P1 Knowledge Summary (December 2016)
Introductory terms
Private and institutional shareholders
Shares in public listed companies are held by a range of individuals and institutions. In most stock exchanges, it is
convenient and relatively cheap to buy or sell shares (usually on an internet-based application) and many
individual people often buy and sell shares in companies in this way.
A second type of shareholder is the institutional shareholder. This is an organisation, rather than an individual, and
accordingly, the number of shares held is usually much higher than individual ‘private’ shareholders hold. Some
investors buy shares directly in companies through the stock exchange whilst others purchase a small part of a
larger fund. Institutional shareholders tend to be large financial institutions with large capital sums and include
pension funds, insurance companies, banks, and specialised investment companies. They have many clients buying
into a certain fund and this fund is then managed in some way with the agreement of the clients who have placed
money into that fund. The fund attracts a management cost (to pay for the transactions and the fund management
costs) which is deducted from the gains (or losses) made.
Corporate governance
A set of relationships between a company’s directors, its shareholders and other stakeholders.(OECD)
Corporate governance is the system by which organisations are configured, co-ordinated and controlled. This
usually involves the characteristics of leadership, the structures, particularly at board level, to help facilitate
desirable outcomes, and the behaviours of senior management in the pursuit of those outcomes.
Agency relationship
Agency relationships underpin any governance situation, in which there is a separation of ownership and control of
an organisation. Agency involves two parties: the principal and the agent. In most situations, the agency is the
director responsibility for the performance of the organisation and this party reports to the principal in a fiduciary
relationship. The principal is the shareholder in the case of a public company but this is less straightforward in
public sector organisations, involving taxpayers and a hierarchy of public sector servants who intermediate on
behalf of the state and the taxpayer.
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The concepts underpinning governance
Corporate governance is based on a series of underlying concepts
Fairness: It suggests that a business respects the rights and views of all stakeholders with legitimate interests. To
be fair is to recognise many interests and to weigh each one against others in an equitable and transparent way.
Transparency: This is the important quality of governance which specifies that companies should disclose all
material information to shareholders and others unless there is a valid and defensible reason to withhold it. It
implies a default position of disclosure over the concealment of information.
Independence: Objectivity is a state or quality that implies detachment, lack of bias, not influenced by personal
feelings, prejudices or emotions.All those in a position of monitoring should be independent of those/what they
are monitoring. It requires an action to be based on objective criteria which service the interests of the firm, its
shareholders and other legitimate stakeholders.
 Non-executive directors should be independent of the executive directors, and of company operations as
their role is to monitor performance.
 External auditors should be independent of the company, especially its accounting department and
processes.
 Internal auditors should be independent of the company, as they are likely to be involved in monitoring
systems throughout the company’s operations.
Honesty: This is not just telling the truth, it also means finding out the truth, not ignoring it and not ‘turning a blind
eye’. Overall, corporate governance involves organizations being transparent and honest in all their dealings, be it
customers, suppliers, investors, employees or any type of stakeholder and shareholder. Honesty is important in
building stakeholders’ confidence that their interests are protected. Probity means honesty and making decisions
based on integrity.
Probity: Probity means honesty and making decisions based on integrity. Probity is a fundamental corporate
governance principle and is concerned with telling the truth and thereby not misleading shareholders or any other
stakeholders. For an individual, it suggests that they should act ethically with integrity, by always conducting their
business dealings in an honest and straight forward manner.
Responsibility: Responsibility means to accept liability for one’s actions. This liability relates to an acceptance of a
penalty that is deemed necessary in order to atone or pay for the action carried out. Responsibility also relates to
accepting a duty to act on behalf of an external party Directors should understand and accept their responsibility
to shareholders and other stakeholders. They should act in their best interests and be willing to accept the
consequences if they fail in this responsibility.
Accountability: Directors must be willing to be held accountable for their actions so they must accept
responsibility for the roles entrusted to them. Accountability is a key relationship between two or more parties. It
implies that one party is accountable to, or answerable to, another. This means that the accountable entity can
reasonably be called upon to explain his, her or its actions and policies.
Judgment: Because corporate governance is based on decision-making, the ability to make sound and balanced
judgements is an important underlying principle. In many cases, judgement is the ability to decide between two
credible courses of action, and making finely-tuned calculations in so doing. The decision-maker’s personal
attitudes to risk, ethics and the timescale of likely returns are likely to be important factors in how a person judges
a given decision.
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Reputation: Reputation concerns the perceptions with which an organisation is viewed by a range of stakeholders.
A strong reputation, perhaps for service delivery and robust governance, can be a strategic asset, whilst a weak
reputation can be a strong disadvantage. Reputation is one of the important underlying principles in corporate
governance. Because there is a separation of ownership and control in many organisations, the reputation which
the management of an organisation enjoys with its principals is important in directors or trustees being given the
licence to manage the organisation as they see fit, for the long-term strategic benefit of the principals. Reputation
is also important for the positioning of an organisation in its environment in terms of society’s trust in the
organisation as a buyer, supplier, employer, etc.
Integrity: This is quite a general term and has a crossover with some of the other terms above. Integrity means
honesty, fair-dealing, presenting information without any attempt to bias opinion and in a more general sense
‘doing the right thing’.
Integrity goes beyond honesty and the law and brings moral and ethical issues into play. Cadbury Report
Summary: ‘Integrity means straightforward dealing and completeness. What is required for financial reporting is
that it should be honest and should present a balanced picture of the state of the company’s affairs. The integrity
of reports depends on the integrity of those who prepare and present them’ At times accountants will have to use
judgment or face a situation which is not covered by regulations or guidance and on those occasions integrity is
particularly important.
Innovation: this means discovering new idea, developing them and commercializing them for profit. This requires
long term commitment of resources .Although innovation is risky, it is necessary for the business to grow and
compete successfully.
Skepticism: this means a critical assessment of information, challenging information and being alert to possibilities
of manipulation/fraud.
The Board Of Directors
Executive directors are full time members of staff, have management positions in the organisation, are part of the
executive structure and typically have industry or activity-relevant knowledge or expertise, which is the basis of
their value to the organisation.
Non-executive directors(NED) are engaged part time by the organisation, bring relevant independent, external
input and scrutiny to the board, and typically occupy positions in the committee structure.
NED
The board should consist of a balance of executive and non-executive directors and should be of sufficient size that
there is a balance of skills and experience in order to effectively manage the company.
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Roles of NEDs
Higgs Report: Summary of the role of non-executive directors
1.
Strategy: as part of the board, they assist with determining the strategy of the company. It is likely that
this is led by the executive directors but NEDs are involved in this process by challenging strategy and
questioning other options before the strategy is implemented.
2.
Performance: NEDs should scrutinize the performance of the executive directors in meeting goals and
objectives. The NEDS lead the process of replacing and recruiting directors through the nomination
committee.
3.
Risk: NEDs should satisfy themselves that the financial information is accurate and the financial controls
and risk management systems are effective. They play a role in ensuring that the company’s systems of
financial reporting, internal control and risk management are operating satisfactorily through the audit
committee.
4.
People role:
a)
Directors and managers: NEDS are responsible for determining appropriate levels of remuneration for
executives and are key figures in appointment and removal of senior managers and succession
planning
b) Shareholders: should take responsibility for shareholders concerns and attend regular meetings with
shareholders.
Independence
NEDs operate as a ‘corporate conscience’ and therefore need to be independent.
• They should not have been an employee within the last five years.
• They should not have had any business relationships with the company in the last three years.
• They should not have any family members in senior positions at the company.
• Any NED who has been on a board for more than nine years is assumed to no longer be independent.
(Directors’ appointments are voted on by shareholders on a three-yearly cycle, so nine years is relevant as it gives
three terms as a director).
• NEDs are only remunerated with a fee for director duties – no profit share or share options.
• They cannot hold cross-directorships This term is used to explain a potential relationship between the executive
directors of two companies. It occurs when an executive director of one company operates as a non-executive in
another company, and there is an identical reciprocal arrangement. Hence the directors are non-executives in each
other’s companies.
This being the case, both directors are in a position to influence the others’ executive rewards assuming they are
both serving members of the remuneration committee (as is common for all non-executive directors).
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NEDs with experience from the same industry
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higher technical knowledge of issues in that
industry
a network of contacts
an awareness of what the strategic issues
are within the industry
might reduce the NED’s ability to be
objective
NEDs with experience from a different industry
-a fresh pair of eyes to a given problem
-a lack of previous material business relationships will usually
mean that a NED will not have any previous alliances or
prejudices that will affect his or her independence
-they will be lesser biased towards people, policies and
practices in that industry
Independence maintained by:
- No business, financial or other connections with the company during the past few years (again, the period
varies by country). This means that, for example, the NED should not have been a shareholder, an auditor, an
employee, a supplier or a significant customer.
- Second, cross-directorships are usually banned. This is when an executive director of Company A serves as a
NED in Company B and, at the same time, an executive director of Company B serves as a NED at Company A.
- Third, restrictions or total bans on share options for NEDs are often imposed
- Fourth, NED contracts sometimes allow them to seek confidential external advice (perhaps legal advice) on
matters on which they are unhappy, uncomfortable or uncertain.
Disadvantages of NEDS
1.
2.
3.
4.
5.
6.
May lack independence
May have difficulty imposing their views upon the board. Some NEDs are too willing to accept what the
executives tell them. There is still the problem that executive directors are really the only ones that know
exactly what is happening at the company.
High caliber NEDs may go to best run companies rather than the ones which are in more need of input from
good NEDs
They can damage company performance by weakening board unity, stifling entrepreneurship and
concentrating on matters other than maximization of financial performance.
Having additional directors increases the size of the board of directors as at least half of the board must be
independent non executives. This will increase costs and may slow down decision making as they may
challenge every decision made by the executives.
As they do not work full time for the company, they may only spend limited time there. It is debatable how
much they actually know about the company and how much they can add value.
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Chairman’s responsibilities
The overall responsibility of the chairman is to:
With regards to protecting
shareholders’ interest
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With regards to BOD’s
effectiveness
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
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With regards to BOD’s
communication


The chairman represents the company to investors and other outside
stakeholders/constituents.
communication with shareholders. This occurs in a statutory sense in the
annual report (where, in many jurisdictions, the chairman must write to
shareholders each year in the form of a chairman’s statement) and at annual
and extraordinary general meetings.
ensure there is a balance in the board ( between the number of EDs and
NEDs excluding the Chairman and in the skills of the board)
ensure the existence and effective composition of the four sub-committees
facilitating good relationships between executive and non-executive directors
Lead in induction program for new directors
Lead in board development
Facilitating board appraisal
setting the board’s agenda and ensuring that board meetings take place on a
regular basis.
Internally, the chairman ensures that directors receive relevant information
in advance of board meetings so that all discussions and decisions are made
by directors fully apprised of the situation under discussion
Ensure no dominant individual dominates the discussions.
CEO's responsibilities ( responsible for all aspects of operations)
The overall responsibility of the CEO is to:
– To develop and implement policies and strategies capable of delivering superior shareholder value and to
assume full responsibility for all aspects of the company’s operations
– implement the decisions of the board. This means that the various divisions and/or departments in the
organisation must work out the strategies agreed, and the CEO must configure and co-ordinate the business to
achieve these.
– Manage the financial and physical resources of the company
– Monitor results: the CEO has to analyse the performance of all parts of the business in terms of each one’s
contribution to strategy and its fit with the rest of the organisational structure
– Ensure that effective operational and risk controls are in place
– Overseeing the management team, co-ordinating the interface between the board and the other employees in
the company
– Relate to a range of external parties including the company’s shareholders, suppliers, customers and state
authorities
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Splitting the role of CEO & Chairman
'A clear division of responsibilities must exist at the head of the company. No individual should have unfettered
power of decision.'
Reasons for splitting the role
- Representation: the chairman is clearly and solely a representative of shareholders with no conflict of
interest having a role as a manager within the firm.
- Accountability: the existence of the separate chairman role provides a clear path of accountability for the
CEO and the management team.
- The chairman provides a channel for the concerns of non-executive directors who, in turn, provide an
important external representation of external concerns on boards of directors.
- Having the two roles separated reduces the risk of a conflict of interest in a single person being
responsible for company performance whilst also reporting on that performance to markets- The removal
of the joint role reduces the temptation to act more in self-interest rather than purely in the interest of
shareholders.
- The chief executive can fully concentrate on the management of the organisation without the necessity to
report to shareholders
- No unlimited power/‘unfettered powers’ with one person therefore greater transparency.
Reasons against splitting the role

Unity: the separation of the role creates two leaders rather than the unity provided by a single leader.

Ability: both roles require an intricate knowledge of the company. It is far easier to have a single leader
with this ability rather than search for two such individuals.

Human nature: there will almost inevitably be conflict between two high powered executive offices.
NOMINATION COMMITTEE-ROLES
1.
2.
3.
4.
5.
6.
7.
Oversees board appointments to maintain a balance in the board.
Establishes desirable size of the board(bearing in mind the current and planned size and complexity of the
operations
It needs to consider a balance between executives and independent NEDs And skills, knowledge and
expertise of the current board
It considers the need to attract board members from diverse backgrounds (diversity in the board)
Succession planning: It acts to meet the needs for continuity and succession planning, especially among
the most senior members of the board. CEO succession: The search for a potential replacement CEO
begins immediately after a new CEO is appointed!)
Arranges induction training of all directors
Arranges CPD activities for all directors
.
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REMUNERATION COMMITTEE-ROLES
1.
2.
3.
4.
5.
Determines remunerations policy on behalf of the board and the shareholders(pay scales applied to
directors’ packages, the proportions of different types of reward within the overall package and the
periods in which performance related elements become payable)
Makes individual director’s packages (ensure fair but not excessive-Contents of the package have been
discussed separately later)
It reports to the shareholders on the outcomes of their decisions, usually in the corporate governance
section of the annual report (usually called Report of the Remunerations Committee). This report, which is
auditor reviewed, contains a breakdown of each director’s remuneration and a commentary on policies
applied to executive and nonexecutive remuneration.
They may also be asked to make severance packages.
Where appropriate and required by statute or voluntary code, the committee is required to be seen to be
compliant with relevant laws or codes of best practice.
Remuneration package
Market rate
The market rate for a reward is the equilibrium point at which supply and demand curves intersect. This is the
price which matches both the supply of suitable candidates for the position and the price which employers are
willing to pay for the job.
Because the shape and position of supply and demand curves differ between jobs (in other words, the supply of
candidates and the willingness to pay varies so much), market rates vary a great deal for different types of jobs.
This is why some senior positions attract a very high level of reward and others less so.
The market rate often expresses itself as the ‘natural’ rate for a given job. It is generally understood, for example,
that the market rate for an office cleaner is lower than that for a qualified accountant or a medical doctor. This is
because of the supply and demand characteristics, as well as the years of professional training, for those jobs.
Key points to consider:
Remuneration should be sufficient to Attract, Retain and Motivate
No individual should have a say in setting his/her own remuneration
DO NOT reward for failure
Components of an ED’s remuneration package
Basic salary
Performance-related
elements
When setting a director’s salary, the remuneration committee should consider what
other directors doing similar jobs in similar setting are getting paid.
Directors’ bonus schemes can be useful as a motivating tool. They are a means of
ensuring that directors are working towards the company’s objectives. For example, if
the company is trying to grow, then a bonus scheme should be set up to reward
directors for company growth.
Bonuses are often given for increased profits, increased market share, increased sales,
reduced costs, increased margins and so on. However, bonuses could also be given for
non-financial measures, for example, reducing employee turnover or better customer
service or environmental targets such as reducing pollution. This may avoid the focus
on inflating short-term profits.
Bonus schemes tend to be short term in nature and focus on one financial year. This
may not be sufficient a time frame for the directors to achieve what shareholders want
them to.
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Share options
-
Share options are contracts that allow the executive to buy shares at a fixed price
or exercise price.
If the stock rises above this price the executive can sell the shares at a profit.
Share options give the executive the incentive to manage the firm in such a way
that share prices increase, therefore share options are believed to align the
managers' goals with those of the shareholders.
Benefits in kind/perks
(transport, health
provisions, holidays,
loans)
The remuneration committee should consider the benefit to the directors and the cost
to the company of the complete package.
Retirement benefits
All awards are ultimately given by the shareholders and should be viewed in relation to
performance achieved by the director. A retirement benefit such as lifetime use of the
company plane or a sizeable pension payout could be awarded.The company makes
payments into directors’ pension schemes so on retirement the director will have an
income.Usually contributions are a fixed percentage of the directors’ salary. The
Combined Code suggests that only a director’s basic salary is pensionable.
COMPENSATION
In some situations a director’s contract will be terminated before the end of its term. This may be the case if a
director is not performing as the company would expect. The Combined Code states that a company must consider
the compensation commitments if this were to happen. There have been many cases in the past where poorly
performing directors have received large payouts when their contracts have been terminated and companies must
avoid rewarding poor performance. The notice period of a director’s contract should be set at one year or less.
APPOINTMENT OF DIRECTORS
Directors can be appointed to the board by the following means:
1.
2.
3.
by resolution of the company’s members – for listed companies this will usually be at the AGM;
by resolution of the directors – the company’s articles of association will usually empower the directors to
appoint a new director to fill a vacancy or act as an additional director. This can be useful if a director leaves
unexpectedly, but for listed companies the appointment is only until the next AGM when the director’s
appointment can be approved by members;
by resolution following direction from the Secretary of State – this intervention would only occur if a company
did not have one director or a public company did not have at least two directors.
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Retirement by rotation
Retirement by rotation is an arrangement in a director’s contract that specifies his or her contract to be limited to
a specific period (typically three years) after which he or she must retire from the board or offer himself (being
eligible) for re-election.
The director must be actively re-elected back onto the board to serve another term. The default is that the director
retires unless re-elected.
REMOVAL OF DIRECTORS
A director may leave office in one of the following ways:
1.
2.
3.
removal by the members of the company – the members of a company can remove a director by passing an
ordinary resolution. This must be done at general meeting of the company and special notice (28 days) must
be given of the meeting;
resignation – a director may terminate their employment by formally giving notice to the company;
cessation of office under terms of the company’s constitution – there may be some circumstances where a
director must vacate their position. For example, if the director is bankrupt or disqualified from holding office.
DISQUALIFICATION OF DIRECTORS
Directors may be disqualified from acting as a director in the following circumstances:
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a director has been convicted of an offence in connection with the promotion, formation, management or
liquidation of the company;
a director has been persistently in default with regard the Companies Act provisions relating to the submission
of accounts or annual returns;
where a director has been found guilty of fraudulent trading on the winding up of a company, or guilty of
fraud in relation to the company;
where a director has been convicted of an offence following the contravention of any requirement to file
returns, accounts or documentation with the Registrar of Companies;
When a company has gone into liquidation and an application has been made to the Secretary of State on the
grounds that conduct renders him/her unfit to be concerned in the management of a company;
Where an application to disqualify is made by the Secretary of State on the grounds of unfitness following a
report made on the company by official inspectors.
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CONFLICTS OF INTERESTS
Company directors have a fiduciary duty to act in the best interests of the shareholders who have appointed them
to their position. They act as agents of the shareholders [the principals], and as such are delegated the power and
authority to make decisions which will ultimately increase shareholder value over the longer term. A director owes
a duty to all shareholders not to place him/herself in a situation where personal self-interest conflicts with the
interests of the company, and vicariously its shareholders.
Conflict of interest is when one’s personal interest is at variance with one’s professional duty of care.
In the context of corporate governance, directors must avoid the temptation to be influenced by factors which
might not be in the best interests of the company. This could include:
– obtaining some personal advantage by virtue of their position as director, possibly to the detriment of the
company;
– avoiding the influence of external parties, such as from a cross-directorship, when this comes into direct conflict
with the best interest of the company; and
– directors contracting with their own company, except where permitted by the articles of association and where
the directors’ interest is fully disclosed.
INSIDER DEALING
Insider dealing (also called insider trading) is the buying or selling of company shares based on knowledge not
publicly available.
Directors are often in possession of market-sensitive information ahead of its publication and they would
therefore know if the current share price is under or over-valued given what they know about forthcoming events.
Why is insider trading unethical and often illegal?
By accepting a directorship, each director agrees to act primarily in the interests of shareholders. This means that
decisions taken must always be for the best long-term value for shareholders. If insider dealing is allowed, then it is
likely that some decisions would have a short-term effect which would not be of the best long-term value for
shareholders.
There is also the potential damage that insider trading does to the reputation and integrity of the capital markets
in general which could put off investors who would have no such access to privileged information and who would
perceive that such market distortions might increase the risk and variability of returns beyond what they should
be.
SERVICE CONTRACTS
A director’s service contract is essentially the director’s employment contract and covers the terms and conditions
of the director’s employment with the company.
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Performance appraisal of the board
Appraisal should be carried out once a year and measured against the following criteria
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performance against objectives
contribution to development strategy
contribution to effective risk management
contribution to development of corporate philosophy (values, ethics, social responsibilities)
appropriate composition of boards and committees
responses to problems or crises
quality of information
fulfilling legal requirement
Positive Aspects of Performance Evaluation
Performance evaluation demonstrates to shareholders that the board takes their responsibilities seriously. It
should provide confidence that the boards are monitoring the extent to which they are meeting their duty of care
and skill and are operating effectively.
It can lead to the introduction of new ideas through new executive and non executive membership and lead to the
realization that change is necessary to continue serving shareholders in an appropriate way.
Performance evaluation also helps to justify the pay of board members by demonstrating the level of effort put
into their work.
Performance evaluation will also highlight any training needs of the directors which can then be implemented to
strengthen the skills of the board.
Performance evaluation also sets the same standard for the board as exists for members of staff. The use of
performance evaluation is widespread in large businesses and as such, in order to ensure buy in at lower levels,
should be demonstrated as important through the spine of the company right to the very top.
Criticisms of Performance Evaluation
Board evaluation may be considered to be unnecessary if the company is performing well since its performance
can be seen in the continued success of the business.
Another argument against its use at this level is that the board is evaluating itself and will not be self critical. This
leads to a rubber stamp approach to the process.
It is also argued that performance evaluation is simply a bureaucratic cost and a necessary form of compliance and
should not be given any credibility beyond this. By the same token it could be argued that any adherence to
corporate governance requirements is simply a compliance issue without any intention to have a practical impact
on the board role.
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INDUCTION OF DIRECTORS
Induction is a process of orientation and familiarisation that new members of an organisation undergo upon
joining. It is designed to make the experience as smooth as possible and to avoid culture or personality clashes,
unexpected surprises or other misunderstandings.
The chairman should ensure that new directors receive a full, formal and tailored induction on joining the board.
If a non-executive director is joining the board, the company should invite major shareholders to meet the
director.
Objectives of induction
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enable the new director to become familiar with the norms and culture
To give the directors an understanding of the nature of the company and its business model
To communicate practical procedural duties to the new director including company policies relevant to a new
employee
To reduce the time taken for an individual to become productive in their duties.
To help them gain an understanding of key stakeholders and relationships including those with auditors,
regulators, key competitors and suppliers
To establish and develop the new director’s relationships with colleagues, especially those with whom he or
she will interact on a regular basis. The importance of building good relationships early on in a director’s job is
very important as early misunderstandings can be costly in terms of the time needed to repair the
relationship.
Elements of induction training
• Brief outline of the role of a director and a summary of responsibilities;
• Company guidelines on directors’ share dealings, procedure for obtaining independent advice, and policies and
procedures of the board;
• Current strategic plan, budgets and forecasts for the year together with the three and five year plans;
• Latest annual report and accounts;
• Key performance indicators;
• Corporate brochures,mission statement, and other reports issued by the company;
• Minutes of the last few board meetings;
• Description of board procedures;
• Details of all directors, company secretary and other key executives;
• Details of board subcommittees and minutes of meetings if the director is to join any committee.
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Continuing professional development (CPD)
CPD is the systematic maintenance, improvement and broadening of knowledge and skills, and the development of
personal qualities necessary for the execution of professional and technical duties throughout an individual’s
working life.
Objectives of CPD
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-
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Maintain knowledge and skills bases ( and so improve overall performance in their roles)
By keeping professional qualifications up-to-date, directors can improve their competence in a wider
context benefiting both themselves and professional roles. CPD can improve and broaden knowledge and
skills to support future professional development,
By updating his knowledge and skills on existing and new areas of business practice, like tackling internet
fraud, directors are able to contribute towards the development of the company. In effect, CPD can act as
a catalyst for improving and enhancing business performance.
By undertaking CPD, directors demonstrate a commitment to their professions and their company.
Features of effective CPD
Individual professionals should be responsible for organising and conducting their own CPD so that it meets their
particular needs. This can be achieved by determining what form of training or other intervention delivers the
necessary output.
ACCA operates a professional development matrix to assist its members analyse their roles and responsibilities,
and then prioritise learning needs.
The matrix comprises four elements:
Planning. The individual should analyse his current role and then identify the competencies which are needed to
deliver the required level of performance for that role. A development plan is then devised which involves
prioritising elements of the role which need most attention, but also addressing any emerging areas.
Action (inputs). The actual CPD undertaken should satisfy the following requirements:
– Relevance of the actual learning activity to the role;
– Understanding how the learning outcomes will apply to the workplace;
– Providing evidence that the learning activity was undertaken, and in part independently verified.
Results (outputs). On completion the individual should compare the results of his learning activities against his
development plan,
and self-assess whether the CPD has met his pre-determined objectives.
Reflection. The individual should examine the evolving requirements of his role, as these will become a key feature
of future planning. This ensures that all CPD he undertakes in the future remains relevant to his role and the needs
of the company and its clients.
Elements of Continuing professional development
CPD activities could include:
• Professional educational courses;
• Planning and running an in-house training event;
• Coaching or mentoring;
• Learning a new discipline;
• Committee membership;
• Attending trade exhibitions and conferences
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Diversity
Diversity means having a range of many people that are different from each other. There is, however, no uniform
definition of board diversity. Traditionally speaking, one can consider factors like age, race, gender, educational
background and professional qualifications of the directors to make the board less homogenous. Some may
interpret board diversity by taking into account such less tangible factors as life experience and personal attitudes.
In short, board diversity aims to cultivate a broad spectrum of demographic attributes and characteristics in the
boardroom. A simple and common measure to promote heterogeneity in the boardroom – commonly known as
gender diversity – is to include female representation on the board.
Benefits of Diversity in the Workplace

