Escolar Documentos
Profissional Documentos
Cultura Documentos
I put together these P1 notes when studying for the exam. Thought that it would be good to share
them with you. Good luck with your Exam. If you have comments or questions you can reach me at
the following email addess: carl.burch@hocktraining.com
|Page
Table of Contents
A. Governance and Responsibility .................................................................................... 1
1.
2.
3.
4.
5.
6.
7.
8.
i|Page
A.
It can help safeguard the organization from the misuse of assets and possible
fraud.
Downside to governance:
There could be too much reporting and not enough time to seek and pursue
profit making activities.
There could be too much excessive supervision, red tape and bureaucracy.
b) Explain, and analyze the issues raised by the development of the joint stock
company as the dominant form of business organization and the separation of
ownership and control over the business activity.
Joint stock companies have multiple shareholders. The shareholders own the
company but generally do not run the company. There is a separation of
ownership and control. In order to maintain control over the company,
shareholders elect a board of directors who have oversight authority. The
board then hires the CEO who is then responsible for putting together the
management team to run the company.
Since management does not have a vested interest in the company, they
might not care as much whether the objectives of the company are met.
ii.
iii.
Independence The emphasis is making sure that there are truly nonexecutive directors on the board who are free to critique the job performance
of management. Independence is not having a conflict of interest issue.
iv.
vi.
vii.
viii.
Fairness This means that all shareholders should receive fair treatment
from the directors (one share one vote). This also means taking into account
the other stakeholders of the company, such as suppliers, creditors,
employees, local community, etc.
ix.
Note: A good way to remember the key concepts of corporate governance is to think
of the mnemonic HAIRDRIFT.
e) Explain and assess the major areas of organizational life affected by issues in
corporate governance.
i.
ii.
iii.
iv.
v.
vi.
vii.
The South African King report commented that The relationship between a
company and its stakeholders should be mutually beneficial. This inclusive
approach is the way to create sustained business success and steady long-term
growth in corporate value.
However, the Hampel report emphasized responsibility towards shareholders and
states that it is impractical for boards to be given lots of responsibilities towards the
wider stakeholder community.
f) Compare, and distinguish between public, private and non-governmental
organizations (NGO) sectors with regard to the issues raised by, and scope of,
governance. THESE ANSWERS MIGHT NEED EXPANDING.
Public Sector Governance requirements stress the need for assessing the
effectiveness of policy and arrangements for dialogue with users of services.
Private The private sector is concerned with the continued existence of the
company. Therefore, having good governance processes is of vital
importance.
g) Explain and evaluate the roles, interests and claims of, the internal parties
involved in corporate governance.
i.
ii.
The company secretary should be the first point of contact for any NED
wanting assistance or information from the company.
iii.
iv.
v.
h) Explain and evaluate the roles, interest and claims of, the external parties
involved in corporate governance.
i.
ii.
iii.
Regulators Regulators (i.e., SEC, etc.) have a role of making sure that
public companies financial information is transparent, reliable and accurate.
Regulation can be defined as any form of interference with the operation of the
free market. This could involve regulating supply, price, profit, quantity, entry,
exit, information, technology, or any other aspect of production and
consumption in the market.
iv.
Government Like regulators, the government has a role to make sure that
regulators are doing their job in making sure that public companies are abiding
by the laws and regulators of the country.
v.
vi.
vii.
Pension funds.
Insurance companies.
In limited companies, the directors and senior managers act as agents of the
shareholders, who own the company.
Agency theory is based on the view that when an agent represents a principal,
the self-interest of the agent is different from the interests of the principal.
Without suitable controls and incentives, the agent will make decisions and
actions that are in his or her own interest rather than those of the principal.
Agents The agents are the directors and senior management of the
company. They are selected and hired to run the company in the best interest
of the shareholders.
ii.
Principals The principals are the shareholders. They elect the board and
the board hire the CEO who is in charge of putting the management team
together.
iii.
iv.
Agency costs Agency costs are the costs of having an agent make
decisions are behalf of a principal. Applying this to corporate governance,
agency costs are the costs that the shareholders incur by having managers
run the company instead of running the company themselves. There are three
costs associated with agency costs:
Having the power to reward or punish the agent for good or bad
performance.
vii.
c) Explain and explore the nature of the principal-agent relationship in the context
of corporate governance.
The owners expect the agents to act in the best interest of the owners. Ideally,
the contract between the owners and managers should be sure that he
managers always act in the between interest of the owners. However, it is
impossible to arrange the perfect contract, because decisions by the
8
managers affect their own personal welfare as well as the interest of the
owners.
Stakeholder theory.
Level of Interest
Low
High
Power
Weak
Strong
Ignore
Keep Informed
Keep Satisfied
Key Players
Ignore quadrant Stakeholders who are in this category can be ignored by the
company. In this quadrant might be the government, or some shareholders, or
employees who really dont have any power or interest. However, this does not
take into account any moral or ethical considerations. It is simply the stance to
take if strategic positioning is the most important objective.
Keep Informed Most shareholders would fall into this quadrant. You need to
keep shareholders informed of whats going on (e.g., annual report), but they
dont exert much power. However, stakeholders in this quadrant can increase
their overall influence by forming coalitions with other stakeholders in order to
exert a greater pressure and thereby make themselves more powerful.
Keep Satisfied In this quadrant the stakeholder doesnt have much interest but
does have strong power over the company. All these stakeholders need to do to
become influential is to re-awaken their interest. This will move them across to the
right and into the high influence sector, and so the management strategy for these
stakeholders is to keep satisfied.
10
Key players Key players are those who have the greatest influence on the
company. This question here is how many competing stakeholders reside in that
quadrant of the map. If there is only one (e.g., management) then there is unlikely
to be any conflict in a given decision-making situation. If there are several, then
there are likely to be difficulties in decision-making and ambiguity over strategic
direction.
Different categories of Stakeholders:
As far as stakeholders, have to understand the differences on how to categorize
stakeholders. Including:
Internal and external stakeholders. This is probably the easiest distinction
between stakeholders.
o Internal stakeholders
management.
will
typically
include
employees
and
Ensuring that the necessary financial and human resources are in place.
Company policies.
Proposing dividends.
b) Describe, distinguish between and evaluate the cases for and against, unitary
and twotier board structure.
In most countries, companies have a single board of directors (unitary board). This
board would consist of executive and non-executive directors, with a chair and a
CEO.
Some countries have a 2-tier board structure (Germany and Netherlands),
consisting of:
The effectiveness of this type of structure will depend on the relationship between the
chair and CEO. In public companies:
2-tier board
Advantages
Disadvantages
Responsibilities
for
management
and
governance are clearly separated.
Supervisory board membership recognizes
interests of stakeholders groups.
14
Unitary board
Advantages
Disadvantages
The Combined Code states that at least one half of the board members
should be independent non-executive directors, with a minimum of 3 NEDs.
There has to be a balance between EDs and NEDs.
The Combined Code also states that a former CEO of a company should not
move on to become the company chairman. The Combined Code argues that
the power of chairman and CEO should not be held by one individual because
it gives too much power on the board to that individual.
Board composition:
Other executive directors, possibly including the CFO, COO, and others.
Other NEDs.
Balance of Power:
The board should contain a suitable balance of power in order to prevent one person
or group of people from dominating the decision making of the board.
Some of the problems that can occur with the appointment of NEDs:
The NED should not have any business, financial or other connection with the
company-apart from fees and shareholdings.
NED must be able to take external professional advice where necessary and
the costs of same have to be borne by the company.
e) Describe and analyze the general principles of legal and regulatory frameworks
within which directors operate on corporate boards.
Duties while in office:
Duty to act within powers. Directors have to operate in accordance with the
companys constitution and only to exercise powers for the purpose for what
they were elected for.
