shareholder pressure and shareholder activism

 Stakeholder theory leads to stakeholder lobbying and concerns over social
responsibility

In addition:

 Company law provides a framework within which operations occur

 Audit and auditors impact on governance and are covered in depth in the internal
control and risk sections of the syllabus
 Codes of governance are developed by government, operate as a prerequisite to
membership of stock exchanges, maybe grounded in legislation, and guide individual
professional bodies

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2. Development of Corporate Governance Codes

Cadbury Greenbury
Hampel

Higgs Turnbull

UK Corporate
Smith Governance Tyson
Code

Combined
Code

The development of codes on governance is closely associated with the UK and hence it
is a good model in discussing global best practice requirements.

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  The Cadbury Report 1992
The Cadbury Report represented the first attempt to formalize or codify corporate governance
best practice in written document, to make explicit that which was implicit in many top UK
companies.
The Cadbury Committee was set up because of the lack of confidence perceived in financial
reporting and in the ability of auditors to provide the assurances required. More specifically
three events caused the Committee to be formed:

- Black Monday, 19th October 1987 when the US stock market lost one quarter
of its value in a few hours
- The collapse of The Bank of Credit and Commerce International in 1991
- The Mirror Group pension fund misappropriation corporate scandal by
owner Robert Maxwell

The Cadbury Committee focused on 3 issues:

- The Board of Directors:
The board requires constant monitoring and assessment. The Chairman must be a separate
individual from the CEO. The Chairman must be independent.

- The Institutional Investors:

The report recognized the importance of these shareholders and thus stressed the need for
increased dialogue.

- Audit and accountability:

The importance of corporate transparency, communication and disclosure was recognized.
In the Cadbury Report there was a Code of Best Practice for the Directors. Some of its
provisions include:
- The Board should meet up on a regular basis. Certain matters such as major
acquisitions or disposal of assets should be referred to the board.
- A minimum of three non executive directors, the majority of whom (i.e. two) should
be independent.
- Details on the length of service for the directors and disclosure of remuneration
(developed further by subsequent reports)
- Setting up an internal audit committee

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  The Greenbury Report 1995

A second committee was formed to investigate shareholder concerns over director

remuneration. The report focused on providing a means of establishing a balance between
salary and performance. It recommended that the remuneration committee should determine
the remuneration of the executive directors, and that it should be comprised only of Ned’s.
Directors’ contracts should be limited to one year.

 The Hampel Report 1998

This was a consolidating report that tried to deal with the criticisms arising from the previous
two. Under Hampel:
- the accounts should contain a statement on how the company has complied with the
principles
- they need to explain the policies including the reasons for departure

 The Combined Code 1998 (revised in 2003 and replaced in 2010)

The London Stock exchange then issued a combined corporate governance code (the
Combined Code) which was the result of the 3 committees. The Combined Code was the
applicable code of best practice for UK listed companies between 1998 and 2010.

The Code was divided into 2 areas:

Companies:
- directors’ role
- directors’ remuneration
- relations with shareholders
- accountability and audit

Institutional investors:
- shareholder voting
- dialogue with companies
- evaluation of governance disclosure

For each of the above areas there is a set of principles of good governance followed by a
series of provisions that detail how the principle might be achieved.

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Since the publication of the Combined Code, more reports have been published on specific
aspect of governance:

 The Turnbull Report 1999

This was revised in 2005 and focused on risk management and internal control

 The Higgs Report 2003

This report was created post-Enron and focused on the role of non-executive directors.
Principles per this report included:
- at least half of the Board should be made up of NEDs
- their remuneration should be appropriate
- NEDs should act as a link between the board and the shareholders to reduce the
agency problem
- Regular communication to important shareholders

 The Smith Report 2003

This was developed form the Higgs Report. It dealt with:

- the relationship between the auditor and the companies
- the role and responsibilities of the audit committee

The report however has failed to ban all auditors from carrying out consultancy work for their
clients.

 The Tyson Report 2003

This developed from the Higgs Report. It dealt with the recruitment and development of NEDS.
- The need to expand the pool of NEDs in the top Public Listed Companies in
the UK
- Diversity in background, skills and experience enhanced board effectiveness

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3. The UK Corporate Governance Code
This was issued in 2010 by the Financial Reporting Council (FRC) following the financial
crisis in 2008-09 and replaced the Combined Code used until then.

The Main Principles of the Code are divided into five areas:

A. Leadership
- Board Effectiveness
- Division of Responsibilities
- Chairman Responsibilities

B. Effectiveness
- Balance of skills, experience and independence
- Formal Procedure for appointment of directors
- Annual Evaluation

C. Accountability
- Disclosures by the board
- Reporting on Risks and Internal Controls

D: Remuneration
- Remuneration levels should be fair
- Executive Directors’ remuneration packages should be set in a transparent way

E: Relations with Shareholders

- Regular Dialogues between directors and shareholders
- Effective use of the Annual General Meeting

4. Reasons for Developing the Codes

- It reduces instances of fraud and corruption, improving shareholder perception
- There is statistical evidence that poor governance equates to poor performance
- Global investors were willing to pay a significant premium for companies that are well
governed
- The existence of governance is a decision factor for institutional investors
- Even if it does not add value, it reduces risk and potential losses to shareholders

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5. Problems with Developing the Codes

- The process is reactive and not proactive

- The impact varies according on the nature of the company
- It restricts individual decision-making power
- It adds bureaucracy in the use of committees and disclosure requirements
- Adherence to governance harms competitiveness and does not add value
- It cannot stop fraud

Page | 39
CHAPTER 3 | The Board of Directors

Page | 40
 Table of content
1. Roles and Responsibilities ........................................................................................... 42
2. Board Structure ............................................................................................................ 46
3. Composition of the Board ............................................................................................. 48
4. Directors’ Training ........................................................................................................ 57
5. Legal Duties of the Board............................................................................................. 59
6. Directors Performance Evaluation ................................................................................ 63
7. The Importance of Board Committees.......................................................................... 66

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1. Roles and Responsibilities

1.1. The Role of the Directors

A director is an officer of the company charged by the shareholders with the conduct and
management of its affairs. The directors collectively are referred to as the board. The
chairman of the board is appointed independently by the shareholders.

The key roles and responsibilities from the UK Corporate Governance Code (2010) are to:

 Provide entrepreneurial leadership of the company

 Represent the company view to the public
 Decide on the matters reserved for board decision e.g. mergers, acquisitions,
acquisitions and disposals of assets, investments, capital projects, bank borrowing.
 Determine the company’s mission and objectives and strategy
 Select and appoint a CEO, a Chairman and members of the Board
 Set the company’s values and standards
 Ensure the management is performing its job
 Establish internal controls to assess and manage risk
 Ensure that there are the necessary financial and human resources available for
the co to meet its objectives. How? By approving operational and capital expenditure
budgets
 Ensure that its obligations to its stakeholders are understood and met
 Meet regularly
 Assess its own performance and report it annually
 Submit themselves for re-election at regular intervals (every 3 years maximum)
 For listed companies: - appoint appropriate NEDs
- establish remuneration committee

- establish nomination committee

- establish audit committee

 Managing conflicts of interest

 Ensure communication of its strategic plans both internally and externally

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Therefore, an effective Board demonstrates the following capabilities:

 Clear strategy aligned with the capabilities of the co

 Vigorous implementation of the strategy
 Key performance drivers monitored
 Focus on the views of other key stakeholders
 Regular evaluation of board performance

The minimum duties of the Board are set by Companies Act as being the minimum legal
requirement:

 Approval of interim and final financial statements

 Approval of interim and recommendation of final dividend
 Approval of changes in accounting policies
 Removal of key staff e.g. company secretary
 Auditors remunerations
 Recommendation of appointment or removal of auditors

An additional requirement by the stock exchange is to approve press releases regarding

matters decided by the Boards.

1.2. Potential Problems

Sometimes achieving all of the above can be difficult due to barriers:

 Most boards rely largely on management to report information to them thus allowing
management to obscure problems and the true state of a company.
 Boards of directors meeting only occasionally may be unfamiliar with each other and
thus make it difficult to question the management.
 CEOs often have dominating personalities and sometimes exercise much influence
over the board
 The CEOs performance is judged by the same directors who appointed him. Unbiased
evaluation is therefore difficult.

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1.3. The UK Corporate Governance Code

 The Board should meet regularly and the results must be included in the annual
reports as a high level statement of operations
 The annual report should identify attendance and name the Chairman, CEO, senior
independent member, the committee nature and composition.
 The chairman should hold separate meetings with NEDs and NEDs should meet to
discuss the Chairman’s performance.
 Any concerns that have not been resolved at the meetings should be recorded. In the
case a NED resigns he needs to notify the chairman of his concerns.
 The company should arrange insurance cover for possible legal action against the
directors

1.4. The Role of the Directors

There are many characteristics and skills required to be a ‘good director’. Some key ones are:

Motivated

Proactive
Characteristics
Experienced

Listening

Questioning

Negotiating
Skills
Leadership

Knowledge in specialist areas

General business knowledge

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 In order to carry out effective scrutiny, directors must have relevant expertise of the industry
and the company. The board needs to contain a mix of expertise and a balance between
executive and NEDs.

2. Board Structures

There are two kinds of board structure: unitary and two tier boards:

Board Structures

Unitary Two – Tier

Single Board Two Boards

Executive Management Supervisory

NED’s
Directors Board Board

Executive
NED’s
Directors

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2.1. Unitary Boards

Advantages of Unitary Boards:

 NED expertise: the presence of NEDs with different perspectives and viewpoints to
question the actions and decisions of the executives should lead to better decisions
being made.
 NED empowerment: all participants have equal responsibility for management. The
NEDs are therefore more actively involved in their independent and supervisory
capacity.
 The independent directors are less likely to be excluded from decision-making and
given restricted access to information. Thus the board may end up making better
decisions.
 Reduction of fraud and malpractice: due to wider involvement in the actual
management of the company.
 The relationship between different types of directors may be better as a single board
promotes easier co-operation.

Disadvantages of Unitary Boards:

 For a NED to be both manager and monitor is too demanding.

 The time requirements on NEDs may be too heavy both in terms of time spent in
meetings and also of time spent to obtain sufficient knowledge.
 There are no provisions for employees or other stakeholder groups to be
represented on the board.
 It emphasizes the divide between the shareholders and the directors and the
general meeting is the only place where the shareholder concerns can be heard.

2.2. Two – Tier Boards

These are predominantly associated with France and Germany.

Using Germany as an example, there are two main reasons for their existence:

 Codetermination: the right for workers to be informed and involved in decisions that
affect them. (Codetermination Act 1976, Germany)
 Better Relationships: banks have a much closer relationship with German
Companies than in the UK. They frequently are shareholders, and other shareholders
deposit often deposit their shares and the rights associated with them with their banks.

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The two tiers are made up as follows:

 Management board (Lower Tier): this board is responsible for managing the
enterprise with the CEO as the co-coordinator. It is composed entirely of managers.
 Supervisory board (Upper Tier): It has workers’ representatives, shareholders’
representatives and banks’ representatives.
It has no executive function although it reviews the company’s direction and strategy.
It is responsible for safeguarding stakeholders’ interests. It appoints, supervises and
advises members of the management board. It receives formal reports, approves the
accounts, appoint committees and undertake investigations.

The chairman co-ordinates its work and its members are elected by the shareholders.

Advantages of Two-Tier boards:

 Clear separation between the monitors and those being monitored

 Wider stakeholder involvement. It encourages transparency within the company
between the management through the supervisory board to the stakeholders. It also
involves the shareholders and employees in the supervision and appointment of
directors.
 Independence of thought, discussion and decision since board meetings and
operation are separate.
 Direct power over the management through the right to appoint members of the
management board
 The supervisory body has the capacity to be an effective guard against management
inefficiency. Its very existence may be determined to be a deterrent to fraud.

Disadvantages of the Two-Tier Structure:

 Dilution of power through stakeholder involvement

 Isolation of supervisory board because of non-participation in management meetings.

The management may restrict the information passed on and the supervisory body
may meet infrequently.
 Agency problems between the two boards
 Added bureaucracy and slower decision making
 Confusion over authority and lack of accountability.

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 3. Composition of the Board
The issues to consider are:

- Size: the greater the size the greater the opportunities for representation of the various
parties. This is at the expense of ease of operation and coherence of decision making
- Inside / Outside mix: the proportion of executive and NEDs
What is Diversity?

 Diversity describes the range of visible and non-visible differences that exist
between people (e.g. race, ethnicity, gender, sexual orientation, socio-economic
status, age, physical ability, religious beliefs, political beliefs)
 Managing these differences, a productive environment can be created in which:
 Everybody feels valuable
 Talents are fully utilized
 Organizational goals are met
 Increased in the effectiveness of the decision making
 Enhancement of corporate reputation and investor relations by establishing
the company a responsible corporate citizen

3.1. Non – Executive Directors

STRATEGY ROLE
Development of strategy

RISK ROLE SCRUTINISING ROLE

Financial systems are Review performance of
accurate and risk ROLES OF NED management in meeting
management robust objectives

PEOPLE ROLE
Decide remuneration and
succession planning

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The NEDs should provide a balancing influence and play a key role in reducing conflicts of
interest between management and shareholders. They should provide reassurance to
shareholders.

The Roles of NEDs:

According to Higgs report the role of NEDs is for:

 Strategy – NEDs should contribute to, challenge and offer advice on the direction of
strategy.
 Scrutiny – they should scrutinize the performance of executives in meeting the goals
and also monitor the reporting performance.
 Risk – NEDs must satisfy themselves that financial information is accurate and that
financial controls and systems of risk management are strong.
 People – determining remuneration, and appointment or removal of managers.

According to the UK Corporate Governance Code, an effective NED is one that:

 Demonstrates the highest ethical standards of integrity and probity

 Supports executives in their leadership while monitoring their performance
 Questions intelligently, debates constructively, challenges rigorously and decides
dispassionately.
 Listens to other people’s views (inside and outside the board)
 Gains the trust and respect of other members
 Promotes the highest standards of CG

Advantages of NEDs:

 They may have external experience and knowledge which the executives do not
possess. The experience may be in different fields such as CG, internal controls,
performance assessment, knowledge of markets etc.
 They can provide a wider perspective than executives who are involved in the
detailed operations of the business
 They are a comfort factor for 3rd parties. It improves the perception of the company.

Page | 49
  They have a dual role: as full members of the board with full knowledge but at the same
time as independent. Therefore they have the knowledge but also the detachment
to monitor the company’s affairs effectively.
 They improve communication between shareholders and directors
 Appointment of NEDs ensures compliance with CG.

Problems with NEDs:

 May lack independence. Even if there is no direct connection, a NED may agree to
become so because of respect or admiration to the company’s CEO or Chairman.
 There may be a prejudice in some companies against widening the recruitment of
NED to include other stakeholders or other than those proposed by the board.
 Well known NEDs are attracted to the best-run companies instead of the ones that
actually need their input.
 NEDs may have difficulty imposing their views on the board.
 Their time is limited and therefore their contribution is limited.
 They can damage the company’s performance by weakening board unity and
suppressing entrepreneurship.

Number of NEDs:

According to the UK Corporate Governance Code, at least half the members of the board
must be NEDs.

The New York Stock Exchange rules now require listed companies to have a majority of NEDs.

Threats to independence:

NEDs operate as a ‘corporate conscience’ and therefore need to be independent.

They cannot be significantly involved in the running of the business. They need to be
detached from the company.

One NED should be the senior independent director who is directly available to the
shareholders.

NED’s independence is discussed in Higgs Report.

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 SUPPLEMENTARY READING

Hong Kong: The evolving role of independent non-executive directors

In a recent speech given by Mr. Carlson Tong, Chairman of the Securities and Futures
Commission, Mr. Tong pointed out that companies can improve corporate governance by
attaching higher importance to the role of their board of directors as an internal
gatekeeper. Mr. Tong said that this can be done more easily by having effective
independent non-executive directors (INEDs) on the board.

It is widely understood that INEDs are involved in the “non-executive” side of the business.
They are not involved in the company’s daily operations but mainly serve a role in
overseeing the chief executive and senior management. Their duties in law, however, may
not be much different from those of the executives. INEDs owe the same duty of care, skill
and diligence as any other members on the board. The new Companies Ordinance which
came into force on 3 March 2014 does not differentiate INEDs from executive directors.
The Corporate Governance Code issued by The Stock Exchange of Hong Kong Limited
also makes clear that non-executive directors have the same duty of care and skill and
fiduciary duties as executive directors. In Law Wai Duen v Boldwin Construction Company
Limited and Chan Shiu Chick & Others [2001] HKCU 842, the Court of Appeal commented
(in the context of a private company) that executive directors and non-executive directors
have the same responsibility in law as to the management of a company’s business, and
that the law does not have any regard to whether a director holds an executive position
within the company.

The fact that the Rules Governing the Listing of Securities on The Stock Exchange of
Hong Kong Limited (or the Listing Rules) require that every board of directors of a listed
company must include at least three INEDs, who must represent at least one-third of the
board, tells us that the INEDs play an additional and important role – to act independently.
INEDs are regarded as a vital component of corporate governance. A classic example to
demonstrate the importance of INEDs would be the corporate failure of HIH Insurance,
which used to be one of the biggest insurance companies in Australia. Whilst the collapse
of HIH happened years ago, it is worthwhile reviewing the lessons of the case, particularly

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in light of the increasingly active regulatory environment. The SFC has recently stated that
it will be more proactive in overseeing corporate conduct of listed companies going
forward.

HIH was listed on the Australian Stock Exchange in June 1992. It ended up being placed
into liquidation in 2001, after a period of rapid growth throughout the 1990s. In April 2003,
the HIH Royal Commission led by the Commissioner, the then Mr. Justice Owen, released
a report inquiring into the reasons for the collapse of HIH (the Report). Mr. Justice Owen
concluded that “HIH’s collapse related more to vanity and inflated egos, poor systems and
lack of monitoring rather than systematic fraud.” It was found that the board of HIH made
decisions to engage in extremely high-risks practices in competitive markets, without any
checks and balances from independent directors. There were independent directors on the
board who had professional qualifications. However, Mr. Justice Owen commented that
the presence of several “independent” directors on the board of HIH provided little
protection against the folly of management.

In the Report, Mr. Justice Owen helpfully summed up the role of an independent director.
He commented that the key to understanding the notion of independence is that
“independence significantly reduces the prospect that performance will be inhibited by
considerations other than the best interests of the company as a whole. This is because
an independent director can bring to bear upon the issues confronting the company a mind
that is not materially influenced by other considerations. An independent director needs to
be engaged with the company – in terms of being an inside participant – but free of
impediment to the exercise of objectivity of judgment”.

Then, how can one ensure an INED’s independence? Rule 3.13 of the Listing Rules sets
out a number of factors to assist listed companies in their assessment of the
independence of non-executive directors. It provides that independence is more likely to
be questioned if, inter alia, the individual holds more than 1% of the total issued share
capital of the listed company, or is a director, partner or principal of a professional adviser
which provides (or has within one year immediately prior to the date of his proposed
appointment provided) services to the listed company, or is or was connected with a
director, the chief executive or a substantial shareholder of the listed company within two
years immediately prior to the date of his proposed appointment. Rule 3.13 does not
purport to provide an exclusive list. Like the SEHK, the Australian Securities Exchange
Corporate Governance Council has also identified similar factors which help determine the

Page | 52
independent status of non-executive directors. However, these objective criteria for an
INED may not necessarily make corporate governance work.

Mr. Justice Owen expressed concerns in the Report that an attempt to be unduly
prescriptive might impose undesirable rigidity, and distract attention from the critical issue
of freedom from possible influences, many of which may be subtle and not susceptible to a
“check-list” approach. For example, it was not immediately clear why a substantial
shareholding in the company should be regarded as compromising independence as such
shareholding may provide greater incentive to focus on the interests of the company. In
addition, a close personal association with the chief executive may be destructive of
independence, but it is still difficult to assess objectively or on a “check-list” basis whether
an INED is truly independent. The critical question, as Mr. Justice Owen put it, is whether
an INED is subjectively capable of exercising independent judgment, and not whether he
fulfils certain objective criteria for assessing independence.

The Guide for INEDs published by the Hong Kong Institute of Directors largely echoes Mr.
Justice Owen’s views: “Independence… is more than a checklist with all the boxes
ticked… Independence is a state of mind and only you [the INED] will know upon reflection
in good faith whether you can or will act independently. At a minimum independent
judgment is judgment formed after a fair consideration of all relevant information available
and made free from the influence of your personal interests whether direct or indirect. You
will need to be honest with yourself in answering whether motives of personal gain, no
matter how derived or in what form, will interfere with the exercise of your judgment.”

In 2012, Korn Ferry, an executive search firm, conducted a study on the role of INEDs built
on the comments of chairmen and board members, which in our view also give some
guidance as to how INEDs should act. First and foremost, INEDs should be independent
so as to bring about objective scrutiny of the executives in the organization on behalf of the
shareholders. They should challenge the executive team’s decisions whilst being
supportive. Whilst they are not actively running the business, they should have a deep
understanding of the business and be well versed in identifying and managing operational,
financial and reputational risks. In other words, INEDs have no excuse for not knowing the
business and operations well or for letting the executives do whatever they think fit.