More effective decision making: by reducing the risk of 'groupthink', paying more attention to managing and
controlling risks as well as having a better understanding of the company’s consumers.( group think: a
psychological behaviour of minimising conflicts and reaching a consensus decision without critically
evaluating alternative ideas in a cohesive in-group environment.)

Better utilisation of the talent pool: One of the problems of searching for suitable directors lies on the
limited number of candidates – there is especially a tendency to search for board members with typical
characteristics, such as male directors. If directors expand the pool of potential candidates by considering
more diversified attributes, like women and ethnic minorities to be included in the boardroom, it will
alleviate the problem of 'director shortage' and therefore better utilise the talent pool.

Enhancement of corporate reputation and investor relations by establishing the company as a responsible
corporate citizen.: It can enhance corporate reputation through signalling positively to the internal and
external stakeholders that the organisation emphasises diverse constituencies and does not discriminate
against minorities in climbing the corporate ladder. This may somehow indicate an equal opportunity of
employment and the management’s eagerness in positioning the organisation as a socially responsible
citizen.
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A board with a broad range of experience is more likely to develop independence of mind and a probing
attitude. It can also enhance corporate decision-making by having sensitivity to a wider range of risks to its
reputation.
Studies suggest that female non-executive directors contribute more effectively than male nonexecutives,
preparing more conscientiously for board meetings and being more prepared to ask awkward questions and
to challenge strategy. Studies also suggest that a gender-balanced board is more likely to pay attention to
managing and controlling risk.
Surveys suggest that in the UK women hold almost half the wealth and are responsible for about 70% of
household purchasing decisions. As women are often the customers of the company’s products, having more
women directors can improve understanding of customer needs. Large companies in consumer-facing
industries have a higher proportion of women on their boards than big companies in other sectors.
P1 Knowledge Summary
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COSTS OF DIVERSIFYING THE BOARD
Diversifying the board is not without costs. Though a board is inherently subject to conflict as it is formed by
individuals collectively, having a diverse board may potentially increase friction between members, especially
when new directors with different backgrounds are stereotyped by existing members as atypical. This may split the
board into subgroups, which reduces group cohesiveness and impairs trust among members, leading to reluctance
to share information within the board.
Another danger of board diversity is sometimes referred to as tokenism. Theoretically, as mentioned in the
previous section, the minorities in the boardroom are said to contribute to value creation of the organisation by
their unique skills and experiences; however, in practice, they may feel that their presence is only to make up the
numbers required by the external stakeholders. They may then tend to undervalue their own skills, achievements
and experiences, which demeans their potential contribution to the organisation.
Further, the board may potentially ignore the underlying important attributes of successful directors as a sacrifice
to meet the requirement of board diversity. The board needs to pay special attention to these costs when
implementing measures to diversify the board.
REGULATORY INITIATIVES OF BOARD DIVERSITY
Board diversity can be promoted by a number of methods. Measures currently adopted by different regulatory
bodies are generally classified into the following approaches: (i) through imposing quotas on the board; and (ii)
enhancing disclosures using the 'comply or explain' approach.
Imposing quotas refers to mandatory requirement in appointing a minimum number of directors with different
attributes on the board. This legislation enactment mainly deals with gender diversity to tackle the relative
underrepresentation of women in the boardroom. For example, since 2008, each listed company in Norway has
had to ensure that women fill at least 40% of directorship positions. Spain and France are implementing similar
mandatory requirements for gender diversity. This approach increases the number of women on the board at a
faster rate and forces companies to follow the legislation.
Another measure to enhance board diversity is through transparency and disclosure. Companies, under corporate
governance codes, are required to disclose their diversity policy in appointing directors so that investors and
stakeholders can make proper evaluation. Those who fail to implement such measures have to explain their noncompliance in the corporate governance report or equivalent. The Corporate Governance Code (2010) of the
United Kingdom, for example, stipulates that companies are required to: (i) incorporate diversity as a
consideration in making board appointments; and (ii) disclose in their annual reports describing the board’s policy
on diversity, as well as its progress in achieving the objectives of that policy. Australia and Hong Kong are
promoting diversity using a similar 'comply or explain' approach. Supporters of this approach believe that board
appointments should be made on the basis of business needs, skills and ability instead of legislative requirements,
which may sometimes be considered excessive in the market.
P1 Knowledge Summary
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The Agency theory
The agents are granted both expressed and implied authority to deal with third parties on behalf of their principal,
and they are held accountable under corporate governance for their actions and outcomes.
Fiduciary duty: Agents owe a fiduciary duty (duty of utmost faith) to their principals. This means they need to act
in the principal’s interest and ensure all relevant information is communicated to them in a timely basis. This duty
can be legal or ethical.
Accountability: The agent is accountable to the principal. Directors, individually and collectively, have a duty under
corporate governance to provide entrepreneurial leadership and run the company to the betterment of the
shareholders.
Agency problem: There may be conflicts of goals which need to be managed ( Shareholders’ interest would be
wealth maximization and the directors would want to maximize their remuneration). This problem is known as the
agency problem.
Agency cost
Agency costs can include:
the time and expense of reviewing published information, and then attending meetings to monitor and
scrutinise the board’s performance;
paying for the services of independent experts and advisers;
external auditor’s fees; and
transaction costs associated with managing the shareholding
An agency cost is a cost incurred by the shareholder (the principal) in monitoring the activities of company agents
(i.e. directors). Agency costs are normally considered as ‘over and above’ existing analysis costs (such as those
involved in making an initial investment decision) and are the costs that arise because of compromised trust in
agents (directors).
They can be classified under two headings; costs associated with monitoring the agent, and those termed residual
loss.
Monitoring costs
This type of agency cost includes costs associated with attempts to control or monitor the organization. The most
important of these will be the provision of information to shareholders, such as financial statements and annual
reports detailing company operations.
Large organizations are required, usually as part of listing rules, to communicate effectively with major
shareholders. Meetings attended by the key board members including the chief executive can be arranged and
institutional shareholders invited, although these will take time and money both to organize and deliver.
The AGM is a regular meeting that can be utilized by shareholders to ask questions of the company.
P1 Knowledge Summary
Page 17
Many companies utilize performance-related incentive schemes to encourage directors to make decisions that are
in the best interest of the shareholders. The most effective of such schemes is that of offering directors share
options, usually with a specified period of time (several years) in which the shares cannot be sold. This provides the
incentive for their decision making to reflect the requirements of shareholders for long-term share price growth.
Residual loss
Residual loss costs are a part of agency costs. These are costs that attach to the employment of high caliber
directors (generally outside of salary) and the trappings associated with the running of a successful company. The
packages of the board members may include benefits in kind such as company cars, medical insurance and school
fee payments and would be considered a residual loss to shareholders.
These agency costs could be reduced when direct action is taken to resolve the alignment of interest problem,
which would improve board accountability
Transaction cost theory
Transaction costs will occur when dealing with another external party:



Search and information costs: to find the supplier.
Bargaining and decision costs: to purchase the component.
Policing and enforcement costs: to monitor quality.
The way in which a company is organised can determine its control over transactions, and hence costs. It is in the
interests of management to internalise transactions as much as possible, to remove these costs and the
resulting risks and uncertainties about prices and quality.
Transaction costs can be further impacted by the following:


Bounded rationality: our limited capacity to understand business situations, which limits the factors we
consider in the decision.
Opportunism: actions taken in an individual's best interests, which can create uncertainty in dealings and
mistrust between parties.
The significance and impact of these criteria will allow the company to decide whether to expand internally
(possibly through vertical integration) or deal with external parties.
Internal transactions: Transaction costs still occur within a company, transacting between departments or
business units. The same concepts of bounded rationality and opportunism on the part of directors or managers
can be used to view the motivation behind any decision.
Possible conclusions from transaction cost theory



Opportunistic behaviour could have dire consequences on financing and strategy of businesses, hence
discouraging potential investors. Businesses therefore organise themselves to minimise the impact of
bounded rationality and opportunism as much as possible.
Governance costs build up including internal controls to monitor management.
Managers become more risk averse seeking the safe ground of easily governed markets.
P1 Knowledge Summary
Page 18
Transaction cost theory versus agency theory
Transaction cost theory and agency theory essentially deal with the same issues and problems. Where agency
theory focuses on the individual agent, transaction cost theory focuses on the individual transaction.


Agency theory looks at the tendency of directors to act in their own best interests, pursuing salary and
status. Transaction cost theory considers that managers (or directors) may arrange transactions in an
opportunistic way.
The corporate governance problem of transaction cost theory is, however, not the protection of
ownership rights of shareholders (as is the agency theory focus), rather the effective and efficient
accomplishment of transactions by firms.
Two- Tier boards
Unitary
Two-tier (used in France & Germany)
In a unitary board, all directors, including all
executive and non executive directors, are
members.
In a two-tier board, responsibilities are split between a supervisory
or oversight board (chaired by the company chairman), and an
operational board (usually chaired by the chief executive).
All directors are of equal ‘rank’ in terms of
their ability to influence strategy and they
also all share the collective responsibility in
terms of legal and regulatory liability.
There is no distinction in constitution or law
between strategic oversight and operational
management.
The supervisory board decides on strategic issues and the
operational board becomes responsible for executing the strategy
determined by the supervisory board.
Why?
1.All directors have equal legal status(equal
accountability and responsibility). This also
ensures that the directors work together and
leads to better decision making.
Responsibilities between the boards are clearly defined with the
supervisory board responsible for many legal and regulatory
compliance issues (such as financial reporting). Directors on the
lower tier (operational board) do not have the same levels of
responsibility or power as those on the supervisory board.
Why?
1.Direct power over management.
2.More stakeholder involvement(therefore their interests
protected)
3.Clear separation between management and monitoring.
2.NEDs are empowered(independent
scrutiny, experience and expertise). They
protect shareholder’s interest.
4.Acts as a deterrent to management fraud.
3.Lesser likelihood of power abuse by a small
number of directors. This may also reduce
chances of fraud as the directors are
involved in actual management.
5. The supervisory board is separated from management therefore
may be more independent.
6.As the supervisory board is relatively a smaller board, it may be
more effective in turbulent environments where quicker decision
making is required ( it will be easier and cheaper to arrange
meetings!)
4.Greater intellectual strength (strategies
scrutinized more)
5. Investor confidence increased through the
above.
P1 Knowledge Summary
Why not?
1.
Lack of accountability of supervisory board.
2.
Slower decision making as there are different stakeholders
involved (whose interest might be in conflict with each other
at times)
Page 19
3.
4.
5.
6.
7.
Owners’ power is diluted as more stakeholders involved.
Agency problems and conflict between the two boards (e.g.
management board doesn’t give complete info to
supervisory board etc)
Management board demotivated as they are not involved in
decision making
Supervisory board may not understand the operations in
detail as they are isolated from management meetings.
Responsibility is divided (as compared to unitary board
where entire board is held accountable)
P1 questions for unitary and two-tier boards
1.
2.
Suitability of the board structure depends on the organizational culture, the country it operates in and the
size of the organization. For example, in Germany, employees have a legal right to have a representative
in the supervisory board.
Questions may have Anglo/Dutch companies which leads to investor unrest! You will need to analyze
which one is suitable. You may be asked to give a convincing argument in favour of either unitary or twotier board.
Generic Discussion
Reasons for developing codes
Problems with codes
-it should reduce risk, fraud and corruption
-They restrict and dilute decision making power
-they improve investor confidence
-They cannot stop fraud
-global investors are willing to pay a higher premium for
well governed companies
-They increase red tape and bureaucracy
-good governance is a major decision factor for
institutional shareholders
-good governance tends to lead to good performance
P1 Knowledge Summary
-The implementation of codes is a costly process(more NEDs, new
systems, compliance with regulations etc)
-The process is reactionary rather than proactive, responding to
major failures in governance rather than setting the agenda.
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Should corporate governance provisions vary by country?
Yes
1.
2.
3.
4.
Some countries have more insider structures than outside because of which accountability relationship is
different
Developing countries may not want incur compliance and monitoring costs
Developing countries need not necessarily follow same levels of formal governance as developed
countries
Some governments may have more flexible governance to attract international companies and hence
improve their economic climate ( when SOX was enforced in the USA, some companies delisted from the
NYSE and got themselves listed on the London stock exchange)
No
1.
2.
3.
Regardless of the culture, standardized corporate governance provisions will ensure that minority interest
is protected
Countries with poor reputation in terms of corruption and fraud need a strict standardized governance
structure
Investor confidence is greater in countries where good governance structures are followed.
Approaches to corporate governance/ Regulating corporate governance
Rules based approach
Principles based approach
In a rules-based approach to corporate governance,
provisions are made in law and a breach of any
applicable provision is therefore a legal offence. This
means that companies become legally accountable for
compliance and are liable for prosecution in law for
failing to comply with the detail of a corporate
governance code or other provision.
A principles-based approach works by (usually) a stock market making
compliance with a detailed code a condition of listing.
.
It is the judiciary rather than investors which monitors
and punishes transgression and this means that there is
no theoretical distinction drawn between major or minor
compliance failures. This is sometimes seen, therefore,
to be clumsy or un-nuanced as a means of enforcement.
In a rules-based approach such as Sarbanes-Oxley
(‘Sarbox’ or ‘Sox’), the legal enforceability of the Act
requires total compliance in all details. This places a
substantial compliance cost upon affected companies
and creates a large number of compliance advice
consultancies to help companies ensure compliance
P1 Knowledge Summary
Shareholders are then encouraged to insist on a high level of compliance
in the belief that higher compliance is more robust than lower
compliance. When, for whatever reason, a company is unable to comply
in detail with every provision of a code, the listing rules state that the
company must explain, usually in its annual report, exactly where it fails
to comply and the reason why it is unable to comply. The shareholders,
and not the law, then judge for themselves the seriousness of the
breach.
If the shareholders are not satisfied with the explanation for lack of
compliance, they can punish the board by several means including
holding them directly accountable at general meetings, by selling shares
(thereby reducing the value of the company) or by direct intervention if
a large enough shareholder.
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For rules based
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Clarity in terms of what you must do
Standardization for all companies
Minimizes chances of going against the rule as
non-compliance results in penalties.
If the law is good then it will give shareholders
assurance that a company is being run
effectively
Against rules based
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Rigidity of law-companies will try to look for
loopholes.
Compliance is seen to be an inflexible ‘box
ticking’ exercise and this can sometimes mean
that companies lose perspective of what are the
most important aspects of governance and what
can sometimes be a less important provision to
comply with. Disproportionate amounts of
management time can be used in ensuring
compliance in an area which may be less
important to shareholders, but which is
nevertheless an important ‘box’ to have ticked.
Costs are incurred in ensuring and
demonstrating compliance. It can be
convincingly argued that a substantial
proportion of this cost adds very little value to
shareholders, especially in small companies, and
resources are diverted to demonstrating minor
areas of compliance which could be used more
effectively elsewhere (such as in company
operations). Because compliance on the ‘big’
issues is accorded equal weight in law to
compliance with ‘small’ issues, costs are
disproportionately incurred in demonstrating
compliance in some non-critical areas.
Infringements and transgressions are punished
by the state through its judiciary and not by
those most directly affected by such
transgressions: the shareholders. Those in
favour of principles-based approaches argue
that there is a greater economic efficiency in
having governance monitored by those with the
strongest stake in gains and losses (the
shareholders), rather than the (in comparison)
inefficient and undiscerning agents of the state.
In many cases, agents of the state are unable to
distinguish between major and minor
infringements, merely noticing that a ‘box’ is
‘unticked’ and pursuing punishment as a result.
P1 Knowledge Summary
For principles based
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Flexibility:. A principles-based approach is flexible and allows
companies to develop their own approach, perhaps with regard
to the demands of their own industry or shareholder
preferences. This places the emphasis on investor needs rather
than legal demands. There may be no reason, for example, why
companies in lower risk industries should be constrained by the
same internal control reporting requirements as companies in
higher risk industries. As long as shareholders recognise and are
satisfied with this, the cost advantages can be enjoyed.
It enables the policing of compliance by those who own the
entity and have a stronger vested interest in compliance than
state regulators who monitor compliance in a legal sense. This
places the responsibility for compliance upon the investors who
are collectively the legal owners of the company. It makes the
company accountable directly to shareholders who can decide
for themselves on the materiality of any given non-compliance.
Regulations can be changed more quickly as compared to law
By avoiding laws, businesses may be more willing to contribute
to the ongoing corporate governance debate
By requiring explanations of non-compliance, companies are
required to think carefully about their reasons for not
complying and this may make them decide to follow the code
after all.
It reduces the costs of compliance and recognises that ‘one size’
does not fit all. There may be legitimate reasons for temporary
or semi-permanent non-compliance with the detail of a
corporate governance code, perhaps because of size or the
company adopting its own unique approach for highly specific
and context-dependent reasons.
Against principles based