Duty to promote the success of the company. The law should encourage
long-termism and regard for all stakeholders by directors and that
stakeholder interests should be pursued in an enlightened and inclusive way.
Duty to exercise reasonable skill, care and diligence. Directors have the
duty of care to show reasonable skill, care and diligence.
Duty not to accept benefits from third parties. This duty prohibits the
acceptance of benefits (including brides) from third parties conferred by
reason of them being a director, or doing, (or omitting to do) something as a
director.
17
Leaving Office:
Departure from office. A director may leave office in the following ways:
o Resignation.
o Not offering him or herself for reelection.
o Death.
o Dissolution of the company (e.g. bankruptcy).
o Being removed from office.
o Prolonged absence (generally more than 6 months).
o Being disqualified.
o Agreed departure.
Time limited appointments. Ordinary directors may have to retire from the
board on reaching a retirement age or may not be able to seek reelection.
o Time-limited appointments. Existing directors are required to stand
for re-election at regular intervals.
o Fixed term contracts. NEDs are usually appointed for a fixed term. In
the UK, normal practice is for 3-years. At the end of this term, the
appointment might be renewed for a further 3-years.
f) Define, explore and compare the roles of the CEO and the board chairman.
Role of the CEO:
The CEO is the leader of the management team, and all senior managers
report to the CEO.
The CEO reports to the board on the activities of the entire management team,
and is answerable to the board for the companys operational performance.
Liaison with stakeholders. The CEO need to deal with those interested in the
company.
Ensuring that the board as a whole and also individual directors contribute
effectively to the work of the board.
o Sets the agenda for the board meetings.
o Provides suitable information before each board meeting.
o At board meetings, encourages open dialogue between members of the
board.
o Helps non-executive directors to contribute effectively to the company.
He or she should provide leadership for the company are represent its views
with external stakeholders, including the shareholders.
Chairman
Reporting Lines
Reporting Lines
Main responsibilities
Make
financing
decisions.
Involvement
committees.
with
and
certain
board
The board can make the CEO more accountable for management of the
company if there is a separate Chairman of the board.
The UK 2nd Combined Code suggests that the retired CEOs should not
become Chair of the same company. The main concern is that he or she
would interfere too much in the running of the company by the new CEO.
The Cadbury report stated that if the roles were combined, there should be a
strong independent element to the board with NEDs. Higgs states that one
senior member of the NEDs should be appointed who would be available to
shareholders who had concerns that could not be resolved through normal
channels.
g) Describe and assess the importance and execution of, induction and
continuing professional development of directors on boards of directors.
The UK Higgs report provides guidance on the development programs.
Induction of new directors:
When directors are appointed to the board of a company, they are expected to
bring the benefits of their knowledge, skill and experience to the discussions
of the board.
21
h) Explain and analyze the frameworks for assessing the performance of boards
and individual directors (including NEDs) on boards.
Performance of the board:
Higgs Report lists a number of criteria that can be used to monitor the
effectiveness of boards.
o Performance against objectives.
o Contribution to strategic development.
o Contribution to risk management.
o Contribution to the development of corporate culture.
o Appropriate composition of the board and committees.
o Effectiveness of responses to crises and problems.
o The proper delegation of matters to lower levels and the reservation of
matters for board decision.
o Effectiveness of internal and external communications.
o The extent to which the board is kept appraised of developments.
o The effectiveness of the board committees.
o The quality of information supplied to board members.
o The number of board meetings held.
o The extent to which the board has met all legal, financial reporting,
regulatory and CG requirements.
22
Committee work: The director participates fully in audit, risk and nominations
committees (remunerations for NEDs).
4. Board Committees
a) Explain and assess the importance, roles and accountabilities of, board
committees in corporate governance.
A board committee is a committee set up by the board, and consisting of selected
directors (both executive and non-executive), which is given responsibility for
monitoring a particular aspect of the companys affairs for which the board has
reserved the power of decision-making.
The role of a committee is to monitor an aspect of the companys affairs, and:
The full board should make a decision based on the committees recommendations.
If a board was to reject the recommendations of a committee, then the board needs
to give a very good reason for doing so.
A board committee needs to meet with sufficient frequency to enable it to carry out its
responsibilities. It is important to remember, however, that a board committee is not a
substitute for executive management and a board committee does not have
executive powers. A committee might monitor activities of executive managers, but it
does not take over the job of running the company from management.
b) Explain and evaluate the role and purpose of the following committees in
effective corporate governance.
i. Remuneration committees.
The Remuneration Committee deals with the remuneration of executive directors
and senior managers.
23
There should be limited contracts of service periods, ideally for one year.
CEO,
The balance between ED and NEDs. The combined code says that there
should be a balance with a minimum of 3 NEDs.
This board would have oversight responsibility for risk and internal control.
Typical roles of the Risk Committee:
Work with the AC on designing and monitoring ICs for the mitigation and
management of risk.
24
Prepare reports on risks and draft the RM strategy note for the annual
accounts.
The board should be satisfied that at least one member of the AC has
recent and relevant financial experience.
The AC needs to review and discuss with management and the external
auditor the effects of changes in accounting standards, and the
implications of these proposed changes.
Needs to ensure that both the external and internal auditors have sufficient
resources to carry out their defined roles.
5. Directors remuneration
a) Describe and assess the general principles of remunerations.
i.
Another director might receive a low basic pay, but a very attractive short-term
bonus incentive scheme.
iii. Links to strategy. Any directors remuneration package should be linked to
the company achieving its long-term objectives. This could entail the company
giving the directors the right to purchase shares at a specified exercise price
over a specified time period in the future. This provides incentive for the
directors to do what they have to do to raise the price of the shares.
iv. Links to labor market conditions. Any remuneration package has to be
linked to local market conditions. Again, every company needs to be able to
attract and retain qualified personnel, but companies need to make sure that
they are not over compensating its directors.
b) Explain and assess the effect of various components of remuneration
packages on directors behavior.
i. Basic salary will be in accordance with the terms of the directors contract of
employment, and is not related to the performance of the company or the
director.
Instead it is determined by the experience of the director and what other
companies might be prepared to pay for the directors service (the market
rate).
ii. Performance related bonuses. Directors may be paid a cash bonus for good
(generally accounting) performance. To guard against excessive payouts,
some companies impose limits on bonus plans as a fixed percentage of salary
or pay.
o There is also something called Transaction bonuses which is where
the CEO get a bonus for acquisitions, regardless of subsequent
performance, possibly indeed further bonuses for spinning off
acquisitions that have not worked out.
iii. Shares and share options (share schemes). Share schemes are used to
provide long-term incentive which gives the executives a personal interest in
the performance of the companys share price over a period of several years.
Since they have an incentive, they will do (or should do) what they can to
improve the financial performance and longer-term prospects.
Problems with these share schemes are:
o Executives might be motivated by short-term targets and cash bonuses
than by longer term targets and share awards.
o If share price falls because of a general decrease in the market, the
options might be worthless, therefore, not providing much incentive for
the executive to perform.
o Share schemes are often for a three year period. The executive
receives an award of fully-paid shares, or is able to exercise share
options after three years. If the executive sells the shares, his or her
interest in the company comes to an end.
(The UK 2nd Combined Code states that non-executive directors should not
normally be offered share options, as options may impact upon their
independence).
27
iv. Loyalty bonuses are intended to get directors to stay with the company for an
extended period of time. For example, if a directors contract expires, the
director may be paid a bonus for extending the contract.
v. Benefits in kind could include transportation (e.g., a car), health provisions,
life assurance, holidays, expenses and loans.
The remuneration committees should consider the benefit to the director and
the cost to the company of the complete package.