Source: Norton Rose Fulbright

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Situations that compromise the independence of NED’s

Receive other
remuneration besides Close family ties
Directors fee with a director
Material business
relationship in the last
3 years
Situations in Which NEDs
are Likely NOT to be Significant shareholder
Independent
Employee in the last 5
years
Served on board for
Cross-directorship in more than 9 years
other companies

A cross – directorship exists when two or more directors jointly sit on the boards of two or
more companies together.

Reasons for NEDs independence:

To provide:

 a detached and objective view of board decisions

 expertise and communicate effectively
 shareholders with an independent voice
 confidence in CG
 reduce accusations of self-interest for the executives

Appraising performance

The Higgs report suggests that the following should be considered when appraising the
performance of NEDs:

- Preparation for meetings

- Attendance level
- Willingness to devote time to understand the co
- Quality and value of contributions
- Demonstration of independence
- Relationship with fellow directors and communication
- Contribution to development of management

EXAM TIP

Whenever a question scenario features NEDs, watch out for threats or

questions over their independence.

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3.2. The Chairman
The board should not be dominated by a single powerful individual, therefore the role of
chairman (the person running the board) and the CEO (the person running the company) must
rest with different people.

 The division of responsibilities must be clearly established and set out in writing
 Appointing a chairman is the main counterbalance to the CEO
 The position may be full-time or part-time. The chairman is usually a NED.

Chairman Responsibilities

 Running the board and setting its agenda – ensuring that the boards focuses on
strategic matters
 Providing leadership to the board, supplying vision and imagination
 Ensuring the board receives appropriate, accurate and timely information
 Chairing all meetings directing the debate toward consensus
 Ensuring effective communication with shareholders by chairing the AGM, and by
communicating to the board the views of the shareholders
 Ensuring that sufficient time is allowed for discussion of controversial issues
 Providing and induction program for new directors
 Deciding on Board development by deciding on the size, the balance, the interaction,
harmony and effectiveness of the boards. Also responsible for meeting the
development needs of individual directors
 Facilitating board appraisal by ensuring the performance is evaluated at least once a
year
 Facilitating effective contribution from NEDs
 Holding meetings with NEDs alone
 Reporting in and signing off accounts

3.3. The Chief Executive Officer (CEO)

The CEO (Chief Executive Officer) is generally responsible for the performance of the
company as determined by the strategy and for reporting to the Chairman. More specifically,
he is responsible for:

 Developing and implementing policies to execute the strategy

 Assuming full accountability to the board
 Managing financial and physical resources

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  Building and maintaining an effective management team
 Adequate systems in place (financial, risk, internal control, operational etc)
 Monitoring operations and financial results
 Interfacing between the board and the employees
 Assisting in selection and evaluation of board members
 Representing the company to suppliers, customers, associations etc

Division of responsibilities?

CG acknowledges the need to have a division of responsibilities at the head of an organization

to avoid the situation where one individual has free control of the decision making process.

Other reasons for splitting the role

 Representation: the Chairman is the representative of the shareholders with no

conflict of interest.
 Accountability: the board cannot make the CEO truly accountable for management if
that board is lead by the CEO.
 Temptation: the removal of the joint role reduces the temptation to act in self-interest.
 Demanding roles: both jobs are very demanding and one person would not be able
to do both of them well. The CEO can run the company and the Chairman can run the
board.
 Freedom of expression – the board is more able to express its concerns effectively
by having a point of reporting for the NEDs.

The UK Corporate Governance Code also suggests that a CEO should not go on to become
a Chairman as he is likely to interfere in matters that are the responsibility of the new CEO,
thus exercising undue influence on him.

Reasons against splitting the role:

 Unity: it creates two leaders rather than the unity that comes with one leader
 Ability: both roles demand a detailed knowledge of the company. It is far easier to
have one leader with this ability rather than look for two.
 Human Nature: the conflict between two high powered individuals is inevitable.

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 4. Directors’ Training
4.1. Induction
The Higgs report provides detailed guidance on the development of an induction program
tailored to the needs of the company and the individual director.

Although the Higgs report is aimed at NEDs, the same induction program applies to new
executive directors as well.

The induction process

Every company should develop its own formal induction program that should:

 Be comprehensive
 Tailored to the needs of the company and the individual director
 Give new appointees a balanced and real-life overview
 Not overload the new director

There are 3 steps in achieving induction:

- Products / services
- Group structure
- Constitution, board procedures, matters
Understanding of the Reserved for the board
Company
- Assets, liabilities, contracts, competitors
- Risks and risk management strategy
- KPIs
- Regulatory constrain

- Meetings with senior management

Build a link with the - Visits to sites, meet employees
employees
- participate in board’s strategy development

- Major customers

Understanding the - Major suppliers

Co’s main - Major shareholders
relationships
- Customer relations policy

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Objectives of Induction:

 To communicate vision and culture

 To communicate practical procedural duties
 To reduce time taken for an individual to become productive
 To assimilate the individual as a welcomed member
 To ensure retention of individuals

Induction Package

The company secretary along with the nomination committee is responsible for creating the
induction package of directors. It includes:

1. Director’s Duties

2. Company Strategies

3. Board Operations

1. Director’s Duties

 Briefly outline the director’s role and responsibilities under codes of best practice.
 Advice on share dealing and disclosure of price sensitive information.
 Company information on the matters reserved for the board.

2. Company strategies:

 Current strategies, plans and budgets

 Annual and interim accounts
 Company brochures, mission statements

3. Board Operations:

 Memorandums and articles

 Minutes if recent previous meetings
 Board composition and profiles of members
 Details of committees and meeting procedures

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4.2. Continuing Professional Development (CPD)

The Higgs report points out that to remain effective the directors should extend their
knowledge and skills continuously.

 Companies need to provide resources for developing and refreshing the knowledge
and skills of their directors.
 The Chairman should address the development needs of the board as a whole with a
view to enhancing its effectiveness.
 The Chairman should also identify the development needs of individual directors. The
Secretary plays a key role in facilitating this.

Objectives of CPD:

 To ensure directors have sufficient skills and ability

 To communicate changes within the business
 To improve board effectiveness and corporate profitability
 To support the personal development of directors.

5. Legal Duties of the Board

Aside from the duties described above, the directors have legal duties and responsibilities that
they need to abide to. These are the absolute minimum they have to apply as non-
compliance will mean criminal prosecution and imprisonment.

The Objective:

The objective of the law is to protect the owners of the company. It exists because of the
nature of the fiduciary relationship.

5.1. Legal Rights and Responsibilities

Power

Directors do not have unlimited power. Their power is restricted by:

 Articles of Association
 Shareholder resolution
 Legal Provision
 Board Decisions – it is the board that makes decision and not the individual directors

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Directors have unlimited liability however, meaning that even if they delegate some actions
they can never delegate liability for the outcome.

Fiduciary Duties:

 The Duty to act in good faith – as long as the motives are honest and they genuinely
believe they are acting for the best interest of the Company then there is no liability.
 The Duty of Care - Directors have a duty of care to show reasonable competence
and may have to indemnify the company against losses caused by their negligence.
This duty of care is analyzed in 3 ways:
- The director is expected to show the degree of skill that is reasonably
expected from a person of his knowledge and experience. The standard set is
personal to the person holding the office.

- He is required to attend board meetings.

- If there are no reasons for suspicion he is entitled to leave the routine

conduct of the business to the management and trust them.

Breach of Legal Duties:

Aside from the criminal liability that may arise, there is always a civil liability. If the director
is in breach, then:

 Any contract made by the director may be void

 The director is personally liable for damages
 The director may be forced to restore company property at their own expense.

5.2. Retirement by Rotation

The Combined Code states that all directors appointed by the nomination committee must be
subject to re-election every 3 years.

NEDs should be appointed for specific terms subject to re-election every 3 years. Any time
over 6 years required rigorous reviews and over 9 years requires annual re-election. This is
because the independence is questionable.

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Advantages of Retirement by rotation:

At each AGM 1/3 of the directors are subject to retirement by rotation. The directors to retire
by rotation are those who have been in office the longest. The advantages of this are:

- ensures that all directors do not retire at the same time thus creating a vacuum
- allows the shareholders an annual say on the board’s composition
- give a vote of confidence (or the opposite) on the performance of the board
- stagger the impact of contract termination costs
- increase director accountability, reducing complacency
- opportunity to replace the board in an orderly manner

5.3. Service Contracts

The Directors’ service contract is the legal document that covers the terms of service
which includes key dates, duties, remuneration, termination provisions and
constraints.

5.4. Removal

The office may be vacated by:

- Law
- Death
- Provision in the articles or by not being successfully re-elected
- Personal bankruptcy
- Resignation
- Absence for more than 6 consecutive months from meetings without the
permission of the directors

5.5. Disqualification of Directors

A director may be disqualified from serving on the board if:

 There is wrongful or fraudulent trading meaning that he has allowed the company
to trade while insolvent

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Wrongful trading – when a director enters into transactions on behalf of the company while
he knows or ought to have known that there is no reasonable prospect that the company could
avoid liquidation.

In such a case the director is required to make a personal contribution to the company’s
assets. However, the director will not be made personally liable if he can show that he took
every step prior to liquidation to minimize the potential loss to the company’s creditors

Fraudulent trading – If in the course of winding up a company, the director knowingly

continued trading with the intent to defraud the creditors then he is required to contribute to
the company’s assets.

Other potential causes of disqualification:

 He does not keep proper accounting records

 Fails to prepare and file accounts
 He has not complied with Companies’ Legislation for 3 or more times in the last 5 years
like not filling documents with the Companies House
 Fails to send tax returns and pays the tax
 Takes actions that are deemed to be unfit in the management of the company

If a director is disqualified (by the courts) then he cannot:

 Be a director of any other company

 Act like a director
 Influence the running of a company
 Be involved in the formation of a new company

A disqualification may be between 2-15 years and ignoring the disqualification is a criminal
offense punishable by maximum 2 years imprisonment.

5.6. Conflict and Disclosure of Interest

As agents, the directors have a fiduciary duty to act in the best interests of shareholders. A
conflict of interest is a breach of this duty. The breach is in relation to the existence of the
conflict and not in relation to the outcome where a breach exists.

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 Specifically:

 Directors must retain their freedom of action and not restrict their discretion by
agreeing to vote as some other person has instructed them to do
 They have to avoid a conflict of duty and personal interest for example a director
may not contract with his company (unless allowed to do so by the Articles of
Association)
 Directors must not obtain a personal advantage from their position without the
consent of the company.

According to Companies Act, the company must disclose any transactions that involve the
directors.

5.7. Insider Dealing

Insider dealing is the illegal purchase or sale of shares by someone who possesses inside
information about a company.

Inside information is any information that is precise and specific and has not yet been made
public but if made public it would have a significant effect on the share price.

As well as being a criminal offence it is also an abuse of directors’ roles as agents.

6. Directors Performance Evaluation

Performance
Evaluation

Board Evaluation Individual Committee

Evaluation Evaluation

The Principles of the UK Corporate Governance Code state:

“The Board should undertake a formal and rigorous annual evaluation of its own
performance and that of its committees and individual directors.”

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The Board should state in the annual report how performance evaluation of the board, its
committees and individual directors has been conducted. NED’s led by the senior
independent director should review the performance of the chairman’s views of executive
directors.

6.1. How is the Evaluation to be Made?

 The evaluation must be made at least once a year.

 The evaluation must be tailored to the needs of the company
 It is the chairman’s responsibility for selecting and effective process and for acting
on its outcome.
 An external 3rd party may perform the evaluation
 The results of the board evaluation must be shared with the board while the results of
the individual assessments must remain confidential between the Chairman and the
director concerned

6.2. Criteria for Board Evaluation

 Performance against objectives

 Contribution to testing and development of strategy
 Contribution to robust and effective risk management
 Contribution to development of corporate philosophy
 Appropriate composition of board and committees
 Responses to crises
 The matters reserved by the Board are the right ones?
 Decisions delegated are the right ones?
 Adequacy of meetings and decision making
 Quality of information
 Quality of feedback
 Effective use of time

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6.3. Criteria for Individual Directors’ Evaluation

 Independence – free thinking, avoiding conflicts of interest

 Preparedness – knowing the key staff, the organization, the industry, his duties
 Participation – active presence in meetings, questions asked
 Committee membership – understands the process, exhibits ideas and
enthusiasm
 Positive impact – suggestions on innovation, strategic direction and planning,
wins the support

6.4. Criteria for Evaluating the Chairman

There are some specific issues relating to the Chairman that should be included in his
evaluation such as:

 Effective leadership of the board

 Relationship and communication with shareholders
 Setting the agenda
 Enable board members to voice their concerns
 Appropriate use of the Secretary

6.5. Criteria for Evaluating the NEDs

 Preparation for board meetings and satisfactory attendance

 Willingness to devote time and effort to understand the company and its business
and readiness to participate in events outside the board room
 Quality and value of their contribution
 Contribution of their knowledge and experience in considering strategy
 Proactive in areas of concern
 Relationship and communication with other members
 Kept up to date with developments on the law and their duties as well as industry
developments

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7. The Importance of Committees

Board Of
Directors

REMUNERATION Nominations
AUDIT Committee Risk Committee
Committee Committee

100% NED Majority Ned Majority Ned

Pay And Benefits Structure Of Risk Exposure

To Directors Board And Strategy

The benefits of using Board Committees are as follows:

 It reduces board workload and enables the board to focus on other issues
 Through these committees expertise can be used to improve decision making
 Communicates to shareholders that directors take these issues seriously
 Communicates to stakeholders the importance of remuneration and risk

7.1. Nomination Committee

The UK Corporate Governance Code states that:

 Nomination committees should have a majority of NEDs and the chairman should
chair this committee.
 Evaluation of the candidate’s skills, knowledge and expertise is vital
 If the Chairman has other commitments, it should be noted in the annual report. No
chairman should chair 2 boards in the FTSE 100.
 Similarly, executives should not be members of any other FTSE 100.
 A separate section of the annual report should describe the work of the committees.

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The duties and responsibilities of the nominations committee:

 Regularly review the structure, size and composition of the board and make
recommendations
 Consider succession planning for directors
 Evaluate the balance of skills, knowledge and experience of the board
 Prepare a description of the role and capabilities required for any board
appointment.
 Identify and nominate candidates for the approval by the board
 Make recommendations concerning the standing of reappointment of directors

Additionally, the nomination committee must:

 Consider the balance between executives and NEDs on the board

 Ensure the diversity of backgrounds in the board.
 Provide an appropriate balance of power in the executives to ensure that the CEO
does not dominate.
 To be seen to be operating independently for the benefit of shareholders

7.2. CEO Succession

The nomination committee is on the lookout for a new CEO immediately after the appointment
of the current CEO. The reasons for this are:

 To have some idea of a successor in case the CEO dies or leaves

 To cultivate possible successors from within the company
 To identify other possible directors

EXAM TIP

In a possible scenario you will be required to assess the strength of Corporate

Governance in a company. Chapter 3 provides benchmarks against which
arrangements can be assessed. There may also be some very specific aspects of
Corporate Governance e.g. the role of NEDs.

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CHAPTER 4 | Directors Remuneration

Page | 68
 Table of Content

1. The Remuneration Committee ..................................................................................... 70

2. Remuneration Principles .............................................................................................. 72
3. Remuneration of Directors ........................................................................................... 75
4. Directors Remuneration – Other Issues ....................................................................... 77
5. Supplementary Reading – Bankers’ Pay Unacceptable ............................................... 78

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1. The Remuneration Committee

Clearly adequate remuneration has to be paid to directors in order to attract individuals of

sufficient caliber.

Remuneration packages should be structured to ensure that individuals are motivated to

achieve performance levels that are in the company and shareholder’s best interests as
well as their own interests.

One of the major corporate abuses for a number of years has been the excessive salaries
and bonuses paid to directors.

The committee is comprised independent NEDs. The NEDs in the committee should never
decide on their own remuneration.

1.1. The Role of the Remuneration Committee

The role of the remuneration committee is to have an appropriate reward policy that
attracts, retains and motivates directors to achieve the long-term interests of
shareholders.

In order for this committee to be effective, it needs both to determine the organization’s
general policy on the remuneration of directors and specific remuneration packages for
each director.

1.2. Objectives

 The committee is and is seen to be independent, with access to its own external
advice.
 It has a clear policy on remuneration that is well understood and has the support of
shareholders.
 Performance packages produced are aligned with long-term shareholder
interests and have challenging targets.
 Reporting is clear, concise and gives the reader a ‘bird’s-eye view’ of the policy
payments and the rationale

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 KEY POINT

In order to create trust or restore trust in terms of directors’ remuneration,

transparency is required through full disclosures that describe the reasoning behind
the structure of pay packages and bonuses.

1.3. Responsibilities

 Determine and review the framework, policy and specific terms for the remuneration,
terms and conditions of employment, including design of targets and bonus scheme
payment.
 Recommend and monitor the level and structure of the remuneration of senior
managers
 Set detailed remuneration for all executives and the chairman including pension
rights and any compensation payment.
 Ensure that the executives and key management are fairly rewarded for their
individual contribution.
 Demonstrate to shareholders that the remuneration is set by individuals with no
personal interest.
 Agree any compensation for loss of office
 Ensure that provides disclosure relating to remuneration, including pensions.

1.4. Considerations in the operation

 To consider the balance between executives and NEDs

 To ensure appropriate diversity to board composition
 To provide a balance of power to reduce the CEO or Chairman’s domination in the
selection of executives

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1.5. CEO/Chairman Succession

The remuneration committee also pays an important role in the CEO and Chairman
succession:

 The remuneration committee should have access to senior management and gauge
performance

 Cultivate successors from senior managers
 To identify other directorships as well

2. Remuneration Principles

DEFINITION

Remuneration is the payment or compensation received for services or employment

and includes base salary, bonuses and other economic benefits that an employee
receives during employment.

Remuneration Principles

Purpose Component Strategy Labor Market

s

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2.1. Purpose of Remuneration

The Remuneration Policy

Affects: Covers:
Attraction Levels of salary
Recruitment Of How it compares with other
Cos
Retention Employees
Mix of salary and benefits
Motivation

2.2. Components and Level of Pay

Typical components are:

- basic salary
- bonus
- share options
- pension contributions
- other benefits e.g. car

Pay levels are set according to:

- the job itself

- the skills of the individual
- the individual’s performance
- the individual’s overall contribution to the strategy
- market rates for that type of job

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2.3. Strategy

A company’s remuneration strategy may consider:

- offering more benefits in kind with lower basic salary

- non-cash motivators e.g. child care, car, extra holiday
- availability of resources e.g. if there is liquidity problems a company may choose to give
share options
- encourages long-term loyalty through share purchase

KEY POINT

Remember: performance should be linked to remuneration.

2.4. The UK Corporate Governance Code

1.
 Level of remuneration should be sufficient to attract, retain and motivate directors. A
significant proportion should be structured so as to link rewards to performance.
 The performance related element should be a significant proportion of the total.
 Share options should not be offered at a discount.
 NED remuneration should reflect time commitment and responsibilities and should
not include share options.
 If a NED works as an executive in another company, this must be disclosed.
 Notice periods for directors should be one year or less.

2.
 There should be a formal and transparent procedure for fixing remuneration
packages. No director should be involved in deciding his own remuneration.
 The remuneration committee should consist of 3 NEDs.
 The committee should determine all executive and Chairman remuneration.
 The board should determine the remuneration of NEDs or delegate the responsibility
to a committee and the Chairman.

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 All the above are from section B from the Code.

Section A also states for performance- related pay:

 the committee must consider eligibility and upper limits to bonuses

 consider eligibility and nature of long-term incentive schemes
 long-term schemes should be approved by the shareholders
 payouts should be phased out as short as possible

3. Remuneration of Directors

3.1. Behavioral Impact

 Each element of a remuneration package must be designed to ensure that the

directors remain focused on the company and are motivated to improve performance.

 A balance must be found. Avoid having a remuneration package:

- that is too small and thus demotivating leading to underachievement
- that is too easily earned
- that is excessive

3.2. Components of Remuneration

 Basic Salary:
This is usually determined by benchmarking from the industry and especially equivalent
sized ventures

 Performance-related elements of remuneration:

These are the elements of remuneration dependent on the achievement of some form of
performance measurement.

The performance related element should form a significant part of the total package.
However, care must be taken so that if the market goes down you are not penalizing
directors for an outcome that has nothing to do with their performance.

The bonus can be based on a number of accounting measures:

Page | 75
 - Operating profit or pre-tax profit: % on yearly profit increase, 2% of salary
for each 1% increase, fixed sum for achieving the profit target
- Earnings per share: this should exclude exceptional charges
- Total shareholder return: this includes both dividend and capital
appreciation over time
- Economic value added: this is the surplus calculated above a charge on all
assets using the WACC, which is considered the minimum return before a
bonus is achieved.