Some companies may present weak or untrue explanations
justifying their actions.
Without the law to back it up, corporate governance becomes
harder to enforce.
There may be confusion over what is compulsory under law
and what is principles-driven under listing rules. A lack of clarity
might be present, especially where compliance expertise is not
available to management (such as in some smaller companies)
between legally-required compliance and listing rules which are
subject to comply or explain. This may confuse some
management teams and cause non-compliance borne of lack of
advice and information.
A rules-based approach provides standardisation and prevents
any individual companies gaining competitive or cost
advantages with lower levels of compliance. This creates a
‘level playing field’ in which all competitors in an industry
understand what is required.
Page 22
Sarbanes Oxley Act(SOX)
In 2002, following a number of corporate governance scandals such as Enron and WorldCom, tough new corporate
governance regulations were introduced in the US by SOX.
SOX is extremely detailed and carries the full force of the law. It includes requirements for the Securities and
Exchange Commission (SEC) to issue certain rules on corporate governance.
Key points











SOX requires the Chief Executive Officer and Chief Financial Officer to personally attest to the accuracy of
the annual report, quarterly reports, and to the effectiveness of internal control systems. If subsequently
it is discovered that the accounts are not accurate and have to be restated, any bonuses paid to those
directors have to be repaid.
SOX has very detailed requirements on internal control. Companies must have a sound system of internal
control and they must also have suitable documentation in place to provide evidence that the system is
working. The directors must do a full review of the internal control system on an annual basis and report
the results of that review in their annual report.
The auditors have to provide a report to say they have checked the internal control systems over financial
reporting and give their opinion as to whether they are working – this is called an attestation report. The
auditors have to do a full audit of internal controls over the financial reporting system at the company.
SOX makes audit partner rotation the law
SOX has a ban on auditors providing a range of other services to their audit clients.
Under SOX, no loans can be made by a public company to its directors or other senior executives.
In SOX there is greater protection of whistleblowers. A whistleblower is someone who reports bad
practice
to those inside or outside the company so it can be dealt with. This was the case in Enron andWorldCom.
Must have an audit committee
Complete transparency and minority interest protection
Complete disclosure of off-balance sheet transactions.
Negative reaction:
-
Doubling of audit fee costs to organizations.
Onerous documentation and internal control costs.
Reduced flexibility and responsiveness of companies.
Reduced risk taking and competitiveness of organizations.
Limited impact on the ability to stop corporate abuse.
Legislation defines a legal minimum standard and little more.
P1 Knowledge Summary
Page 23
Insider vs outsider systems
OUTSIDER SYSTEM
An outsider system is one where those that own the company are separate from those that run the company.
• Ownership is largely in the hands of non-participating shareholders, e.g. institutions such as pension funds and
investment trusts.
• There is a clear gap between those who run the company and those who own it, hence the agency problem.
• Investors have traditionally played a passive role, leaving directors alone to run the company. Over the last 10
years, institutional investors require more accountability from the board on strategy and how they are running the
company. The more involved these shareholders become, the less of an agency problem there is.
• They have more formal organizational and reporting structures and systems for accountability to external
shareholders.
• generally, larger companies (public companies in particular) are more highly regulated and have more
stakeholders to manage than privately owned, smaller family businesses.
INSIDER SYSTEM
An insider system is one where there are strong links between those that run the company and major
stakeholders.
The major shareholders may also feature on the board, for example bankers or employees may have
representatives on the board.
Family dominated companies often have a similar structure with family members sitting on the board.
(There are a small number of major shareholders who both own and control the company e.g. government, family
members, banks)
Pros