Also, the committee should consider how the directors package relates to the
package for employees. Ideally, perhaps, the package offered to the directors
should be an extension of the package offered to the employees.
vi. Pension benefits. Many companies offer pension contributions for directors
and staff. In some cases, however, there may be separate schemes available
for directors at higher rates than for employees.
The Combined Code states that as a general rule, only basic salary should be
pensionable.
The Code emphasizes that the remuneration committee should consider the
pension consequences and associated costs to the companys basic salary
increases and any other changes in pensionable remuneration, especially for
directors close to retirement.
c) Explain and analyze the legal, ethical, competitive and regulatory issues
associated with directors remuneration.
The remuneration for the year for each director, analyzed into salary and fees,
bonuses, expenses received, compensation for loss of office and other
severance payments, and non-cash benefits.
For options exercised during the year, the market price of the shares when the
options were exercised should also be shown.
28
For options have not been exercised, the report should show the exercise
price, the date from which the options may be exercised and the date they
expire.
Details should also be provided of any large payments made during the year
to former directors of the company.
The rate of increase in the directors pay has been much greater than the rate
of increase in the pay of other employees.
All companies are required to meet the same minimum standards of corporate
governance.
Investors confidence in the stock market might be improved if all the stock
market companies are required to comply with recognized corporate
governance rules.
Disadvantages are:
The same rules might not be suitable for every company, because the
circumstances of each company are different. A system of corporate
governance is too rigid if the same rules are applied to all companies.
29
A principles-based approach to corporate governance is an alternative to a rulesbased approach. It is based on the view that a single set of rules is inappropriate for
every company. Circumstances and situations differ between companies. The
circumstances of the same company can change over time. This means that:
The best corporate governance practices for a company might change over
time, as its circumstances change.
In the UK, the Combined Code is the relevant code of corporate governance for
listed companies. All UK listed companies must comply with rules known as the
Listing Rules, which are issued and enforced by the financial markets regulator.
Advantages of principles-based:
It avoids the need for inflexible legislation that companies have to comply
with even though the legislation might not be appropriate.
Criticized as so broad that they are of very little use as a guide to best
corporate governance practice.
Which is more effective. It has been suggested that that the burden of the detailed
rules in the US, especially the requirements of section 404, has made the US an
unattractive country for foreign companies to trade their shares. As a result, many
foreign companies have chosen to list their shares in countries outside the US, such
as the UK.
Comply or Explain
The comply or explain approach is the trademark of corporate governance in the
UK. The Listing Rules require companies to apply the Main Principles and report to
shareholders on how they have done so. The principles are the core of the Code and
the way in which they are applied should be the central question for a board as it
determines how it is to operate according to the Code.
30
31
c) Describe and critically evaluate the reasons behind the development and use
of codes of practice in corporate governance (acknowledging national
differences and convergence).
The international guidelines include the OECD principle and ICGN report.
Not surprisingly, convergence models that have been developed lie between
the insider/outsider models, and between profit-orientated and ethical
stakeholder approaches.
These international codes can often represent an attempt to find the lowest
common denominator.
including
any
The London Stock Exchange issued the 1st Combined Code in 1998, which was
derived from the recommendations of Cadbury, Greenbury and Hampel reports.
The 2nd Combined Code took the 1st Combined Code and includes the following
reports:
o The Turnbull Report (1999 and revised 2005) focused on risk
management and internal controls.
o The Smith Report (2003) discussed the role of the audit committee.
o The Higgs Report (2003) focused on the role of the NED.
e) Explain and explore the Sarbanes-Oxley Act of 2002 as an example of a rulesbases approach to corporate governance.
i. Impetus and background: SOX was a reaction to the Enron scandal of 2002.
The main reasons why Enron collapsed was over-extension in energy
markets, eventually too much reliance on derivatives trading which eventually
went against the company, breaches of federal law, and misleading and
34
determined
by
the
PCAOB
to
be
7) Corporate responsibilities:
8) Directives to the SEC: The SEC was directed to issue rules regarding:
9) Whistleblowing provisions:
Employees of issuers and accounting firms were extended
whistleblower protection that would prohibit their employers
from taking actions against them. Whistleblowers were also
granted a remedy of special damages and attorneys fees.
iii. Effects of:
f) Describe and explore the objectives, content and limitations of, corporate
governance codes intended to apply to multiple national jurisdictions.
i. OECD report of 2004: The objective of OECD is to encourage development in
the worlds economy. The principles of OECD are the minimum for corporate
governance since the confidence of the investors is dependent on the quality
of corporate governance in companies whose shares are traded on the stock
market.
Principles are:
38
Because they apply to all countries they can only be general principles.
They cannot be detailed guidelines and because they are not detailed,
they are of limited practical value.
Full consensus is difficult or impossible to achieve and the solution may not be
strategically desirable.
Ethical code of conduct. Having a code a conduct is a way for the company
to signify its pursuit of good corporate behavior.
The original Combined Code in 1998 included provisions relating to the responsibility
of the board for the effectiveness of the system of internal control and risk
management. The Turnbull Committee was established by the Institute of
Chartered Accountants in England and Wales (ICAEW), and was given the task of
providing guidelines to companies about this aspect of the Combined Code. The
Turnbull Report was published in 1999.
General principles of disclosures:
Here are the disclosure requirements:
There is a process to deal with the internal control aspects of any significant
problems disclosed in the annual report and accounts.
Financial information about the past performance of the company, its financial
position and its future prospects.
Information about the ownership of shares in the company, and voting rights
associated with the shares. This is important for global investors, who may
have problems with investing in companies where there is a majority
shareholder, or where there is a complex structure of share ownership, or
where some shareholders have more voting rights than other shareholders.
Information should
communication.
be
made
available
by
convenient
channels
of
42
best
practice
corporate
governance
disclosure
Annual reports must convey a fair and balanced view of the organization. They
should state whether the organization has complied with governance
regulations and codes. It is considered best practice to give specific
disclosures about the board, internal control reviews, going concern status
and relations with stakeholders.
Good disclosure helps reduce the gap between the information available to
directors and the information available to shareholders, and addresses one of
the key difficulties of the agency relationship between directors and
shareholders.
Financial position.
Auditors report.
Directors remuneration.
Voluntary can be defined as any disclosure above the mandated minimum. This is
information is not required to be published but often is because it gives stakeholders
information that they like to see.
Statement of risk.
d) Explain and explore the nature of, and reasons and motivations for, voluntary
disclosure in a principles-based reporting environment (compared to, for
example, the reporting regime in the USA).
The UK government set the process when trying to decide what voluntary
disclosures to include.
o The process should be planned and transparent, and communicated
to everyone responsible for preparing the information.
44
o The process should involve consultation within the business and with
shareholders and other key groups.
o The process should ensure that all relevant information should be
taken into account.
o The process should be comprehensive, consistent and subject to
review.
e) Explain and analyze the purpose of the annual general meeting and
extraordinary general meetings for information exchange between board and
shareholders.
The AGM (Annual General Meeting) is the most important formal means of
communications. Governance guidance suggests that boards should actively
encourage shareholders to attend the AGM.
Hampel report contains recommendations on how the AGM can be used to enhance
communications with shareholders:
Companies should propose a resolution at the AGM relating to the report and
accounts.
f) Describe and assess the role of the proxy voting in corporate governance.
Proxy form can allow the shareholder either to instruct the proxy how to vote
on some or all the motions, or nominate someone attending the meeting (often
a director) to exercise the shareholders vote at his discretion.
A problem is that unless the proxy card is very elaborately worded, it cannot
anticipate all the possible amendment to the resolution(s) sent out in the
notice of meeting.
o If a substantial amendment is carried, the proxys authority to vote is
unaffected, but he/she no longer has instructions as to how he/she
should vote.
46
B.
Help ensure the quality of external and internal financial reporting (financial
controls).