 Shares and share options:

DEFINITION

Share options are contracts that allow the directors to buy shares on a future date, at
a fixed price determined at the date of purchase of the shares. These are the most
common form of long-term market orientated scheme.

Why share options?

- Because they give the incentive to manage the firm in such a way so that share
prices increase. They align the managers’ goals with the shareholders’.
- this overcomes the agency problem (at least in theory)

The option or the shares need to be approved by the shareholders and must be rewarding
but not excessive.

The company following the work of the remuneration committee should:

- consider if the directors should be eligible for long-term benefits

- ensure that executive shares are not offered at a discount
- ensure that options granted should not be exercisable in under 3 years
- encourage the directors to hold their shares for a further period

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  Benefits in kind

Also referred to as perks, are various non-wage comparisons. Basic things to consider:

- only basic salary should be pensionable

- the committee should provide whatever other ancillary services expected to
go with the position eg company car, health insurance etc

 Loans
Loans are prohibited in the US under the SOX.

 Retirement benefits
A retirement benefit could be things like a sizeable payout or a lifetime use of the company
jet.

 Termination
An award at termination simply for the services rendered, or protection for the employee

4. Directors Remuneration – Other Issues

1. Legal – what are the legal implications of the company-director relationship in terms
of remuneration?
The company should carefully consider compensation commitments and the terms of
employment.

2. Ethical – what ethical considerations should a company have in setting directors’

remuneration?
The traditional view that ethics and business do not mix is now rarely accepted.
Increasing companies are demonstrating sensitivity to combining ethical issues with
commercial success.

The UK 2006 Companies Act make it a legal requirement that directors act as ‘good
corporate citizens’ meaning that the directors should pay attention to the ethical
effects of company decisions.

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 3. Competitive – how does a company remain competitive and ensure that they attract
good quality directors?
A company should have a proficient, motivated board that can recruit and retain the
individuals required for best performance.

4. Regulatory – the UK Directors’ Remuneration Report Regulations 2002 require that:

- directors submit remuneration report at the AGN
- the report must have full details of the remuneration
- it must be clear, transparent and understandable
- In situations where the company allows and executive to act as a NED in
another company, the report should include a statement as to what the
directors’ earnings are.

5. Supplementary Reading – Bankers’ Pay Unacceptable

SUPPLEMENTARY READING

Bankers' pay 'unacceptable' after scandals, says IoD head

The boss of the influential Institute of Directors has launched a stinging attack on the
pay packets handed out at Royal Bank of Scotland and Barclays, which together
paid 523 of their bankers more than £1m in the scandal-hit year of 2012.

Simon Walker, the IoD director general, told an audience of public relations
executives that the payouts were "unacceptable".

"Thousands of people in those two companies alone earn more even than the prime
minister. This is in scandal-hit companies who have had a far from successful year,"
Walker said.

Barclays was fined £290m for rigging Libor last year while RBS paid £390m for
attempting to rig the key benchmark rate while both banks were also hit by mis-
selling scandals.

Page | 78
Walker spoke as one of the biggest fund managers in the City, F&C Asset
Management, prepared to write to the chairman of nearly 60 financial firms around
the world to warn that "the public perception of unjustified excessive pay can create
long-term reputational damage".

The F&C fund managers are calling for "joined up" thinking in how banks are
managed in terms of "ethical performance, risk management and the incentive
system for bank executives - as expressed in terms of their remuneration".

"There is growing need for bank executive management, as well as bank boards, to
promote appropriate corporate values," F&C will say. The fund managers give credit
to Barclays and HSBC - fined £1.2bn for money laundering offences in the US - for
adopting reviews of cultures and values.

Walker was referring to Barclays and RBS in his speech in which he also talked
about the "serious cause for concern" caused by the public's lack of confidence in
capitalism, in part caused by "rewards for failure" in pay levels.

"Now I recognise that Antony Jenkins [chief executive] and Sir David Walker
[chairman] at Barclays are working hard to introduce a new culture in Barclays in
particular. And as you can imagine given my job, I'm not a rabid anticapitalist. But
even I believe that this state of affairs is unacceptable."

"Shareholder value has been destroyed, capitalism has been given a bad name, key
measures of the market have been manipulated for cynical gains, taxpayers have
shelled out billions to bail banks out, and yet vast rewards packages are still being
handed out," Walker said.

"That is why I think it is understandable that many people are concerned about the
state of rewards for failure, and the disastrous effects of short-termism in some
businesses. Many IoD members are concerned about exactly the same things," he
said.

Addressing the public relations audience, Walker said: "People outside the
communications industry sometimes think that it is possible to spin anything – that

Page | 79
the proverbial turd can indeed be polished, if you'll pardon the metaphor. But
sometimes it can't – sometimes the underlying facts are the problem".

The fund managers at F&C call on banks "as a whole" to be accountable for "past
transgressions" even when management has left after wrong-doings: "This means
that regulatory or legal penalties should impact the incentive pool that is distributed
to its executives." F&C warned about the impact of the EU plan to cap bankers'
bonuses at one times their salary, or twice in some circumstances. Walker also
picked up on this: "Just look at the EU's bonus cap – wrong-headed and counter-
productive as it is, the behaviour of some of our banks makes it difficult for anyone to
stand at their side to credibly fight against it. They are harming the whole of British
business by focusing only on their own short-term self-interest".
Source: The Guardian

Page | 80
CHAPTER 5 | Relationships with the
Shareholders and Disclosure

Page | 81
 Table of Content

1. Shareholders Ownership, Property and Responsibility ................................................. 82

2. Disclosure – General Principles ................................................................................... 84
3. Disclosure – Corporate Governance Requirements ..................................................... 85
4. Mandatory VS Voluntary Disclosure ............................................................................. 87
5. Institutional Investors ................................................................................................... 89
6. General Meetings......................................................................................................... 91
7. Proxy Voting ................................................................................................................ 92

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1. Shareholders Ownership, Property and Responsibility

The rights of ownership of an asset are:

- the right to use the property as you wish

- the right to regulate anyone else’s use of the property
- the right to transfer rights to the property on whatever terms he wishes

But ownership has the responsibility of making sure that the use of one’s property is not
damaging someone else.

However, ownership of a share in a corporation is different:

- The shareholder does not own the corporation. The corporation is a separate legal
entity. The shareholder owns a right to participate in the risks and rewards of
ownership and again that right is limited.
- Risk is limited because of the limited liability and reward is limited to the value of
the shareholding. Both risk and reward are regulated by those outside individual
shareholder control.
Due to the above limitations the shareholders have certain rights to protect them which are:

- the right to sell the stock

- the right to vote at the AGM
- the right to certain information
- the right to sue for misconduct
- the residual right in case of liquidation

The responsibilities of shareholders are:

- Shareholder democracy: Institutional shareholders should be able to use their

position to influence greater corporate accountability
- Shareholder activism: By owing shares in a company investors have a voice at
the AGM and so should use their voting rights
- Ethical investment: using ethical, social and environmental criteria in selecting
and managing investment portfolios

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Unethical investments should be rejected based on the following negative criteria may
include: animal rights violation, child labor, trading with oppressive regimes, genetic
engineering, nuclear power, poor employment conditions, and arms dealing.

Some positive criteria will include: conservation and protection of the environment, ethical
employment practices, and green technologies.

2. Disclosure – General Principles

Shareholders, as the owners of a company are entitled to sufficient information to enable them
to make investment decisions.

The annual report and accounts are often the only information shareholders receive from the
company.

The disclosure becomes the mechanism through which governance is given transparency.

The UK CG Code states:

The Board should present a balanced and understandable assessment of the company’s
position and prospects.

This requirement extends to interim reports and other price-sensitive reports as well as
reporting to regulators and other statutory requirements.

Dialogue with institutional shareholders:

There should be a dialogue with shareholders based on a mutual understanding of objectives.

The board as a whole has responsibility for ensuring that a satisfactory dialogue with
shareholder takes place

(Although the major shareholder contact with the company is with the CEO and the Finance
Director at the AGM the UK CG Code tries to emphasize the need for the Chairman and the
NEDs to be more involved.)

The Board should use the AGM to communicate with investors and encourage their
participation.

The company should have appropriate measures for dealing with proxy votes.

Separate resolutions should be held for each issue.

All directors and committee chairmen (head of the committees) should attend.

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3. Disclosure – Corporate Governance Requirements
Disclosure is the means by which governance is communicated and assured since it leads to
stakeholder scrutiny and shareholder activism.

Adherence to the Code can only be communicated through transparency of Code

implementation. This transparency can be seen in its detailed inclusion in the annual report.

The report states that the directors should explain their responsibility for preparing
accounts. They should report that the business is a going concern with supporting
assumptions and qualifications as necessary.

Further statements that are required are:

o Information about the board of directors:

Composition of the board

Information regarding the independence of NEDs

Frequency of meetings

Attendance of meetings

How Board performance is evaluated

o Reports on the committees:

The remuneration, the audit and nomination committee

Composition

Frequency of meetings

o Relations with auditors:

Reasons for change

Steps taken to ensure auditor objectivity and independency when non-audit services
have been provided

o Statement that the directors have reviewed the effectiveness of internal controls
including risk management
o Statement on relations and dialogue with shareholders
o Statement that the company is a going concern
o Sustainability reporting including the nature and extent of
Social policies and practices

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 Transformation policies

Ethical policies

Safety and health policies

Environmental management policies

o An Operating and Financial Review (OFR) that sets out the director’s analysis of the
business in order to provide to investors an analysis ‘through the eyes of management’.
It should include discussion of its performance and its structure of its financing. It
should be forward-looking rather than historical.

The OFR is written to non-financial language in order to ensure the information is

understandable and accessible to a broad range of users.

The London Stock Exchange requires the following general disclosures:

1. A narrative statement of how the companies have applied the principles set out in
the CC providing explanations which enable the shareholders to assess how the
principles have been applied.
2. A statement as to whether or not they complied throughout the accounting period
with the provisions set out in the CC. Listed companies that did not comply throughout
the accounting period with all the provisions must specify the provisions and give
reasons for non-compliance.

Generally, beyond the above, the disclosure guideline for a principles based regime is to
disclose such information necessary to give the reader balanced and detailed information
in order to assess the company’s potential.

This leaves too much to the judgment of the Board, in deciding what is important to disclose.

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4. Mandatory VS Voluntary Disclosure

Disclosure

MANDATORY VOLUNTARY
Information which must Information which a
be publicly disclosed to company may disclose
comply to comply with should it choose to do
the Law so.

1. Chairman and CEO statements regarding company position (voluntary): This is a

voluntary statement as it is required by the UK CG Code. However, not to include this
would be unimaginable!

2. OFR (voluntary):

The OFR was nearly made compulsory; however in the end a softer Business Review has
become mandatory.

3. The accounts (compulsory):

These include the Income Statement, the Balance Sheet and Cash Flow statements plus
the notes and compliance statements.

4. Governance (voluntary):

There needs to be a section devoted to compliance with the Code including all the
provisions shown above.

5. Any other business (voluntary):

AOB includes shareholder information including notification of AGM, dividend history and
shareholder taxation position.

6. Business Review (compulsory):

This report is written in non-financial language and forms an addition to the Financial
Statements after it was made compulsory by the UK government.

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 Additional voluntary disclosure can also be made by other means and not just by the annual
report, such as:

- press releases
- management forecasts
- analysts presentations
- the AGM
- website
Reasons for voluntary disclosure:

- Attracts Investment
- Demonstrates Compliance
- Provides Assurance
- Stakeholders: greater voluntary disclosure helps in discharging various
accountabilities towards interested parties in the business

To promote the Company in a

Strong disclosure regime can positive light and act as a
help to attract capital and marketing tool
maintain confidence in the Co

Weak disclosure and Helps improve public

non-transparent Voluntary understanding of the
practices can contribute Disclosures structure, activities,
to unethical behavior corporate policies and
and loss of market performance
integrity

Investors require access to regular,

reliable, comparable information for
decision making

Page | 88
5. Institutional Investors

In the UK there are 4 types of institutional investors:

- pension funds
- life assurance companies
- unit trust
- investment trusts

These shareholders contribute a possible solution to the agency problem.

Advantages of Institutional shareholders:

- Individuals are given the opportunity to have a personal pension plan and this is
separately held form the companies by whom they are employed.
- Similarly, investors have the opportunity to invest through the medium of insurance
companies, unit trusts and investment trusts.

Disadvantages of Institutional shareholders:

- for capital markets to be competitive then there should not be any investor of such
size or influence
- Many institutions tend to avoid shares that are speculative as they believe they have
a duty to their customers to be investing only in ‘blue chip’ shares (only commercially
sound companies). This results to the high share price of such companies.
- Fund managers are accused of ‘short-termism’ in that they seek short term gains
and if those are not achieved then they sell the stock and invest elsewhere.
However, institutional investors have become so powerful lately that divesting their
stock is almost impossible without suffering a substantial loss. Thus they have been
forced to adopt a more long-terms approach.

Page | 89
5.1. Shareholder Activism

Following the Cadbury Report and the Code there has been a significant change in institutional
investor relationships with organizations. From a simple trader the institutional investor has
become a responsible owner and from a passive role to one of shareholder activism.

This can be done by:

- One-to-meetings – to discuss strategy, quality of management, objectives and

target setting
- Voting – generally institutional investors work before the AGM and therefore avoid
voting against the board at the AGM. They state their intention of negative vote in
advance
- Focus list – keeping a list of the companies that are underperforming will increase
the pressure on the boards to improve performance
- Contributing to CG rating systems – they put pressure on the board to follow CG
and set Key Performance Indicators according to the Code.

5.2. Intervention by Institutional Investors

In extreme circumstances the institutional investors may intervene more actively by for
example calling an EGM. Reasons why investors may want to intervene:

- concerns about the strategy pursued

- poor operational performance
- management being dominated by a small group of executive directors
- major failures in internal controls
- failure to comply with the laws and regulations or governance codes
- excessive levels of remuneration
- poor attitudes towards CSR

Page | 90
 6. General Meetings
A general meeting is one which all shareholders are entitled to attend. There are 2 types of
general meetings:

General
Meetings

Annual General Meeting Extraordinary General Meeting

- Must be held once a year - Held as required

- Legally required - No legal obligation to have any

- Separate resolutions for each issue - Separate resolutions for each issue

- 21 days notice must be given - 14 days’ notice must be given for OR

21 days for SR

- 1st ever AGM must be held within

the first 18 months and thereafter - No set timetable – held on an ‘as
not more than 15 months between
Required’
meetings

- All shareholders must be notified and

- All shareholders must be notified
all are entitled to attend
and all are entitled to attend

- Agenda dictated by need for meeting

- Annual accounts are approved.

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6.1. Annual General Meeting

At the AGM various corporate actions may be presented and voted upon by shareholders.
These might include:

- accepting the directors’ report and statement of accounts for the year
- appointment of directors and auditors
- approval of directors’ and auditors’ remuneration
- approval of final dividends

The UK CG Code states that:

The Chairman should arrange for the chairmen of the audit, remuneration and nomination
committees to be available to answer questions at the AGM and for all directors to attend.

6.2. Extraordinary General Meeting

These are special meetings arranged to approve special events such as acquisitions,
takeovers, rights issues etc

All general meetings other than the AGM are called EGMs.

7. Proxy Voting

Proxy voting systems are implemented to make sure that shareholders that are unable to
attend a meeting can still vote and make their opinions heard.

A proxy is a person appointed by a shareholder to vote on behalf of that shareholder at

company meetings.

The UK CG Code states that for each resolution proposed there must be a different proxy
appointment form.

The company must ensure that all valid proxy appointments received for general meetings are
properly recorded and counted.

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For every resolution and after the vote has been taken, the company must publish on its
website the following information as soon as possible:

- the number of shares in respect of which proxy appointments have been made
- the number of votes for the resolution
- the number of votes against the resolution
- the number of shares of which the ‘vote was withheld’ (not a legal vote and so will
not be counted)

Page | 93
CHAPTER 6 | Corporate Governance
Approaches

Page | 94
 Table of Content

1. Approaches to Corporate Governance ......................................................................... 97

2. Principles Based Approach .......................................................................................... 97
3. Rules Based Approach ................................................................................................ 99
4. The Sarbanes – Oxley Act 2002 ................................................................................ 100
5. Impact of SOX ........................................................................................................... 101
6. Criticisms of SOX ....................................................................................................... 102
7. Organization for Economic Cooperation and Development (OECD)........................... 102
8. International Corporate Governance Network (ICGN) ................................................ 102
9. Insider Dominated/Relationship Based Systems ........................................................ 103
10. Outsider Dominated Systems..................................................................................... 103

Page | 95
 Chapter Overview:

CORPORATE
GOVERNANCE

Impact of Development and Use of

Approaches
Ownership Governance Codes
Models

Rules Based Principles Based

UK Combined
US SOX Code Multiple Jurisdinctions

Page | 96
1. Approaches to Corporate Governance

Codes of Governance are developed by government and are a prerequisite to membership of

stock exchanges and guide professional bodies.

A continuing debate on corporate governance is whether the guidance should predominantly

be in the form of principles or whether there is a need for detailed laws and regulations.

The rules based approach instills the code onto law with appropriate penalties

The principles based approach requires the company to follow the spirit rather than the letter
of the code. The company will then either comply with the code or explain why it has not. The
latter is done through reports to the appropriate body and its shareholders.

Factors that influence the approach to be followed:

 Dominant ownership (bank, family etc)

 Legal system and its power/ability
 Government structure and policies
 State of the economy
 Culture and history
 Levels of capital inflow
 Global and political climate

2. Principles Based Approach

I. Characteristics of the Principles-based approach

 The focus is on the objectives rather than the mechanisms by which these objectives
will be met e.g. the objective of treating minority shareholders fairly.
Thus principles are easier to integrate into strategic planning.
 It can stress elements that the rules cannot easily apply e.g. maintain a sound
system of internal control, or organizational culture
 It can be applied across different legal jurisdictions e.g. OECD guidelines

Page | 97
  The recommendations that are made through the codes are on a “comply or explain
basis”
 This approach is often adopted where the prime governing bodies in setting the
standards have been the stock markets.

ii. Advantages of a principles based approach (and disadvantages of a rules based

approach):

 It avoids the need for inflexible legislation that companies must comply with even if
the legislation is not appropriate

 It is less burdensome in terms of time and expenditure.

 It allows companies to develop their own approach to CG that is appropriate for their
circumstances.

 Enforcement on comply or explain basis means that the company can explain why
they have departed from the specific provisions if it is appropriate.

 It puts the emphasis on investors to make up their own minds about what businesses
are doing.

iii. Disadvantages of principles-based approach (and advantages of rules based

approach):

 The principles set out have been criticized as so broad that they are of very little use
as a guide. e.g. the suggestion that non-executive directors must come from a wide
variety of backgrounds in order to make a contribution is not seen as strong enough.

 There may be confusion over what is compulsory and what is not. Although codes
are not prescriptive, their adoption by the local stock exchange means that companies
have to obey in order to retain their listing.

 Some companies may perceive that this approach is non-binding and fail to comply
without giving an adequate explanation

Page | 98
3. Rules Based Approach

i. Characteristics of the rules-based approach

 More emphasis on definite achievements rather than underlying factors.

 Allows no leeway or margin for abuse; you have either complied or not.

 It should be easy to see whether there has been compliance with the rules. The rules
have to be unambiguous and the clarity of evidence of compliance.

 Enforcers of rules (regulators, auditors) may find it difficult in questionable situations

that are not covered by the rule

 This approach is more popular in jurisdictions / cultures that lay a great emphasis on
obeying the letter of the law rather than the spirit.

ii. Advantages of a rules-based approach (and disadvantages of principles based

approach:

 There is clarity in terms of what you must do

 Standardization for all companies – this creates a fairer approach for all businesses

 Sanctions (legal actions taken against the company as a result of a criminal offence)
are applied if there is non-compliance

iii. Disadvantages of a rules-based approach (and advantages of principles based

approach):

 Rigidity – at this allows for the existence of loopholes

 Limits – there is no room to maneuver or go beyond the minimum level set

Page | 99
4. The Sarbanes – Oxley Act 2002

Auditor Audit Committee

Independence Must have and audit
Restricted in the committee
services they
provide

US Stock Internal Control

Exchange SOX KEY Report
Regulations POINT
Report must be
included in annual
report

Increased Financial
Disclosures
Details of balance
sheet finance to be
included

The SOX was the direct result of the Enron scandal. It applies to all companies that are
required to file reports with the SEC (Securities and Exchange Commission).

Generally the SOX shifts responsibility for financial probity and accuracy to the board’s audit
committee that comprises of 3 independent NEDs. One of whom has to meet certain financial
requirements.
Among other things, the Sox also increases financial disclosures, requires the company to
have an internal code of ethics and impose restrictions on share trading and loans to
directors.

Page | 100
The SOX is very detailed and carries out the force of law
Measurements introduced:
- Non-Audit Services
Auditors are expressly prohibited from carrying out a number of services,
including internal audit, bookkeeping, systems design, actuarial services, HR and
management functions etc.