There are usually lower agency costs associated with insider-dominated businesses owing to there being
fewer agency trust issues. Less monitoring is usually necessary because the
owners are often also the managers
Ethics – it could be said that threats to reputation are threats to family honour and this increases the
likely level of ethical behaviour. Principals (majority shareholders) are able to directly impose own values
and principles (business or ethical) directly on the business without the mediating effect of a board.
Fewer short-term decisions – the longevity of the company and the wealth already inherent in such
families suggest long-term growth is a bigger issue.
Decision making may be quicker as there are relatively lesser number of people and they are likely to have
the same mindset
P1 Knowledge Summary
Page 24
Cons
 Minority shareholders and non-included stakeholders may lack protection from the dominant insiders as they
have little representation within the company.
 There is a potential lack of transparency as information is kept inside the company.
 no need to account to public shareholders for either the performance of the company or its postures on such
issues as ethics.
 There are relatively lesser formal governance structure, systems, policies and procedures.
 lack of external expertise in the form of an effective non-executive presence (however, some companies employ
non-executive directors (NEDs) on a voluntary and ‘best practice’ basis)
 ‘Gene pool’ and succession issues are common issues in family businesses. It is common for a business to be
started off by a committed and talented entrepreneur but then to hand it on to progeny who are less equipped
or less willing to develop the business as the founder did.
 ‘Feuds’ and conflict resolution can be major governance issues in an insider-dominated business. Whereas a
larger bureaucratic business is capable of ‘professionalising’ confl ict (including staff departures and
disciplinary actions) this is less likely to be the case in insider-dominated businesses. Family relationships can
suffer and this can intensify stress and ultimately lead to the deterioration of family relationships as well as
business performance.
Important discussion to be read
Compare family businesses with listed companies
A family business, when incorporated as a company, is an example of a private limited company. This means that
the shares are privately held and are not available for members of the investing public to buy and sell. This is in
contrast to a public company, which is listed on a stock exchange and in which members of the public, including
private and institutional shareholders, can purchase or sell shares. Being a public listed or public limited company
carries a number of requirements, imposed either by statute or the stock exchange, which do not apply to private
companies. These requirements include compliance with a number of corporate governance provisions which
include the adoption of certain governance structures, adherence with internal control and internal audit
standards, and the external reporting of some types of information. A private limited company, in contrast, must
comply with company law and tax regulations, but is not subject to listing rules.
There are a number of differences between the governance arrangements for a privately-owned family business
like and a public company.
In general, governance arrangements are much more formal for public companies than for family businesses. This
is because of the need to be accountable to external shareholders who have no direct involvement in the business.
In a family business that is privately owned, shareholders are likely to be members of the extended family and
there is usually less need for formal external accountability because there is less of an agency issue.
Linked to this, it is generally the case that larger companies, and public companies in particular, are more highly
regulated and have many more stakeholders to manage than privately-owned, smaller or family businesses. The
higher public visibility that these businesses have makes them more concerned with maintaining public confidence
in their governance and to seek to reassure their shareholders. They use a number of ways of doing this.
The more formal governance structures that apply to public companies include the requirement to establish a
committee structure and other measures to ensure transparency and a stronger accountability to the shareholders.
Such measures include additional reporting requirements that do not apply to family firms.
P1 Knowledge Summary
Page 25
Contents of an annual report
Several corporate governance codes of practice prescribe the content for a report as part of an annual report.
Although these vary slightly, the following are prominent in all cases.
1.
2.
3.
4.
5.
6.
7.
8.
Financial statements
Independent Auditor’s report
Chairman’s statement / Operating and financial review statement (a narrative statement about the
organiisation’s past performance and future plans)
Statement of compliance with corporate governance
Information on the board and its functioning. Usually seen as the most important corporate governance
disclosure, this concerns the details of all directors including brief biographies and the career information
that makes them suitable for their appointment. Information on how the board operates, such as
frequency of meetings and how performance evaluation is undertaken is also included in this section. This
section is particularly important whenever unexpected or unanticipated changes have taken place on the
board. Investors, valuing transparency in reporting, would always expect a clear explanation of any
sudden departures of senior management or any significant changes in personnel at the top of the
company. Providing investor confidence in the board is always important and this extends to a high level
of disclosure in board roles and changes in those roles.
The committee reports provide the important non-executive input into the report. Specifically, a ‘best
practice’ disclosure includes reports from the non-executive-led remuneration, audit, risk and
nominations committees. In normal circumstances, greatest interest is shown in the remuneration
committee report because this gives the rewards awarded to each director including pension and
bonuses. The report on the effectiveness of internal controls is provided based in part on evidence from
the audit committee and provides important information for investors.
There is a section on accounting and audit issues with specific content on who is responsible for the
accounts and any issues that arose in their preparation. Again, usually a matter of routine reporting, this
section can be of interest if there have been issues of accounting or auditor failure in the recent past. It is
often necessary to signal changes in accounting standards that may cause changes in reporting, or other
changes such as a change in a year-end date or the cause of a restatement of the previous accounts.
These are all necessary to provide maximum transparency for the users of the accounts.
There is usually a section containing other papers and related matters which, whilst appearing to be
trivial, can be a vital part of the accountability of directors to the shareholders. This section typically
contains committee terms of reference,
AGM matters, NED contract issues, etc.
Mandatory and voluntary disclosures
Annual reports contain both mandatory and voluntary components.
Mandatory disclosures are those which are required, either by statute (e.g. company law), reporting standard or
listing rule. The main financial statements, with their related disclosure notes, and the audit report fall into this
category. These are the statement of profit or loss, the statement of financial position (balance sheet), the
statement of changes in equity and the statement of cash flows. Some parts of the directors’ report are also
mandatory in some jurisdictions as are notes on the composition of the board and the remuneration of directors.
Listing rules in some jurisdictions have increased with regard to disclosure requirements. In many countries, for
example, a substantial amount of corporate governance disclosure is required, as is the ‘comply or explain’
statement. The presence of the ‘comply or explain’ statement is often mandatory but the content is used to
convey the extent of non-compliance with the relevant corporate governance code.
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Voluntary disclosures are those not required by any regulatory constraint but are often made nevertheless. Some
of these are made because of tradition and shareholder expectation (such as the chairman’s statement) whilst
others are thought to be concerned with managing the claims of a company’s wider stakeholders. Some
companies include disclosure on objectives so that shareholders can understand the board’s ideas for the future,
possibly including a mission statement or similar. Likewise, social and environmental information is often included,
detailing, for example, the company’s policy and objectives with regard to a range of social and environmental
measures. Some risk disclosures are also voluntarily supplied, for example, when a company is adopting an
integrated reporting approach.
Reasons and motivations behind voluntary disclosure
Can help attract capital and maintain confidence in the company
Can act as a marketing tool and help company in a positive light
They help improve public understanding of the structure, activities, corporate policies and performance
Provide regular, reliable and comparable information for shareholders and potential investors
Decrease chances of unethical behaviour
Stakeholders
Any group or individual who can affect or [be] affected by the achievement of an organisation’s objectives’.
An organisation’s stakeholders are likely to include: Shareholders; Directors/management;
Employees;Customers;Suppliers; The local community;The wider community;The environment.
Why should stakeholders be identified?
-to assess the validity of their claims
-to identify source of risk/disruption
-to identify blockers and facilitators to the organization’s strategies
Stakeholders are important to an organization as they make demands of it – this is known as a stakeholder claim.
Some stakeholders wish to influence the organization and others are concerned with how the organization affects
them.
For Example
- Trade union’s claim/expectations: To be consulted and involved in decisions which affect their members.
- Employees claim: Regular salary, pleasant working conditions, job security, interesting work and career
progression.
Direct stakeholder claims are made by those with their own ‘voice’. These claims are usually unambiguous, and
are often made directly between the stakeholder and the organisation. Stakeholders making direct claims will
typically include trade unions, shareholders, employees, customers, suppliers etc.
Indirect claims are made by those stakeholders unable to make the claim directly because they are, for some
reason, inarticulate or ‘voiceless’. Although this means they are unable to express their claim direct to the
organisation, it is important to realise that this does not invalidate their claim. Typical reasons for this lack of
expression include the stakeholder being (apparently) powerless (eg an individual customer of a very large
organisation), not existing yet (eg future generations), having no voice (eg the natural environment), or being
remote from the organisation (eg producer groups in distant countries). This raises the problem of interpretation.
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The claim of an indirect stakeholder must be interpreted by someone else in order to be expressed, and it is this
interpretation that makes indirect representation problematic. How do you interpret, for example, the needs of
the environment or future generations? What would they say to an organisation that affects them if they could
speak? To what extent, for example, are environmental pressure groups reliable interpreters of the needs (claims)
of the natural environment? To what extent are terrorists reliable interpreters of the claims of the causes and
communities they purport to represent? This lack of clarity on the reliability of spokespersons for these
stakeholders makes it very difficult to operationalise (to include in a decision-making process) their claims
Stakeholder Theory Proposes That There Should Be Corporate Accountability To A Broad Range Of Stakeholders.
The basis for stakeholder theory is that companies are so large and their impact on society so pervasive that they
should discharge accountability to many more sectors of society than solely their shareholders.
Stakeholder Theory versus Agency Theory – Convergence
Stakeholder theory may be the necessary outcome of agency theory given that there is a business case in
considering the needs of stakeholders through improved customer perception, employee motivation, supplier
stability, shareholder conscience investment.
Agency theory is a narrow form of stakeholder theory.
Stakeholder Classification
Internal and external stakehodlers: Perhaps the easiest and most straightforward distinction is between
stakeholders inside the organisation and those outside. Internal stakeholders will typically include employees and
management, whereas external stakeholders will include customers, competitors, suppliers, and so on. Some
stakeholders will be more difficult to categorise, such as trade unions that may have elements of both internal and
external membership.
Narrow and wide stakeholders: Narrow stakeholders are those that are the most affected by the organisation’s
policies and will usually include shareholders, management, employees, suppliers, and customers who are
dependent upon the organisation’s output. Wider stakeholders are those less affected and may typically include
government, less-dependent customers, the wider community (as opposed to the local community) and other
peripheral groups. The Evans and Freeman model may lead some to conclude that an organisation has a higher
degree of responsibility and accountability to its narrower stakeholders.
Primary and secondary stakeholders: According to Clarkson: ‘A primary stakeholder group is one without whose
continuing participation the corporation cannot survive as a going concern’. Hence, whereas Evans and Freeman
view stakeholders as being (or not being) influenced by an organisation, Clarkson sees the important distinction as
being between those that do influence an organisation and those that do not. Secondary stakeholders are those
that the organisation does not directly depend upon for its immediate survival.
Active and passive stakeholders: Mahoney (1994) divided stakeholders into those who are active and those who
are passive. Active stakeholders are those who seek to participate in the organisation’s activities. These
stakeholders may or may not be a part of the organisation’s formal structure. Management and employees
obviously fall into this active category, but so may some parties from outside an organisation, such as regulators
(in
the
case
of,
say,
UK
privatised
utilities)
and
environmental
pressure
groups.
Passive stakeholders, in contrast, are those who do not normally seek to participate in an organisation’s policy
making. This is not to say that passive stakeholders are any less interested or less powerful, but they do not seek to
take an active part in the organisation’s strategy. Passive stakeholders will normally include most shareholders,
government, and local communities.
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Voluntary and involuntary stakeholders: This distinction describes those stakeholders who engage with the
organisation voluntarily and those who become stakeholders involuntarily. Voluntary stakeholders will include, for
example, employees with transferable skills (who could work elsewhere), most customers, suppliers, and
shareholders. Some stakeholders, however, do not choose to be stakeholders but are so nevertheless. Involuntary
stakeholders include those affected by the activities of large organisations, local communities and ‘neighbours’,
the natural environment, future generations, and most competitors.
Legitimate and illegitimate stakeholders: This is one of the more difficult categorisations to make, as a
stakeholder’s legitimacy depends on your viewpoint (one person’s ‘terrorist’, for example, is another’s ‘freedom
fighter’). While those with an active economic relationship with an organisation will almost always be considered
legitimate, others that make claims without such a link, or that have no mandate to make a claim, will be
considered illegitimate by some. This means that there is no possible case for taking their views into account when
making decisions.
While terrorists will usually be considered illegitimate, there is more debate on the legitimacy of the claims of
lobby groups, campaigning organisations, and non-governmental/charitable organisations.
Recognized and Unrecognized (By the Organization) Stakeholders: The categorization by recognition follows on
from the debate over legitimacy. If an organization considers a stakeholder’s claim to be illegitimate, it is likely that
its claim will not be recognized.
This means the stakeholder’s claim will not be taken into account when the organization makes decisions.
Known About and Unknown Stakeholders
Finally, some stakeholders are known about by the organization in question and others are not. This means, of
course, that it is very difficult to recognize whether the claims of unknown stakeholders (e.g. nameless sea
creatures, undiscovered species, communities in close proximity to overseas suppliers, etc) are considered
legitimate or not. Some say that it is a moral duty for organizations to seek out all possible stakeholders before a
decision is taken and this can sometimes result in the adoption of minimum impact policies.
For example, even though the exact identity of a nameless sea creature is not known, it might still be logical to
assume that low emissions can normally be better for such creatures than high emissions
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Managing Stakeholder Relations
UNDERSTANDING THE INFLUENCE OF EACH STAKEHOLDER (MENDELOW)
In strategic analysis, the Mendelow framework is often used to attempt to understand the influence that each
stakeholder has over an organisation’s objectives and/or strategy. The idea is to establish which stakeholders have
the most influence by estimating each stakeholder’s individual power over – and interest in – the organisation’s
affairs. The stakeholders with the highest combination of power and interest are likely to be those with the most
actual influence over objectives. Power is the stakeholder’s ability to influence objectives (how much they can),
while interest is the stakeholder’s willingness (how much they care).
Influence = Power x Interest
There are issues with this approach, however. Although it is a useful basic framework for understanding which
stakeholders are likely to be the most influential, it is very hard to find ways of effectively measuring each
stakeholder’s power and interest. The ‘map’ generated by the analysis of power and interest (on which
stakeholders are plotted accordingly) is not static; changing events can mean that stakeholders can move around
the map with consequent changes to the list of the most influential stakeholders in an organisation.
Level Of Interest
Low
High
Minimum effort
Keep informed
e.g. community reps &
charities
(give them reasons as they
might be able to influence
more important stakeholders!)
Keep satisfied
e.g. institutional shareholders
(they can move to key players
at any time)
Key players
e.g. major customer
(strategy should be acceptable
to them)
Power
Low
High
Power is the ability to bring pressure to bear over the objectives and policies of the project and interest is the
capital which a stakeholder has invested in the organisation or project (or, an assessment of how much they care
or are interested in the development)
Low interest – low power
Those with neither interest nor power (top left) can, according to the framework, be largely ignored, although 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
These stakeholders include small shareholders, the unskilled element of the labour force and the general public.
They have low interest in the organization primarily due to lack of power to change strategy.
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High interest – low power
Stakeholders with high interest (ie they care a lot) but low power can increase their overall influence by forming
coalitions with other stakeholders in order to exert a greater pressure and thereby make themselves more
powerful. By moving downwards on the map, because their power has increased by the formation of a coalition,
their overall influence is increased. The management strategy for dealing with these stakeholders is to ‘keep
informed’.
Low interest – high power
those in the bottom left of the map are those with high power but low interest. 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’.
High interest – high power
These stakeholders have a high interest in the organization and have the ability to affect strategy. Stakeholders
include the directors, major shareholders and trade unions.
Those in the bottom right are the high-interest and high-power stakeholders, and are, by that very fact, the
stakeholders with the highest influence. The question here is how many competing stakeholders reside in that
quadrant of the map. If there is only one (eg management) then there is unlikely to be any conflict in a given
decision-making situation. If there are several and they disagree on the way forward, there are likely to be
difficulties in decision making and ambiguity over strategic direction.
Institutional investors
Institutional investors tend to have large numbers of shares in companies and invest on behalf of individual
investors. They include pension funds, insurance companies, and investment trusts. For many listed companies,
the biggest individual shareholders are institutional investors.
In recent years, institutional shareholders have become much more active for the following reasons:
• Corporate governance regulations has encouraged them to use their votes wisely.
• Many institutional investors have seen that improved governance leads to increased share prices.
• Those whose funds they are investing are putting more pressure on them to act.
When should institutional shareholders intervene?
Specifically, an institutional investor may intervene in the following circumstances:
 the company’s performance is consistently poor;
 the company is engaged in unethical practices or has a poor reputation;
 there is excessive risk taking or perhaps not enough risk taking;
 there is a breakdown of communication between directors and shareholders;
 they have a loss of faith in the management running the company;
 there is consistent fail in the company’s systems or repeated fraud.
 The NEDs are ineffective
 There are inappropriate remuneration policies
 Law and regulations are not being followed
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How institutional shareholders should monitor their client companies
1.
2.
3.
4.
5.
A formal documented process through which client companies are monitored. Monitoring tends to
include a formal review of company accounts, resolution, voting and accompanying disclosure such as
press releases.
The Institutional Investor must provide adequate resources to allow this to happen and must train
analysis and other staff in company procedures.
Following investigation the shareholder must intervene as necessary. Intervention can involve dialogue
through meetings with the Chairman or senior non executive directors.
Extending the active participation in corporate management may include the need to discuss client cases
with other large shareholders or, in extreme cases calling on the company to explain its position through
an extraordinary general meeting.
The process of monitoring is one of continuous review and improvement steadily increasing the
responsibilities of the Institutional Investor in taking an active interest. The extent to which this is actually
done in part depends on the company’s attitude towards ownership of the company.
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Internal Controls and review
At its simplest, an internal control is any action or system put in place by management which will increase the
likelihood that organisational objectives will be met and assets safeguarded. Internal control measures are put in
place to control the internal activities in an organisation so that they achieve the purposes intended. By having
internal activities co-ordinated and configured appropriately, with means of measuring and reporting on
compliance levels, waste (i.e. non value-adding activity) is minimised and efficiencies are gained which increase the
effectiveness of the organisation in meeting its strategic purposes
Internal controls can be at the strategic or operational level. At the strategic level, controls are aimed at ensuring
that the organisation ‘does the right things’; at the operational level, controls are aimed at ensuring that the
organisation ‘does things right’. Those controls that operate at the strategic level are capable of influencing
activities over a longer period.
Objectives of internal control
An internal control system comprises the whole network of systems established in an organisation to provide
reasonable assurance that organisational objectives will be achieved.
Specifically, the general objectives of internal control are as follows:
-
-
-
-
-
To ensure the orderly and efficient conduct of business in respect of systems being in place and fully
implemented. Controls mean that business processes and transactions take place without disruption with
less risk or disturbance and this, in turn, adds value and creates shareholder value.
To safeguard the assets of the business. Assets include tangibles and intangibles, and controls are
necessary to ensure they are optimally utilised and protected from misuse, fraud, misappropriation or
theft.
To prevent and detect fraud. Controls are necessary to show up any operational or financial
disagreements that might be the result of theft or fraud. This might include off-balance sheet financing or
the use of unauthorised accounting policies, inventory controls, use of company property and similar.
To ensure the completeness and accuracy of accounting records. Ensuring that all accounting transactions
are fully and accurately recorded, that assets and liabilities are correctly identified and valued, and that all
costs and revenues can be fully accounted for.
To ensure the timely preparation of financial information which applies to statutory reporting (of year end
accounts, for example) and also management accounts, if appropriate, for the facilitation of effective
management decision-making.
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COSO: Committee of Sponsoring Organisations--- an American voluntary
organisation with the aim of guiding executive management towards
the establishment of more effective, efficient and ethical business
operations. It provided detailed advice on application of controls
The Turnbull Report(1999)-provided guidance on
creating strong internal control systems. This has
now been incorporated into the Combined Code.
The Turnbull guidance is still available as a stand
alone document (last revised in October 2005).
COSO-FIVE Elements of sound internal controls
Turbnbull :Sound system of internal controls
The Turnbull guidance described three features of a
‘sound’ internal control system.
Control environment:
A control environment capable of supporting the internal control
arrangements needs to be established. This includes a suitable ‘tone from
the top’ and a high level commitment to effective controls.
1. Firstly, the principles of internal control
should
be
embedded
within
the
organisation’s structures, procedures and
culture(All employees have responsibility for
internal control and this tone needs to be set
by management,who must be seen to be
abiding by the controls they have put in place.
The control environment is defined as the overall attitude, awareness and
actions of the directors and management regarding internal controls and
their importance in the entity
The internal control procedures put in place are unlikely to be effective
unless there is a strong control environment.
2. Secondly, internal control systems should be
capable of responding quickly to evolving
risks to the business arising from factors
within the company and to changes in the
business environment.
Numerous factors comprise the control environment. Among these are:
o
o
o
o
o
o
Communication and enforcement of integrity and ethical values
– essential elements which influence the effectiveness of the
design, administration and monitoring of controls.
Commitment to competence – management’s consideration of
the competence levels for particular jobs and how those levels
translate into requisite skills and knowledge.
Management’s philosophy and operating style – management’s
approach to taking and managing business risks, and
management’s attitudes and actions towards financial reporting,
information processing and accounting functions and personnel.
Organisational structure – the framework within which an
entity’s activities for achieving its objectives are planned,
executed, controlled and reviewed.
Assignment of authority and responsibility – how authority and
responsibility for operating activities are assigned and how
reporting relationships and authorisation hierarchies are
established.
Human resources policies and practices – recruitment,
orientation, training, evaluating, counselling, promoting,
compensating and remedial actions.
P1 Knowledge Summary
3. Thirdly, sound internal control systems
include procedures for reporting immediately
to appropriate levels of management any
significant control failings or weaknesses that
are identified, together with details of
corrective action being undertaken.
.,
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Risk assessment: The entity’s risk assessment process includes how
management identifies and manages business risks.
Controllable risks – for these risks internal control procedures can be
established.
Uncontrollable risks – for these risks the company may be able to
minimise the risk in other ways outside the internal control environment.
Control activities: The policies and the procedures which help to ensure
that the management directives are followed are known as control
activities.
Examples:
Authorization, Comparison, Computer controls, Arithmetic controls,
Maintain a trial balance and control accounts, Accounting reconciliations,
Physical controls, Segregation of duties
Information and communication:
It is the board’s responsibility to provide information and maintain
relevant communications with those affected by
the control measures, and to ensure that important measures are fully
implemented and understood
It is important to remember that the management needs timely, relevant
and reliable information to assess the performance of the control
systems.
Information systems produce reports, containing operational, financial
and compliance-related information, that make it possible to run and
control the business. They deal not only with internally generated data,
but also information about external events, activities and conditions
necessary to informed business decision-making and external reporting.
Effective communication also must occur in a broader sense, flowing
down, across and up the organization. All personnel must receive a clear
message from top management that control responsibilities must be
taken seriously. They must understand their own role in the internal
control system, as well as how individual activities relate to the work of
others. They must have a means of communicating significant
information upstream. There also needs to be effective communication
with external parties, such as customers, suppliers
Monitoring
All controls should be monitored for the degree of compliance and for
their effectiveness. This should be a continuous, ongoing process, capable
of immediately highlighting any weaknesses or breaches in the
implemented controls.
Internal audit may assist in implementing new systems as a result of
weaknesses.
External audit may highlight weaknesses as part of their audit work.
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Possible causes of internal control failures (also limitations of Internal controls or reasons for ineffective
controls)
1.
2.
3.
4.
5.
6.
7.
Failures in human judgement when assessing a control, or fraud in measuring or reporting a
control. Where a control relies upon human measurement, error is always a possibility either
through lack of training, incompetence, wilful negligence or having a vested interest in control
failure
Human error can cause failures although a well-designed internal control environment can help
control this to a certain extent.
Control processes being deliberately circumvented by employees and others.
Management overriding controls, presumably in the belief that the controls put in place are
inconvenient or inappropriate and should not apply to them.
Non-routine or unforeseen events can render controls ineffective if they are intended to monitor
a specific process only. Most internal controls are unable to cope with extraordinary events and
so need to be adapted or circumvented when such events occur.
Previous or existing controls can become obsolete because they are not updated to meet
changed conditions. A control introduced to monitor a process or risk that has changed, reduced
or been discontinued will no longer be effective. Changes to key risks, for example, need to
modified if they are to continue to remain effective in controlling the risk.
The control can be over or under-specified. An under-specified control is one which is not capable
of actually controlling the risk or activity intended. Conversely, an over-specified control is one
which over-controls and may have the effect of losing the confidence of employees and others
influenced by the control. An over-specified control is one which is poor value for money and
may constrain activity if the control does not adequately allow normal levels of performance.
Controls which do not enjoy the support of those affected are sometimes ignored or bypassed,
thereby rendering them less effective than they might be
Internal Audit
Internal audit is an independent appraisal function established within an organisation to examine and evaluate its
activities as a service to that same organisation. The objective of internal audit is to assist members of the
organisation in the effective discharge of their responsibilities. To this end, internal audit furnishes them with
analyses, appraisals, recommendations, advice and information concerning the activities reviewed. The main
functions of concern to internal audit are reviews of internal controls, risk management, compliance and value for
money.
Internal auditors: can be in-house or outsourced. Should not design or implement controls as this affects their
independence!
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Functions of Internal Audit Department
 Evaluating controls and advising managers at all levels Internal audit’s role in evaluating the
management of risk is wide ranging because everyone from the mailroom to the boardroom is involved in
internal control. The internal auditor’s work includes assessing the tone and risk management culture of
the organisation at one level through to evaluating and reporting on the effectiveness of the
implementation of management policies at another.
 Evaluating risks: It is management’s job to identify the risks facing the organisation and to understand
how they will impact the delivery of objectives if they are not managed effectively. Managers need to
understand how much risk the organisation is willing to live with and implement controls and other
safeguards to ensure these limits are not exceeded. Some organisations will have a higher appetite for
risk arising from changing trends and business/economic conditions. The techniques of internal auditing
have therefore changed from a reactive and control based form to a more proactive and risk based
approach. This enables the internal auditor to anticipate possible future concerns and opportunities
providing assurance, advice and insight where it is most needed.
 Analysing operations and confirm information: Achieving objectives and managing valuable
organisational resources requires systems, processes and people. Internal auditors work closely with line
managers to review operations then report their findings. The internal auditor must be well versed in the
strategic objectives of their organisation and the sector in which it operates in, so that they have a clear
understanding of how the operations of any given part of the organisation fit into the bigger picture
 Promote Ethics –raise red flags when they discover improper conduct.
 Monitor Compliance: assess the organization’s compliance with applicable laws, regulations
 Investigate Fraud: investigate possible fraudulent behavior throughout the organization
 Other Assignments as deemed necessary by the Audit Committee
Factors to consider when determining the need of internal audit








The scale, diversity and complexity of the company’s activities.
The number of employees.
Cost-benefit considerations.
Changes in the organisational structures, reporting processes or underlying information system(as they
affect risk)
Problems with existing internal control systems.
An increased number of unexplained or unacceptable events.
Ability of current management to carry out assignments which would normally be carried out by internal
auditors
Need of special assignments that normally internal audit carries out (IT audits for example)
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Independence of Internal Audit
Typically internal auditors report on the company they work for so they can never be completely independent as
they are reliant on the company for their employment.
As such, their independence is bound to be questionable. For example:
• They may ignore frauds because they trust workplace colleagues, or feel sympathy for them;
• They may decide not report problems for fear of upsetting their ultimate bosses, the directors;
• They may decide not to report problems for fear that the company may get into trouble and they might lose
their jobs;
• As internal staff, they may be pressured or intimidated into keeping quiet;
• If they report to directors and directly criticise them, the report may be ignored.
As a result of the independence issues above, the internal audit function could be outsourced to experts (e.g. a
firm of accountants) although this will bring with it the need for independence in the same manner as with
external audit.
REPORTING STRUCTURE
 The internal audit function should report to theAudit Committee, made up entirely of independent NEDs.
 The head of the internal audit department, the Chief Internal Auditor, should have access to the Chairman
so if anything serious has been discovered, such as a material fraud then it can be quickly reported to the
top of the organisation.
 Where the internal audit team are internal employees:
o They should have no operational duties, nor should they have had in the recent past to avoid the
possibility that the internal auditor may have to review work they have been responsible for (self-review
threat);
o Ideally, they should have no major family or personal ties to operational staff or departments on whom
they report (familiarity threat).
 When internal audit is outsourced, independence can be improved by following similar guidelines as with
external auditors:
o The same outsource firm should not act as internal auditor for a company for too many years in a row.;
o The outsource firm should not be performing too many other services for the company (as a self-review
or self-interest threat may arise);
o Fee levels should be monitored to ensure that the outsource firm is not too dependent on a single
internal audit client.
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AUDIT COMMITTEE-ROLES ( entirely NEDs)- At least one NED with recent relevant financial experience

1.Monitoring the integrity of the financial statements
monitors integrity of financial statements (including
reviewing significant judgments)
and any formal announcements relating to financial
performance;

checks the clarity and completeness of the disclosures
in the financial statements.
2.Reviewing internal financial controls and, unless there is a separate board risk committee, reviewing the
company’s internal control and risk management systems.

3.Monitoring and reviewing the effectiveness of the
internal audit function.
If there are no internal auditors, the committee
should review each year whether there is a need for
such a service; if it concludes there is not, it should
explain why in the annual report.
Should approve the appointment and removal of the
head of internal audit.
Monitors effectiveness of Internal audit department,
review their plan and ensure their recommendations
are actioned
Ensures Internal Auditors are accountable to AC and
preserve their independence

4.Making recommendations to the board in relation
to the appointment, re-appointment and removal of
the external auditor and approve the remuneration
and terms of engagement of the auditor;

5.Reviewing the auditor’s independence and
objectivity;