Help ensure the compliance with applicable laws and regulations, and also
with internal policies for the conduct of business (compliance controls).
The Turnbull Guidelines state that a sound system of internal control should:
Be embedded in the operations of the company and form a part of its culture.
b) Explain and explore the importance of internal control and risk management in
corporate governance.
48
Benefits vs. costs. It can sometimes be difficult to estimate the benefit arising
from having an internal control until such time as an organization suffers a loss
from not having such an internal control.
Set appropriate policies on internal controls and seeks assurances that the
internal control system is functioning effectively.
49
The CEO:
Has to consider the risk and control environment, focusing on how to promote
the right culture.
Should also monitor other directors and senior staff, particularly those whose
actions can put the company at significant risk.
50
They specify the competence level needed for particular jobs, hire and retain
competent people, and assign authority and responsibility appropriately.
The board of directors is responsible for setting corporate policy and for
seeing that the company is operated in the best interest of
shareholders. The attention and direction provided by the directors is critical.
The board consists of both inside and outside directors who have adequate
expertise and who are active and involved. Independence from management
is critical, so that if necessary, difficult and probing questions will be raised.
The control environment is influenced by the fact that all individuals in the
organization realize that they will be held accountable.
Risk Assessment:
Within the control environment, management is responsible for the assessment of
risk. A risk is anything that endangers the achievement of an objective. The
questions should always be asked: What could go wrong here? What assets do we
need to protect?
Risk assessment is the process of identifying, analyzing, and managing the risks that
have the potential to prevent the organization from achieving its objectives.
Assessment of risk involves determining the volume of transactions and the average
dollar amount per transaction, the dollar value of assets that are exposed to loss, as
well as the probability that a loss will occur.
The companys objectives must be established before the risks can be assessed.
Risk assessment forms the basis for determining how the risks (external or internal)
should be managed.
Control Activities:
After the risks have been assessed, controls should be designed to limit the risk. To
accomplish this, control activities are implemented. Control activities are the
policies that address the identified risks and the procedures that ensure that
management directives are carried out, thus helping ensure that the organizations
objectives will be achieved. Thus, controls should be designed to limit risk, wherever
risk exposure is determined to exist, for the purpose of protecting the
organizations ability to achieve its objectives.
This risk could be in the form of loss of assets, or it could be a misstatement of
accounting or management information. The identified risks cannot be completely
eliminated, but designing appropriate control activities and ensuring that those
control activities are implemented can minimize them.
In addition, management must comprehend laws and regulations imposed on the
organization from the outside and ensure that compliance policies and procedures
are in place.
Control activities can be preventive, to avoid the occurrence of an unwanted event;
detective, to detect the occurrence of an unwanted event; directive, to ensure the
occurrence of a desirable event; or corrective, to correct an occurrence of an
52
There are five core principles that drive the financial reporting process. These
principles are:
1) Segregation of duties. Segregation (separation) of duties is considered to be
the most important control devices that a company has in order to reduce risk
of errors or inappropriate activities (fraud). It is simply the process of dividing
duties among various employees. This ensures that no single individual is
given too much responsibility so that no employee is in a position to both
perpetrate and conceal irregularities.
The following four functions should be done by different people.
1) Authorizing a transaction;
2) Recording the transaction, preparing source documents, maintaining journals;
3) Keeping physical custody of the related asset for instance, receiving checks in the mail; and
4) The periodic reconciliation of the physical assets to the recorded amounts for those assets
53
for products and services, credit limits on customers, reorder points for
making inventory purchases, and others.
Communication must be ongoing, both within and between various levels and
activities of the organization. All personnel must understand their roles in the
54
Monitoring:
Finally, management monitors the entire system. Monitoring assesses the quality of
the internal control systems performance over time. Management must also revisit
previously identified problems to make sure that they have been corrected.
Monitoring can be done in two ways: (1) ongoing monitoring during normal
operations, and (2) separate evaluations by management with the assistance of the
internal audit function. If monitoring is done regularly during normal operations, it
lessens the need for separate evaluations.
The UK Combined Code states that where there is no internal audit function,
the audit committee should consider annually whether there is a need for such
a function.
55
Promoting appropriate ethics and values with the organization. The internal
auditor needs to be an ethics advocate.
Ensuring
effective
accountability.
organizational
performance
management
and
Safeguarding assets.
b) Explain, and discuss the importance of, auditor independence in all clientauditor situations (including internal audit).
In order for auditors to be effective, they must:
56
For internal auditors, internal auditors must not audit areas for which they may have
had responsibility.
c) Explain, and assess the nature and sources of risks to, auditor independence.
Assess the hazard of auditor capture.
When reviewing the independence of the external auditor, the AC should take
into consideration the non-audit work performed for the company by the audit
firm, as well as the audit work.
o The AC should check that the audit firm complies with ethical guidelines
issued by the accountancy bodies and regulatory issues, such as:
The amount of income fee that the audit firm receives from the
company, in relation to the overall fee income of (1) the audit
firm, or (2) regional office of the audit firm, or (3) an individual
audit partner.
The risk that the external auditors might lose their independence from a
company is sometimes called the hazards of auditor capture.
57
The role of IA will vary according to the organizations objectives, but is likely
to include a review of internal controls, risk management, legal
compliance and value for money.
Internal auditors
organization.
provide
independent
appraisal
function
within
an
In the UK:
o The board is responsible for an annual review of the effectiveness of
internal control and risk managements (only for listed companies).
o Management reports to the board about internal control and risk
management.
o The board might carry out the annual review itself or delegate the
detailed work to the audit committee or a risk committee.
The nature of the annual review will depend on the size, nature and
complexity of the companys business.
58
The board must be able to justify its statement to shareholders on its review of
internal controls and risk management. It must have documented evidence to
back up its claims.
f) Describe and analyze the work of the internal audit committee in overseeing
the IAA.
IA should functionally report to the AC. The purpose of this is to provide proper
organizational status to IA. By reporting to AC, IA can maintain its
independence. Although, administratively, IA must still report to someone
(such as the CEO) in administrative.
At some stage during the year, the head of internal audit should be required to
report to the AC.
59
g) Explain and explore the importance and characteristics of, the audit
committees relationship with external auditors.
The AC should ensure the integrity of financial reporting and external auditing
(Smith report).
o Management is responsible for the preparation of complete and reliable
financial statements.
o The AC should monitor the preparation of the financial statement, and
give consideration to the significant estimates and judgments made by
management in their preparation.
o When two or more accounting methods could be used, the AC should
obtain an explanation from management for its choice of methods.
o The AC should compare the views of management with those of the
external auditors.
The AC should refer any problems it finds with the external audit to the full
board for considerations.
Satisfy itself that the audit fee is sufficient for the amount of audit
work to be done.
Audit effectiveness. The AC should review the adequacy of work done in the
external audit.
61
o The AC should ensure that an audit plan has been prepared and the
audit firm is committing sufficient resources on the work.
o At the end of the audit, the AC should review the work done by the audit
firm, and:
Listed companies in the US have to report under Section 404 of SOX. In this
case, companies have to provide a detailed statement to shareholders
including details of major control weaknesses about financial controls only.
The Turnbull report states that there should be an annual review of internal
controls. The review should cover:
o The changes since the last assessment in risks faced and the
companys ability to respond to changes in its business environment.
o The scope and quality of managements monitoring of risk and internal
control, and of the work of internal audit, or consideration of the need
for an internal audit activity (IAA) if the company does not have one.
o The extent and frequency of reports to the board.
o Significant controls, failings and weaknesses which have or might have
material impacts upon the accounts.
o The effectiveness of the public reporting processes.