The senior audit partner working on a client’s audit must be changed at least every
5 years

- Audit Committees
Audit committees must be established in all companies. Non-compliance will result
in the company being taken off the stock market

Its members must be independent and not accept any consulting or advisory fee
from the company. At least one member must be of a financial background

- Public Oversight Board

The act has set up a new regulator – the Public Accounting Oversight Board –
responsible for setting auditing, quality control, independence and ethical standards.

- Whistle blowing provisions

Employees and auditors are granted whistleblower protection against their
employers for disclosure in a fraud claim.

5. Key Effects of SOX

- Personal liability of directors for mismanagement and criminal punishment

- Improved communication with shareholders
- Improved perception and public confidence
- Improved internal control and external audit
- Greater arm’s length relations between the company and its auditors
- Improved governance through the audit committees

Page | 101
6. Criticisms of SOX

- The biggest expense of the SOX is documenting the internal controls. Although
these controls existed before, they now have to be documented comprehensively
and have the external auditors report on them.
- The auditors have been stripped off any additional services they used to offer
- Doubling of audit fee
- Reduced flexibility and responsiveness
- Limited impact on the ability to stop corporate abuse
- It has not been strong enough on certain aspects such as selection of external
auditors and too rigid in some areas.

7. The OECD Guidance

CG structures should be credible and understood across the national borders. The
principles of OECD are not binding. It deals with fair treatment of all shareholders, the
rights of shareholders, disclosure and transparency and Board responsibilities.

8. The ICGN

It tries to enhance the guidance of OECD and to provide practical guidance. It deals with
issues like the Board (structure, skills and committees), Shareholders, audit and ethics.

The contribution of the international codes:

They highlight the significance of CG, emphasize the dangers, provide benchmarks and
promote specific good practice.

Limitations:
Represent the absolute minimum, no legislative power

Page | 102
9. Insider Dominated/Relationship Based Systems

Companies listed on the stock exchange but owned and controlled by a small number of
major shareholders.

Advantages: ties between owners and managers, fewer agency costs, lower cost of
capital, no short-termism

Disadvantages: No minority protection, unclear operations and no transparency, misuse

of power, not monitored effectively by banks and shareholders, no formal CG structure, no
proper NEDs

10. Outsider Dominated Systems

Where shareholding is more widely dispersed and there is the manager-ownership

separation.

Advantages: robust legal and governance regimes, shareholders can use their votes

Disadvantages: agency problems, shareholders may have short term priorities

Page | 103
CHAPTER 7 | Corporate Social
Responsibility and Corporate
Governance

Page | 104
 Table of Content

1. Definition of Social Responsibility .............................................................................. 106

2. Carroll’s model of CSR............................................................................................... 107
3. Social Responsiveness .............................................................................................. 108
4. Classification of Stakeholders .................................................................................... 108
5. Assessing the Relative Importance of Stakeholder Interests ...................................... 110
6. Social Accounting ...................................................................................................... 113
7. The Organization as a Corporate Citizen ................................................................... 113

Page | 105
1. Definition of Social Responsibility

CSR refers to organizations considering and managing their impact on a variety of

stakeholders:

Environment

Local
Employees
Community
The
Company

Customers
Shareholders

Suppliers

A company is an artificial person and has the same rights and responsibilities as human
beings. The company is owned by its shareholders but exists independently of them. The
shareholder has a right to vote and be paid a dividend but the company owns its own assets.

Page | 106
One school of thought argues that a corporation has no responsibility outside of making profit
for its shareholders.

On the other hand, corporations perceived as ethically sound are rewarded with extra
customers while ethically unsound companies are boycotted.

Employees are more attracted to work for and are more committed to socially responsible
companies.

2. Carroll’s Model of CSR

Carroll argues that there are 4 levels of CSR:

- Economic responsibility
Companies have responsibilities to:

o Shareholders that demand a reasonable return

o Employees that want fairly paid jobs, fair conditions and safety
o Customers that seek good quality products at a fair price

Businesses are set up to be properly functioning economic units and so this responsibility
forms the basis of all others.

- Legal responsibility
Since laws codify society’s moral views, obeying these laws must be the basis of
operating within the society.

- Ethical responsibility
There are responsibilities that require corporations to:

o do what is right, just and fair

o reaffirm a social legitimacy by their actions taken

Page | 107
 This is beyond the previous 2 levels

- Philanthropic responsibility
These are desired rather than required of companies. It relates to discretionary behavior
to improve the lives of others such as:

o Charitable donations and recreational facilities

o Sponsoring arts and sports events

Under Carroll’s model, CSR encompasses the economic, legal, ethical and philanthropic
expectations placed on organizations by society at a given point in time.

3. Social Responsiveness

This refers to the capacity of the corporation to respond to social pressure. Carroll suggests 4
possible strategies:

- Reaction
The company denies any responsibility for social issues

- Defense
The company admits responsibility but fights it doing the very least that seems to be required

- Accommodation
The company accepts responsibility and does what is demanded of it by relevant groups

- Proaction
The company seeks to go beyond industry norms

4. Classification of Stakeholders

Who is a stakeholder?

A stakeholder is any person or group that can affect or be affected by the policies or activities
of an organization.

Bidirectional claim – the action of the corporation can impact a person and the actions of
that person can impact the corporation

Page | 108
Traditionally we used to say that our stakeholders are:

- customers
- suppliers
- shareholders
- employees

Now under the stakeholder theory we have added:

- government
- civil society
- competitors

There are a number of ways of classifying stakeholders according to criteria based on how
stakeholders relate to organizational activities:

- Narrow and Wide Stakeholders

This is the extent to which the stakeholder group is affected by the company’s activity:

o Narrow – those most affected or who are dependent on the company e.g.
shareholders, employees, customers, suppliers.
o Wide – those less affected such as the government, the community and non-
dependent customers.
One implication of this classification might be that the company should pay more attention to
its narrow stakeholders.

- Primary and Secondary Stakeholders

This is the extent to which the stakeholders affect the company’s activities:

o Primary – those that have a direct effect on the company and without whom it would
be difficult to operate, such as government, shareholders, suppliers, customers.
o Secondary – those whose loss of participation won’t affect the company’s existence
such as the community and the management.

An organization must keep its primary stakeholders happy.

Page | 109
 - Active and Passive Stakeholders

This distinguishes between those that wish to participate in organizational activity and those
that do not:

o Active – those that wish to participate such as the management, regulators,

environmental pressure groups and suppliers.
o Passive – those that do not wish to participate. This may include shareholders,
community, customers.

Do not mistake passive stakeholders as disinterested or weak.

One of CG aims is to make the powerful passive shareholders become more involved in the
business.

- Voluntary and Involuntary Stakeholders:

This categorization removes the element of choice associated with the passive and active
participation above. It basically subdivides the active group into 2 elements:

o Voluntary – these are the stakeholders that want to be involved in the decision making
such as management, employees, environmental groups and active shareholders.
o Involuntary – these are stakeholders that do not want to be involved in the decision
making but are due to a variety of reasons. This category includes regulators, key
customers, key suppliers, government and local communities.

5. Assessing the Relative Importance of Stakeholder Interests

The organization needs to weigh shareholder interests when considering future strategy. One
way of doing so is by looking at the power they can exert on the company. The greater the
power of a stakeholder group the greater its influence will be on strategy.

Page | 110
Mendelow’s Power Matrix:

LEVEL OF INTEREST

LOW HIGH

A B

Minimal Effort Keep Informed

LOW Strategy:

Strategy: Direction Education/communication

Tell them what to do Consultation, prevent them from

joining forces with D

POWER

C D

Keep Satisfied Key Players

HIGH
Strategy: Strategy:

Intervention Participation

Reassure in advance of the outcome They have the power and interest to
to avoid interest building and moving force chain. Consultation is vital
to D

- The organization’s strategy must be acceptable to the key players, such as major
customers.
- Stakeholder in C must be treated with care. While passive, they are capable to moving
to segment D. An example of those is institutional stakeholders.
- Stakeholders in B do not have great ability to influence strategy but their views are
important in influencing the powerful stakeholders by lobbying. Community and
charities fall in this category.

Page | 111
Customers, shareholders and employees may be the most important stakeholders but
continual assessment helps to focus in those that require immediate attention.

The model provides a framework for assessing the general nature of the action to be taken
following classification of stakeholders to power and interest. The implications of this are:

- The framework of CG and the direction and control of the business should recognize
stakeholders’ levels of interest and power.
- Companies must try to reposition certain stakeholders and discourage others from
repositioning themselves, depending on their attitudes.
- Stakeholder mapping can be used to establish future priorities

The problem with the traditional stakeholder theory is that it gives no indication of how to trade
off competing interests and therefore managers are left unaccountable for their actions.

Donaldson and Preston state that there are 2 motivations as to why organizations act in
relation to the concerns of stakeholders:

a. The instrumental view of stakeholders:

Motivation is from the possible impact of stakeholder action on profits. The organization reacts
because it believes that if it does not it would have an impact on its profit. This view ignores
any moral obligations

b. The normative view of stakeholders:

Motivation comes from a moral consciousness that accepts a moral duty towards others in
order to maintain the good of society. This view believes in doing what is right rather than what
is right for the company to achieve its profit targets.

Developing a CSR strategy:

1. Identify stakeholders
2. Classify stakeholders
3. Establish stakeholders’ claims
4. Assess importance of stakeholders (Mendelow)
5. Decide upon social pressures (Carroll’s strategies)

Page | 112
6. Social Accounting

Due to the different needs of the various stakeholders, there is an increased need for social
accounting. These take various forms and are included in the OFR (Operating and Financial
Review) as part of the Annual Reports:

- The Ethical accounting: tends to focus in internal management systems or codes of

practice at an individual level and how the company audits and complies with this.
- Environmental accounting: tends to focus exclusively on the organization’s impact on
the natural environment
- Social accounting: incorporates employee conditions, health and safety, equal
opportunities, human rights, charity work.
- Sustainability accounting: this incorporates all the above with an emphasis on
environmentalism

How to be effective in social accounting:

- Inclusivity: not a one way reporting process but incorporates the thoughts of the key
stakeholders
- Comparability: benchmarking previous periods or industry standards
- Completeness: inclusion of negative as well positive activity
- Disclosure: clear disclosure in reporting to meet stakeholders needs
- External verification: the perceived independence of verifiers where needed

7. The Organization as a Corporate Citizen

Corporate Citizenship (CC) suggests an expanded viewpoint of the corporate role, moving
beyond the boundaries of direct stakeholder relationships.

It is linked to the concept of corporate accountability.

Corporate accountability refers to whether the organization is answerable for the

consequences of its actions beyond its relationship with shareholders.

Page | 113
The demand for corporations to be more accountable and become valid members of the
society comes from the government failure and the increasing corporate power:

Government Failure – the government fail to deal with the risks that accompany rapid
changes in the commercial sector. This is because sometimes:

- the risks are beyond the control of a single government

- the government is part of the problem
- it is simply too difficult to change lifestyles

Corporate Power – Corporations can shape lives in many ways:

- liberalization and deregulation of markets increase market power and restrict the ability
of governments to intervene
- privatization of many previous state monopolies places great power of the corporation
- complex cross-border legal agreements are difficult and corporations are encouraged
to self-regulate

There are 3 views as to the scope and nature of the CC:

- Limited view of CC – this is Carroll’s 4th level or philanthropic view. The scope is
limited to charitable donations to the local community.
- Equivalent view: this is where the CC is equivalent to CSR. The extent to which
business meets economic, legal, ethical and discretionary responsibilities.
- Extended view: this is the most appropriate since the citizenship has rights and
responsibilities. Rights such as freedom of speech, ownership of property.
Responsibilities such as to protect and promote civil liberties of shareholders.

Page | 114
CHAPTER 8 | Internal Control Systems

Page | 115
 Table of Content

1. Development of Corporate Governance Regarding Accountability and Control .......... 117

2. Definition of Internal Management Control ................................................................. 117
3. Internal Control and Risk Management in Corporate Governance ............................. 118
4. Objectives of Internal Control Systems ...................................................................... 120
5. Executive Management Roles in Risk Management .................................................. 123
6. Elements of an Internal Control System ..................................................................... 125
7. Information Flows....................................................................................................... 127
8. Information Characteristics and Quality...................................................................... 128

Page | 116
1. Development of Corporate Governance Regarding
Accountability and Control
The Cadbury Report confirmed that directors should establish a sound system of internal
control and review the system on a regular basis.
The Turnbull Report emphasized on the importance of reporting the reviews on the
system to shareholders.
The Smith Report emphasized on the importance of the clear relationships between firm
and auditors in order to get an objective review of Internal Controls.

2. Definition of Internal Management Control

Internal management and control refers to the procedures and policies in place to ensure
that company objectives are achieved.
o INTERNAL CONTROL

MANAGEMENT PROCESS

MANAGEMENT OF RISKS ACHIEVEMENT OF

OBJECTIVES

o INTERNAL CONTROL SYSTEMS

SYSTEM OF FINANCIAL OR OTHER

CONTROLS

COMPONENTS OF INTERNAL CONTROL

SYSTEM = INTERNAL CONTROLS

Page | 117
3. Internal Control and Risk Management in Corporate
Governance

Internal control and risk management are fundamental components of good corporate
governance.
 Good corporate governance means that the board must identify and manage all
risks within a company
 In terms of risk management, internal control systems span financial, operational,
compliance and other areas, i.e. all the activities of the company.
 In 1992, the Cadbury Report confirmed that directors should establish a sound
system of internal control and review this system on a regular basis.
 Guidance on establishing and reviewing internal control systems have been
provided by COSO and the Turnbull Report
 However, internal control systems are only as good as the people using them.

Connection between risk management and corporate governance

Direct requirement from the combined code Management of all risks

 The directors are responsible for  The company should protect itself
looking after the assets of the from all downside risks including
company and protecting shareholder fire, flood, accident claims from staff
interests  The board needs to ensure that a
 Protection includes avoiding losses system is in place for monitoring
due to error, omission and fraud and controlling these risks
 Measures to ensure that these  The system will ensure that
events do not occur are provided in managers take into account both the
the internal control system of the up-side and the down-side risk of
company any decision made.

Risk management and Cadbury

The initial definition of risk management according to Cadbury was: ‘the process by which
executive management, under broad supervision, identifies the risk arising from
business and establishes the priorities for control and particular objectives’.
The concept of a broad view of risk management was not initially accepted in the early 90’s
although the Combined Code eventually contained the statement that:

Page | 118
 KEY POINT

‘Directors should, at least annually, conduct a review of the

effectiveness of the group’s system of internal control and
should report to shareholders that they have done so. The
review should cover all controls, including financial,
operational and compliance controls and risk management’.

This reporting requirement was voluntary, whereas the Sarbanes-Oxley Act identified the
need for reporting and made it compulsory in the US.

While Cadbury recognized the need for internal control systems for risk management,
detailed advice on application of those controls was provided by the Committee of
Sponsoring Organizations, (COSO) and the Turnbull Report.

Internal Control and COSO

COSO was formed in 1985 to sponsor the national commission on fraudulent reporting. The
‘sponsoring organizations’ included the American Accounting Association (AAA) and the
American Institute of Certified Public Accountants. COSO now produces guidance on the
implementation of internal control systems in large and small companies.
In COSO, internal control is seen to apply to three categories of the business:

1. Effectiveness and efficiency of operations – this is the basic business objectives including
performance goals and safeguarding resources.
2. Reliability of financial reporting – including the preparation of any published financial
accounts.
3. Compliance with applicable laws and regulations to which the company is subject.

Internal Controls and Turnbull

The Turnbull committee was established after the publication of the 1998 Combined Code in
the UK to provide advice to listed companies on how to implement the internal control
principles of the code.

Page | 119
Requirements:

1. Implement a sound system of internal controls by:

 Facilitating the effective and efficient operation of the company enabling it to
respond to any significant risks
 Ensuring the quality of both internal and external reporting
 Ensuring compliance with laws and regulations and with the company’s
internal policies regarding the running of the business
2. Make sure that the system is checked on a regular basis
 This review is a normal responsibility of management
 The review itself will be delegated to the audit committee
 The board must provide information on the internal control system with the review
being carried out at least annually

4. Objectives of Internal Control Systems

Ensure Goals and

Objectives of the
Organisation Are Met

Protect The Ensure Reliable

Organisation’s An Internal Control Financial and
Reputation System Helps To Management
Reporting

Ensure Compliance
with Laws and
Regulations

Page | 120
 OBJECTIVES:

SAFEGUARD
THE ASSETS

o COMPLETENESS
o ACCURACY
o VALIDITY (Adherence/Compliance)
o ECONOMY,EFFICIENCY,EFFECTIVENESS

o INTERNAL CONTROL AND RISK MANAGEMENT ARE FUNDAMENTAL

COMPONENTS OF GOOD CORPORATE GOVERNANCE.

INTERNAL CONTROL AND RISK MANAGEMENT ARE THE RESPONSIBILITIES OF

THE BOARD OF DIRECTORS.

Auditing Practices Board (APB) objectives

The APB in the UK provides guidance to auditors with specific reference to the
implementation of International Standards on Auditing. A definition of internal controls from
the APB is:

‘The internal control system includes all the policies and procedures (internal records)
adopted by the directors and management of an entity to succeed in their objective of
ensuring, as far as possible:

Page | 121
 Definition Commentary

The orderly and efficient conduct of its There will be systems in place to ensure
business that all transactions are recorded

The safeguarding of assets Tangible and intangible

The prevention and detection of fraud and At the operational through to the strategic
error level

The accuracy and completeness of Ensuring that all transaction are recorded,
accounting records and liabilities are not ‘hidden’ and assets are not
overstated

The timely preparation of financial Adhering to reporting deadlines

information

COSO Objectives

COSO defines internal control as ‘a process, effected by the entity’s board of directors,
management and other personnel, designed to provide reasonable assurance regarding the
achievement of objectives’, in three areas:

1. Effectiveness and efficiency of operations

2. Reliability of financial reporting
3. Compliance with applicable laws and regulations

Page | 122
 5. Executive Management Roles in Risk Management

Roles and responsibilities within an internal control system

Role Responsibility

Ensuring Adequacy &

Effectiveness of Internal Control Board of Directors
Systems

Setting internal control policies Senior Executive

Monitoring effectiveness of internal Management
control system

Establish Specific Internal Control

Head of Business Units
Policies and Procedures

Operating And Adhering To Internal

Controls All Employees

Important points:

1. Responsibility for internal control is not simply an executive management role

2. All employees have some responsibility for monitoring and maintaining internal
controls.
3. Roles in monitoring range from the CEO setting a tone for internal control
compliance, to the external auditor, reporting on the effectiveness of the system.
4. Guidance on responsibilities is available from the COSO and King reports

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Directors should:
1. Set appropriate internal control policies
2. Seek regular assurance that the system is functioning
3. Review the effectiveness of internal control
4. Provide disclosures on internal control in annual reports and accounts

Directors should review internal controls under the five headings identified by COSO:
1. Control environment
2. Risk assessment
3. Information systems
4. Control procedures
5. Monitoring

Management should:
1. Implement board policies
2. Identify and evaluate the risks faced by the company

The King Report

The King Report provides a list of eight points regarding responsibilities for risk management
within a company. These are summarized below:
1. The board are responsible for the process of risk, while management are responsible
for implementing internal control systems
2. The board and management together set risk management policies and
communicate those to all employees
3. The board set risk tolerance levels within the company and then identify, measure
and manage the risk
4. The board are required to use acceptable models to ensure risk management
policies are working
5. The board should receive regular reports on risk management and make an annual
statement of risk management
6. The risk management process should be addressed by a special committee
7. Risk management and internal controls are embedded in the day to day activities
8. A whistle blowing process should be in place in the company

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Sarbanes Oxley Act – Summary of responsibilities

SOX sets out responsibilities regarding risk management. However, in direct contrast to
other corporate governance systems, remember that these responsibilities are statutory.

There are two main areas of responsibility. Management is likely to delegate the authority to
obtain information on internal controls to the audit committee and internal audit department.
Obviously, the responsibility for the managements’ report cannot be delegated.

The management’s responsibility is to learn about the system of internal controls in place.
They need to evaluate the effectiveness of both the design and effectiveness of the system.
They should prepare a written assessment at the end of the year on the effectiveness of
internal control which must be included in the company’s annual return.

The auditor’s responsibility is to express an opinion on the management’s assessment of

the effectiveness of internal controls in the company by testing them.

6. Elements of Internal Control as Stated by COSO in 1992

1. Control Environment

 Behave with integrity and ethics

 Maintain an appropriate culture in the organization
 Set up a good structure
 Set proper authorization limits
 Employ appropriately qualified staff and conduct staff training

2. Risk Assessment

Identifying controllable risks and uncontrollable risks. Control procedures can be established
to safeguard against controllable risks, and steps should be taken to minimize the impact of
uncontrollable risks.

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3. Control Activities

S Segregation of duties
P Physical controls
A Authorization and approval
M Management
S Supervision
O Organization structure
A Arithmetic and accounting controls
P Personnel

4. Information and Communication

Information provided to managers must be:

 Timely
 Accurate
 Understandable
 Relevant to decisions and actions
5. Monitoring

The internal audit function is the key monitor of internal controls. Internal auditors will test the
internal controls, and where appropriate, will make recommendations for improvement to
management.