6.Developing and implementing the non-audit
services policy.
7.Whistleblowing arrangements
P1 Knowledge Summary
he committee has some specific duties in relation to
external auditors. It recommends the appointment of
auditors to the board and approves their fees and the
other terms on which they are retained. If there is
dissatisfaction with their performance, it may
recommend their replacement. In the very unlikely
event that the board disagrees with the committee,
the arguments on both sides need to be put forward
to shareholders in the annual report and AGM
papers.
The committee must keep a close check on the
external auditors’ independence and objectivity. Is it
time for a change, if only to get fresh thinking and a
new perspective on some old issues? Are the auditors
getting too close to management?
Where non-audit services are performed, disclosures
are required in the annual report, and the committee
must explain how auditor objectivity and
independence are to be preserved.
It needs to be confident that there are opportunities
throughout the company for employees to act as
‘whistleblowers’ and report improprieties and abuses.
This may mean giving employees contact details for
committee members for use if other avenues fail.
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Many companies have introduced confidential fraud
hotlines for employees; others use an outside agency
that can take calls and forward the information to the
right person. A fraud response plan will be needed to
guide investigations into any allegations of
wrongdoing.
8.Monitors compliance with laws and regulations.
Benefits of Audit Committees
One of the main roles of the audit committee is to ensure compliance with external reporting obligations, for
example, compliance with the Sarbanes Oxley Act. The monitoring activities of the audit committee help to ensure
that an organization has complied with the statutory obligations, while providing assurance to third parties of that
compliance.
The committee provides a whistle blowing facility for company employees. Potential wrong doing or illegal acts can
be brought to the attention of the committee for further investigation and potential reporting. Advertising this role
in an organization helps to promote the environment of openness and compliance with corporate governance
policies. It may also provide some security for employees wishing to make reports, hopefully removing the fear of
being made unemployed simply because a report was made.
The committee acts as a separate layer of management between the board and the external auditors. In this
sense, the committee helps to remove independence threats between the board and the auditors (e.g. familiarity
threats). However, this does not mean that the audit committee and the auditors will not be affected by those
same threats.
In terms of account preparation and checking, at least one member of the committee should have recent and
relevant financial experience (at least in terms of the UK codes). This means an independent and professional
check can be made on the accounts prior to audit, and similarly a review carried out the auditor’s report prior it
being issued. Again, the reviews help identify errors, check consistency in terms of information disclosure in
different sections of the annual report, ensure sufficient disclosure is made in terms of corporate governance (e.g.
information in any OFR) and enhance the assurance given to the financial statements.
Many audit committee members are also non-executive directors (NEDs), or even executive directors, of other
companies, or have had experience working in other organizations. They will bring this experience to their current
organization, which should enhance their ability to identify problem areas and make appropriate comments on
documentation, etc. Where the audit committee has a risk management function, this will also be enhanced by
employing NEDs with business experience.
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Disadvantages of an Audit Committee
The audit committee can only be effective where it receives full disclosure of all relevant information and is
allowed to act on that information. For example, where the board, the external auditors or the internal auditors
refuse or simply omit to provide the audit committee with relevant reports, then the committee cannot, obviously,
review or act on those reports.
Similarly, as recommendations of the audit committee may not be statutory in nature, and then the full board
could ignore these, thus limiting the committee's effectiveness.
Effectiveness will also be limited by the amount of power vested in the committee and the amount of access
provided to key decision makers. There may be situations where the committee requires additional information to
understand reports (e.g. head of internal audit); denial of access will again limit the effectiveness of the
committee.
As noted above, the committee is not necessarily free of threats to independence from external auditors, although
frequent rotation of members will help to alleviate those threats. The fact that audit committee members must be
rotated on a regular basis (the normal maximum period of office being nine years – at least in the UK) may actually
work against effective running of the committee. Where members resign or are rotated after three years, it can be
argued that there is insufficient time to fully understand the company or its accounts, or to have sufficient
seniority to actively influence the main board in its decision-making role.
Audit committee overseeing internal audit
There are several reasons why internal audit is overseen by, and has a strong relationship with, the audit
committee.
The first reason is to ensure that internal audit’s remit matches the compliance needs of the company. The internal
audit function’s terms of reference are likely to be determined by strategic level objectives and the risks associated
with them. The audit committee, being at the strategic level of the company, will frame these for implementation
by the internal audit function.
Second, the audit committee will be able to ensure that the work of the internal audit function supports the
achievement of the strategic objectives of the company. Whilst this applies to all functions of a business, the
supervisory role that the audit committee has over the internal audit function means that this responsibility rests
with the audit committee in the first instance.
Third, oversight by the audit committee provides the necessary authority for the internal audit function to operate
effectively. This means that no-one in the company can refuse to co-operate with the internal audit function and
that members of that function, whilst not being necessarily senior members of staff themselves, carry the
delegated authority of the audit committee in undertaking their important work.
Fourth, by reporting to the audit committee, internal auditors are structurally independent from those being
audited. Because they and their work is sanctioned and authorized by the audit committee, the IA function should
have no material links with other departments of similar hierarchical level which might compromise independence.
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Characteristics of effective, useful information
Relevant: The information obtained and used should be relevant for specific decision-making rather than
producing too much information simply because the information systems can ‘do it’.
Reliable: free from errors, trustworthy (Information should come from authoritative sources to ensure its
reliability. It is good practice to quote the source used – whether it be internal or external sources. If estimates or
assumptions have been applied, these should be clearly stated and explained )
Timely: Information needs to be timely for decision making if it is to be useful.
Understandable: clear, no unexplained jargon. Often, the decision makers do not have time to trawl through
masses of information, so it should be clearly presented, not too long and communicated using an appropriate
medium.
Cost beneficial: the cost of generating the information should be less than the benefits to be gained from that
information (for example a simple report may be as useful as a long complicated one!)
Reporting on Internal Controls to Shareholders
Shareholders, as owners of the company, are entitled to know whether the internal control system is sufficient to
safeguard their investment. To provide shareholders with the assurance they require, the board should, at least
annually, conduct a review of the effectiveness of the group’s system of internal controls and report to
shareholders that they have done so.
The review should cover all material controls, including financial, operational and compliance controls and risk
management systems.
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.
External reports on the effectiveness of internal controls are intended to convey the robustness of a company’s
internal controls to an external audience (usually the shareholders). As with other reports, however, the company
must make preparations and institute systems to gather the information to report on. This in itself is capable of
controlling behaviour and constraining the professional and ethical behaviour of management.
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Contents of the Report to Shareholders on Internal Controls
1.
Firstly, the report should contain a statement of acknowledgement by the board that it is responsible for the
company’s system of internal control and for reviewing its effectiveness. This might seem obvious but it has
been shown to be an important starting point in recognising responsibility. The ‘tone from the top’ is very
important in the development of my proposed reporting changes and so this is a very necessary component of
the report.
2.
Secondly, the report should summarise the processes the board (or where applicable, through its committees)
has applied in reviewing the effectiveness of the system of internal control. These may or may not satisfy
shareholders, of course, and weak systems and processes would be a matter of discussion at AGMs for nonexecutives to strengthen.
3.
Thirdly, the report should provide meaningful, high level information that does not give a misleading
impression. Clearly, internal auditing would greatly increase the reliability of this information but a robust and
effective audit committee would also be very helpful.
4.
Finally, the report should contain information about any weaknesses in internal control that have resulted in
error or material losses.
Reporting under SOX
In the UK, the Combined Code provides guidance on internal control, but SOX is law and therefore must be
complied with or penalties will be incurred.
Under UK guidance on internal controls directors are expected to:
 Maintain a sound internal control system (Combined Code);
 Regularly monitor the internal control system;
 Ensure there is a full annual review of the system;
 Report this process in the annual report.
The external auditors do not report on the work the directors have done on the internal control system, but they
will review the system themselves when planning their audit work and establishing the amount of testing that is
required on the system. Any weaknesses in the system will be reported to the board. There is no report to the
shareholders on internal control from the external auditors; this is the responsibility of the directors and the audit
committee.
Under the SOX, directors are expected to ensure that there is a reliable internal control system, but as this is a law
it must be documented and recorded to prove it exists. On an annual basis it must be reviewed and assessed
against performance criteria to ensure it is working. Any problems discovered as part of this review must be dealt
with. The appraisal of the system must be documented and the process is reported to the shareholders along with
the key results from the process. The company’s external auditors must then report to shareholders on whether
the directors have carried out the annual review of the system properly.
This is a lot of additional work for both directors and auditors. The external auditors have two audits to run -one
on the financial statements and one on the internal control system. It is not surprising that audit costs have risen
since the introduction of SOX.
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As a result of this, directors will want to put a lot more effort into their internal control systems as they are
breaking the law if they are not in place and working properly. There has been a huge focus on complying with the
law but there may not be a cost benefit of having excellent internal control when very good controls would have
sufficed.
Advantages of an external report on internal controls
With any report required by regulation, the board must take control of the process and acknowledge its
responsibility for the company’s system of, in this case, internal controls. This means that it would be unable to
knowingly circumvent or undermine the internal controls
Any reporting (including one on internal controls) creates greater accountability because stakeholders can hold to
account those making those statements. Any stakeholder can then point to what was said in the report and hold
the board to account for its performance against any given statement.
A report on the effectiveness of internal controls (such as Sarbanes Oxley s.404) typically requires the inclusion of
a statement on the processes used by the directors to assess the effectiveness of internal controls. This includes
the disclosure of any material internal control weaknesses or any significant problems which the company
encountered in its internal controls over the period under review. The value of the report as a means of reassuring
investors is to use this statement to demonstrate the robustness of the processes. An unconvincing disclosure on
this would potentially undermine investor confidence.
Because the report is subject to an auditor’s review (or full audit in some jurisdictions), the auditors can demand
evidence of any statement on the report and follow any claim made back along the relevant audit trail. It is a
serious and often easily detectable offence to deceive an auditor or to make a knowingly false statement in an
audited or auditor-reviewed report. Such a deceit (of the auditors) would result in an immediate loss of confidence
in management on the part of the auditors and, in consequence, also on the part of shareholders and regulators.
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Management information systems
level
Strategic
-
Tactical
-
Operational
/Functional
-
description
Senior management
Fewest members
strategic management of the
organisation including setting its
mission and long term objectives
and making fundamental decisions
middle management
develops the strategies outlined by
strategic management and find
ways to realize them.
supervisors and junior
management
largest group
management day to day
operations and implement tactical
plans
-
Info needs
from internal and external sources
less frequent
less precise
Examples of information
include: the need for and availability of finance, details about
competitors, analysis of the profitability of the business
and information on external threats and opportunities facing the
organisation.
-
Internal sources mainly
More frequent
Slightly more detailed and precise
Examples of information required at a tactical level include:working
capital requirements, cash flow and profit forecasts and information
about business productivity.
Operational information is used to make sure that specific operational
tasks are carried out as planned. Examples
include: results of quality control checks and information about labour
hours used to perform a certain task, process or job.
-
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IDENTIFYING, CONTROLLING & ASSESSING RISK
Risk is the ‘chance of exposure to the adverse consequences of uncertain future events’. If and when those risks
actually occur, they can have an adverse impact on the organization’s objectives.
Risk awareness: Risk awareness describes the ability of an investor to recognise and measure the risk associated
with it
Risks vary by sector
Risks do not apply equally to all companies. This is because risks are associated with particular activities, and
companies in different industrial sectors are exposed to different risks because of what they do. So, for example,
banks are more exposed to a range of financial risks whilst manufacturing and mining are usually more concerned
with health and safety risks.
This is because of the different environments, and the business models, strategies and financial structures adopted
by companies in different industries.
Sectors exist in different environments. This means that the external factors which affect businesses and give rise
to risks are different. Some industries, for example, are mainly located within a certain geographical area whilst
others are international, thereby giving rise to such risks as exchange rate risk, etc. Some exist in relatively simple
and stable environments whilst others are in more turbulent and changeable environments. Thus, in more
unstable and complex environments, perhaps with greater levels of regulation, changing consumer patterns and
higher technology, companies will be subject to greater risks than those in more stable and simple environments.
Companies in different sectors adopt different business models. This means that the ways in which value is added
will differ substantially among companies in different sectors. In a service industry, for example, value is added by
the provision of intangible products, often with the direct intervention of a person. In a manufacturing company,
there will be risks associated with inventory management which a service industry will not be exposed to.
Conversely, a company in a service industry such as insurance or banking is more likely to be exposed to certain
technical skill shortages and fraud risks.
Different sectors have different financial structures, strategies and cost bases. Some companies, by virtue of their
main activity, rely heavily on short or long-term loan capital whereas others have lower structural gearing. Others
have even more complex financial structures. These financial structures give rise to different costs of capital and
differential vulnerabilities to such external factors as monetary pressure. So whereas a traditional manufacturing
company might have very little debt, a civil engineering business undertaking individual large projects might take
on large amounts of medium-term debt to finance the project. This means that risks are greater in such a business
because of the financial gearing which is lower in the traditional company funded mainly by shareholders’ equity
or retained surpluses. Banks rely on a range of funding sources and become vulnerable to losses when these
become difficult or the price of gaining these funds rises for any reason. Some companies have different cost
structures which make them more risky in different economic circumstances. Companies with high operational
gearing, such as those having very high fixed costs compared to variable costs, have more volatile returns simply
because of the structure of their cost base.
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IMPORTANCE OF RISK MANAGEMENT
Risk, in a business sense, is uncertainty. If uncertainty is not properly managed, then forward planning will be
almost impossible, and there is a greater risk of business catastrophe. Directors who fail to manage risk are failing
in their duty to shareholders.
Risk is not always negative. By taking on risk, organizations may increase their returns. If an organization chooses
to take no risk at all, it is unlikely that business will grow.
The amount of risk that an organization needs to take, or wants to take,will depend on a number of factors that
will be looked at in this summary!
RISK STRATEGY
A company’s risk strategy will be tied into its corporate strategy - what the company is trying to achieve as an
organization. For example, if an organization is seeking rapid growth, it is likely that it will have to take more risks
than an organization that is seeking to maintain its position in the market.
RISK APPETITE
An organization’s risk appetite is the amount of risk an organization is willing to accept.
The risk appetite will vary amongst organizations. Often small businesses in startup situations will be willing to
take on high levels of risk to achieve growth. Large, well established companies with a position to protect may be
less willing to take on very risky projects as they do not want to erode their position.
Risk-averse entities will tend to be cautious about accepting risk, preferring to avoid risk, to share it or to reduce it.
In exchange, they are willing to accept a lower level of return. Those with an appetite for risk will tend to accept
and seek out risk, recognising risk to be associated with higher net returns.
Risk appetite has an important influence on the risk controls that the organization is likely to have in place.
Organizations that actively seek to avoid risks, perhaps found more in the public sector, charitable sector and in
some ‘process’-oriented companies, do not need the elaborate and costly systems that a risk seeking company
might have. Organizations such as those trading in financial derivatives, volatile share funds and venture capital
companies will typically have complex systems in place to monitor and manage risk. In such companies, the
management of risk is likely to be a strategic core competence of the business.
Therefore, Risk appetite can be explained as the nature and strength of risks which an organisation is prepared to
accept or seek. It comprises two key elements:
(i) the level of risk which the company’s directors consider desirable; and
(ii) the capacity of the company to actually bear the level of risk.
RISK ATTITUDE : Risk strategy is affected by the directors’ attitudes to risk. Some directors will be willing to take on
more risks than others. This can be down to their own personalities, but directors may take risks if they believe that
the shareholders want them to and vice versa. Shareholders may invest in companies or select directors who are
willing to take the amount of risk they wish for.
RISK CAPACITY: Risk capacity is about having the resources available to deal with risks. A company cannot always
take high risks if they do not have the resources to deal with those risks.
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EMBEDDING RISK
Risk awareness: is the knowledge of the nature, likelihood and potential costs of risks facing an organization.
Senior management will have an awareness of risks, but this awareness needs to be embedded throughout the
organization at all levels in order to manage risk effectively.
-
Awareness and acceptance of risk management is needed at all levels
Risk management is not a stand-alone activity- it is normal behavior
The methods by which risk awareness and management can be embedded in organizations are as follows:
1. Establish a visible policy on risk awareness, and have this unreservedly supported by management, trade
unions and staff. This should encourage everybody to identify risks, including those arising from the behaviour
of management, and bring them to the attention of appropriate people without fearing a negative or hostile
response. A philosophy and culture of risk awareness would be developed so that everybody recognises the
importance of all risks and seeks to address them as far as possible.
2.
Linked to this is the encouragement of open communication and a supportive culture. No-one should think
themselves too junior or uninformed to raise a risk issue with management. It is often at the operational levels
where risks can have the most unfortunate effects and so many previously unnoticed risks can arise from
there. Similarly, management should welcome all discussion of risk as a normal part of their responsibilities
and should never dismiss an idea, even if it is something of which management is already aware.
3.
It is always good practice to establish formal systems such as a risk committee and a risk auditing procedure.
The establishment of a risk audit forces the company to identify all risks affecting the business, both internal
and external. Once listed on a risk register, each of these can then be assessed according to their perceived
probability of being realised and their likely impact. A risk strategy can then be assigned to each risk and any
changes to the risk environment can be ‘fed’ into the system to ensure that it remains current. This also
provides a reporting mechanism by which individual managers, including the most senior, can be held
accountable for their behaviour in respect of risks.
4.
Such risk management systems work when they are embedded into human resource systems such as job
descriptions and appraisals. If the reporting and management of key risks are treated as a standing item in job
descriptions and then considered annually as part of staff appraisals, it will soon become normalised into
employees’ work roles, and will be considered nothing out of the ordinary.
5.
Another way to embed risk awareness in general is to publicise success stories in the company and to reward
risk awareness behaviour through whatever mechanisms are appropriate. It would be welcomed if the
discovery of a new risk or a change in its assessment was something which employees thought to be an
exciting thing and something which might attract an additional day’s holiday, a one-off cash payment or a
weekend break away somewhere
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RISK MANAGEMENT
1.
2.
3.
4.
5.
Identify risk
Assess/analyse risk
Manage/strategy
Report
Monitor
Identify risks
How to identify risk?
1. The use of models such as:
- SWOT analysis (strengths,weaknesses, opportunities and threats);
- PESTLE analysis (political, economic, social, technological, legal and environmental).
2. Brainstorming sessions from the board of directors and senior management.
3. The use of risk questionnaires for staff throughout the organisation who are closer to operations than the
directors.
4. The use of external risk consultants who have industry experience but can bring a fresh perspective.
Types of risk
Strategic Risk
It is the current and prospective impact on earnings or capital arising from adverse business decisions, improper
implementation of decisions, or lack of responsiveness to industry changes
These arise from the overall strategic positioning of the company in its environment. Some strategic positions give
rise to greater risk exposures than others. Because strategic issues typically affect the whole of an organization and
not just one or more of its parts, strategic risks can potentially involve very high stakes – they can have very high
hazards and high returns. Because of this, they are managed at board level in an organization and form a key part of
strategic management.
The factors contributing to the strategic risks are:
-types of industry / markets within which the business operates
-competitors’ strategy and new products coming into the market
-political state of the economy in which the company operates
-capacity of the company to operate in a highly dynamic environment
-fluctuating prices of the inputs upon which the business is dependent
-the company readiness to adapt to changing technologies
Operational Risk
Operational risks refer to potential losses arising from the normal business operations which are more likely to
affect a part of the business rather than the whole organisation. Accordingly, they affect the day-to-day running of
operations and business systems in contrast to strategic risks that arise from the organization’s strategic
positioning.
Operational risks are managed at risk management level (not necessarily board level) and can be managed and
mitigated by internal control systems
Directors and senior management need to ensure they do not ignore operational issues because they are focusing
on higher level strategy.
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Distinguishing features between strategic and operational risk
Strategic risks take time to affect the business whereas operational risks have an immediate impact.
Therefore events that lead to operational risks usually require immediate action .
Strategic events, generally provide management with time to assess the new position, choose an appropriate
strategy and implement it(although sometimes may also require an immediate response)
Although operational risks may have a combined impact on strategic risk they are usually related to day-to-day
operations such as buying, supplier logistics, manufacture, delivery of products and services, marketing and selling
and after-sales service.
Business risks ( financial, operational and compliance)
These are risks which can threaten the survival of the business as a whole and they can arise from many sources.
Essentially though, they arise because of the business model which an organisation operates and the strategies it
pursues. Some business activities, by their nature, give rise to certain risks which can threaten the business as a
whole. Some business risks can affect the ‘going concern’ status and threaten the survival of the business. This is
when the continuation of a business in its present form is uncertain because of external threats to the business at a
strategic level, or a failure of the business’s strategy.
Financial risks
These are the risks which arise from the way a business is financially structured, its management of working capital
and its management of short and long-term debt financing. Cash flow can be strongly influenced by how much debt
to equity a business has, its need to service that debt and the rate at which it is borrowed. Likewise, the ability of a
business to operate on a day-to-day basis depends upon how it manages its working capital and its ability to control
payables, receivables, cash and inventories. Any change which makes its cash flow situation worse, such as poor
collection of receivables, excessive borrowing, increased borrowing rates, etc, could represent an increased
financial risk for the business.
Credit Risk : This is the risk that customers fail to pay their bills on time, or do not pay at all. This can be minimized
by not offering credit, doing credit checks on customers before giving credit, and debt factoring.
Market Risk: Market risks are those arising from any of the markets that a company operates in. Most common
examples are those risks from resource markets (inputs), product markets (outputs) or capital markets (finance).
Financial Market Risk: Financial market risk is 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’.+
Liquidity Risk: Liquidity risk refers to the difficulties that can arise from an inability of the company to meet its
short-term financing needs, i.e. its ratio of short-term assets to short term liabilities. Specifically, this refers to the
organisation’s working capital and meeting short-term cash flow needs. The essential elements of managing
liquidity risk are, therefore, the controls over receivables, payables, cash and inventories.
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Exchange rate risk: Most international transactions involve a currency exchange (unless the countries are in a single
currency trading block).Because currencies rise and fall against each other as a result of supply and demand for
those currencies, an adverse movement of one against the other can mean that the cost of a transaction in one
currency becomes more expensive because of that adverse movement. The loss incurred by that adverse
movement multiplied by the company’s financial exposure is the impact of exchange rate risk.
Interest Rate Risk:This is similar to currency risk. As interest rates change, the ability to borrow cheaply and the
returns received on investments will change.
Derivative Risk :Derivative risk arises from the use of derivative financial instruments such as options, futures and
forward contracts in order to manage the business.
Legal and Compliance Risk :This is the risk of breaching laws and regulations and being fined (or even closed down)
as a result. The cost is not necessarily just financial, the time taken in dealing with an investigation can be
distracting to the board. Compliance with legal regulations also creates reputation risk.
Political Risk: Political risk refers to a potential failure on the part of the state to fulfil all or part of its functions. It
can also relate to any potential influence a government has on the business environment in the country concerned.
The state’s role is to legislate, to formulate and implement public policy, to enforce justice through regulation and
statutes, and to administer the functions of the state (such as education, local services, health, etc). A change in
government or sudden imposition of new laws could make it difficult for companies to operate.
Technology Risk: The risk of technological failure. Failures could be caused by weather, water damage, overheating
or a badly designed system that fails, or is corrupted. Additionally, a lack of computer controls could lead to a virus
or staff with a grudge deliberately placing false transactions on the system. Another aspect of technological risk is
that competitors could have better technology and the company falls behind. People often associate technology
with computers but it need not be so – it could also be engineering, designs, etc.
Health and Safety Risk: These are risks to individuals, employees or others, arising from any failure in our
operations giving rise to compromised human welfare.
Environmental Risk : An environmental risk is an unrealised loss or liability arising from the effects on an
organisation from the natural environment or the actions of that organisation upon the natural environment. Risk
can thus arise from natural phenomena affecting the business such as the effects of climate change, adverse
weather, resource depletion, and threats to water or energy supplies. Similarly, liabilities can result from emissions,
pollution, waste or product liability.
Fraud Risk: This is the risk of fraud by employees, customers, suppliers or other parties.
Intellectual Property Risk: Intellectual property is the knowledge, skills and experience that a company’s staff have
built up. If those staff leave the company, they may take company secrets, designs and strategies on to their new
employer.
Reputation Risk :A bad reputation can wreck a business (for example, Andersens after Enron) although sometimes
a bad reputation can actually improve profits (any song banned by the radio stations).
Business Probity Risk: This is the risk that a company is seen to be doing the wrong thing. For example company
paying bonuses to directors when the business is not performing well or company using child labour.
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Entrepreneurial risk: Entrepreneurial risk is the necessary risk associated with any new business venture or
opportunity.It is expressed in terms of the unknowns of the market/customer reception of a new venture or of
product uncertainties, for example product design, construction, etc. There is also entrepreneurial risk in
uncertainties concerning the competences and skills of the entrepreneurs themselves.
Trading risk
International trade presents its own special risks due to the increased distances and times involved. The types
of trading risk include:
1. Physical risk of goods being lost, stolen or damaged in transit, or the legal documents accompanying the
goods going missing;
2. The customer refusing to accept the goods on their delivery; and
3. Cancellation of an order whilst in transit.
Analyze risks
Once risks are identified the next steps are to measure and manage those risks.
There are two main variables that make a risk important – its impact and its likelihood. The impact relates to the
effect it will have on the organization and the likelihood is the chance that the outcome will occur.
These can be mapped in diagrammatic form as follows:
Tools and techniques for analyzing risks
A number of tools can be used to quantify the impact of risks on the organization, some of which are described
below.
Scenario planning: in which different possible views of the future are developed, usually through a process of
discussion within the organization.
Sensitivity analysis: in which the values of different factors which could affect an outcome are changed to assess
how sensitive the outcome is to changes in those variables.
Decision trees: often used in the management of projects to demonstrate the uncertainties at each stage and
evaluate the expected value for the project based on the likelihood and cash flow of each possible outcome.
Software packages: designed to assist in the risk identification and analysis processes.
Risk perceptions: objective and subjective risk perceptions.
Risk perception is the belief about the chance of a risk occurring and/or about the extent, magnitude, and timing of
its effects.
Some risks can be assessed (which involves establishing the likelihood and impact) with a very high degree of
certainty.
If likelihood and/or impact can be measured with scientific accuracy then we can say that the risk can be objectively
assessed.
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In many cases, however risk problems can be ‘messy’ and it can be difficult to accurately assign a value to a
likelihood or an impact. This is where subjective judgements can be used although there are obvious limitations
with such judgments.
Why should risk assessment be on-going?
The first reason why there needs to be a continuous and ongoing risk assessment is because of the strategic
importance of many risks and because of the dynamic nature of those risks being assessed. Some risks reduce over
time and others increase, depending upon changes in the business environment that organizations exist in.
Accordingly, it should not be seen as a ‘once and for all’ activity. If there is a risk that companies who borrow money
become less able to repay their loans than previously, this is a negative change in the business environment
(thereby affecting liquidity risk). When business recovers and bank customers’ ability to repay large loans improves,
the liquidity risk for the banks is reduced.
Second, it is necessary to always have accurately assessed risks because of the need to adjust risk management
strategies accordingly. The probabilities of risk occurring and the impacts involved can change over time as
environmental changes take effect. In choosing, for example, between accepting or reducing a risk, how that risk is
managed will be very important. In reducing their lending, the banks have apparently decided to reduce their
exposure to liquidity risk. This strategy could change to an ‘accept’ strategy when the economy recovers.
Manage risks
A useful mnemonic to remember this process is TARA,which is:
Transfer risk
Avoid risk
Reduce risk
Accept risk
TRANSFERRING RISK
This would involve the company accepting a portion of the risk and seeking to transfer a part to a third party.
- Insurance
- Joint venture to spread risk
- Franchising
- Outsourcing production can transfer risk as if there are problems with the quality of a product, the
company can refer back to the supplier with any problems.
AVOIDING RISK
Not engage in the activity or area in which the risk is incurred. Some risks can be totally avoided. If a business has
identified that opening a subsidiary in a foreign country appears to be high risk, then not opening the subsidiary
solves the problem.
However, to totally avoid a business opportunity is often a rather extreme reaction as the company avoids the risk
and the potential returns. If no risks are taken, the chance of returns being earned is small.
REDUCING RISK
A risk reduction strategy involves seeking to retain a component of the risk (in order to enjoy the return assumed to
be associated with that risk) but to reduce it and thereby limit its ability to create liability.
- Primarily through Internal controls
- Lesser of the activity which causes risk
If it is decided that the risk cannot be transferred nor avoided, it might be asked whether or not something can be
done to reduce or mitigate the risk. This might mean, for example, reducing the expected return in order to
diversify the risk or re-engineer a process to bring about the reduction.
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ACCEPTING RISK
A risk acceptance strategy involves taking limited or no action to reduce the exposure to risk and would be taken if
the returns expected from bearing the risk were expected to be greater than the potential liabilities.
Some businesses will accept risks as they want to receive potential returns. However others will be accepted
because there is nothing that can be done about them. In this case the organization must know the potential costs
and the probability of the risk occurring.
For example, if a profitable product has a high return rate, costing the company warranty and refund costs, they
may decide that it is worth putting up with these costs as they want to earn the profits from the product.
Risk diversification.
Diversification of risk means adjusting the balance of activities so that the company is less exposed to the risky
activities and has a wider range of activities over which to spread risk and return.
Risks can be diversified by discontinuing risky activities or reducing exposure by, for example, disposing of assets or
selling shares associated with the risk exposure.
Risk is the uncertainty caused by variable returns. One way to deal with uncertainty in the business is to diversify.
This spreads a company’s risk in many areas. By operating in many different sectors, it is likely that when one sector
is performing badly, another will be doing well, leading to a smoothing of profits.
A common example of diversification is a business that sells umbrellas and ice creams. If the weather is bad,
umbrellas will sell well and if it is good ice creams will sell well.
Methods of diversifying risks are as follows:
Diversifying risks through financial management techniques such as hedging
Investing in different businesses and geographical locations so that the loss incurred at one location
/business can be offset by the profit made in another
Sharing the risk by entering into partnerships and joint ventures so that risk is spread over other parties
When is diversification appropriate?
1. Companies may diversify in various businesses that complement each other. These businesses are generally
different lines of investment in the same profession. By investing in similar businesses, companies guard against the
risk of loss from one area by the gain that will incur in another.
Companies might also diversify their business in the same line of business but in different geographical locations.
This may mitigate any risk since low results in one location might be offset by better results in another. Locationspecific marketing strategies may result in variable sales results.
2. Diversification, however, does not work in situations where two business lines are positively related. In this case,
an adverse change in one of the businesses will lead to an adverse change in the other.
3. Diversification involves a risk when it comes to diversifying into areas that are not related at all. In these
situations adverse changes in one business may coincide with either adverse or favourable changes in the other.
The outcomes are very unpredictable in each business since the products are totally unrelated. This only leads to
partial diversification of risks since risks are only reduced to a certain extent. However if each business faces
adverse change then losses increase.
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The ALARP (as low as reasonably practical) principle in risk assessment
Risks and their acceptability
It is normally perceived that there is an inverse relationship between risks and their acceptability i.e. lower risk is
more acceptable as compared to a higher risk. This is demonstrated in diagram.
It would be irrational simply to say that higher risks should never be taken because higher return is often associated
with higher risk: risk and return are usually positively associated. It is also the case that many risks are unavoidable
in a given situation and must be accepted, at least in part.
ALARP relates to the level of risks which are unavoidable and so should be controlled. An example of the ALARP
principle is in incurring health and safety risk
Employees are often exposed to personal injury in work place on account of oil spillage, gas leaks, loss of limbs due
to operating unsafe machinery, etc. These are some health and safety risks (caused due to occupational hazards)
which are inherent risks faced by many entities. As the returns associated with the exposure of health and safety
risk are high, the risks cannot be totally avoided. That is why ALARP is a commonly used risk assessment technique
to mitigate health and safety risks.
ALARP technique involves incurring certain risk mitigating costs like installation of anti-pollution equipment at the
work place, compliance costs like providing safety equipment like shoes, helmets to employees, etc. In short the
investment in health and safety risk mitigation is a trade-off between the costs incurred and assessment of the
likelihood and impact of the risk assessed.
Therefore the risk must be ‘as low as reasonably practicable’ (ALARP). Here there must be a reasonable proportion
between the quantum of risk and the costs incurred for mitigating the risk. On the other hand if there is a
significant disproportion between the two variables the cost incurred cannot be considered as “ALARP”.
Reporting
risks
Summary:
Reporting of risks
a) A summary of the measures that the board has taken to address risks such as environmental risk and corporate
social responsibility should be reported in the annual accounts.
b) Risks that result in a material error in the financial statements are reported by the auditor in the audit report.
c) The audit committee usually reports on the risks internally to management.
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Details:
Process of externally reporting on internal controls and risks
The Turnbull Guidance
1. Narrative statement: How annual review of effectiveness of internal controls has been conducted
2.
The board should disclose that there is an ongoing process for identifying, evaluating and managing the
significant risks faced by the company and that this process was in place for the entire year.
3.
The board should take full responsibility for the maintenance and review of the internal control systems
and state that these have been installed to manage the risks
4.
The steps taken to mitigate the significant failings reported in the annual report and accounts should be
reported
In the US, the Sarbanes-Oxley Act requires the company directors as well as the auditors of all the companies listed
on an exchange to report on the risk management techniques in place in the company.
Monitor risks
( BOD’s
responsibility)
The risk committee monitors risks.
It has the right to appoint independent external parties to identify and assess the various risks that the business
faces. Risk committees may involve a person external to the company in the planning stage as a risk auditor who
will analyse the existing risk management processes and suggest better methods of dealing with the existing and
future risks.
RISK AUDITING
A risk audit will provide an organization with an independent, external view of the risks facing the organization and
the controls in place to mitigate those risks.
The auditor will review the identification and assessment of risks that the board undertook as part of the risk
management process and will review the controls in place over the identified risks.
There are four stages to a risk audit
Risk audit
a) Risk identification
b) Risk assessment
c) Review of controls over risk
d) Report
1.
The first stage in a risk audit is risk identification. It is especially important that all relevant risks are identified
because it is only when risks are identified that subsequent stages of the audit can be conducted. The
maintenance of a risk register is one way in which companies achieve this, with new risks being added and
obsolete ones being deleted if they no longer apply
2.
Once identified, each risk must then be assessed. This requires estimating the probability of each risk
materialising and the impact of such a risk realisation. For some risks, these might be relatively straightforward
to calculate but for others, more subjective estimates must be made
3.
The review of controls is the third stage of the audit. Once a risk has been identified and assessed, this stage
considers the effectiveness with which it is controlled or mitigated. Those risks with higher probabilities or
higher impacts may, for example, require more effective mitigation strategies than those assessed as less so. If
a control is found to be inadequate, this stage of the risk audit will highlight the need for strengthening the
control. If a control is currently more than is necessary (perhaps costing a disproportionate amount given the
probability or the impact), it can be reduced.
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4.
The final stage is to issue a report to management for future planning and decision-making. This report will
highlight the key risks, those requiring the most immediate and urgent attention, and a comment on the quality
of existing assessment procedures. Any assessment shortcomings or resource constraints will be clarified and
barriers to subsequent risk audits highlighted
Internal risk audit and external risk audit
Internal risk audit is one undertaken by employees of the company being audited and is usually carried out by the
internal audit function. It involves an identification of the risks within given frames of reference (the whole
company, a given area of activity, a given department or location) and advice on managing those risks in terms of a
risk assessment
Externally, consultants provide this service to clients. In some cases, this is a non-audit service offered by
accounting practices and other consultancies specialise more specifically on risk including the provision of risk audit
services.
External risk auditing is an independent review and assessment of the risks, controls and safeguards in an
organization by someone from outside the company.
Why is external risk auditing preferable?
– ‘Fresh pair of eyes’
– Unbiased view
– Reassures external stakeholders
– current thinking and best practice can be more effectively transferred
The process is a continuous cycle. As risks will change on a regular basis a company cannot afford to design
solutions and then relax.
Managing the upside of risk
Historically, the focus of risk management has been on preventing loss.
However, recently, organizations are viewing risk management in a different way, so that:
 risks are seen as opportunities to be seized
 organizations are accepting some uncertainty in order to benefit from higher rewards associated with
higher risk
 risk management is being used to identify risks associated with new opportunities to increase the
probability of positive outcomes and to maximize returns
 effective risk management is being seen as a way of enhancing shareholder value by improving
performance.
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RISK COMMITTEE-ROLES
The primary function of a risk committee is to recommend to the board a sound system of risk oversight,
management and internal control.
Its roles include:
1.
2.
3.
4.
5.
The recommendation to the board of a risk management strategy which identifies, assesses, manages and
monitors all aspects of risk throughout the company.
Reviewing reports on key risks prepared by business operating units, management and the board, and then
assessing the effectiveness of the company’s internal control systems in dealing with them.
Advising the board on risk appetite and acceptable risk tolerances when setting the company’s future strategic
direction.
Advising the board on all high-level risk matters and monitoring overall exposure to risk and ensuring it
remains within limits set by the board.
Informing shareholders, and other key stakeholders, of any significant changes to the company’s risk profile.
Although not a prescribed requirement in corporate governance codes and legislation, a risk committee would
ensure the robust oversight of the management of risk throughout the company. In its absence, its duties and
responsibilities would be discharged by the mandatory audit committee.
RISK MANAGER: manages the risk management process!
This role will report to the risk committee, or the audit committee if the organisation doesn’t have a risk
committee.
1. Providing overall leadership, vision and direction, involving the establishment of risk management (RM)
policies, establishing RM systems etc. Seeking opportunities for improvement or tightening of systems.
2.
Developing and promoting RM competences, systems, culture, procedures, protocols and patterns of
behaviour. It is important to understand that risk management is as much about instituting and
embedding risk systems as much as issuing written procedure
3.
Reporting on the above to management and risk committee as appropriate. Reporting information should
be in a form able to be used for the generation of external reporting as necessary
4.
Ensuring compliance with relevant codes, regulations, statutes, etc. This may be at national level (e.g.
Sarbanes Oxley) or it may be industry specific. Banks, oil, mining and some parts of the tourism industry,
for example, all have internal risk rules that risk managers are required to comply with
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COSO has suggested an eight-stage method for managing risks.
The stages involved are
1. Assessment of internal environment(attitude and actions of directors and managers regarding
internal controls)
2. Objective setting
3. Event identification(events may cause loss AND what conditions are likely to lead to these events
4. Risk assessment (risk mapping)
5. Risk response(consider risk appetite and apply TARA)
6. Control activities (controls in place to reduce risk)
7. Information and communication (at all levels)
8. Monitoring
Related and correlated risk factors
Related risks are risks that vary because of the presence of another risk or where two risks have a common cause.
This means when one risk increases, it has an effect on another risk and it is said that the two are related.
Risk correlation is a particular example of related risk. Risks are positively correlated if the two risks are positively
related in that one will fall with the reduction of the other, and increase with the rise of the other. They would be
negatively correlated if one rose as the other fell..
Correlated risks can be:
Positively correlated (i.e. both risks move
in the same direction either upward or
downward). For example environmental
risk and reputation risk move in the same
direction.
Negatively correlated (i.e. both risks move
in the opposite direction one upward and
the other downward).
P1 Knowledge Summary
Persons who suffer from high level of diabetes run the risk of the
degeneration of eyes and the risk of kidney failure. However if the
level of diabetes is reduced, risk of eye diseases or risk of kidney
failure is reduced.
Therefore risk of eye diseases or risk of kidney failure are positively
correlated.
An entity which borrows money to install anti pollution equipment
will reduce its environmental risk. However if the amount of
borrowing is high its financial risks are increased on account of high
gearing. Higher gearing exposes the company to the risk of higher
interest rates which in turn affects the cash flow. Therefore
environmental risk and financial risk are negatively correlated.
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The necessity of incurring risk as part of competitively managing a business organisation.
The risks faced by organisations present different levels of profit opportunities to the organisation. The decision to
undertake these risks depends on the risk return trade-off.
The profit opportunities that the organisation gets are known as competitive advantages. Business choices can be
aided with the help of some simple analysis using a modified version of Mendelow’s matrix. The matrix is used to
assess risk levels and the ensuing competitive advantages, as shown below. Each business opportunity is
categorised into a cell of the matrix and analysed accordingly.
Risk monitoring more important in larger companies than in smaller companies?
Small companies exist in different strategic environments to large companies and because of this, a number of
differences apply when it comes to corporate governance systems. There are a number of compliance issues, for
example, where large companies are required to comply with provisions that smaller companies are not. Some of
the differences in regulation and shareholder expectations are driven by differences in the legal status of the
organization (e.g. whether incorporated, whether listed, where domiciled, etc).
In the case of risk management systems in smaller companies, there will be a lower overall (aggregate) loss to
shareholders than in a large company in the event of a major risk being realised. In larger companies, especially
listed companies, a major event can affect markets around the world and this can affect the value of many funds
including pension funds, etc. This is unlikely to be the case in any given smaller company.
Many smaller companies are privately owned and they are therefore not subject to listing rules and, in some cases,
other legal regulations. In many smaller companies, any loss of value when a risk is realised is a personal loss to
owners and does not affect a high number of relatively ‘disconnected’ shareholders as would be the case in a large
public company.
Risk probability and impact is often correlated with size. Smaller companies have fewer risks because of their lower
profiles, fewer stakeholders and less complex systems than larger organizations.
Accordingly, the elaborate risk management systems are less necessary in smaller companies and could be a
disproportionate use of funds.
This is not to say that smaller companies do not face risks, of course, but that the impacts, say to shareholders or
society, are less with a smaller rather than a larger company because of the totality of the losses incurred.
The costs of risk monitoring and control may often outweigh the impacts of losses being incurred from risks, if not
in a single financial period then maybe over a period of years. There are substantial set-up fixed costs in
establishing some risk management systems and, in some cases, variable costs also (e.g. linked to production
output). With fewer total risks, there could be less value for money in having risk controls.
In summary, risk committees and risk mitigation systems are more important in larger companies than in smaller
companies. However it is good practice for all companies, however small, to carry out some form of risk
monitoring in order to remain competitive in their environment.
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Relativism and absolutism (relate to ethical & moral beliefs in society)
‘Absolutism’ /Dogmatic/non-consequentialist
Ethical absolutism is concerned with whether an action or conduct is right or wrong. Therefore, from the
standpoint of ethical absolutes, some things are always right and some things are always wrong, no matter how
one tries to rationalise them.
Ethical absolutism requires that individuals always defer to a set of rules to guide them in the ethical decisionmaking process. It holds that whether an action is ethical does not depend on the view of the person facing the
dilemma; instead it depends on whether the action conforms to the given set of ethical rules and standards.
Absolutism takes no account of who is making the ethical judgement, but defers to universal principles which
should guide anyone’s behaviour in the situation, regardless of their background.
‘Relativism’ /pragmatic/consequentialist
Ethical relativism is the broad acceptance that nothing is objectively right or wrong, but depends on the
circumstances of the situation and the individuality of the person facing the situation or dilemma.
It suggests that an ethical position held by one person may be viewed as right for them, but may be wholly
unacceptable to another person in the same situation. Relativism therefore insists that what is considered true by
an individual replaces the search for an absolute truth by denying the existence of objective moral standards.
Rather, according to ethical relativism, individuals must evaluate actions on the basis of what they feel is best for
themselves.
Ethical relativism takes account of who is making the ethical decision and what their psychological, cultural and
moral background is and accepts that different people will form different moral opinions of the most ethical
approach to be taken in any given situation.
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Deontological and teleological approaches to ethics
DEONTOLOGY
Deontological ethics focuses on actions and rules and lays down criteria by which these actions may be judged in
advance. In this respect it is similar to ethical absolutism, but it is primarily concerned with the decision-making
process itself rather than the broad principles underpinning it. It is also accepted that the outcome of the decision
taken is not relevant to the decision itself.
Deontological ethics is based on the idea that facts themselves are neutral; they are what they are and should not
suggest what action should be taken. The criteria by which a situation is judged should always be independent
from the facts themselves.
According to deontological theory, there are three key maxims, or tests, for any action. An action is morally 'right'
if it satisfies all three maxims:
 Act only according to that maxim by which you can at the same time will that it should become a universal
law. This is the principle of consistency. An action can only be 'right' if everyone can follow the same
underlying principle. Therefore murder is 'wrong' because if it was 'right' then human life would have no
value.
 Act so that you treat humanity, whether in your own person or in that of another, always as an end and never
as a means only. This is the principle of human dignity. It means that everyone should be treated with respect
and not simply as an object providing services.
 Act only so that they will through its maxims could regard itself at the same time as universally lawgiving. This
is the principle of universality. An action is 'right' if other people also consider that action to be 'right'.
TELEOLOGY
Teleological theory is similar to relativism as it believes that ethics is driven by outcomes and not actions.
Therefore, if an action achieves a good or desirable outcome, the action is ethical.
Teleology does not focus on any action taken or how well the action adheres to a system of rules. Teleological
ethics, often referred to as consequentialism, is more concerned with the end result. The essence of all forms of
teleological ethics is best expressed using utilitarianism as ‘the greatest good for the greatest number’. This
approach differs from deontology in that there is no set of hard and fast rules in place; actions are viewed as
ethical depending on individual circumstances and the consequential effects, so is more consistent with a relativist
approach.
Egoism
An egoist believes that if the outcome is good for oneself, then the action causing the outcome is ethical.
There is a focus on self-interest but the egoist may also consider what is right in society as that makes them feel
good about themselves, which is a good outcome.
Utilitarianism
A utilitarian believes that if the outcome is good for society, then the action causing the outcome is ethical.
This seems to suggest that anything viewed to be in the public interest is ethical. An action may be viewed as
ethically right if it benefits the greatest number.
This can be difficult in practice as when a decision is made, the decision maker needs to understand:
 Who would be affected by the decision?
 How will they be affected?
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Kohlberg’s Levels of Moral Development
Laurence Kohlberg devised a theory which explained the rationale behind human moral reasoning, where he was
less concerned about the actual decision taken but rather the cognitive process which arrived at each judgement.
Kohlberg described the development of individual moral and ethical reasoning through three discrete levels: preconventional, conventional and post-conventional.
At the preconventional level of
moral reasoning,
morality is conceived of
in terms of rewards,
punishments and
instrumental
motivations. Those
demonstrating
intolerance of norms
and regulations in
preference for selfserving motives are
typically preconventional.
At the conventional
level, morality is
understood in terms of
compliance with either
or both of peer
pressure/social
expectations
or regulations, laws and
guidelines. A high
degree of compliance is
assumed to be a highly
moral position. A
person who is
ethically engaged at the
conventional level will
consider it important to
learn the rules and
expectations which
apply to them and then
comply in detail. These
can concern legal rules,
social norms and
accepted standards of
behaviour.
1.1 Pre conventional–
Obedience and
punishment
At the most basic level, individuals make decisions based
on punishment and reward and at this stage have not
developed any particular ethical beliefs. How can I avoid
punishment?
1.2 Pre conventional–
Instrumental purpose and
Exchange
At a slightly higher level, individuals learn to do something
for the promise of future benefits. What’s in it for me?
2.1
Conventional–
Interpersonal
accord and conformity
At this stage, individuals start to develop behaviour
patterns that are based on their family, friends,work
colleagues and peers. Good behavior is that which
pleases others in the immediate group
Sometimes referred to as the ‘good boy–good girl’
orientation, this stage focuses on living up to social
expectations and accepted roles in society. Due
consideration is given to the expectations of peers with an
emphasis on conformity when arriving at an appropriate
decision.
2.2
Conventional–
Social accord and system
maintenance
P1 Knowledge Summary
The previous level expands from following the norms of a
peer group into following the norms for society as a
whole. Laws and social norms
As individuals progress towards this more advanced stage
of moral
development, focus shifts towards a sense of duty and
responsibility by observing law and order, adhering to
rules and respecting authority.
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At the postconventional level,
morality is understood
in terms of
conformance with
‘higher’ or ‘universal’
ethical principles as
perceived by the
person being
considered.
Post-conventional
assumptions often
challenge existing
regulatory regimes and
social norms, and so
post-conventional
behaviour is often
costly in personal
terms. The nature of
the ‘higher’ ethical
principles
is subjective and
specific to the person.
3.1 Post conventional–
Social contract and
individual rights
The post conventional level recognises that individuals are
separate from society and that the individual’s perception
may take precedence over society’s view.
Individuals start to challenge social norms. In this stage,
the individual believes that laws that do not promote
general welfare should be changed where necessary to
meet the greater good for the greatest number.Laws are
open to question but are still being upheld for the good
of the community and in the name of democratic values.
3.2 Post conventional–
Universal ethical Principles
At the highest level, individuals will reject social norms by
behaving in the way they believe to be right, and will
campaign to change the views of others so that their
norms become society’s norms.
Kohlberg believed that stage six existed but that very few
individuals operated consistently at this level. self-chosen
ethical principals- high value is placed on justice, dignity,
and equality of all persons.
Ethical decision making models
THE AMERICAN ACCOUNTING ASSOCIATION (AAA) MODEL
The American Accounting Association (AAA) model comes from a report for the AAA written by Langenderfer and
Rockness in 1990. In the report, they suggest a logical, seven-step process for decision making, which takes ethical
issues into account.
The model begins, at Step 1, by establishing the facts of the case. While perhaps obvious, this step means that
when the decision-making process starts, there is no ambiguity about what is under consideration.
Step 2 is to identify the ethical issues in the case. This involves examining the facts of the case and asking what
ethical issues are at stake.
The third step is an identification of the norms, principles, and values related to the case. This involves placing the
decision in its social, ethical, and, in some cases, professional behaviour context. In this last context, professional
codes of ethics or the social expectations of the profession are taken to be the norms, principles, and values. For
example, if stock market rules are involved in the decision, then these will be a relevant factor to consider in this
step.
In the fourth step, each alternative course of action is identified. This involves stating each one, without
consideration of the norms, principles, and values identified in Step 3, in order to ensure that each outcome is
considered, however appropriate or inappropriate that outcome might be.
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Then, in Step 5, the norms, principles, and values identified in Step 3 are overlaid on to the options identified in
Step 4. When this is done, it should be possible to see which options accord with the norms and which do not.
In Step 6, the consequences of the outcomes are considered. Again, the purpose of the model is to make the
implications of each outcome unambiguous so that the final decision is made in full knowledge and recognition of
each one.
Finally, in Step 7, the decision is taken.
Scenario for the AAA model
An auditor uncovers an irregular cash payment and receives an unsatisfactory explanation for it from the client’s
finance director. He suspects the cash payment is a bribe paid to someone but can’t prove it. The client then offers
to pay the auditor a large amount of money if he pretends not to have noticed the payment. The amount of money
offered by the client is large enough to make a significant difference to the auditor’s wealth. Should the auditor
take the money?
Step 1: What are the facts of the case?
The facts are that the auditor has uncovered what he believes to be a bribe and has, in turn, been offered a bribe
to ignore or overlook it.
Step 2: What are the ethical issues in the case?