Based on the Turnbull report, the board should disclose as a minimum in the
accounts, the existence of a process for managing risks, how the board has
reviewed the effectiveness of the process and that the process accords with
the Turnbull guidance. The board should include:
o Acknowledge that the board is responsible for the companys system of
control and reviewing its effectiveness.
o An explanation that the system can only provide reasonable assurance
against material misstatements or loss. This means that system is
meant to manage rather than eliminate the risk of failure to achieving
business objectives.
o A summary of the process that the directors (or a board committee)
have used to review the effectiveness of the system of internal control
and consider the need for an internal audit activity if the company does
not have one. There should also be disclosure of the process the board
has used to deal with material internal control aspects of any significant
problems disclosed in the annual accounts.
o Information about those weaknesses in internal control that have
resulted in material losses, contingencies or uncertainties which require
disclosure in the financial statements or the auditors report on the
financial statements.
c) Explain and assess how internal controls underpin and provide information for
accurate financial reporting.
Internal control helps the company achieve its financial reporting objectives.
Internal control objectives over financial reporting include:
o Transactions are authorized.
o All transactions are recorded:
as
quality
reports,
customer
There are various ways that management can get the information they need
for decision-making.
64
Materiality.
The COSO guidance stresses the importance for boards and management to
have good quality information.
Accurate The numbers add up and there are no typos, items should
be allocated to the correct category, assumptions should be stated for
uncertain information.
66
C.
Everyone who works in a company has responsibility for risk management, not
just risk specialists.
The Board the board has a very important role in managing risk.
o Determines risk management strategy and monitoring risks
o Setting appropriate policies on internal controls and seeking assurance
the IC is functionally effectively.
o Communicate the organizations strategy to employees.
Risk assessment starts by first identifying the risks that face the business.
Changes in the environment that may have changed the nature and scale of
risks will be considered.
How often risk assessment will be done in an organization will depend on the
dynamic nature of the environment in which the organization operates.
How dynamic the nature of the risk will depend on the nature of the business.
In some businesses, risks will change very little, but in others they may
change a great deal.
67
Management needs to be aware of the environment that they are operating in.
Management always needs to be in a position to changes in the environment
that could cause changes in the risks faced by the company.
In some environments, the risks change very little, but in others it changes a
great deal.
o Changes in the environment might arise because of changes in the
strategic decision made by the business. For example, if a company
decides to launch a new product, or penetrate a new market or
significantly change the financial structure of the business.
o Changes in risk might be the result of external changes, including (think
of PEST):
Political Businesses
environments.
operating
in
unstable
political
Risk appetite has to do with the amount of risk a company is willing and able
to tolerate.
This directly affects the risk policy of the organization. For example, some
types of organizations, such as charities or public sector, will seek to avoid
certain risks. Other organizations may accept the same risks. This means that
the organization is accept the risk in order to achieve its objectives.
2. Categories of risk
a) Define and compare (distinguish between) strategic and operational risks.
Strategic risks are risks that are related to the fundamental decisions that the
directors take about the future of the organization.
Operational risks relate to the matter that can go wrong on a day-to-day basis
while the organization is carrying out its business.
Strategic
Operational
Resource allocation.
Competition.
IT failures.
Environmental factors.
Human error.
Fraud.
68
Product/service portfolio.
Staff dependency.
Business
recovery.
continuity
and
disaster
processes
to
adapt
to
different
b) Define and explain the sources and impacts of common business risks.
Business risks are strategic risks that threaten the survival of the whole business.
Strategic risks. Is the potential volatility of profits caused by the nature and type of
business operations.
Market risk and derivatives risk:
Market risk is the risk that changes in the market price or market rates can
negatively affect a company. This risk is higher when the market is subject to
large or unexpected movements both up and down.
IFRS 7 defines market risk as the risk that the fair value or cash flows of a
financial instrument will fluctuate due to changes in market prices. Market risk
reflects interest rate risk, currency risk, and other price risks.
69
There have been reported cases in the past where treasury departments of
companies or government organizations have suffered severe losses through
speculation in derivatives, for example, Orange County, near Los Angeles
had to file for bankruptcy because of losses suffer through derivative trading.
This is the risk to a company from a failure of its debtors to meet their
obligations on time.
o Most common credit risk is where a company fails to pay its supplier on
time.
Liquidity risk:
Liquidity risk is the risk that a company will not have the funds to pay its short
term obligations. Its a mismatch between cash inflows and cash outflows.
Sources of cash are near-cash assets, such as marketable securities that can
be sold quickly in the financial markets to obtain cash.
Companies should also avoid taking actions that could create long-term
liquidity problems, such as paying for capital assets out of operating cash
flows, when the company cannot afford this.
Efficient working capital management can also help to improve cash flows and
reduce liquidity risk. In particular, companies should avoid investing in slow
moving inventory, and should have efficient procedures for collecting
receivables, like having a lockbox collection system.
Technology risk:
The potential cost of having to invest in new technology can be a serious risk
for profitability.
This risk is greater for companies that operate in the high tech field and the life
cycle of the product is shorter.
Legal:
Companies that fail to comply with the law run the risk of legal penalties and
bad publicity.
This includes loss of employees time because of injury and the risks of having
to pay compensation or legal costs because of breaches. Health and safety
risks can arise from:
o Lack of health and safety policies.
o Lack of emergency procedures.
o Failure to deal with hazards.
o Poor employee welfare. Risk because of poor working conditions.
o General poor health and safety culture.
Reputation risk:
Lord Jeffrey said, A good name, like good will is got by many actions, and lost
by one.
Reputation risk levels depend not only on the levels of other risks, but the
reaction of stakeholders to those other risk materializing how much less of
the organization do stakeholders think, and what actions they take.
In a large global company, the effect of reputation risk may also be localized,
because an event that damages the companys reputation in one part of the
world might not be considered so bad in other countries.
o A reputation for unethical selling or poor quality can have a lasting
impact on customer demand.
71
Of all the major risks, reputation risk is the risk that is most strongly correlated
to other risks, since its level partly depends on the likelihood that other risks
materialize.
Additionally, there is entrepreneurial risk, which if the risk that arises from any new
business venture or opportunity.
c) Describe and evaluate the nature and importance of business and financial
risks.
The company faces a wide range of business risks, such as risk from
competitor activity, risk of low sales demand, economic risks, political and
legal risks and so on.
Financial risk is one of many types of business risks. The ultimate risk that any
company faces is the risk that it will not continue as a going concern.
o Liquidity risk. This is the risk of loss due to a mismatch between cash
inflow and outflow.
The attitudes of risk of the board and major finance providers will impact significantly
on how risky the companys financial structure is.
d) Recognize and analyze the sector or industry specific nature of many business
risks. (NOTE: On pg. 176, it says that you may have to identify the risks that may
affect a specific industry).
Commercial bank
Retailing organization
Reputation risk.
IT systems risk.
on
Oil companies
Reputation risk.
Competition risk.
IT failure risk.
Regulatory risk.
73
Debt providers and creditors Debt providers are concerned about threats
to the amount the organization owes and can take various actions with
potentially serious consequences such as denial of credit, higher interest
charges or ultimately putting the company into liquidation. Creditors are going
to be concerned about receiving a profit from the company, therefore they may
limit the amount of product they deliver to a company.
The impact of customer-supplier attitudes will partly depend on how much the
organization wants to build long-term relationships with them.
b) Explain and analyze the concepts of assessing the severity and probability of
risk events.
Risk map and risk dashboard are graphic means of assisting management
with the understanding and assessment of risks.
The risk map is a simple 2x2 matrix, where one side of the matrix
represents probability and the other side represents impact.
Low
High
Severity
(TERMINATE/AVOID)
Low
(TOLERATE/ACCEPT)
o What the risks are and strategies for identifying, evaluating and
managing them.
o The effectiveness of the management and internal control systems in
the management of risk, in particular how risks are monitored and how
any weaknesses have been dealt with.
o Whether actions are being taken to reduce the risks found.
o Whether the results indicate that internal control should be monitored
more extensively.
d) Describe the process of and importance of, externally reporting on internal
control and risk.