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7. Information Flows

To enable management to identify and manage risks and

monitor internal controls within an organization, they need
adequate information.

There should be effective channels of communication.

Information should be provided regularly to management

Managers need both internal and external information

There are three general levels of management in an organization:

 STRATEGIC
 TACTICAL
 OPERATIONAL

Information systems for management control

The information systems providing the management information must vary so that
appropriate information is provided to each level of management and focused on their
specific objectives regarding internal control and risk. The diagram below depicts the
management levels and indicates the general type of information system that will be
provided for that management level.

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 Executive
information
system
Strategic
(EIS) Planning

Decision
Support
Management
System
control and tactical (DSS)
Transaction planning
processing
system
(TPS)

Operational planning and control

The most important point is that all systems provide information appropriate to each
management level

8. Information Characteristics and Quality

The information received by management needs to be of a certain standard to be useful in

internal control and risk management and monitoring.
 There should be an adequate, integrated, information system, supplying internal
financial, operational and compliance data and relevant external data
 The information should be reliable, timely, accessible and provided in a consistent
format

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  The characteristics of that information will change depending on the management
level using that information

The table below shows the characteristics of information and how their quality varies
depending on what is made available.

Range of quality
Characteristic
Strategic Operational
Time period Forecast Historical

Timeliness Delayed Immediately available

Objectivity Subjective Objective

Quantifiability Qualitative Quantitative

Accuracy Approximate Accurate

Certainty Uncertain Certain

Completeness Partial Complete

Breadth Broad Specific

Detail Little detail Highly detailed

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CHAPTER 9 | Audit and Compliance

Page | 130
 Table of Content

1. Function and Importance of Internal Audit .................................................................. 132

2. Auditor Independence ................................................................................................ 134
3. Potential Threats to Independence ............................................................................ 136
4. The Audit Committee and Internal Control ................................................................. 138
5. Effective Internal Control Systems ............................................................................. 140
6. The Audit Committee and Internal Audit ..................................................................... 141
7. The Audit Committee and External Audit.................................................................... 142
8. Reporting on Internal Control to Shareholders ........................................................... 143
9. Internal Audit Reporting ............................................................................................. 143

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1. Function and Importance of Internal Audit

What is Internal Audit?

Internal Audit can be identified as ‘an independent appraisal activity established within an
organization as a service to it. It is a control which functions by examining and evaluating the
adequacy and effectiveness of other controls’.

What factors affect the need for internal audit?

1. The scale, diversity and complexity of the company’s activities
2. The number of employees
3. Cost/benefit considerations
4. Changes in the organizational structures, reporting processes or underlying
information systems
5. Changes in key risks could be internal or external in nature
6. Problems with existing internal control systems

Work that the internal audit department carries out

Reviewing Accounting and Examining Financial and

Internal Control Systems Operating Information

Assisting With the Roles Of

Special Investigations, E.G.
Identification Of
Internal Audit Into Suspected Fraud
Significant Risks

Department

Reviewing the Economy, Reviewing Compliance With

Efficiency And Effectiveness Of Laws And Other External
Operations Regulations

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Organization structure

Internal audit is a key reviewing and monitoring

activity
That is undertaken by management.

In LARGE ORGANIZATIONS the internal audit function will be a SEPARATE

DEPARTMENT.

In a SMALL COMPANY it might be the responsibility of INDIVIDUALS to perform

specific tasks even though there will not be a full-time position.

Some companies OUTSOURCE their internal audit function

It is important that it is STRUCTURED AND OPERATED in an appropriate way.

Why is internal audit important?

 In some situations it is required by law (SOX)

 In some situations it is required by codes of good practice (codes of corporate
governance)
 It provides an independence check on the control systems in a company
 It is a management control

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2. Auditor Independence

Must Be And Be Seen To Be

Independent!

Independence Requires:

 Independence of mind
 REQUIRES:

 Independence in appearance
 REQUIRES:

Measures to protect independence

The independence of internal audit is enhanced by following accepted standards of internal
audit work. These are divided into the Attribute Standards, and the Performance
Standards.

Attribute Standards:
1. Independence
2. Objectivity
3. Professional Care

Performance Standards:
1. Managing internal audit - thus ensuring it adds value to the organization
2. Risk management – The internal audit department should evaluate and identify
significant risk exposure, and minimize it
3. Control – by evaluating the efficiency and effectiveness of internal controls
4. Governance – make recommendations for improvement in achieving the objectives
of corporate governance
5. Internal audit work – following normal standards of internal audit work thus
maintaining independence
6. Communicating results – to authorized individuals on the board who have the power
to take appropriate action based on the report of the internal auditor

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  Separation from senior management

 Not auditing systems internal audit has

established

 Internal audit reports go to audit committee

Internal audit function

INDEPENDENCE achieved
by:  Head of internal audit reports to senior
director

 Access to chair if required

 Audit committee approves appointment of

head of internal audit.

POTENTIAL RISKS

IF AUDITORS NOT
INDEPENDENT

Fail To Report Ignore

Control Breaches Discrepancies

TURN A BLIND EYE TO GIVE UNDESERVED

UNETHICAL PRACTICES POSITIVE FEEDBACK

Back Down On Matters Accept Explanations

of Principle without Checking

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3. Potential Threats to Independence
 SELF-INTEREST THREAT
Occurs when the audit firm or a member of the audit team could benefit from a financial
interest in an audit client.

 SELF-REVIEW THREAT
Occurs when the audit firm, or an individual audit member, is put in a position of reviewing a
subject matter for which the firm or individual was previously responsible, and which is
significant in the context of the audit engagement.

 ADVOCACY THREAT
Occurs when the audit firm, or a member of the audit team, promotes, or may be perceived
to promote, an audit client’s position or opinion.

 FAMILIARITY THREAT
Occurs when, by virtue of a close relationship with an audit client, its directors, officers or
employees, an audit team becomes too sympathetic to the client’s interests.

 INTIMIDATION THREAT
Occurs when a member of the audit team my be deterred from acting objectively and
exercising professional skepticism by threats, actual or perceived, from the directors, officers
or employees of an audit client.

Threats to independence

1. Financial interest in a client

Occurs when an auditor holds shares in a client company. The auditor may disregard
adverse events at the client and not qualify the audit report. The auditor should not hold
shares in client companies.

2. Loans and guarantees

This occurs when the auditor loans money to a client company or the auditor receives a loan
from a client. The auditor may be unwilling to qualify his audit report, since if the client goes
out of business; he is unable to repay the loan. The auditor should not make or accept loans
and guarantees from audit clients.

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 3. Close business relationships
This occurs if an audit partner is a director in a company with another director who is also a
director in a client company. The auditor should not have close business relationships with
an audit client and their staff.

4. Family and personal relationships

A member of the audit team is living with a member of the client’s staff. Independence is lost
as the auditor has a conflict between maintaining professional standards and potentially
upsetting or ending the personal relationship. Therefore, members of the audit team who
have personal relationships with a client are removed from the audit team of that client.

5. Employment with assurance clients

This occurs when a member of an assurance team accepts a senior position at a client
company. The ex-audit team member can exert significant influence over the auditor due to
existing close personal or business relationships. Therefore, key members of the audit team
cannot accept senior appointment at a client until two years have lapsed since the last
involvement in the audit.

6. Size of fees
This occurs when the audit firm has a significant amount of fees derived from one client. The
auditor might not want to upset the client by giving a qualified opinion since the client could
simply move to another auditor resulting in a huge loss in audit fees. Because of this, audit
firms can earn no more than 10% of their fees from one listed company, and 15% from
privately owned companies.

7. Gifts and hospitality

The auditor could be provided with a holiday by the client. The provision of these gifts could
impair auditor independence and create a familiarity threat. Audit firms therefore have
guidelines for their staff regarding the level of gifts that can be accepted. For example, a
meal is acceptable, whereas a holiday to Hawaii is not!

Ethical Threats to independence

Situations may arise in which an auditor might be asked to behave in a way that conflicts
with ethical standards and guidelines due to conflicts of interest. Examples of such ethical
conflicts of interest are:
1. There could be pressure from an overbearing manager in case where the auditor
could be asked not to report adverse findings. The threat could be made more personal by
indicating that the auditor’s employment will be terminated if disclosure is made.

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2. An auditor might mislead his employer as to the amount of experience or expertise
he has, when in reality the expert advice of someone else should be sought. This could
happen when an auditor wants to retain his position and thus income, when in reality he
might not be qualified to deal with a specific issue.

3. An auditor may be asked to act contrary to a technical or professional standard. Divided

loyalty between the auditor’s superior and the required professional standards of conduct
could arise. This could take place when an auditor is asked to ignore an incorrect application
of an accounting standard.

4. The Audit Committee and Internal Control

Ensure That Review The

Recommendations of Organization’s
Internal Audit Regarding Strategies and Risk
Controls Are Implemented Limits

Objectives of The
Board Of Directors
Regarding Internal
Controls

Hold Discussions with Review the

Management About Assessments And
Effectiveness Of Evaluations Of The
Internal Controls Internal Control System

Page | 138
 The audit committee is a committee of the board of directors
consisting entirely of independent non-executive directors (at
least three in larger companies), of whom at least one has
had recent and relevant financial experience.

In relation to internal controls, the audit committee should:

 Review the company’s internal financial controls

 Review all the company’s internal control and risk management systems

 Give its approval to the statements in the annual report relating to internal control
and risk management

 Receive reports from management about the effectiveness of the control systems it
operates

 Receive reports of the conclusions of any tests carried out on the controls by the
internal or external auditors.

The Smith Guidance on audit committees states that:

‘While all directors have a duty to act in the interests of the company
the audit committee has a particular role, acting
independently from the executive, to ensure that the interests of
shareholders are properly protected in relation to financial reporting
and internal control’.

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5. Effective Internal Control Systems

For a system of internal controls to be effective, it needs to successfully mitigate the

business risks identified by management:

 A system of internal control plays a key role in managing significant risks to the
achievement of business objectives.
 A sound system of internal controls contributes to protecting the investment of
shareholders, safeguarding the assets of the company and ensuring compliance with
laws and regulations.
 One of the objectives of an internal control system is to prevent or reduce fraud.
 The internal control system should be reviewed continually.
 The costs of a control should not exceed the likely benefits from reduced risk,
therefore, the suitability of specific internal controls varies between organizations.
 Internal control systems should be an integral part of an organization, not just a ‘bolt
on’ set of processes.
 Effective financial controls, including the maintenance of proper accounting records,
are important elements of a system of internal controls.

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6. The Audit Committee and Internal Audit
The audit committee is responsible for overseeing the work of the internal audit function.

Monitor And Review And Assess

Assess The Annual Internal
Effectiveness Audit Work Plan

ENSURE Audit Committee Role Approve The

ACCOUNTABLETO THE In Overseeing Internal Appointment Or
AUDIT COMMITTEE Termination Of Head
Audit Function
Of Internal Audit

ENSURE
RECOMMENDATIONS Preserve
ARE ACTIONED
Independence
Check Efficiency

The Smith Guidance on audit committees recommends that the

committee should meet with internal auditors at
least once a year, without management present, to
discuss audit-related matters.

If the company does not have an internal audit function:

 The committee should consider annually whether there is a need for an internal
audit function, and

 The reasons for the absence of an internal audit function should be explained in
the relevant section of the annual report.

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7. The Audit Committee and External Audit

The Combined Code states that the audit committee should:

- Have the primary responsibility for making a recommendation to the board on the
appointment, re-appointment or removal of the external auditors
- ‘oversee’ the selection process when new auditors are being considered
- Approve the terms of engagement of the external auditors and the remuneration for
their audit services
- Have annual procedures for ensuring the independence and objectivity of the
external auditors
- Review the scope of the audit with the auditor, and satisfy itself that this is sufficient
- Make sure that appropriate plans are in place of the audit at the start of each annual
audit
- Carry out a post-completion audit review.

The independence of the external auditors

The audit committee should have annual procedures for ensuring the independence
and objectivity of the external auditors.
The Smith Guidance suggests that the audit committee should:

 Seek reassurance that the auditors and their staff have no family, financial,
employment, investment or business relationship with the company
 Obtain each year from the audit firm information about its policies and
processes for
(1) maintaining its independence and
(2) monitoring compliance with relevant professional requirements
 Agree with the board and then monitor the company’s policy on employing
former employees of the external auditor
 Develop and recommend to the board the company’s policy on the provision
of non-audit services by the external auditors.

The audit committee should establish a policy that specifies the types of
work:

 From which the external auditors are excluded

 For which the external auditors can be engaged without referral to the audit
committee
 For which a case-by-case decision is necessary.

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8. Reporting on Internal Controls to Shareholders

The combined code states that a company’s board of directors should maintain a sound
system of internal control to:
Safeguard shareholders’ investment and the company’s assets.

 Shareholders, as owners of the company, are entitled to know whether the internal
control system is sufficient to safeguard their investment.

 The board should, at least annually, conduct a review of the effectiveness of the
group’s system of internal controls.

 The review should cover all material controls.

 The annual report should also inform members of the work of the audit committee.

 The chair of the audit committee should be available at the AGM to answer queries
from shareholders regarding their work.

9. Internal Audit Reporting

Once an internal control audit has been completed, the final stage of the assignment is the
audit report.

 The audit does not have a prescribed format.

 How much depth the report goes into will depend on the nature of the engagement.

Page | 143
CHAPTER 10 | Risk and the Risk
Management Process

Page | 144
 Table of Content

1. Risk and Corporate Governance ................................................................................ 146

2. Management Responsibility for Risk Management ..................................................... 147
3. Strategic and Operational Risks ................................................................................. 148
4. Sources and Impactis of Business Risks .................................................................... 148
5. Sector – Specific Risks .............................................................................................. 149
6. The Impact of Stakeholders ....................................................................................... 150
7. Analyzing Risks.......................................................................................................... 151
8. The Role of the Board ................................................................................................ 152
9. External Reporting ..................................................................................................... 152
10. The COSO Enterprise Risk Management (ERM) Framework ..................................... 153

Page | 145
1. Risk and Corporate Governance
 The issue of corporate governance and risk management has become an
important area of concern across the world.

 UK’s Turnbull Committee has identified risk management as key to effective internal
control.

Following Good Corporate Governance

Procedures Will Decrease The Impact Of Many
Risks On An Organization.

The OECD Principles of Good Corporate Governance

Principle Explanation in the context of risk

Rights of shareholders Company does not allow shareholders
Shareholders’ rights are protected their rights, e.g. does not provide
and facilitated. necessary communications to, or allow
comments in, general meetings.
Equitable treatment of shareholders Preferential treatment is seen to be given
All shareholders including those with to one group compared with another (e.g.
small shareholdings or those in larger shareholders) which other groups
foreign countries) are treated the resent and this may result in poor publicity
same. for the company.
Role of stakeholders Companies ignore stakeholders or treat
There should be co-operation between some stakeholder group incorrectly (e.g.
companies and stakeholders to create attempt to make employees redundant
wealth, jobs, etc. without appropriate consultation).
Disclosure and transparency Directors do not provide appropriate
Timely and adequate disclosure reports or financial statements do not
should be made of all material matters disclosure the true situation of the
(e.g. financial situation of the company (as in situations such as Enron).
company). This heading implies that internal control
systems will also be adequate to detect
fraud and other irregularities.
Responsibility of the board The board either does not control the
The board should be effective and company adequately (leading to losses) or
provide strategic guidance for the attempts to run the company for its benefit
company. rather than for the benefit of other
stakeholders.

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2. Management Responsibility for Risk Management

Risks can have an adverse impact on the

organization’s objectives

 Risk management is therefore the process of reducing the possibility of adverse

consequences either by reducing the likelihood of an event or its impact.

PROCESS OF RISK MANAGEMENT

RISK LIST OF

IDENTIFICATION POTENTIAL RISKS

RISK PRIORITISED RISK LIST

ANALYSIS

RISK RISK AVOIDANCE AND

PLANNING CONTINGENCY PLANS

RISK RISK

MONITORING ASSESSMENT

2.1 Why manage risk?

Management needs to monitor risks on an

ongoing basis.
 To identify new risks that may affect the
company
 To identify changes to existing or known
risks
 To ensure that the best use is made of
opportunities.

Page | 147
2.2 Managing the upside of risk

The focus of risk management has been on preventing loss.

BUT:

 Risks are seen as opportunities to be seized

 To increase the probability of positive outcomes and to maximize returns

 Enhancing shareholder value by improving performance.

3. Strategic and Operational Risks

3.1 Strategic risks

 Are risks arising from the possible consequences of strategic decisions taken by the
organization.

 Strategic risks should be identified and assessed at senior management and board
or director level.

3.2 Operational risks

 Refer to potential losses that might arise in business operations

 Risk of loses resulting from inadequate or failed internal processes

 Include risks of fraud or employee malfeasance

 Can be managed by internal control systems.

4. Sources and Impacts of Business Risks

Businesses face risks from a number of different sources:

 Market: Risks which derive from the sector in which the business is operating.

 Credit: The possibility of losses due to non-payment by debtors.

 Liquidity: The risk of running out of liquid assets, and thus not being able to finance
operating activities.

 Technological: This arises from the possibility that technological change will
inevitably occur. Like many other categories of risk, technology risk is two-way. It
creates both threats and opportunities for a company.

Page | 148
  Legal: Arises from the possibility of legal action being taken against an
organization. For many organizations, the risk can be high, depending on the type
of industry they are in.

 Health, safety and environmental issues: This depends on the nature of work
performed at the workplace.

 Reputation: Some businesses rely heavily on brand image and product reputation.
An adverse event could very easily put its reputation at risk.

 Environmental: Arises from changes to the environment over which an

organization has no direct control, e.g. global warming, or for occurrences for which
the company might be responsible, e.g. oil spillages and other forms of pollution.

5. Sector – Specific Risks

BUSINESS RISK

CATEGORISED BY

GENERIC: SPECIFIC:

AFFECTS ALL AFFECTS

BUSINESS INDIVIDUAL

Business risks can be either generic that is the risk affects all businesses, or specific to
individual business sectors.
 Examples of generic risks include changes in the interest rate, non-compliance with
company law, or poor use of derivative instruments. Generic risks can also affect
different businesses in different ways, e.g. a company with substantial borrowing will
be affected more by an increase in interest rates than a company with little or no
borrowings.
 Specific risks depend on the industry sector. For a university, a specific sector risk
can be the inability to attract good quality staff as academic salaries might be falling
below salaries in a profession or business industry.

Page | 149
6. The Impact of Stakeholders

BUSINESS RISK

EFFECT ON STAKEHOLDER

STAKEHOLDER CAUSED STAKEHOLDER DID NOT

RISK CAUSE RISK

IMPACT NEGATIVE ON
IMPACT MAINLY NEGATIVE
COMPANY AND ON
ON STAKEHOLDER
STAKEHOLDER

Business risks initially affect the company subject to those risks. However, there will be a
‘knock-on’ effect of those risks on shareholders:
 The amount of the effect will depend on how close the stakeholder is to the company.
 In many situations, the actual impact is to affect the company again; the stakeholders
will mitigate the risk by distancing themselves from the company.
 Impact on stakeholders is likely to be more severe if they have actually caused the
business risk themselves
A summary of different stakeholders and the impact of business risk to them is provided
below:
Shareholders: Potential loss of value of investment in company (fall in share price) and loss
of income (decreased dividends).
Directors: Loss of income (assuming that remuneration is linked in some way with company
performance). Also, there will be potential for poor reputation if any business risks are
identified as resulting from actions of a specific director.
Managers: Likely to mean that the department they are in charge of falls behind budget in
some way. Quite likely therefore that managers become demotivated, especially if business
risk was not their fault. Possible fall in remuneration if part of salary is performance related.
Employees: Similar impact to managers – may see any fall in output and/or remuneration
as ‘not their fault’ and become demotivated as a result.
Customers: The impact is likely to depend on the nature of the risk. However, risks such as
poor product reputation will have an impact on customers in that the company’s product will

Page | 150
not be purchased. The overall impact is therefore mainly negative on company in terms of
lost sales.
Suppliers: If business risk results from poor quality of supplies, then the impact of the risk is
loss of supply to that particular company. Loss of supply may also result where the risk is not
the fault of the supplier, but the purchasing company manufacturers fewer items –
decreasing the amount of inputs purchased.
Government: The main impact is likely to less revenue raised (either in terms of sales taxes
and/or corporation taxes). It is probable that the company will make less profit, resulting in a
fall in tax revenue.
Banks: At the extreme, any loans and interest due to the bank are not repaid because the
company is no longer trading. Impact may be less severe, in terms of the company’s
profitability or ability to repay loans, which will enable the bank to limit its risk. In other
words, the risk assessment of the company increases, limiting the amount of money the
bank is willing to lend.