The ethical issue is whether or not an auditor should accept a bribe. In accepting the bribe he would be acting
illegally and would also be negligent of his professional duties.
Step 3: What are the norms, principles, and values related to the case?
The norms, principles, and values are that auditors are assumed (by shareholders and others active in capital
markets) to have impeccable integrity and to assure that the company is providing a ‘true and fair view’ of its
financial situation at the time of the audit. Auditors are entrusted with the task of assuring a company’s financial
accounts and anything that prevents this or interferes with an auditor’s objectivity is a failure of the auditor’s duty
to shareholders.
Step 4: What are the alternative courses of action?
Option 1 is to accept the bribe and ignore the irregular cash payment. Option 2 is to refuse the bribe and take
appropriate actions accordingly.
Step 5: What is the best course of action that is consistent with the norms, principles, and values identified in
Step 3?
The course of action consistent with the norms, principles, and values in Step 3 is to refuse the bribe. The auditor
would report the initial irregular payment and then also probably report the client for offering the second bribe.
Step 6: What are the consequences of each possible course of action?
Under Option 1, the auditor would accept the bribe. He would enjoy the increase in wealth and presumably an
increase in his standard of living but he would expose himself to the risk of being in both professional and legal
trouble if his acceptance of the bribe was ever uncovered. He would have to ‘live with himself’ knowing that he
had taken a bribe and would be in debt to the client, knowing that the client could expose him at any time.
Under Option 2, the auditor would refuse the bribe. This would be likely to have a number of unfortunate
consequences for the client and possibly for the future of the client–auditor relationship. It would, however,
maintain and enhance the reputation and social standing of auditors, maintain public confidence in audit, and
serve the best interests of the shareholders.
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Step 7: What is the decision?
The ethical decision is Option 2. The auditor should refuse the bribe.
Tucker’s 5-question model
.
The decision should be:
1. Is it profitable? This is a difficult question, because it does not address for whom the decision is profitable and it
doesn’t compare the profitability of other options, which may be better.
2. Is it legal?
3. Is it fair? This is another difficult question, as the company has to consider if it is fair to all stakeholders and the
effect the decision has on them.
4. Is it right? This is also difficult, as what is right will depend on the ethical view of the organization ( is the
company a pristine capitalist or social ecologist?)
5. Is it sustainable or environmentally sound?
This model is conceptually slightly different from the AAA model but is nevertheless a powerful tool for
determining the most ethical outcome in a given situation. It might be the case that not all of Tucker’s criteria are
relevant to every ethical decision. If it were used when considering the AAA model scenario above, for example,
there is no indication of the environmental relevance of the auditor’s decision. In addition, the reference to
profitability means that this model is often more useful for examining corporate rather than professional or
individual situations.
Applying Tucker’s model requires a little more thought than when using the AAA model in some situations,
however. This is because three of the five questions (profitable, fair, and right) can only be answered by referring
to other things. So when the model asks, ‘is it profitable?’, it is reasonable to ask, ‘compared to what?’ ‘Similarly,
whether an option is ‘fair’ depends on whose perspective is being adopted. This might involve a consideration of
the stakeholders involved in the decision and the effects on them. Whether an option is ‘right’ depends on the
ethical position adopted. A deontological perspective may well arrive at a different answer than a teleological
perspective, for example. In order to see how Tucker’s model might work in practice, we will consider two decision
scenarios, one fairly clear cut and one that is a little more complicated.
Tucker: Scenario 1
Big Company is planning to build a new factory in a developing country. Analysis shows that the new factory
investment will be more profitable than alternatives because of the cheaper labour and land costs. The
government of the developing country has helped the company with its legal compliance, which is now fully
complete, and the local population is anxiously waiting for the jobs which will, in turn, bring much needed
economic growth to the developing country. The factory is to be built on reclaimed ‘brownfield’ land and will
produce a lower unit rate of environmental emissions than a previous technology.
Is it profitable?: Yes. The investment will enable the company to make a superior return than the alternatives. The
case explains that these are ‘because of the cheaper labour and land costs’.
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Is it legal?: Yes. The government of the developing country, presumably very keen to attract the investment, has
helped the company with its legal issues.
Is it fair?:As far as we can tell, yes. The only stakeholder mentioned in the scenario is the workforce of the
developing country who, we are told, is ‘anxiously waiting’ for the jobs. The scenario does not mention any
stakeholders adversely affected by the investment.
Is it right?: Yes. The scenario explains that the factory will help the developing country with ‘much needed
economic growth’, and no counter - arguments are given.
Is it sustainable or environmentally sound?: Yes. The scenario specifically mentions an environmental advantage
from the investment. So in this especially simplified case, the decision is clear as it passes each decision criteria in
the 5-question model. In more complex situations, it is likely to be a much more finely balanced decision.
Tucker: Scenario 2
Some more information has emerged about Big Company’s new factory in the developing country. The
‘brownfield’ land that the factory is to be built on has been forcefully requisitioned from a community (the ‘Poor
Community’) considered as ‘second class citizens’ by the government of the developing country. The Poor
Community occupied the land as a slum and now has nowhere to live.
Is it profitable? Yes.The same arguments apply as before.
Is it legal? It appears that the government of the developing country has no effective laws to prevent the forced
displacement of the Poor Community and may be complicit in the forced removal. While the investment may not
be technically illegal, it appears that the legal structures in the host country are not particularly robust and are
capable of what amounts to the oppression of the Poor Community.
Is it fair? While the issue of the much needed employment remains important, it must be borne in mind that the
jobs are provided at the cost of the Poor Community’s homes. This apparent unfairness to the Poor Community is a
relevant factor in this question. The answer to ‘is it fair?’ will depend on the decision maker’s views of the
conflicting rights of the parties involved.
Is it right? The new information invites the decision maker to make an ethical assessment of the rights of the Poor
Community against the economic benefits of the investment. Other information might be sought to help to make
this assessment including, for example, the legality of the Poor Community’s occupation of the site, and options for
rehousing them once construction on the site has begun.
Is it sustainable or environmentally sound? Yes. The same arguments apply as before.
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Kohlberg’s four stages of ethical decision making
Stage 1: Recognize moral issue (lying about product can increase sales)
Stage 2: Make moral judgment (realize that lying is wrong)
Stage 3: Establish moral intent (decide to be honest)
Stage 4: Engage on moral behavior ( tell the truth)
So the salesperson could still lie about the cars being sold even though this had been recognized as immoral
behavior.
Ethical behavior(stage 3 or 4 of Kohlberg’s ethical decision making model)
Ethical behavior depends on Issue related factors and Context related factors
Issue related factors
A. Moral intensity (the importance of the issue to the decision maker.
It depends on 6 factors listed below)
Factors affecting moral intensity
1.
2.
3.
4.
5.
6.
Concentration of effort ( is there a MAJOR impact of your action on a
few people or a MINOR impact on a large number of people)
Proximity ( how close are you to the people being affected by the
decision. For e.g. you may not be very concerned about the working
conditions of an overseas factory)
Temporal immediacy (speed of consequences of your action. Long time
delay decreases intensity)
Magnitude of consequences (sum of the harm/benefit of your action.
For example a faulty product may cause death)
Social consensus (is your act considered unethical by others?)
Probability of the effect (likelihood that harm will actually happen! If the
likelihood is high, the moral intensity of your action will be high as well.)
Context related factors
Situation-based
If everyone in a workplace
does something in a certain
way, an individual is more
likely to conform: this can
result in both higher and
lower standards of ethical
behaviour.
Key factors
-
Systems of reward
and punishment
Authority
Org norms and
culture
National culture
B. Moral framing (the situation in which a decision is made. For
example, if you are working in an organization where ethics are not
discussed, you’ll ignore ethics when making a decision)
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Corporate Social Responsibility(CSR)
Definition
CSR REFERS TO ORGANISATIONS CONSIDERING AND MANAGING THEIR IMPACT ON A VARIETY OF STAKEHOLDERS.
CSR is a term used to include a series of measures concerned with an organisation’s stance towards ethical issues.
These include the organisation’s social and environmental behaviour, the responsibility of its products and
investments, its policies (over and above compliance with regulation) towards employees, its treatment of
suppliers and buyers, its transparency and integrity, how it deals with stakeholder concerns and issues of giving
and community relations.
Behaviour in all of these areas is largely discretionary and it is possible to adopt a range of approaches from being
very concerned about some or all of them, to having no such concern at all..
CSR Strategy: To have a strategy for CSR is to have a set of policies which guide and underpin CSR activities. This
means that some causes or areas of activity are favoured over others, in line with the strategy adopted. So, for
example, a company might have a policy to invest in some communities or charitable causes and not others. The
policy or strategy may be agreed based on a number of issues: perhaps the preferences of the employees, the
preferences of senior people in a business, or the preferred outcomes may be chosen based on strategic concerns.
Strategic CSR: When CSR is undertaken to maximise its effects on the long-term economic benefit of the business,
it can be described as strategic CSR. When CSR activities are strategic, they generally support the main business
areas of the business. So a financial company such as a bank might favour financial education causes whilst a
medical supplies company might prefer medical or nursing research causes or overseas medical efforts. It would be
seen as strategically wasteful to use CSR to support activities which are not aligned to the core activities. An
assumption underpinning strategic CSR is that all assets in
a company belong to the shareholders and so all activities, including CSR, should be configured in such a way as to
support shareholder value.
Archie Carroll’s model of social responsibility suggests there are 4 levels of social responsibility
Economic responsibilities
Legal responsibilities
Ethical responsibilities
Philanthropic responsibilities (behavior to
improve the lives of others)
P1 Knowledge Summary
Shareholders demand a reasonable return.
Employees want safe and fairly paid jobs. Customers demand
quality at a fair price.
Since laws codify society’s moral views, obeying those laws
must be the foundation of compliance with social
responsibilities
Businesses should act in a fair and just way even if law does not
compel them to do so
This includes charitable donations, contributions to the local
community and providing employees with opportunities
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Social responsiveness: This refers to the capacity of the corporation to respond to social pressure.
Archie Carroll suggests four possible strategies: reaction, defence, accommodation and proaction.
Reaction: The corporation denies any responsibility for social issues.
Defence: The corporation admits responsibility but fights it, doing the very least that seems to be required.
Accommodation: The corporation accepts responsibility and does what is demanded of it by relevant groups.
Proaction: The corporation seeks to go beyond industry norms.
INSTRUMENTAL AND NORMATIVE MOTIVATIONS OF STAKEHOLDER THEORY
An debate, from an ethical perspective, is why organisations do or do not take account of stakeholder concerns in
their decision making, strategy formulation, and implementation. A parallel can be drawn between the ways in
which organisations view their stakeholders and the ways in which individual people consider (or do not consider)
the views of others. Some people are concerned about others’ opinions, while other people seem to have little or
no regard for others’ concerns. Furthermore, the reasons why individuals care about others’ concerns will also
vary.
In attempting to address this issue, Donaldson and Preston described two contrasting motivations: the
instrumental and the normative.
The instrumental view of stakeholders
The instrumental view of stakeholder relations is that organisations take stakeholder opinions into account only
insofar as they are consistent with other, more important, economic objectives (eg profit maximisation, gaining
market share, compliance with a corporate governance standard). Accordingly, it may be that a business
acknowledges stakeholders only because acquiescence to stakeholder opinion is the best way of achieving other
business objectives. If the loyalty or commitment of an important primary or active stakeholder group is
threatened, it is likely that the organisation will recognise the group’s claim because not to do so would threaten
to reduce its economic performance and profitability. It is therefore said that stakeholders are used instrumentally
in the pursuit of other objectives.
The normative view of stakeholders
The normative view of stakeholder theory differs from the instrumental view because it describes not what is, but
what should be. The most commonly cited moral framework used in describing ‘that which should be’ is derived
from the philosophy of the German ethical thinker Immanuel Kant (1724–1804). Kant’s moral philosophy centred
around the notion of civil duties which, he argued, were important in maintaining and increasing overall good in
society. Kantian ethics are, in part, based upon the notion that we each have a moral duty to each other in respect
of taking account of each others’ concerns and opinions. Not to do so will result in the atrophy of social cohesion
and will ultimately lead to everybody being worse off morally and possibly economically.
Extending this argument to stakeholder theory, the normative view argues that organisations should
accommodate stakeholder concerns not because of what the organisation can instrumentally ‘get out of it’ for its
own profit, but because by doing so the organisation observes its moral duty to each stakeholder. The normative
view sees stakeholders as ends in themselves and not just instrumental to the achievement of other ends.
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SEVEN POSITIONS ALONG THE CONTINUUM: GRAY, OWEN AND ADAMS
The stakeholder/stockholder debate can be represented as a continuum, with the two extremes
representing the ‘pure’ versions of each argument. But as with all continuum constructs, ‘real life’ exists
at a number of points along the continuum itself. It is the ambiguity of describing the different positions
on the continuum that makes Gray, Owen and Adams’s ‘seven positions on social responsibility’ so useful.
1. Pristine-capitalists: At the extreme stockholder end is the pristine capitalist position. The value
underpinning this position is shareholder wealth maximisation, and implicit within it is the view that
anything that reduces potential shareholder wealth is effectively theft from shareholders. Because
shareholders have risked their own money to invest in a business, and it is they who are the legal owners,
only they have any right to determine the objectives and strategies of the business. Agents (directors)
that take actions, perhaps in the name of social responsibility, that may reduce the value of the return to
shareholders, are acting without mandate and destroying value for shareholders.
2. Expedients: The expedient position shares the same underlying value as that of the pristine capitalist
(that of maximising shareholder wealth), but recognises that some social responsibility expenditure may
be necessary in order to better strategically position an organisation so as to maximise profits.
Accordingly, a company might adopt an environmental policy or give money to charity if it believes that
by so doing, it will create a favourable image that will help in its overall strategic positioning.
3. Social-contract-position:The notion of social contract has its roots in political theory. Democratic
governments are said to govern in a social contract with the governed. This means that a democratic
government must govern broadly in line with the expectations, norms and acceptations of the society it
governs and, in exchange, society agrees to comply with the laws and regulations passed by the
government. Failure by either side to comply with these terms will result in the social contract being
broken. For businesses, the situation is a little more complex because unlike democratic governments,
they are not subject to the democratic process. The social contract position: argues that businesses enjoy
a licence to operate and that this licence is granted by society as long as the business acts in such a way as
to be deserving of that licence. Accordingly, businesses need to be aware of the norms (including ethical
norms) in society so that they can continually adapt to them. If an organisation acts in a way that society
finds unacceptable, the licence to operate can be withdrawn by society, as was the case with Arthur
Andersen after the collapse of Enron.
4. Social-ecologists:Social ecologists go a stage further than the social contractarians in recognising that
(regardless of the views of society), business has a social and environmental footprint and therefore bears
some responsibility in minimising the footprint it creates. An organisation might adopt socially and/or
environmentally responsible policies not because it has to in order to be aligned with the norms of society
(as the social contractarians would say) but because it feels it has a responsibility to do so.
5. Socialists In the context of this argument, socialists are those that see the actions of business as those of a
capitalist class subjugating, manipulating, and even oppressing other classes of people. Business is a
concentrator of wealth in society (not a redistributor) and so the task of business, social, and
environmental responsibility is very large – much more so than merely adopting token policies (as
socialists would see them) that still maintain the supremacy of the capitalist classes. Business should be
conducted in a very different way – one that recognises and redresses the imbalances in society and
provides benefits to stakeholders well beyond the owners of capital.
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6. Radical-feminists: Like the socialists, radical feminists (not to be confused with militants, but rather with a
school of philosophy) also seek a significant re adjustment in the ownership and structure of society.
They argue that society and business are based on values that are usually considered masculine in nature
such as aggression, power, assertiveness, hierarchy, domination, and competitiveness. It is these
emphases, they argue, that have got society and environment in the ‘mess’ that some people say they are
in. It would be better, they argue, if society and business were based instead on values such as
connectedness, equality, dialogue, compassion, fairness, and mercy (traditionally seen as feminine
characteristics). This would clearly represent a major challenge to the way business is done all over the
world and hence would require a complete change in business and social culture.
7. Deep-ecologists: Finally, the deep ecologists (or deep greens) are the most extreme position of coherence
on the continuum. Strongly believing that humans have no more intrinsic right to exist than any other
species, they argue that just because humans are able to control and subjugate social and environmental
systems does not mean that they should. The world’s ecosystems of flora and fauna, the delicate balances
of species and systems are so valuable and fragile that it is immoral for these to be damaged simply (as
they would see it) for the purpose of human economic growth.
There is (they argue) something so wrong with existing economic systems that they cannot be repaired as
they are based on completely perverted values. A full recognition of each stakeholders’ claim would not
allow business to continue as it currently does and this is in alignment with the overall objectives of the
deep ecologists or deep greens.
Corporate ethical stances
1.
2.
3.
4.
Short term shareholder interest : only responsibility is to maximize shareholder wealth
Long-term shareholder interest: to maintain existence in the long term, an organization has to maintain
its reputation therefore it needs to be proactive with CSR. Orgs will comply with best practice
Multiple stakeholder obligations: An org does not have responsibility towards shareholders only.
Therefore, they accept greater social and environmental responsibility. It is difficult to satisfy all
stakeholder expectations
Shaper of society: Orgs will seek to change society. Financial considerations are secondary.
Corporate Citizenship
Corporate citizenship is an approach which can be adopted by any business with the aim of shaping its core values
so that they more closely align the decisions made each day by its directors, managers and employees with the
needs of the society in which the business operates.
There are three principles which take into account successful corporate citizenship:
(i) Minimising any harm caused to society by the decisions and actions of a business, which could include avoiding
harm to the natural environment as well as the social infrastructure.
(ii) Maximising any benefit created for society as a consequence of normal business activity. Any successful
business will stimulate local economic activity and increase employment, but a good corporate citizen will do this
with greater sensitivity to its environmental and social impacts.
(iii) Remaining clearly accountable and responsive to a wide range of its stakeholders, thereby combining business
self-interest with a greater sense of responsibility towards society at large.
By embracing the corporate citizenship agenda, an organisation is able to recognise its fundamental rights and
acknowledge that it has responsibilities towards the wider community.
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Rights of the business as a corporate citizen
A business has the right to exist as a separate legal entity and carry out its lawful business within a society
A business has the right to be protected by the law in the pursuit of its normal business activities.
It has the right to receive the support of society in the pursuit of business in terms of its investors, employees and
customers. It has the right, in other words, to have customers free to purchase products without feeling bad about
it, and have employees happy to work for the company without fear of criticism from people believing themselves
to be in a superior moral position.
Responsibilities of the business as a corporate citizen
Just as an individual has the responsibility to obey the law, fit in with the social and ethical norms of society, and
behave in an appropriate way, so does a business.
Its responsibility is to always comply with the laws and social norms which apply in each country it deals with. This
extends to being a good employer, maintaining prompt payment of payables accounts, encouraging good working
conditions at supplier companies and similar areas of good business practice.
The 3 perspectives are:
1.
2.
3.
limited view: stakeholders considered when in business’ interest (main groups considered are employees and
local community)
Equivalent view: self interest is not primary motivation. Organization is focused on legal requirements and
ethical fulfillment.
Extended view: Combination of self interest promoting the power that organizations have and wider
responsibility towards society.
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Code of ethics
Corporate code of ethics
Professional ethics
Purpose
Fundamental principles
The first is communicating the organisation’s values into a
succinct and sometimes memorable form. This might involve
defining the strategic purposes of the organisation and how this
might affect ethical attitudes and policies.
1.Integrity
2.Objectivity
3.Competence
4.Confidentiality
5.Professional behavior
Second, the code serves to identify the key stakeholders and
the promotion of stakeholder rights and responsibilities. This
may involve deciding on the legitimacy of the claims of certain
stakeholders and how the company will behave towards them.
Third, a code of ethics is a means of conveying these values to
stakeholders. It is important for internal and external
stakeholders to understand the ethical positions of a company
so they know what to expect in a given situation and to know
how the company will behave. This is especially important with
powerful stakeholders, perhaps including customers, suppliers
and employees.
Fourth, a code of ethics serves to influence and control
individuals’ behaviour, especially internal stakeholders such as
management and employees. The values conveyed by the code
are intended to provide for an agreed outcome whenever a
given situation arises and to underpin a way of conducting
organisational life in accordance with those values.
Fifth, a code of ethics can be an important part of an
organisation’s strategic positioning. In the same way that an
organisation’s reputation as an employer, supplier, etc. can be a
part of strategic positioning, so can its ethical reputation in
society. Its code of ethics is a prominent way of articulating and
underpinning that.
Threats to objectivity/Conflict of interest
1.Self-interest
2.Self-review
3.Advocacy
4.Familiaruty
5.Intimidation
Safeguards
1.created by profession (CPD, corporate
governance, disciplinary proceedings)
2.Work environment(code of ethics, ICS, review
procedures)
3.Individual(contact professional bodies,
mentor,comply with professional standards)
Contents
Values of the company. This might include notes on the
strategic purpose of the organisation and any underlying
beliefs, values, assumptions or principles. Values may be
expressed in terms of social and environmental perspectives,
and expressions of intent regarding compliance with best
practice, etc.
Shareholders and suppliers of finance. In particular, how the
company views the importance of sources of finances, how it
intends to communicate with them and any indications of how
they will be treated in terms of transparency, truthfulness and
honesty.
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Employees. Policies towards employees, which might include
equal opportunities policies, training and development,
recruitment, retention and removal of staff.
.
Customers. How the company intends to treat its customers,
typically in terms of policy of customer satisfaction, product
mix, product quality, product information and complaints
procedure.
Supply chain/suppliers. This is becoming an increasingly
important part of ethical behaviour as stakeholders scrutinise
where
and how companies source their products (e.g. farming
practice, fair trade issues, etc). Ethical policy on supply
chain might include undertakings to buy from certain approved
suppliers only, to buy only above a certain level of quality, to
engage constructively with suppliers (e.g. for product
development purposes) or not to buy from suppliers who do
not meet
with their own ethical standards.
Community and wider society. This section concerns the
manner in which the company aims to relate to a range of
stakeholders with whom it does not have a direct economic
relationship (e.g. neighbours, opinion formers, pressure groups,
etc). It might include undertakings on consultation, ‘listening’,
seeking consent, partnership arrangements (e.g. in community
relationships with local schools) and similar.
Implementation(The process by which the code is finally issued
and then used. Implementation will also include some form of
review function so the code is revisited on an annual basis and
updated as necessary)
Code of ethics-should there be such codes?
Yes
• They provide guidance to accountants on what is, and is not, acceptable behaviour.
• The principles may help to solve difficult ethical situations (ethical dilemmas).
• The existence of a code sends a message to the outside world that accountants believe ethical behavior and
acting in the public interest, to be important.
• For trainee accountants who do not understand acceptable professional behaviour, the code represents a useful
educational and training aid.
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No
• Codes of ethics can give the impression that professional ethics are nothing more than rules. This is not the case
as not every situation can be covered by a rule; an accountant will also have to follow ethical principles.
• If someone intends to act unethically, it is unlikely that the existence of a code of ethics will change their
behaviour, unless they genuinely did not understand that their behaviour was unethical until they saw the code.
• Culture can play a factor as, in different parts of the world, different behaviour may be considered ethical or
unethical. This means that international codes of ethics may not be applicable in every case.
• Ethical codes are not enforceable, although breach of a code may mean that an accountant is not allowed to
continue to be a member of their professional body. In most cases, adherence to ethical codes is voluntary.
• Producing ethical codes, and keeping them up to date can be costly.
PRINCIPLES AND RULES BASEDAPPROACHES TO ETHICS
Ethics is a difficult area in which to try and impose prescriptive rules. For example, if a code of ethics says that
auditors cannot accept free lunches from clients as this may pose a threat to independence, does this mean that
they can accept free flights to Barbados? The ethical dilemmas accountants face will all differ in their exact detail
so it would be unrealistic to create a set of rules that covers every eventuality.
This problem is solved by having ethical codes and guidance for accountants which are based on principles, with
only a limited number of rules. There are several reasons for this:
 It is hard to define rules that would be acceptable to all accountants, and appropriate in all situations;
 Accountants are professionals and should have the ability to make their own behavioural decisions in most
cases – they should use their professional judgment;
 Where there are rules, they can be avoided by looking for loopholes. It is much harder to ignore principles.
Of course, an opposing argument is that it is easy to see when someone breaks a law, but very difficult to prove
that someone has breached a principle – as the latter are less defined.
Most professional institutes use a principles-based approach to resolving ethical dilemmas.
Use of a rules-based approach is normally inappropriate as rules cannot cover every eventuality.
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ENVIRONMENTAL FOOTPRINT
It is the impact that a business’s activities have on the environment including its resource environment and
pollution emissions.
A company’s environmental footprint assesses its impact on the natural environment in a variety of ways,
including:
– its resource and energy consumption, with particular concern for unsustainable resources;
– the amount of waste produced and disposed of; and
– the harm or damage caused by emissions to the environment.
Ideally every organisation, commercial or otherwise, should work towards attaining a zero environmental footprint
by conserving, restoring and replacing those natural resources used in its operations whilst at the same time taking
necessary measures to eliminate pollution and emissions.
Examples of footprints
-
Consumption of exhaustible natural resources
Pollution
Wastage
Use of land
Water
Negative impacts can be reduced by:
-
Better resource management(e.g.use different resources)
‘green; procurement policies
Waste management (recycling)
Carbon neutrality
Examples of environmental costs
waste management
compliance costs
permit fees
environmental training
R& D regarding environment
Legal costs and fines
Record keeping and reporting
Public opinion
Employee health and safety
Risk posed by future regulatory changes
Uncertain future compensation costs
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Internal controls and environmental footprint
One of the most obvious ways in which internal controls are necessary for controlling environmental footprints is
in the operational controls which measure and determine the input consumption and the production of emissions.
It is only by the accumulation of accurate environmental consumption and emissions data that the footprint can be
identified and therefore monitored, scrutinised and improved. Internal controls capable of making these
measurements (say in terms of energy, water and raw material consumption, and waste emissions) are therefore
essential in measuring and therefore controlling the environmental footprint.
Internal controls can also be used in the management of the plant and equipment Sound internal controls are a key
part of the normal efficient management of operations. They are also necessary for producing accurate
information upon which regular reporting is based. These make internal controls able to act as an ‘early warning
system’ for any inefficiency in environmental systems which help to control the environmental footprint
SOCIAL FOOTPRINT
The term ‘footprint’ is used to refer to the impact or effect that an entity (such as an organisation) can have on a
given set of concerns or stakeholder interests. A ‘social footprint’ is the impact on people, society and the
wellbeing of communities. Impacts can be positive (such as the provision of jobs and community benefits) or
negative, such as when a plant closure increases unemployment or when people become sick from emissions from
a plant or the use of a product..
Examples of social footprint