Because of the corporate accounting scandals over the past ten years, there
is stricter requirements on external reporting.
e) Explain the sources, and assess the importance of, accurate information for
risk management.
self-assessment
process
by
line
f) Explain and assess the ALARP (as low as reasonably possible) principle in risk
assessment and how this relates to severity and probability.
The general principle is that the higher the level of risk, the less acceptable it
is. However, there are many risks which cannot be avoided completely, for
example, hazardous activities where there is a risk of injury or loss of life (e.g.
an oil rig, or factory or farm).
The level of risk mitigation is a trade-off between the cost and the assessment
derived from the risks likelihood and impact.
The graph shows the relationship between risk and level of acceptability.
Risk
Acceptability
You can see that as you decrease risk, the level of acceptability increases,
which gives it the downward sloping effect.
The matrix above assumes that risk can be accurately quantified or at least
ranked.
In some case, the assessment can be made with a high degree of certainty
and maybe even scientific accuracy. In this case, risks can be objectively
assessed.
Accuracy will depend on the skills and knowledge of the person making the
assessment, and also depend on the information available and the factors that
may influence the risk levels.
Need to be careful about having bias when judging the consequences of the
risks.
o Examples of a risk in which the likelihood can be measured objectively
is the next outcome of tossing a coin. A risk, the impact of which can be
objectively measured, is the number of shareholders affected by a loss
of company value.
A risk with subjective likelihood is the risk of an accident occurring, and a risk
with a subjective impact is the possible financial loss from a spillage from a
factory.
h) Explain and evaluate the concepts of related and correlated risk factors.
An example of a negative correlation (as the risk of one item increases, the
risk of something else decreases): In order to reduce the risk of stock out, a
company increases the level of inventory stock. However, when doing this, the
risk of obsolescence/damage/spoilage increases.
78
D.
The risk manager needs technical skills in credit, market and operational risks.
Also needs to have good leadership skills to convince those in the
organization that risk management is not to stifle initiative.
The role of the risk manager is to be the leader of the risk management
committee. The risk manager:
o Reports directly to the board.
o The risk managers role is to oversee implementation of the
boards risk management policies.
o The risk manager is supported by the risk management
committee.
o The risk manager is not normally involved in determining strategy.
o Has more of an operational role. This means identifying, evaluating
and determining specific risks within the entity.
The risk management policies to be implemented are decided by the board and risk
management committee.
b) Explain and evaluate the role of the risk committee in identifying and
monitoring risk.
If internal auditors carry out the audit, they have to be familiar with the
organization, its culture, its regulations, et cetera.
Internal auditors need to provide value added services which help the
organization achieve its objectives. A value added service is monitoring
recommendations for mitigating risks.
The external auditor may have a better awareness of certain risks than
internal auditors do.
If embedded then there is a greater chance that when risk becomes known, it
will be properly dealt with.
COSO suggests:
o Risk management should be a part of everyones job description.
o Personnel need to understand that they should resist pressure from
superiors to engage in improper activities.
o Whistleblowing procedures should exist.
o Risk management should be part of the annual MbO process.
Risk should also be embedded in its values. This means that the company
should recognize the importance of risk management and it takes risk
management seriously.
COSO suggests:
o Link risk management to job descriptions.
o Ethical and appropriate behavior is to be expected.
o Have effective staff training.
o Ownership of risks encourages their management.
o Top-down communication as to what the companys risk appetite is and
what is expected from employees.
d) Explain and analyze the concepts of spreading and diversifying risk and when
this would be appropriate.
81
3) You can avoid (terminate) the risk. Companies take immediate action
to reduce severity and frequency of losses, e.g., charging higher prices
to customers or ultimately abandoning activities.
4) You can accept (tolerate) the risk. These risks are not significant.
Keep under view, but costs of dealing with risks is unlikely to be worth
the benefits.
Whether a company spreads and diversifies the risk will depend on:
o Its likelihood of materializing.
o Its probability of materializing.
Higher the likelihood and probability of occurring, the higher the chance that
the company will do something to mitigate the risk.
e) Identify and assess how business organizations use policies and techniques to
mitigate various types of business and financial risks.
Business risks are strategic risks that threaten the survival of the whole
business.
o Business risk is a risk to both debt issuers and equity shareholders.
Financial risk. The ultimate risk for a company is not to be able to continue
functions as a going concern. Financial risks include the risks relating to the
structure of finance the organization has, in particular the risks relating to the
mix of equity and debt capital, etc.
o Financial risk is a risk just to equity shareholders. This is because debt
holders get preference in a liquidation.
This distinction refers to the way risk management operates at different levels
in an organization.
o Risk policies are agreed at very senior levels of the organization, by
the board, risk committee or risk manager. They may be directed at
particular risks.
o Risk mitigation techniques will be the means of implementing the
policies, applied at various levels in the organization by operational
managers and staff, guided by the risk management function.
These responses to risk are also commonly referred to as the 4Ts or TARA (in
the brackets).
82
Its premiums will not be unnecessarily large and its policy terms
will be reasonable.
b) Explain and evaluate the different attitudes to risk and how these can affect
strategy.
How organizations deal with risk is not only influenced by events and
information but by managements perceptions of those risks.
Business by its very nature is risky. Businesses have to take risk in order to
develop.
Concerning risk there are two possible extreme views of risks: risk averse
businesses and risk seeking businesses.
o Risk averse: Willing to tolerate risk up to a point provided it receives
acceptable return.
o Risk seeking: Are focused on maximizing returns and may not be
worried about the level of risks that have to be taken to maximize
returns.
Most risk has to be managed to some extent, and some should be eliminated
as being outside the business.
Attitudes towards risk does depend on the size, structure and stage of
development of the organization.
o Larger organizations are more likely to have formal systems and will
have to take account of varying risk appetites and incidence amongst
its operations.
85
E.
1. Ethics Theories
a) Explain and distinguish between ethical theories of relativism and absolutism.
Absolutism There are absolute right and wrong which are applied
universally.
For example, you might think that slavery, war, child abuse and death penalty
are morally wrong and cannot be justified under any circumstance.
Relativism This view rejects the absolutist view. It states that there are no
objective or absolute moral truths, and there are no universal standards of
moral behavior. There are two aspects to relativism:
o Descriptive ethical relativism. This view is that different cultures and
societies have different ethical systems and cultures.
o Normative ethical relativism. The beliefs or moral values within each
culture are right within that culture. Moral values can only be judged
from within the culture.
(4) Law/Order. Individual is concerned with society as a whole (not just the
opinion of those around them), and the need to maintain social order. Have
respect for social conventions, authority and obeying the law. This stage
underlies most behavior by accountants, as they have to comply with financial
reporting and CG requirements.
3. Post-conventional level of morality. This is the most advanced level that
relates to individual development towards making their own ethical decisions in
terms of what they believe to be right, not just acquiescing in what others believe
to be right.
(5) Social contract. Individual thinks about society differently from the
conventional way. Recognize that people are different and have the right to
their own views and opinions. At this stage, individuals talk about morality and
rights from their own individual perspective, recognizing that people might
disagree.
(6) Universal ethical principles. Kohlberg suggested that individuals rarely
reach level six of moral development. This stage is based on abstract
universal ethical principles (i.e. justice, equity, rights, etc.). Individual
questions the validity of laws and considers that laws are only valid if they are
based on justice.
Business decisions made on these grounds could be disclosure on grounds of
right-to-know that isnt compelled by law, or stopping purchasing from a
suppliers who test products on animals.