7. Analyzing Risks
A common qualitative way of assessing the impact of risk is to produce a ‘risk map’:
Consider impact and probability, listed below for a tuition provider.
Impact/Consequence

Likelihood Low High

ACCA change their syllabus Company loses key tuition
High
staff

Materials increase slightly in price ACCA scrap their

Low
examination qualification

A number of tools can be used to quantify the impact of risks:

• Scenario planning
• Sensitivity analysis
• Decision trees
• Computer simulations
• Software packages
• Analysis of existing data

Page | 151
8. The Role of the Board

The board of an organization plays an important role in risk management.

 It considers risk at strategic level.

 Ensuring that managers responsible for implementing risk management have

adequate resources.

 For ensuring that risk management supports the strategic objectives of the
organization.

 The board will determine the level of risk which the organization can accept.

 Risk management strategy is communicated to the rest of the organization and

integrated with all the other activities.

 The board will determine the risks which will be accepted which cannot be managed
or which it is not cost-effective to manage – this is residual risk.

9. External Reporting

EXTERNAL REPORTING: INTERNAL CONTROLS + RISKS

PROCESS

IDENTIFY MAKE REPORT IF

CHECK COMPLIANCE
REPORTING REQUIRED
WITH LEGISLATION/
SITUATION
ETHICAL GUIDANCE

Document reason for

Companies Act / Stock
Internal control failure / report (e.g. Qualified
exchange requirements
directors making Audit Report /Whistle
Professional Ethical
inappropriate decisions blowing and make
guidelines may require
(as in Enron). report to appropriate
disclosure
third party

External reporting of internal control and risk relates to reporting sources outside the
company.

Page | 152
  Reporting may be voluntary or required by statute
 In the extreme, third parties will be required to report where the company is either
unaware of reporting situations or declines to report voluntarily
 The process of reporting implies some form of decision making prior to an external
report being made
 The process will normally imply compliance with the relevant statutory or ethical
guidance appropriate to the entity and the person making the external report

10. The COSO Enterprise Risk Management (ERM)

Framework
Risk Management has transformed from a department focused approach to a coordinated
integrated process which manages risks throughout the organization.

Principles of ERM
1. Consideration of risk management in the context of business strategy
2. Risk management is everyone’s responsibility
3. The creation of a risk awareness culture
4. Consideration of a broad range of risks

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Components of the ERM Framework
1. Internal environment: This is the tone of the organization including the risk
management and risk appetite
2. Objective setting: These must be aligned with the organization’s mission
3. Event identification: These are internal and external events which impact on
the organization’s ability to achieve its objectives
4. Risk assessment: Analysis to consider likelihood and impact
5. Risk response: Avoid, accept, reduce or share risks
6. Control activities: To ensure risk responses are properly carried out
7. Information and communication: The relevant information is identified and
communicated timely
8. Monitoring: Modifications to the process should be made if necessary

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CHAPTER 11 | Controlling Risk

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 Table of Content

1. Role of the Risk Manager ........................................................................................... 156

2. Role of the Risk Committee ....................................................................................... 158
3. Purpose of Risk Auditing ............................................................................................ 159
4. Risk Awareness ......................................................................................................... 159
5. Embedding Risk in Systems....................................................................................... 160
6. Embedding Risk in Culture ......................................................................................... 161
7. Diversifying/Spreading Risk ....................................................................................... 161
8. Risk Avoidance and Retention ................................................................................... 163
9. Attitudes to Risk ......................................................................................................... 164
10. Necessity of Risk ....................................................................................................... 175
11. Risk Attitudes and the Organization ........................................................................... 175
12. Dynamic Nature of Risk Assessment ......................................................................... 167
13. ALARP ....................................................................................................................... 167
14. Objective and Subjective Risk Perception .................................................................. 168
15. Related and Correlated Risks .................................................................................... 168

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 1. Role of the Risk Manager

KEY POINT

The risk manager is a member of the risk management committee.

Primary role implementation of risk management policies
The manager is supported and monitored by the risk management committee
The role is more operational than strategic.
Policy is set by the board and the risk management committee

Identification and evaluation of the risks

Implementation of risk mitigation strategies

Seeking opportunities to improve risk management

methodologies strategies

Monitoring the status of risk mitigation strategies and

internal audit

TYPICAL ACTIVITIES
CARRIED OUT BY A RISK
Developing, implementing and managing risk
MANAGER: management programmes

Maintaining good working relationships with the board

and the risk management committee strategies.

Depending on the Laws of the jurisdiction in which the

organization is based, working with the external auditors
to provide assurance and assistance in their work.

Again, depending on the jurisdiction, producing reports

on risk management, (for example Sarbanes-Oxley).

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2. Role of the Risk Committee

RISK COMMITTEE

RAISE RISK UPDATE

IMPLEMENT PROCESSES TO COMPANY
AWARENESS RISK PROFILE
MONITOR AND REPORT RISK
AND APPETITE

KEY POINT

Under terms of good corporate governance, larger organizations will normally

have a risk management committee.

Where no risk management committee is formed, audit committee will usually

perform similar duties.

Secondary objectives of the risk management committee

These objectives may also be contained in the terms of reference of the risk management
committee.

 Advising the board on the RISK PROFILE and APPETITE OF THE COMPANY.
 Acting on behalf of the board, to ensure that APPROPRIATE MECHANISMS are in
place with respect to risk identification, assessment, assurance and management.
 CONTINUAL REVIEW of the company’s risk management policy.
 Ensuring that there is APPROPRIATE COMMUNICATION of risks, policies and
controls.
 Ensuring that there are ADEQUATE TRAINING ARRANGEMENTS in place for risk
management.
 Where necessary, obtaining APPROPRIATE EXTERNAL ADVICE to ensure that
risk management processes are up to date.
 Ensuring that BEST PRACTICES in risk management are used.

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3. Purpose of Risk Auditing
 Risk auditing ASSISTS THE OVERALL RISK MONITORING.
 In many situations, audit work is OBLIGATORY (e.g. Sarbanes-Oxley requirements).
 Following review, internal and external audit can MAKE RECOMMENDATIONS to
amend the risk management system or control as necessary.

PROCESS FOR CARRYING OUT

INTERNAL RISK AUDIT

IDENTIFY RISKS ASSESS RISKS

REVIEW
REPORT on inadequately – CONTROLS OVER
Controlled risks RISK

4. Risk Awareness

RISK AWARENESS

STRATEGIC OPERATIONAL

HIGH LEVEL TACTICAL

MONITORING OF

MONITORING MONITORING OF
RISK IN DAY TO
OF RISK AT DIVISION LEVEL DAY

RISK OPERATIONS

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 KEY POINT

A LACK OF RISK AWARENESS MEANS THAT AN ORGANIZATION HAS AN

INAPPROPRIATE RISK MANAGEMENT STRATEGY

5. Embedding Risk in Systems

 Embedding risk applies to the concept of ENSURING THAT RISK MANAGEMENT
IS INCLUDED WITHIN THE CONTROL SYSTEMS of an organization.

SOX

 In many jurisdictions, this is a statutory requirement (e.g. US) while in others it is a

code of best practice (e.g. UK).

Embedding risk management is unlikely to

be successful within an organization
unless it is:

 Supported by the board and communicated to all managers.

 Supported by experts in risk management
 Incorporated into the whole organization.
 Linked to strategic and operational objectives.
 Supported by existing committees.
 Given sufficient time by management to provide reports to the
board.

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6. Embedding Risk in Culture
Various cultural factors will affect the extent to which risk management can be embedded into
an organization whether the culture is open or closed:

 Whether the culture is open or closed

 The overall commitment to risk management policies at all levels
 The attitude to internal controls
 Governance, i.e. the need include risk management in the organization.

How can you help embed risk management in the culture and values of an organization
includes?

 Aligning individuals goals with those of the organization

 Including risk management responsibilities within job descriptions
 Establishing metrics and performance indicators that can monitor risks and
provide an early warning if it is seen that risks will actually occur and effect the
organization.
 Informing all staff in an organization of the need for risk management, and
publishing success stories to show.

7. Diversifying/Spreading Risk

DIVERSIFYING / SPREADING RISK

ONLY WORKS
AIM TO REDUCE CAN DIVERSIFY
WITH LACK OF
TOTAL RISK OPERATIONS
POSITIVE

CORRELATION

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 BACKWARD

INTEGRATION

E.G. RAW
Diversification
MATERIALS

SUPPLIER

Related
UNRELATED
Development beyond the HORIZONTAL INTEGRATION
Development beyond the present product and market,
present industry into E.G. COMPETITOR
but still within the broad
products and / or markets confines of the industry
that may bear no clear
relationship to their
current products

FORWARD
INTEGRATION

E.G. DISTRIBUTION
OUTLET

Problems with diversification:

 If diversification reduces risk, why are there relatively few conglomerate industrial and
commercial groups with a broad spread of business in their portfolio?
 Many businesses compete by specializing.
 There is a possible risk that by diversifying too much, an organization might become
much more difficult to manage.
 Many organizations diversify their operations, both in order to grow and to reduce risks,
but they do so into related areas, such as similar industries.
 Investors diversifying for themselves by holding a portfolio of stocks and shares from
different industries and in different parts of the world.

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8. Risk Avoidance and Retention
 Risk avoidance: organization literally avoids a risk.
 Risk retention: risk strategy by which an organization retains that particular risk within
the organization.

A risk avoidance strategy is likely to be followed where an organization has a low risk appetite.
This strategy will involve avoiding those activities that will incur risk, e.g. activities that have a
higher probability of failure where alternative risk strategies such as transference can not be
used.

A risk retention strategy will be followed where the risk is deemed to be minimal or where other
risk strategies such as transference are simply too expensive.

Risk management using TARA or SARA

Transference/Sharing: The most common example of risk transference is insurance.

Businesses arrange a wide range of insurance policies for protection against possible losses.

Avoidance: Risks can be completely avoided if there is absolutely no investment. This is

unrealistic for business ventures, so it is logical to assume that they cannot avoid risk
altogether.

Reduction/mitigation: Risk can be reduced either by limiting exposure in a particular area,

or attempting to decrease the adverse effects should the risk actually crystallize.

Acceptance: This strategy is normally acceptable if the adverse effects are minimal. For
example: there is nearly always a risk of rain; unless the business activity cannot take place
when it rains then the risk of rain occurring is not assured against.

Risks minimization – Risk Pooling

When risks are pooled together, the risks from different transactions and items are brought
together. Each individual transaction or item has a potential upside or downside risk. By
pooling the risks, they tend to cancel each other out, and are lower for the pool as a whole
than for each item individually.

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9. Attitudes to Risk
 An organization’s attitude to risk is determined by its risk strategy, risk appetite and
risk capacity.
 The overall risk strategy determines the overall approach to risk.
 The risk appetite determines how risks will be managed.
 The risk capacity indicates how much risk the organization can accept.

Ansoff’s Production/market matrix

This model can be used to provide a basic risk strategy for a company. It provides a summary
of strategic options for an organization when it is looking for expansion. The matrix is shown
below:

Existing Product New Product

Internal efficiency and market

Existing Market Product development (2)
penetration (1)

New Market Market development (3) Diversification (4)

(1) Low risk as the product and the market are already familiar. The risk here lies in
the attempt to sell the product in the marketplace when demand is failing.

(2) Higher risk since although the market is known, there is a risk that the consumers
won’t like the new modified product.

(3) Higher risk – the product is known, but the marketplace is not. The main risks
relate to poor sales strategy or poor market research indicating that customers want
the product when they actually do not.

(4) Highest risk – both the market and the product are combining risks from options (2)
and (3). While the risk is the highest here, we must keep in mind that so are the
potential returns if the new product can be successfully sold in the new market.

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10. Necessity of Risk
 Incurring an acceptable amount of risk tends to make a business more competitive.
 Conversely, not accepting risk tends to make a business less dynamic, and implies a
‘follow the leader’ strategy.
 Incurring risk also implies that the returns from different activities will be higher, let us
not forget: The higher the risk, the higher the return!
 Benefits obtained from risk taking can be financial (decreased costs) or intangible
(better quality information).
 In both cases, these will lead to the business being able to gain competitive advantage.

11. Risk Attitudes and the Organization

There is no easy correlation between the risk attitude of an organization and its size, structure
and development.

In general terms:

 A small young company may have a higher risk appetite as it takes risks in order to
get its product into the market.
 A larger older company may appear to be more risk averse as its primary objective
would be to protect its current market position.

Specific comments about risk and its relationship with size, structure and development
SIZE

Size normally relates to the overall size of an organization in terms of turnover, market
share or value on the balance sheet.

Small size

Small size normally indicates higher risk for the organization

A small organization will have a smaller product range meaning it is more likely to be
adversely affected by fall in sales of one product. This would suggest a risk averse stance.

However, small size may also be indicative of a young company attempting to sell its first
products. In this case, more risk will be accepted in order to get the product “launched”.

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Large size

Large size normally indicates lower risk for the organization.

A larger company will have a wider product range meaning it is less dependent on any one
product; a fall in sales in one product does not necessarily place the organization at risk.

However, large size may also be indicative of the organization having many employees, good
brand names, etc. The organization will therefore be risk averse, attempting to protect its own,
and its stakeholders’, interests.

STRUCTURE

Structure normally relates to the internal structure of an organization in terms of functional

or divisional format.

Functional structure

A functional structure normally indicates that risk is managed at board level Consider a
company selling the same product in many countries (e.g. Dell computers). The board will
consider the risk of selling computers and the related risk of selling in different jurisdictions.

Depending on the attitude of the board, the company will attract more or less risk, e.g.
expansion into related fields such as printer sales, or expansion into new jurisdictions.

Divisional structure

A divisionalised structure indicates that risk is managed by having a diversified portfolio of

companies. Risk appetite will be determined by the current portfolio of companies in terms
of their overall risk for the organization. A portfolio with limited risk may indicate that more
risky investments can be made. Similarly, a higher-risk portfolio indicates that lower-risk
investments will be attractive.

DEVELOPMENT

Development normally relates to the stage of development of an organization in terms of

the product life cycle.

Product life cycle

The initial stages of the product life cycle are risky. Initial investment may not result in a
viable product, while the launch of a new product does not mean it will actually be accepted
into the market. However, organizations will take some risk here because new products are
required to replace older products.

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Products at the end of the life cycle are declining is sales. The organization will limit risk by
stopping investment in the product and finally withdrawing it from the marketplace.

Most companies will attempt to mitigate this risk be resolving the crises as quickly as possible.
Risk is also managed by urgently identifying crisis point and planning to overcome them as
soon as the company can.

The overall point here is that general trends can be established. However, there is no
definitive link between size, structure and development and the level of risk within an
organization.

12. Dynamic Nature of Risk Assessment

As the environment changes, so do the risks that affect an organization. Therefore, a

continuous risk assessment is necessary to make sure the organization is protected
against new or changing risks. So the risk map (impact and likelihood) will need to evolve all
the time.

The management responses to risk management need to also be in line with the
changes in the environment.

13. ALARP

DEFINITION

The ALARP (As low as reasonably practicable) approach states that the residual
risk shall be as low as reasonably practicable. It has particular aim to provide a way to
reduce risks (so far as is reasonably practicable)

For a risk to be ALARP it must be possible to demonstrate that the cost involved in reducing
the risk further would be grossly disproportionate to the benefit gained. The ALARP principle
arises from the fact that infinite time, effort and money could be spent on the attempt of
reducing a risk to zero. It should not be understood as simply a quantitative measure of
benefit against detriment. It is more a best common practice of judgment of the balance of
risk and societal benefit.

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14. Objective and Subjective Risk Perception
Objective risk perception is when different measures are used to quantify the risk.

Subjective risk perception is when a manager or director believes whether or not a risk will
materialize and what its impact will be based on past experience and ‘gut feeling’.

15. Related and Correlated Risks

Related risks are risks arising from similar activities and in similar industries.

A correlated risk is a risk that is affected by another risk. This means that if a risk takes place
the correlated risk will also have a higher chance of taking place.

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CHAPTER 12 | Ethical Theories

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 Table of Content

1. Relativism VS Absolutism .......................................................................................... 171

2. Kohlberg’s Levels of Moral Development ................................................................... 172
3. Deontological VS Teleological Approaches ................................................................ 174
4. Application of Ethical Decision Making ....................................................................... 176
5. Gray’s Positions on Social Responsibility ................................................................... 178
6. Corporate and Personal Ethical Stances .................................................................... 180
7. Cultural Context of Ethics and CSR ........................................................................... 181

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1. Relativism vs Absolutism

DEFINITION

What is ethics?

Ethics is concerned with right and wrong and how conduct should be judged to be good
and bad. As individuals need to be ethical so do business organizations. There are 2
main approaches to ethical and moral belief systems in society: relativism and
absolutism.

 Relativism:
Relativism or non-cognitivism argues that what is correct in a given situation will depend on
the conditions of the time. Therefore all moral statements are subjective and arise from the
culture, belief and emotions.

 Strengths of Relativism:
- It highlights differences in cultural beliefs
E.g. all cultures say it is wrong to kill innocents – but who are innocent?
- Our morals are affected by what we observe with our senses and what we see.
Therefore different people have different morals.
 Weaknesses of Relativism:
- Some universal truths exist called “natural moral laws. e.g. wrong to kill innocents
- It leads to the philosophy of “anything goes” denying the existence of morality,
permitting activities that are harmful to others.
- Under this theory no objectivity and final truth can exist accountants must be objective

 Absolutism:
Absolutism or cognitivism is the view that there are objective, unchanging and universally
applicable truths. These standard beliefs and practices are common to all societies.

 Strengths of Absolutism:
- Some absolute truths do exist
- It lays down certain clear rules that people can follow, knowing that their actions are
right.

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  Weaknesses of Absolutism:
- It does not take into account evolving norms
- What is the source of these absolute ethics?
- What happens when two absolutist positions contradict? e.g. Is it permissible to tell a
lie to save an innocent life?

 Relativism v Absolutism

RELATIVISM ABSOLUTISM
Many sets of moral rules that change over One set of moral rules
time that never change
“Truth” cannot be imposed due to differing “Truth” in one culture may be imposed in
cultures. another
Allows different beliefs to every individual New absolutists believe that each culture
e.g. abortion. has its own truths.
Some basic morals are still the same in
every culture e.g. child labor

In the business context:

Legislation and various standards set absolute rules on directors, auditors etc.
However, the directors and auditors still choose to interpret them in the light of relativism.

 Dogmatic v Pragmatic approach:

Dogmatic – there is one truth and this truth must be imposed in all situations. This
corresponds to absolutism. Dogma – a given truth
Pragmatic – this approach tries to find the best route through a specific moral situation. It
corresponds to relativism as it tries to find the solution based on the given belief system.

2. Kohlberg’s Levels of Moral Development

Kohlberg’s developed the Cognitive Moral Development theory (CMD) to explain the ethical
reasoning process develops through 3 levels.
This theory attempts to show how the decision is reached and not what the decision is.
It is possible that individuals at different levels will make the same moral decisions but they
will reach this decision through different reasoning processes.

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  The theory:
Individuals move from Level 1 to Level 3.
Each level has 2 stages.

Pre – Conventional:
Obedience & Punishment
Level 1 Focus on self-interest and
External rewards and Purpose & exchange
punishment

Interpersonal accord &

Conventional: conformity
Level 2 Individuals tend to do what is
expected of them Social accord & system
maintenance

Social contract & individual

Post – Conventional:
rights
Level 3 Autonomous decision based
on internal principles of right
and wrong
Universal ethical principles
Stage Explanation
1.1 Right or wrong defined according to rewards or punishment
Employee believes that he will not be punished
1.2 Whether there is fairness in the exchange, concern for own interests
Covering for a colleagues’ absence in order to reciprocate later
2.1 Actions defined by what is expected by peers
Using Co’s phone for personal use because everybody does it.
2.2 Actions defined by what is expected by society
Working conditions raised above minimum due to pressure
3.1 Right or wrong determined by reference to basic rights and values
Full disclosure of ingredients even though there is no statutory obligation or
pressure

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 3.2 Decisions based on self-chosen ethical principles that believe everyone should
follow
No purchasing from suppliers that do animal testing

 Criticism on Kohlberg
- It has been founded based on the principles of American males. It is argued that
women tend to focus more on empathy, harmony and interdependence.
- The framework was based on Kohlberg’s own value judgment and it values rights and
justice above other bases of morality, a fact that is not necessary true.
- It argues that a solution is acceptable depending on how the decision was reached.
The stage of moral development also appears significant.
- It assumes that moral action is primarily decided by a formal process of reasoning.
- It also assumes that individuals develop and progress during their lives.

EXAM TIP

Emphasized significantly in the syllabus. You need to ask whether the organization
in a company allows people to make up their own minds on ethics or if it promotes
a lower level of ethical awareness.
You must identify the level someone is at, explain why and argue for and against
the certain level.

3. Deontological VS Teleological Approaches

These 2 theories are approaches to ethical decision making.

 Deontological Approach

Deontology is concerned with the application of universal ethical principles in order to arrive
at rules of conduct.

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This is a non-consequentialist theory. It does not look at the consequence of an action to deem
the action right or wrong; instead it looks at the motivation and principles for taking that action.
Deontology therefore lays down the criteria by which actions may be judged in advance.
Deos = duty
Kant identified that there are 3 maxims/tests for any action. An action is morally right if it
satisfies all three:
1. Principle of Consistency: An action can only be right if everyone can follow the same
underlying principle e.g. lying and murder. We cannot lie or commit murder because then
no truth would exist and human life would not be allowed to exist.
We should act only according to that maxim that could hold as a principle establishing
universal law.

2. Principle of Human Dignity: Humans should be seen as the providers of goods and
services with their own needs and expectations.
Do not treat people only as means to an end but as an end in themselves. People should
be treated with humanity and should not be regarded as objects.
3. Principle of Universality: The test is that a person would be uncomfortable if their
action were reported in the press then the action would be of doubtful moral status.
Act as though you were through your maxims a law making member. This means that an
action is deemed to be moral or suitable when viewed by others to be so.

 Criticism on Kant
- One cannot take actions in a vacuum without regard to their consequences
- Although people expect others to follow Kant’s maxim, they sometimes fail to apply
Kant’s duties to themselves.

 Teleological Approach
This is a consequentialist theory – the decision is right or wrong depending on the
consequences and the outcome of the decision. As long as the outcome is right the action is
irrelevant.
Telos = end

a. Utilitarianism:
This is the “greatest good” principle where an action is morally right if it results in the greatest
good for the greatest number of people. It applies to the society as a whole and not to the
individual.

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This theory contrast the notion of universal morality: the right can vary between situations and
over time according to the greatest happiness of the greatest number.

 Criticism for utilitarianism

- It is very subjective: who decides what is good for the people and what makes people
happy?
- Effect on minorities?

b. Egoism
This is the view of “what is best for me?”. The theory states that an act is morally right if the
decision maker freely decide to pursue their own desires. The subject to all ethical decisions
is the self.
The egoist will also do what is right to the society because it suits them or makes them feel
better- the theory of the ‘invisible hand’.

Examples:
- Poor quality goods will not be produced because customers will not buy them.
This also benefits the society.
- Donations to charity make the donor feel good and promote a good image (Tate
& Lyle)

 Criticism for Egoism

- It does not always lead to the benefit of the whole society. Some people can
benefit themselves at the expense of others and also at the expense of the
environment.
- It makes short-term desires equivalent to long term desires (that tend to be more
beneficial)
- It is argued to be the ethics of the thief as well as the short-termist.

4. Application of Ethical Decision Making

In ethics education, ethical decision making models are used to provide a framework for
making such decisions. The main body is the International Accounting Education Standards

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Board (IAESB) which has formulated a framework. Two models are used to apply this
framework: the American Accounting Association and the Tucker’s 5 Questions model.

 Framework for development of ethical education

The IAESB formulated the Ethics Educational framework (EEF) which recognizes that ethics
education is a lifelong process. There are 4 stages:

Education on fundamental ethical knowledge about professional

values, ethics and attitudes.
Aim – to develop ethical intelligence
Ethical Knowledge
The accountant will understand the ethical framework within which he
operates
Application of the principles to the actual work of the accountant
Aim – ensure accountants can recognize ethical threats
Ethical Sensitivity How- Case studies sensitize the accountant on how and where ethical
threats arise.
Teaches how to integrate and apply ethical knowledge to form
reasoned and well informed decisions
Aim – help in deciding ethical priorities and being able to apply a
Ethical Judgment
process for making ethical decisions
How – applying ethical decision making models to ethical dilemmas.
An accountant should act ethically in all situations.
Ethical Behaviour
How – through case studies

 The American Accounting Association model:

It provides a framework on how an ethical decision is made – it is therefore useful for stage 3
of the EEF.

It argues that when there is an ethical dilemma the following questions must be answered
before reaching to the decision:
1. What are the facts?
2. What are the ethical issues?
3. What are the norms, principles and values?
4. What are the alternative courses of action?

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 5. What are the best courses of action that is consistent with the norms,
principles and values identified?
6. What are the consequences of each possible course of action?
7. What is the decision?

 Tucker’s 5-question model:

Once a decision is reached, Tucker can apply the 5 question model on which the decision can
be tested to ensure that it is the ‘correct’. The decision should be:
1. Profitable
2. Legal
3. Fair
4. Right
5. Sustainable or environmentally sound

5. Gray’s Positions on Social Responsibility

Gray argues that companies have some social responsibility and are therefore socially
accountable.
He argues that there are 7 viewpoints on social responsibility:
They support the liberal democratic economy. Businesses have
no moral obligation beyond their responsibilities to the
shareholders.
 The underpinning value is shareholder wealth maximization,
Pristine maximization of profits, and there is no concern for CSR

Capitalist  Anything that reduces shareholder wealth such as acting in a

socially responsible way is theft from the shareholders
 Directors that take actions that may reduce the value of the
return to shareholders, are destroying value for shareholders
Long term stability and welfare can be achieved only by
accepting minimal social responsibilities but only if that is in the
Expedients interest of the business

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  Recognition of necessity of some social responsibility in
order to strategically position the business and maximize
profits
 A company might adopt an environmental policy or give
money to charities if it believes this will create a favorable
image and help its overall strategic positioning
Companies exist only at society’s will and must behave in
conformance with the ethical norms in society
 Businesses enjoy a license to operate granted by society as
long as the business acts in an appropriate way

Proponents of  Businesses need to be aware of social norms and abide by

them
Social Contract
 If organizational acts are found unacceptable by society,
then the license to operate can be withdrawn by society
This viewpoint shows concern for the environment and
recognition that companies have caused environmental and
social problems.
 There is recognition that a business has a social and
Social Ecologist
environmental footprint and bears responsibility for
minimizing it
 The company adopts socially and environmentally
responsible policies because it has an obligation to do so
Capital should not be allowed to dominate social, economic and
political life, as it manipulates workers and other groups.
 Business should be conducted so as to address imbalances
in society and promote equality
Socialist  All stakeholders, even the ones beyond the owners of capital
should be provided with benefits
Society and business should be based on feminine
characteristics such as equity, dialogue, compassion and fairness
 Systems reflect masculine concepts. Feminine values
(compassion, love, co-operation) are ignored from the
Radical business world
Feminist  Radical readjustment is required in the ownership and
structure of society in order to move to a feminist viewpoint.

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 Humans do not have more rights on resources than other forms
of life. Businesses cannot be trusted with the environment. Deep
ecologists argue that just because humans are able to control
social and environmental systems does not mean that they
should.
Deep Ecologist  Systems are completely incorrect. As a minimum
economic activity should be sustainable.
 A full recognition of each stakeholder’s claim would not
allow business to continue as it currently does

6. Corporate and Personal Ethical Stances

There are 4 possible ethical stances that a person or a corporation may take:
(Corporate stance – the approach of the organization to the different theories
Personal stance – the approach of the individual)

Theory Corporate stance Personal stance

Short-term To provide an adequate return to the shrs. Conflict - Small shrs require
SHR interests Conflict – the need to pay dividends now annual returns as they are looking
What SHRS require and the need to invest for the future. for income.
in the ST Conflict – regarding shareholder Large shrs require long term
expectations growth

Long-term Co needs to maintain its existence. In the LT shrs are concerned with
SHR interests Conflict - with short-term need. If no security of investment and capital
What SHRS require dividends are paid, large scale sales of growth.
in the LT shares may happen and this will affect the No conflict with the corporate
long term prospects. stance.

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Multiple Identify the stakeholders with the highest Lack of action for each group’s
stakeholder power and attempt to involve them needs will result in increased
obligations (Mendelow). pressure.
How different Conflict – between the different needs of
stakeholder each group.
requirements are
managed

Shaper of society When a company can improve the society There is little an individual can do
Obligations to the eg McDonalds assisted in poor eating (think of Porter’s Five Forces)
society habits → not shaper Individuals can affect the
Toyota assisted in sensitizing society on organization by the choices it
fuel pollution by the research in solar makes
powered cars → a shaper eg buying organic foods

7. Cultural Content of Ethics and CSR

The extent of ethics and CSR vary according to the culture of the society:
Economic - the economic responsibility has to be achieved before moving on to higher level
of responsibilities.
eg loss making subsidiaries are kept by organizations to avoid poor public image
Legal – the organization must act within the law to show that it is socially responsible. Not
complying with the law results in lack of CSR. Legal responsibilities may limit economic
responsibilities.
eg working hour legislation
Ethical – organizations relate to doing what is seen to be right compared with doing what is
simply legal.
eg genetically motivated foods is a major issue without being a law
Philanthropic – certain actions are desired of organizations rather than required. These
responsibilities are less important than the other 3.
eg Donations to charity by company

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CHAPTER 13 | Professional and
Corporate Ethics

Page | 182
 Table of Content

1. Profession and Professionals ..................................................................................... 184

2. Definition of Public Interest ........................................................................................ 184
3. Influence of the Accounting Profession ...................................................................... 184
4. Accountant’s Role in Society ...................................................................................... 185
5. The Influence of Accounting ....................................................................................... 185
6. Accounting and the Public Interest ............................................................................. 186
7. Corporate Ethics ........................................................................................................ 186
8. Professional Codes of Ethics ..................................................................................... 189
9. Conflict of Interest ...................................................................................................... 190
10. Ethical Threats and Safeguards ................................................................................. 191
11. Threats to Independence ........................................................................................... 195
12. Corruption and Bribery ............................................................................................... 197

Page | 183
1. Profession and Professionals
Profession – a body of Professional – taking action
theory and knowledge that to support the public interest
supports the public interest

Members must act to the

A body of theory – standards, interest of the public
exam system

Proactive and not reactive

A knowledge that guides – approach.
guidance notes, a trusted
profession

2. Definition of Public Interest

DEFINITION

Public Interest – the common well-being or the general welfare

3. The Influence of the Accounting Profession

The influence of accounting professionals regarding the ethical and other areas is limited by
the following factors:

 Auditing organizations in difficulties:

To check if the organization prepares accounts that are true and fair:
By reporting adversely on the accounts may push the organization into insolvency

 Relationships with clients:

Long term relations are favored by firms because they are more cost efficient, information is
kept secured. However, there is the risk of loss of independency.

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 Size of accountancy firms:
Larger firms gain economies of scale, standardization of procedures makes personal service
and relations unlikely. However, the quality of service may be reduced and oligopolies are
formed.
 Competition:
High competition between the big 4 implies cost cutting which is against the public interest as
standards fall.

4. Accountant’s Role in Society

The accounting profession is accountable to the society:
- they must act to the public interest
- use their skills and knowledge to help in the development of new initiatives

Why accountants get involved with change?

- Accountant tend to have a variety of generic skills that apply to any situation
- Any new initiative will involve some financial impact
- New initiatives are seen as new business opportunities

One area that the accountant can be involved in public interest is the CSR report.

5. The Influence of Accounting

Accountants may be able to influence the distribution of power and wealth in the following
ways:
 Organisations comply with regulations regarding the payment and disclosure of directors’
emoluments. Directors may be less inclined to pay large incentives or bonuses as the
public may react.
 Advising the government on different tax regimes.
 Advise on the content of legislation
 Act as whistleblowers on the illegal actions of company officials

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6. Accounting and the Public Interest
The public interest can be defined as that which supports the good of the society as a whole.
 Accountants do act against the public interest
 Lack of disclosure may be against the public interest
Lack of disclosure:
- decreases accountability
- leads to lack of enforcement of laws eg money laundering
 Sometimes disclosure is against the interest of the public
eg disclosure will adversely affect the economic
Interest of the company

7. Corporate Ethics

CORPORATE ETHICS

PURPOSE AND
VALUES OF IMPLEMENTATION
BUSINESS
CUSTOMER SHAREHOLDERS

RELATION

EMPLOYEES SUPPLIERS SOCIETY

Corporate Ethics relate to the application

of ethical values to business behavior.

Many companies provide details of their ethical approach in a corporate and

social responsibility (CSR) report
Page | 186
 Key Area Explanation

The purpose and This provides the reason for the organization’s existence.
values of the business The role of the business IN SOCIETY as seen by the
company itself.

Employees have rights and they must not be seen simply

as a means of producing goods/services.
The company will therefore have POLICIES on:
 Working conditions
 Recruitment
 Development and training
Employees  Rewards
 Health, safety and security
 Equal opportunities
 Retirement
 Redundancy
 Discrimination
 Use of company assets by employees.

Customer faith in the company and its products MUST BE

ESTABLISHED and built up over time.
Key areas for the company to invest in include:
Customer relations
 Product quality
 Fair pricing
 After sales service.

The company must commit to:

Shareholders or other
 Providing an proper return on shareholder
providers of money
investment

Page | 187
  Providing timely and accurate information to
shareholders on the company’s historical
achievements and future prospects.

The company will therefore normally:

 Attempt to settle invoices promptly
 Co-operate with suppliers to maintain and improve
Suppliers the quality of inputs
 Not use or accept bribery or excess hospitality as a
means of securing contracts with suppliers.

Many companies produce a CSR report as a means of

communicating this relationship to third parties.
Explained in the CSR will be features of the company’s
activities including:
 How it complies with the law
Society or the wider
 Obligations to protect, preserve and improve the
community
environment
 Involvement in local affairs, including specific staff
involvement
 Policy on donations to educational and charitable
institutions.

The process by which the code is finally issued and then

Implementation
used.

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 8. Professional Codes of Ethics

Professional codes of ethics are issued by most professional bodies; the ACCA
CODE WAS REVISED AND RE-ISSUED IN 2006.

FUNDAMENTAL ETHICAL PRINCIPLES

Objectivity Competence Confidentiality Professional

Integrity
behavior

Members should Members do Duty to Information on Members must

be not allow maintain clients not comply with
straightforward bias or professional disclosed relevant laws
and honest in all conflict of knowledge without and avoid
professional/ interest in and skill at appropriate actions
business business appropriate specific discrediting
relationships judgments level authority the profession

Fundamental ethical principles are obligations placed on members of a professional

institute:

 Principles apply to all members, whether or not they are in practice

 The conceptual framework provides guidance on how the principles are
applied
 The framework also helps identify threats to compliance with the principles
and then applies safeguards to eliminate or reduce those threats to
acceptable levels

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9. Conflict of Interest

PROFESSIONAL CODE OF ETHICS

Conflicts of Safeguards Conflict resolution

interest

 Self-interest
 Self-review  Profession  Obtain all necessary
 Advocacy  Work environment information.
 Familiarity  Individual  Consider courses of
 Intimidation action

Conflicts of interest and their resolution are explained in the conceptual framework
to the code of ethics.

A framework is needed because it is impossible to define every situation

where threats to fundamental principles may occur or the mitigating
action required.

Different assignments may also create different threats and mitigating

actions.

The framework helps to identify threats – using the fundamental

principles as guidance.

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10. Ethical Threats and Safeguards
The Potential Threats which may lead to conflicts of interest:
Self-Interest
Self-Review
Advocacy
Familiarity
Intimidation.

SAFEGUARDS seek to reduce or

eliminate threats.

They fall into three categories created by the:

Profession
These include:
 education and training including CPD requirements
 setting or corporate governance regulations and professional standards
 monitoring of professional work including disciplinary proceedings

Work environment
These include:
 internal control systems
 review procedures
 disciplinary procedures
 organizational codes of ethics
 separate review and reporting for key engagements.

Individual
These include:
 complying with professional standards
 maintaining records of contentious issues
 mentoring
 Contacting professional bodies with queries.

Page | 191
Ethical conflict resolution
ETHICAL CONFLICT
RESOLUTION

OBTAIN

ETHICAL ISSUES ESTABLISHED ALTERNATIVE

RELEVANT FACTS INVOLVED RELEVANT INTERNAL COURSES OF
FUNDAMENTAL PROCEDURES ACTION
PRINCIPLES

CONSIDER DECIDE COURSE CONSIDER

CONSEQUENCES OF OF ACTION CONSULTING WITH
EACH THOSE CHARGED WITH
COURSE OF ACTION GOVERNANCE

MATTER REMAINS CONSULT WITH

UNRESOLVED APPROPRIATE
PERSONS IN FIRM

OBTAIN ADVICE FROM MATTER STILL

PROFESSIONAL UNRESOLVED
INSTITUTE

MATTER STILL CONSIDER

UNRESOLVED WITHDRAWING FROM
ENGAGEMENT TEAM /
ASSIGNMENT

4. Ethical threats and safeguards

Ethical Threats apply to accountants – whether in practice or in business

The safeguards to those threats vary depending on the specific threat
The professional accountant must always be aware that fundamental principles may
be compromised and therefore look for methods of mitigating each threat as it is
identified

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 Illustration 1 – Ethical threats and safeguards

Ethical threat Safeguard

Conflict between requirements of the
employer and the fundamental  obtaining advice from the employer,
principles. professional organization or professional
For example, acting contrary to laws or advisor
regulations or against professional or  the employer providing a formal dispute
technical standards. resolution process
 legal advice.

Preparation and reporting on  Consultation with superiors in the employing

information company
Accountants need to prepare / report on  Consultation with those charged with
information fairly, objectively and governance
honestly.  Consultation with the relevant professional
However, the accountant may be body.
pressurized to provide misleading
information.
Having sufficient expertise
Accountants need to be honest in
stating their level of expertise – and not  obtaining additional advice / training
mislead employers by implying they  negotiating more time for duties
have more expertise than they actually  obtaining assistance from someone with
possess. relevant expertise.
Threats that may result in lack of
expertise include time pressure to carry
out duties, being provided with
inadequate information or having
insufficient experience.

Financial interests  Remuneration being determined by other

Situations where an accountant or close members of management
family member has financial interests in  Disclosure of relevant interests to those
the employing company. charged with governance

Page | 193
Examples include the accountant being  Consultation with superiors or relevant
paid a bonus based on the financial professional body.
statement results which he is preparing,
or holding share options in the
company.
Inducements – receiving offers
Refers to incentives being offered to
encourage unethical behaviour.  Do not accept the inducement!
Inducements may include gifts,  Inform relevant third parties such as senior
hospitality, preferential treatment or management and professional association
inappropriate appeals to loyalty. (normally after taking legal advice).
Objectivity and/or confidentiality may be
threatened by such inducements.
Inducements – giving offers
Refers to accountants being
pressurized to provide inducements to  Do not offer the inducement! I necessary,
junior members of staff to influence a follow the conflict resolution process outlined in
decision or obtain confidential the previous section.
information.
Confidential information
Accountants should keep information
about their employing company  Disclose information in compliance with
confidential unless there is a right or relevant statutory requirements, e.g. money
obligation to disclose, or they have laundering regulations.
received authorization from the client.
However, the accountant may be under
pressure to disclose this information as
a result of compliance with legal
processes such as anti-money
laundering/terrorism – in this situation
there is a conflict between
confidentiality and the need for
disclosure.

Page | 194
 Whistleblowing  Follow the disclosure provisions of the employer,
Situations where the accountant needs e.g. report to those responsible for governance.
to consider disclosing information  Otherwise disclosure should be based on
although there is no obligation from assessment of:
statute or regulation. Disclosure would - legal obligations
therefore be in the public interest. - whether members of the public will be
adversely affected
- gravity of the matter
- likelihood of repetition
- reliability of the information
- reasons why employer does not want to
disclose.

11. Threats to Independence

A threat to independence is any matter, real or perceived, that implies the

accountant is not providing an independent view or report in a specific situation
There are many threats to independence explained in the ACCA Code of Ethics
For each threat identified, the accountant has to determine the ethical danger and
take appropriate measures to mitigate the threat

Illustration 2 – Independence and Ethical Behaviour

Threats to Independence Possible Effect on Ethical Behaviour

Financial interests – an Conflict between wanting a dividend from the shareholding
accountant holds shares in a client and reporting the financial results of the company correctly.
company. May want to hide liabilities or overstate assets to improve
dividends.
Financial interests – an auditor Conflict between wanting a dividend from the shareholding
holds shares in a client company. and providing an honest audit report on the entity. May
want to hide errors found in the financial statements to avoid
qualifying the audit report and potentially decreasing the
dividend payment.

Page | 195
Close family member has an Self-interest threat. May decide not to qualify the audit
interest in the assurance client. report to ensure that the financial interests of the family
member are not compromised.
May also be an intimidation threat – if an employee, the
assurance client may threaten to sack the family member if
a qualified audit report is produced.

The assurance partner plays golf Self-interest threat. There may be a conflict between
on a regular basis with the potential qualification of the company financial statements
chairman of the board of the and losing the friendship/golf with the chairman.
assurance client.
Fee due from a client is old and Intimidation threat. The client may threaten to default on the
the assurance firm is concerned payment unless more work is carried out by the assurance
about payment of that fee. firm. The assurance firm may also be seen to be supporting
the client financially, implying that any report will be biased
because the firm wants the ‘loan’ to be repaid.
A company offers an assurance Potential conflict because the partner may want the car, but
partner an expensive car at a also recognizes the ethical threat of appearing to be bribed
considerable discount. by the client. The partner may accept the car and not report
this.
A close family member is a Potential conflict because an assurance partner would not
director of a client company. want to qualify the audit report and create bad feeling
between the partner and the director. The audit report may
therefore not be qualified when it should be.
An assurance partner serves as Self-interest and self-review threats. The partner would
an officer on the board of an have a conflict between producing information for audit and
assurance client. then reporting on the information.
The partner may either miss errors or even decide to ignore
errors identified to avoid having to admit to mistakes being
made.