Need to stress that when at this stage 6, reasoning may involve a personal
cost, since it may mean failing to comply with existing social norms and
regulations as they are seen as unethical.
c) Describe
and
distinguish
between
teleological/consequential approaches to ethics:
deontological
and
Step
Comment
1.
2.
3.
decision?
4.
5.
6.
7.
2)
3)
4)
Social Ecologist. They take the social contract position a step further in
stating that companies should do everything they can to minimize the
harm they do to the environment. Companies adopt environmentally
89
friendly positions, not because they have to, but because it is their
responsibility to do so.
5)
Socialist. They believe that there is class struggle between business and
workers. Believe that there has to be a redistribution of wealth.
6)
Radical Feminist. They argued that society and business are based on
values that are usually considered masculine in nature, such as
aggression, power, assertiveness, hierarchy, domination, and
competitiveness. They argue that it is these traits, that got the world be in
such a mess. They believe it would be better if society were based on
feminine traits, such as equality, dialogue, compassion, fairness and
mercy.
7)
Deep Ecologist. They believe that man does not have a right to use
worlds resources. The current system is immoral and cannot be repaired. I
guess they want us all to live in caves, or disappear completely.
Individual Influences:
90
Age and gender: Studies suggest that men and women might react differently
to ethical dilemmas; however, empirical data does not support the idea that
women are more ethical than men.
Magnitude of consequences.
Social consequences.
Probability of effect.
91
Proximity. The feeling of nearness that the decisionmaker has for those who will be affected. For example, if
the decision maker has to decide who is going to be laid
off.
Values.
Beliefs.
Behaviors.
92
Profession has to do with the nature of the individuals work. For example, if
you are an accountant, then you would probably have to belong a professional
organization (e.g. ACCA, ACA, AICPA, CIMA, etc.), which intends to promote
the work that you do.
Professions are organized groups of highly-skilled individuals. And, organized
by self-regulating professional body.
c) Describe the role of, and assess the widespread influence of, accounting as a
profession in the organizational context.
93
Accountants put together the numbers that are used by all spheres of society (i.e.
investors, managers, governments (tax collectors), employees, employee unions,
etc.).
Therefore, the numbers included in the accounts can have a number of impacts:
o Mechanistic issues are where the numbers are used to judge the
performance of a company or its directors in line with the regulation or
contract.
Examples are company borrowing limits which are frequently defined as a
multiple of share capital and reserves and directors bonus schemes that
are based on some portion of reported profit.
o Judgmental issues are where the figures in the accounts influence the
judgment of their users. The accounts may influence not just the view of
investors, but governments seeking to assess what a reasonable tax
burden would be and employees determining their wage claims.
Accountants put together the numbers that go into the accounts are used by all
facets of society; from an organizations management whose performance is
judged based on the numbers; to the tax authorities who use the numbers to
determine the amount of tax owed to the government; to the employees whose
bonuses are based on the profitability of the company, to the government who
uses the numbers to judge the effectiveness of the governments services
provided; to investors who use the numbers make a decision on whether to invest
or not, or even determine the share price of the organizations shares.
Ultimately, organizations are successful if they are able to use the numbers in the
accounts (e.g. financial statements) to make decisions that will help an
organization grow and be profitable.
94
o If this is moral justification, then this has to do with the idea of liberal
economic democracy, where individuals should be free to exercise their
economic choices and are equally able to do so.
o The result of this is that individuals pursuit of economic benefit is economic
efficiency, maximum profits and economic growth, and everyone with
society being better off.
Criticism has to do with the rules that the profession has to follow. They argue
that the rules:
o Are too passive. This allows for variety has accounting treatment; failing
to impose meaningful responsibilities on auditors such as the explicit
responsibility to detect and report fraud.
o Emphasize the wrong principles. This has to do with giving priority over
confidentiality over disclosures in the wider public interest.
o Allows auditors to develop long-term cozy relationship with clients
rather than forcing them to maintain their distance.
o Allow the creation of a too small a number of large firms (Big 4) who
dominate the audit of major listed companies.
However, we have seen over the past ten years, particularly from the fallout from
the Enron case, where governments have established stricter rules over the
accounting profession and the ways an organizations board operates (e.g. board
is made up of a majority of independent NEDs).
95
There are five main areas that are covered in an organizations code of ethics.
1) Stating what an organizations values are. Code is intended to promote
values that are linked to the organizations mission statement.
2) Promotion of stakeholder responsibilities. Code can be used to identify
whom the organization regards as important stakeholders. They can show
what action can be taken to maintain good stakeholder relationships. They
can show external stakeholders that they are dealing with people who do
business fairly.
3) Control of individuals behavior. Ethical codes can be referred to when
employee actions are questioned.
4) Promotion of business objectives. Codes can be very useful when trying
to solidify a companys strategic position. Taking a strong stance on
responsibility and ethics and earning a good ethical reputation can
enhance appeal to consumers in the same way as producing the right
products of good quality can.
5) Conveying values to stakeholders. The code can be used as a
communication devise, not only acting to communicate between partners
and staff, but also increasing the transparency of the organizations
dealings with its stakeholders.
b) Describe and assess the content of, and principles behind, professional codes
of ethics.
The content of a corporate code of ethics is normally quite short, dealing with
each point in just a few sentences, and sometimes in just one sentence.
Might contain statements about the values of the company, such as:
o Acting with integrity at all times.
o Protecting the environment.
o The pursuit of excellence.
Fundamental principles:
o Technical standards. The accountant must perform his or her job within
the relevant technical and professional standards. Technical and
professional standards would include::
of
the
members
professional
o Objectivity. This means being unbiased and impartial, not having any
conflict of interest issues. This also means not having undue pressure from
others, for example, management wants the accountant to modify an
engagement report because the conclusion is unpopular.
o Professional competence and due care. Accountants need to be
competent in the work they do. This means have the necessary skills and
knowledge to perform their duties. Should strive to improve and stay on top
of what is going on in the profession.
o Professional behavior. Accountants are required to observe relevant laws
and regulations and to avoid any actions that would discredit the
accountancy profession. This requirement covers advertising by
accountants, which must be truthful and must not disparage the services
provided by rival firms.
o Integrity. Requirement of fair dealing. The accountant needs to be straight
forward, honest and truthful. This means that the accountant should not
supply any information which could be misleading, false or deceptive. For
example, the accountant will not modify a report unless factual errors are
known to exist.
o Confidentiality. Need to respect the confidentiality of information obtained
during your work. Information may not be used to enrich oneself.
97
The ACCA Code explains the fundamental principles as follows: Ethics is about
the principles we use today to judge the right and wrong of our actions. It is
about the fundamental principles that our members view and agree to each year
when they review their ACCA membership and submit their CPD (continuing
professional development) return.
A threat to independence of accountants in practice includes self-interest, selfreview, advocacy, familiarity, and intimidation.
Accountants in practice may face conflict of interest between their own and
clients interest, or between the interest of different clients.
Therefore, audit firms should take reasonable steps to identify circumstances that
could pose a conflict of interest.
Safeguards
Financial interest.
High % of fees.
Lowballing.
General services.
Preparing accounting
financial statements.
Valuation services.
Tax services.
records
and
Corporate finance.
Litigation.
move
to
b) Explain and evaluate the nature and impacts of ethical threats and safeguards.
Safeguard
Obtaining advice from the employer,
professional organization or professional
advisor.
The employer providing a formal dispute
99
standards.
resolution process.
Legal advice.
or
relevant
adversely affected.
Likelihood of damage to reputation.
Reliability of the information.
Reasons why employer does not want
to disclose.
c) Explain and explore how threats to independence can affect ethical behavior.
There are number of different threats to independence, such as:
Threats to independence
Others may be complicit if they know of the bribe and fail to report it.
102
Legislation such as the Foreign Corrupt Practices Act and Bribery Act of
2011 makes commercial organizations liable if their employees pay bribes,
unless they take adequate procedures to prevent bribery.