Page | 196
12. Corruption and Bribery
Corruption is recognized as one of the world’s greatest challenges and a common form of
fraud.

Definition:
Corruption is bribery and any other behavior in relation to persons entrusted with
responsibilities in the public or private sector which violates their duty and is aimed at
obtaining undue advantages for themselves or others.

Why corruption is wrong for businesses

1. Legal Risk
2. Reputational Risk
3. Financial Costs
4. Pressure to repeat offend
5. Blackmail
6. Impact on staff
7. Impact on Development

Relevant Legislation

 The US Foreign and Corrupt Practices Act (1977)

 The UN Convention against Corruption (2003)
 The UK Bribery Act (2010)

Anti-bribery and Corruption measures that can be introduced by businesses:

1. improved reporting
2. screening of staff
3. accounting policies
4. depth of audit
5. clear and transparent procurement regulations
6. controls of the setting of prices and discounts
7. guidelines for handling major bids

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Barriers to implementing Anti-bribery and Corruption policies

1. Competitive advantage
2. Managerial apathy
3. Off-the-shelf solutions
4. Corporate structures
5. Shadow hierarchies
6. Excessive pressure to hit targets
7. Cultures of secrecy
8. Heterogeneous cultures

Page | 198
CHAPTER 14 | Ethical Decision Making

Page | 199
 Table of Content

1. Ethical Decision Making ............................................................................................. 201

2. Ethical Behavior ......................................................................................................... 202
3. Ethical Dilemmas ....................................................................................................... 204

Page | 200
 1. Ethical Decision Making

Ethical Decision Making

Individual Factors 4 – STAGE Situational Factors

PROCESS

Applicable To Kohlberg

Remember Chapter 12 –
Decision Making Process Of
Kohlberg

The four stages of ethical decision making can be summarised as follows:

Stage Of ….

Recognise Moral Make Moral Establish Engage in Moral

Issue Judgment Moral Intent Behaviour

Ethical Decision Making

Lying About Realise That Lying To Decide To

Products Can Customers Is Wrong Tell the Truth
Be Honest.
Increase Sales

Page | 201
In order to assess whether the decision is ethically sound we use the following two models
(see chapter 12):
1. American Accounting Association (AAA)
What are the facts?
What are the ethical issues?
What are the norms, principles and values?
What are the alternative courses of action?
What are the best courses of action that is consistent with the norms, principles
and values identified?
What are the consequences of each possible course of action?
What is the decision?

2. Tucker’s 5 question model: Is it legal fair right profitable and sustainable?

The actual moral decision taken will also depend on:

Individual Factors Situational Factors

Unique characteristics of Particular factors in the

the individual making the decision area that cause an
decision such as age & individual to make an ethical or
gender unethical decision.

2. Ethical Behaviour
Depends on

Issue- Related Factors: Context- Related Factors

- Moral Intensity - Rewards

- Moral Framing - Authority
- Bureaucracy Work Rotes
- Norm/Culture
- National Context

Page | 202
 Issue- Related Factors

How important the decision is to the decision maker.

The higher the INTENSITY the more likely it is that the decision
maker will make an ethical rather than an unethical decision

MORAL INTENSITY:
The factors affecting moral intensity are shown below:

Concentration of Effort Proximity Temporal Immediacy

Whether effects of action are The nearness the How soon the
concentrated on a few people decision maker feels to consequences of any
or affect many people a little people affected by the effect are likely to occur
decision

Factors Affecting Moral Intensity

Magnitude of Social Consensus Probability of Effect

Consequence

Degree to which The likelihood that

Sum of the harms or people agree over the harms (or benefits) will
benefits impacted by ethics of a problem or actually happen
the problem or action action

Moral Framing is how:

That issue is actually represented in the workplace.

- Use of moral words will normally provide a framework where

decision making is ethical

- Many businesses use moral muteness which means that morals are
rarely discussed so ethical decision making may suffer

Page | 203
Context Related Factors:

That Relate to how a particular issue would be viewed within a certain

context:

- System of reward
- Authority
- Bureaucracy
- Work roles
- Organizational group norms and culture
- National and cultural context

Managers tend to reframe moral decisions into organizational or practical issues for one of
three reasons:

1. Harmony
2. Efficiency
3. Image of power and effectiveness

3. Ethical Dilemmas

Ethical Dilemma

Rules-Based Approach Principles-Based Approach

Most Professional Institutes

Use This Approach

Page | 204
 Rules-Based Approach Principles-Based Approach
1. Establish ethical rules that members 1. Establish fundamental ethical principles
must follow that members must follow
2. Ensure members are aware of the rules 2. Ensure members are aware of the
principles
3. Ensure members comply with those 3. Require members to identify and
rules address threats to compliance with the
principles and make an appropriate
response to mitigate each threat.

Benefits
Easy to check compliance as based on Recognises that every threat cannot simply
fact. be ‘listed’
Allows for subjective judgment, so the
Easy to amend rule set as required member can apply the principles in
accordance with their specific situation and
nature of the threat.

Disadvantages
In some situations it may be difficult to
confirm that the compliance action was
The list of rules may not be complete appropriate as two people may make
different and valid decisions based on the
same threat and circumstances.
There is no room for individual decision
making

Page | 205
CHAPTER 15 | Social and Environmental
Issues

Page | 206
 Table of Content

1. Economic Activity ....................................................................................................... 208

2. Sustainability .............................................................................................................. 210
3. Environment Accounting Systems .............................................................................. 211
4. Social And Environmental Audits ............................................................................... 212
5. Social And Environmental Reporting .......................................................................... 215
6. Integrated Reporting .................................................................................................. 216

Page | 207
1. Economic Activity

There are a number of different environmental and social effects which should be
considered when examining economic activity.

Economic
Activity

Social Environmental
Sustainability
Footprint Footprint

 Economic activity is only sustainable where its impact on society and the environment
is also sustainable.
 Sustainability can be measured empirically (using quotients) or subjectively.
 The environmental footprint measures sustainability in terms of resources used by
economic activity.

Sustainability:

Economic activity has social and environmental effects. If the impacts are not
sustainable, then the economic activity itself is unsustainable.

In terms of organizations, the effect of their social and environmental activities,

i.e. their social and environmental footprints, must be sustainable.

There are two methods of measuring sustainability; the quotients approach and the subjective
approach.
Quotients approach Subjective approach
In terms of the amount of a resource Measures intentions of organizations to
available compared with the actual use achieve certain goals or objectives.
of that resource.
It provides a quantifiable method of
checking social and environmental
footprints.

Page | 208
 Environmental footprint:
The environmental footprint extents to:
Activity Environmental footprint – and how to decrease it
Use of chemicals within the product:
 Improving the chemical formula to decrease
the amount of chemicals used
Production of Detergent
 Manufacturing the product in fewer locations to
obtain manufacturing economies and reduce
emissions.

Social footprint:
The social footprint evaluates sustainability in three areas termed ‘Anthro capital’.

Anthro Capital
Social Human Constructed
Social networks and Personal health Physical infrastructures
mutually – held knowledge, skills, in society such as roads,
knowledge for collectives experience and other utilities, etc. that people
to take effective action. resources. build.

Environmental accounting can also be

explained in terms of the ‘mass balance’.
Mass balance The mass balance shows the inputs to a
production process in weight terms
compared to the outputs produced.

Another view on sustainability was

Brundtland Commission provided by the 1983 World Commission on
Environmental and Development (WCED)
also known as the Brundtland Commission
after its chairman Harlem Brundtland.

Page | 209
2. Sustainability

Sustainability

Meets Needs Of The ‘FULL COST’ Long-term Maintenance

Present Without ACCOUNTING And Of Systems According
Compromising The To Environmental,
Needs Of Future Triple Bottom Line Economic And Social
Generations. Accounting Considerations.

Environmental
Economic Objectives Objectives Social Objectives

Definitions of sustainability:
 Sustainability development is development that meets the needs of the present
without compromising the ability of future generations to meet their own needs
(WCED 1987).
 It relates to the continuity of economic, social, institutional and environmental aspects
of human society, as well as the non-human environment.

Two methods which attempt to account for sustainability are ‘full cost’ and TBL accounting.

Full cost accounting means calculating the total cost of company activities, including
environmental, economic and social costs even though there might be no financial effect

TBL accounting is explained through the triple P headings of People Planet and Profit. It
expands the traditional company reporting framework to take into account environmental and
social performance in addition to financial (economic) performance.

 People: Consider all stakeholders and not only shareholders. E.g. pay fair wages,
maintain a safe working environment, not use child labor, and provide educational
opportunities. Although, such actions will reduce the profit available to the
shareholders

Page | 210
  Planet: whether environmental practices are sustainable or not. E.g. manage
resource consumption, energy usage, toxic waste

 Profit: a non-TBL company will try to maximize this measure to improve shareholder
return. A TBL company will try to achieve a balance of the profit in relation to the other
two elements of TBL

Significance of sustainability

1. Sustainability affects every level of organization, from a local neighborhood to the

entire planet
2. It is the long term maintenance of systems according to environmental, economic and
social considerations
3. It can be measured. The two ways are empirically (through quotients and past
experience) and subjectively. In mathematics, a quotient is the result of a division. For
example, when dividing 6 by 3, the quotient is 2. Quotients can be measured in
different ways. With regard to economic activity we can take the scarce natural
resource used in production (eg petroleum) and divide by the final product produced
(eg gasoline). So if we have 200 litres of petroleum divided by 100 litres of gasoline,
this gives us a quotient of 2.

3. Environmental Accounting Systems

Environmental
Accounting Systems

Emas ISO 14000

Focus On Disclosure Of Focus on compliance
Environmental with internal
Systems. environmental systems.

Page | 211
 EMAS ISO 14000
What is it?
EMAS is the Eco-Management and Audit ISO 14000 is a ‘series’ of standards dealing with
Scheme. It is a voluntary initiative ‘designed environmental management and a supporting audit
to improve companies’ environmental programme.
performance. It was established by the EU in
1993.

What Does It Do (In Overview)

Its aim is to recognize and reward those The ISO formulates the specifications for an
organizations that go beyond minimum legal Environmental Management System (EMS),
compliance and continuously improve their guidance for its use and the standard against which
environmental performance. it can be audited and certified.

What Must The Organization Do To Comply?

The EMS must meet the requirements of the To gain accreditation, an organization must:
International Standards BS EN ISO 14001.  Implement, maintain and improve an EMS
 Assure itself of its conformance with its own
ISO 14000 is a prerequisite to applying EMAS. stated environmental policy
 Demonstrate conformance
 Ensure compliance with environmental laws and
regulations
 Seek certification of its EMS by an external third
party organisation

Key Elements Of The Standard

Legal requirement – organizations must show Produce objectives for improvement and a
that they understand and can implement all management system to achieve them, with regular
relevant environmental legislation. reviews of continued improvement.
Dialogue/reporting – information needs of
stakeholders must be recognized and the Applicable to any type of business.
company must provide environmental
information to meet those needs.
Employee involvement – employees are
involved from all levels of the organization.

Page | 212
Benefits of compliance with either standards:
 Reduced cost of waste management
 Saving in consumption of energy and materials
 Lower distribution costs
 Improved corporate image among regulators, customers and the public
 Framework for continuous improvement of the company’s environmental performance

4. Social and Environmental Audits

Social Auditing Environmental Auditing

Environmental Accounting

There are THREE KEY AREAS mentioned in this learning objective

Social Auditing:
A process that enables an organization to access and demonstrate its social, economic, and
environmental benefits and limitations.

Elements of a social audit:

- Overview: statement of purpose, review results of last year’s purpose and plans, establish
this year’s purpose and plans
- External view: obtain the view of external stakeholders to form a view of the company’s
position within the wider context
- Internal view: obtain views of the board of directors and volunteers. This helps to ensure
that organisation management and systems can achieve the stated purposes and plans
- Review and planning

TYPICAL SECTIONS OF SOCIAL REPORT:

 Overview of the company

 Company’s stance regarding employees, job security, payments of salary, policies on

discrimination

Page | 213
  Overview of product with negative environmental impacts

 Environmental impact in terms of pollution, emissions, recycling

 Social impact in terms of community support

 Response from the company, if any

• Generally, the social audit evaluates the organization's footprint (social,

environmental) within a given period from the external perspective
ENVIRONMENTAL AUDITING:

 Aims to assess the impact of the organization on the environment.

 Normally involves the implementation of appropriate environmental standards such as

ISO 14001 and EMAS.

 Provides the raw date for environmental accounting.

 It includes three element (OR STAGES):

-Agreed metrics (what should be measured and how), -Performance measured

against those metrics, -Reporting on the levels of compliance or variance

ENVIRONMENTAL ACCOUNTING:

 This is the development of an environmental accounting system to support the

integration of environmental performance measures.

 It builds on social and environmental auditing by providing empirical evidence of the

achievement of social and environmental objectives.

 The aims of environmental accounting are:

 To use metrics produced from an environmental audit and incorporate these
into an environmental report
 Integrate environmental performance measures into core financial processes
to generate cost savings and reduce environmental impact

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  Benefits:

 Cost savings through the effective and efficient use of resources

 Environmental improvements

 Corporate governance (management of risks and inclusion of information in

CSR report)

Without social and environmental auditing, environmental accounting would not be possible.

5. Social and environmental reporting

• Except in some highly regulated situations (water), the production of a social and
environmental report is voluntary. The issue is what should be the typical contents
of such a report and how do we measure it.

• Environmental Reporting: “disclosure of information on environmental related issues

and performance by an entity”. It usually contains details of environmental
performance such as:

 Measures of emissions (pollution, waste, greenhouse gases)

 Consumption (energy, water, non-renewable resources)

• Social Reporting: related to CSR as the companies should be concerned about

society at large (which is always stakeholder)
• Contents of reporting will vary based on the industry however, some issues are
common:
 Human rights
 Health and safety
 Training and employee issues
 Fair payments of employees and suppliers
 Fair business practices
 Minority and equity
 Customer issues
 Charities, donations, sponsorships

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  Social and environmental reporting is of increasing importance as more and
more investors and stakeholders want to know the social and environmental
footprint of a company in addition with its economic performance (that’s why it
has become part of C.G)

Why the additional information is useful?

• By reporting on S&E issues companies become more aware of risks and less likely to
suffer from unforeseen liabilities and reputational damages

• Ethical performance is a factor taken into account in an investing decision

• Employees use ethical performance as a criterion in their choice

• Consumers prefer to buy from ethical companies

• Shows compliance with Corporate Governance

• Strengthens the brand and therefore, the share price

• Shareholders are entitled to as much information as possible

 However, the additional cost and the ambiguous nature of the information should be
also considered

6. Integrate Reporting

6.1 What is Integrate Reporting

• It is the basis for a fundamental change in the way in which entities are managed
and report to the stakeholders.

• The aim is to support integrated thinking and decision making. Integrated thinking is
the active consideration by an organisation of the relationships between its various
operating and functional units and the capitals that the organisation uses or affects.

• It demonstrates the linkages between a company’s strategy, governance and

financial performance and the social, environmental and economic context within
which it operates.

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 • It can help companies to take more sustainable decisions and led investors and other
stakeholders to understand how a company is really performing.

• It should be a single report and each element should provide insights into a company’s
current and future performance.
• It is a concise communication about how an organisation’s strategy, governance,
performance and prospects, in the context of its external environment, lead to the
creation of value in the short, medium and long term.

• It is needed by businesses and investors. Businesses need a reporting environment

that is conductive to understanding and articulating their strategy, which helps to
drive performance internally and attract financial capital for investment. Investors
need to understand how the strategy being pursue creates value over time.

6.2 Traditional definitions of capital

 Financial assets or the financial value of assets, such as cash.

 The factories, machinery and equipment owned by a business and used in production.

• Financial capital plays an important role in our economy, enabling the other types of
Capital to be owned and traded.
• Unlike the other types of capital, it has no real value itself but, is representative of
natural, human, social or manufactured capital.

6.3 Alternative definitions of capital

• Manufactured Capital: comprises material goods or fixed assets which contribute to

the production process (e.g. tools, machineries, buildings).

• Intellectual Capital: the value of a company or organization's employee knowledge,

business training and any proprietary information that may provide the company with
a competitive advantage. It is considered as an asset and it can be defined as the
collection of all information resources a company has at its disposal that can be used
to drive profits, gain new customers, create new products and generally, improve the
business.

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 • Human Capital: consists people’s health, knowledge, skills and motivation. All these
things are needed for productive work. Enhancing human capital through education
and training is central to a flourishing economy.
• Social Capital: concerns with the institutions that help us to maintain and develop
human capital in partnerships with others (e.g. families, businesses, trade unions,
schools).

• Natural Capital: any stock or flow of energy and material within the environment that
produces goods and services. The value that nature provides for us, the natural assets
that society has. It includes renewable and non-renewable materials (e.g. land, water,
energy).

6.4 Purpose and objectives of IR

• The primary purpose is to explain to providers of financial capital how an entity

creates value over time. An IR benefits all stakeholders interested in an entity’s ability
to create value over time, including employees, customers, suppliers, local
communities; regulators

• The objectives include:

 To improve the quality of information available to providers of financial capital.

 To provide a more cohesive and efficient approach to corporate reporting that draws
on different reporting strands and communicates the full range of factors that materially
affect the ability of an organisation to create value over time.

 To enhance accountability and stewardship for the broad base of capitals and
promote understanding of interdependencies.

 To support integrated thinking, decision making and actions that focus on the
creation of value over short, medium and long term.

6.5 The Value creation process

• The external environment, including economic conditions, technological change,

societal issues and environmental challenges, sets the context within which the
organisation operates.

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 • The mission and vision identifies the purpose and intention of the organisation.

• Those charged with governance are responsible for creating an appropriate oversight
structure to support the ability of the company to create value.

• At the core of the organisation is its business model, which draws on various capitals
as inputs and through its activities converts them to outputs (e.g. products, services).

• The company’s activities and its outputs lead to outcomes in terms of effects on the
capitals.

• Business activities include the planning, design and manufacture of products or the
deployment of specialized skills and knowledge in the provision of services.
Encouraging a culture of innovation is often a key business activity in terms of
generating new products and services that anticipate customer demand, introducing
efficiencies and better use of technology, substituting inputs to minimize adverse
social/environmental effects and finding alternative uses of outputs.
• Outcomes are the internal and external consequences (positive and negative) for the
capitals as a result of an organisation’s business activities and outputs.

• Continuous monitoring and analysis of the external environment in the context of the
organization's mission and vision identifies risks and opportunities relevant to the
organisation, its strategy and its business model.

• The company’s strategy identifies how it intends to mitigate or manage risks and
maximise opportunities. It sets out strategic objectives and strategies to achieve them,
which are implemented through resource allocation plans.

• The company needs information about its performance, which involves setting up
measurement and monitoring systems to provide information for decision making.

• The value creation process is not static (it is dynamic), regular review of each
component and its interactions with other components and a focus on the
organization's outlook, lead to revision to improve all the components.

6.6 How to prepare an IR

• IR should include all the key requirements unless the unavailability of reliable data,
specific legal prohibitions or competitive harm results in an inability to disclose
information that is material.

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 • IR report should include a statement from those charged with governance that it
meets particular requirements.

• Guiding principles: underpin the preparation of an IR, informing the content of the
report and how information is presented.

• Content elements: the key categories of information required to be included in an IR.

6.6.1Guiding principles

• Strategic focus and future orientation: IR should provide insight into the company’s
ability to create value in the short, medium and long term and to its use of and effects
on the capitals. For example, highlights significant risks, opportunities and
dependencies flowing from the company’s market position and business model and
give the management’s view of how the company balances short, medium and long
term interest.

• Connectivity of information: IR should show a holistic picture of the combination,

inter-relatedness and dependencies between the factors that affect the company’s
ability to create value over time.

• Stakeholder relationships: an IR should provide insight into the nature and quantity
of the company’s relationships with its key stakeholders. This reflects the importance
of relationships with key stakeholders because value is not created by or within a
company alone, but through relationships with others. However, it does not mean that
an IR should attempt to satisfy the information needs of all stakeholders. An IR
enhances transparency and accountability which are essential in building trust.

• Materiality: an IR should disclose information about matters that affect the company’s
ability to create value over the short, medium and long term. The materiality process
involves:

 Identifying relevant matters based on their ability to affect value creation.

 Setting priorities regarding the matters based on their relative importance.

 Determining the information to disclose about material matters.

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• The process should apply to both positive and negative matters, including risks and
opportunities, favourable and unfavourable performance, financial and non-financial
information.

• Conciseness: an IR should be concise, it should give sufficient context to understand

the company’s strategy, governance and prospects without being burdened by less
relevant information.

• Reliability and completeness: an IR should include all material matters, both positive
and negative, in a balanced way and without material error in consistency and
comparability.

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