Corruption
Conflict of interest
Those taking brides face a conflict between their legitimate duty and
responsibilities, and any personal gains they may make through unethical
activities.
Personal gains does not necessarily always mean taking money. A manager
involved in bid rigging may generate higher profits for the company, which
enhances the managers performance bonus.
Economic issues
Bribery and corruption results in a misallocation of resources. Contracts
are not necessarily going to the most efficient producer but to the producer
that pays the highest bribe.
103
Professional reputation
If accountants are found of guilty of bribery or corruption, then the accountant
could lose his/her license.
e) Describe and assess best practice measures for reducing and combating
bribery and corruption, and the barriers to implementing such measures.
Recent legislation in certain countries has put pressure on businesses to introduce
sufficient controls, such as UK Bribery Act. In the US there is the Foreign Corrupt
Practices Act which deals with bribery and corruption.
Measures to combat bribery and corruption include:
Note: UK guidance stresses that risk may change over time (for example as the
business enters new markets) and so may need to be reassessed. A poor internal
control environment may also be a factor that contributes significantly to increased
risk.
104
Conduct of business. The UK guidance states, a strong tone at the top and
the ethical code may be undermined by a lack of detailed guidance on the
implementation of anti-bribery procedures.
Note: UK Bribery Act suggests that what is seen as adequate protect against bribery or
corruption will depend on the bribery risks faced by the organization, and the nature, size
and complexity of the business. The Act is based on six principles:
Risk assessment organizations should assess the nature and extent of their
exposure to bribery internally and externally.
Due Diligence The organization should carry out due diligence procedures in
relation to those who perform services for it, or on its behalf.
Monitoring and review The organization should monitor and review anti-bribery
procedures and improve them as required. The guidance states that risks are
dynamic and thus, may need to change if risks alter.
Ethics models (i.e. Tucker model and AAA model) are intended to help you
come to the right ethical decision. It does this by understanding the ethical
issues, and then getting you to understand the possible alternatives that can
be taken. Once you understand the alternative actions, it should be easier for
you evaluate the alternatives so you can make the right decision.
Kohlbergs model cannot be used to derive the right ethical decision, but it can
be used to understand how different people would operate at each of
Kohlbergs level (pg. 271).
o For example, the text book related this to Tuckers ethical model.
Profitability
Pre-conventional
Conventional
Post-conventional
105
profit maximization.
In any situation dealing with ethical decisions, the following are the practical
steps that can be taken.
o Analyze the situation for ethical problems.
o Identify the ethical issues.
o Consider the alternative solutions.
o State the best course of action based on the steps above.
o Justify your recommendation (decision).
Rules-based is a code would contain specific rules about how they should act
in a specific situation.
o Weakness to rules based, is that some circumstances can be complex and
varied and thus make it impossible to plan for every situation.
o Over time, situations might change. Therefore, would have to update the
code on a regular basis.
o Ethical views differ between countries and cultures. Behavior that might be
considered unethical in one country might be considered OK in another.
Many businesses anticipate increased regulation in this area and wish to avoid
the costs associated with poor reputations.
106
Other businesses are motivated by the increased need for efficiency and the
need to reduce waste.
The effects that businesses have on society and the environment is often
referred to as footprints. We describe these below:
Social and Environmental footprint. A footprint is the mark that is left behind
in the sand.
o A social footprint is the effect the company has on the society (i.e.,
employees, communities) in which it operates.
o In general, economic activity provides social benefits: wealth, higher
standards of living, better health; however, it might also create social
damage (e.g. use of child labor).
o A social footprint might be measured in terms of:
Impact of environmental costs. These costs can be divided into direct and
indirect costs.
o Direct costs would include the costs of disposing of waste, remediation
costs, compliance costs, legal costs, fines, environmental labeling and
certification costs and staff training.
o Indirect costs would include compensation costs to those whose
health may be adversely affected, the sustainability of certain natural
resources and the need to replace them with more expensive
alternatives, the risk of impaired asset values like share prices due to
poor environmental policies and impact of public perception on brand
values, market share and sales.
107
b) Explain and assess the concept of sustainability and evaluate the issues
concerning accounting for sustainability (including the contribution of full
cost accounting).
Sustainability means limiting the use of natural resources to a level where they
can be replaced by the environment.
Sustainability questions:
o For whom: what species other than man.
o In what way: Purely an ecological focus or does it extend to social
sustainability which includes physical and mental health and wellbeing?
o For how long: This is the question of generational equity, should this
generation reduce per capita consumption or how many generations.
o At what cost: This is the cost to the economy.
o By whom: Governments or individuals, unilateral or multi-lateral, national
or global.
Weak sustainability:
o Human beings need to prevail.
o The natural environment can regarded as a resource. However, the human
race needs to have better mastery of the natural environment.
Strong sustainability:
o Harmony with the natural world is our aim.
o The environment sustains all species of life.
o Current economic consumption must change.
o Supporters of strong sustainability argue that fundamental changes are
needed in society.
o They argue that the time span may be several centuries and will require
participation from governments and society to achieve.
o This viewpoint is linked to the deep ecologist approach identified by Gray,
Owens & Adams.
Tier 1 (Hidden costs) These costs include those hidden costs such
as overhead costs of management systems and safety.
Tier 3 (Less tangible costs) These costs include the costs of poor
environmental management costs, which might include loss of good
will, reputation risks, etc.
Advantages of FCA:
o Better knowledge of the extent of a companys environmental
footprint. Investors are in a better position to assess the risks involved in
the companies activities.
o Able to reduce environmental footprint. If able to assess the
significance of the organizations environmental footprint, then in a better
position to actually reduce per unit and absolute resource usage.
o Assist in decision-making. FCA can inform decision-making by allowing
comparisons between externalities created by different investment
decisions. Environmental costs identified under FCA will be indicators of
future business costs in other areas.
o Can lead to favorable PR. By using FCA, a company is able to
demonstrate that its products or processes do not have a significant impact
on the environment.
Disadvantages of FCA:
o Have to collect and process a lot more data. Some suggest to adopt lifecycle accounting.
o Not understanding which costs figures to use. One example is the
choice between using the costs of correction (clean-up costs) or using
costs of prevention (costs of changing the way business is conducted).
o Translating activities into impacts. The translation process depends on
the (possibly limited) state of scientific knowledge.
o Limitation of business level analysis. In a lot of cases, businesses are
just too small to use FCA.
o Inclusion of social externalities. If using natural environmental effects,
then it would seem reasonable to try to account for social effects. However,
there are then additional problems of definition and measurement.
o Impression given. FCA may show an alarming picture, suggesting that
strong sustainability are needed rather than weak sustainability solutions.
109
Companies that want to be in compliance with ISO 14000 are required to have
an audit each year of their system. These audits are to be undertaken by an
independent external expert. Internal auditors can help to make sure that the
company is in compliance with ISO 14000.
Critics argue that it places more emphasis on the procedures for maintaining
environmental quality than on the measurement of environmental results.
Environmental policy statement (EPS) should outline the basis for future
actions to be undertaken.
o It should be based on reliable data.
o It should set specific targets.
o There are two types of EPSs:
f) Explain the nature of social and environmental audit and evaluate the
contribution it can make to the development of environmental accounting.
Social and environmental audits are designed to ascertain whether the
organization is complying with codes of best practice or internal guidelines, and is
fulfilling the wider requirements of being a good corporate citizen.
It also measures the extent to which an entity achieves its objectives as set
out in its mission statement.
An activity is identified for costing: it might be an environmentrelated activity such as waste recycling or pollution control.
Costs are identified and recorded for the activity (environmentalrelated costs).
All the costs of the product, including its environmental costs are
measured over the life of the product.
112