Obtaining supplies from sustainable sources and companies following appropriate social and
environmental practices.
Enhancing social capital e.g. business/community relationships to provide on-the-job training to assist
some social groups 'return to work'
Allowing employees paid time off to provide community services.
Fair trade
Diversity in employees
Lesser injury rate
SUSTAINABILITY
Ensure that development needs of the present are met without compromising the ability of the future generations
to meet their own needs.
Importantly, it refers to both the inputs and outputs of any organisational process. Inputs (resources) must only be
consumed at a rate at which they can be reproduced, offset or in some other way not irreplaceably depleted.
Outputs (such as waste and products) must not pollute the environment at a rate greater than can be cleared or
offset. Recycling is one way to reduce the net impact of product impact on the environment. The business
activities must take into consideration the carbon emissions, other pollution to water, air and local environment,
and should use strategies to neutralise these impacts by engaging in environmental practices that will replenish
the used resources and eliminate harmful effects of pollution. A number of reporting frameworks have been
developed to help in accounting for sustainability including the notion of triple-bottom-line accounting and the
Global Reporting Initiative (GRI). Both of these attempt to measure the social and environmental impacts of a
business in addition to its normal accounting
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Environmental sustainability means that resources should not be taken from the environment or emissions should
not be made into the environment, at a rate greater than can be corrected, replenished or offset
Economic sustainability
This is how countries and companies use resources optimally to achieve responsible and long term economic
growth and wealth. Economic development is often put ahead of environmental sustainability as it involves
people’s standards of living. However, quality of life can decline if people live in an economic place with a poor
environmental quality because of economic development
The balance between environmental conservation and economic development is a longstanding one, and one
which applies to all parts of the world in which business activity takes place. A lot of business activity takes place at
a net cost to the environment and so the sustainability of one (environment or economy) may be achieved only at a
net cost to the other. Some believe that a lot of business activity can be made more environmentally sustainable
but the economic costs of this, possibly by accepting a lower rate of economic growth with its associated effects,
are often unpopular.
Environmental accounting & reporting
FCA(full cost accounting)
Costs and benefits of all company
activities (including social and
environmental impact) ,whether
financial or non-financial in nature
are shown within a company’s
performance figures.
Example of costs included
Contingent liabikity costs
(fines)
Cost of loss of reputation
Costs to ensure zero
negative environmental
effect
TBL (triple bottom line)
This refers to the growth in social and
environmental disclosures alongside
financial information and is
sometimes referred to as reporting
‘people, planet and profits.’
This raises the following additional
issues:
• Are there any rules on what should
be reported?
• Will there be any comparability year
on year, or within industries?
• Will information reported be
balanced or will it inevitably be more
positive than negative?
• Who (if anyone) will check the
accuracy of this information?
It is encouraged by GRI, an
international body promoting
sustainability reporting.
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EMAS(eco-management & audit scheme)
A scheme which recognizes and rewards organisations
that go beyond the minimum legal compliance and
continuously improve their environmental performance.
Key elements
1. Environmental reports made
2. Env reports independently verified
3. Laws and regulations complied with
4. Continuously improve env management
5. Implement ISO 14000
(it provides guidance on:
-How to identify issues and their consequences
-How to produce information regarding setting &
meeting targets)
-EMS (environmental management systems which are
systems used to monitor and manage impact of an org
on the env)
-Audit
-General principles and policies regarding internal and
external communication regarding environmental issues.
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Social and environmental audits
Environmental audits
Environmental audits are structured investigations which can quantify an organisation’s environmental
performance and position by a systematic and objective evaluation of how well the company, its management and
equipment are performing with respect to the primary aim of aiding the natural environment.
An environmental audit enables an organisation to demonstrate its commitment to the reduction of its
environmental footprint.
Environmental audits are voluntary and typically contain the following elements:
The first stage is agreeing suitable metrics for the organisation, which detail what specifically should be monitored
and the best way this is to be achieved. For example, this could be concerned with the measurement of any
chemical leakages from a company’s manufacturing processes and storage facilities.
This selection is important because it will determine what will be measured against, how costly the audit will be
and how likely it is that the company will be criticised for ‘window dressing’ or ‘green washing’..
The second stage is measuring actual performance against the metrics -the audit team then measures actual
performance against the agreed metrics using a representative sample related to the level of risk and the
confidence required in the results. A mixture of compliance and substantive testing will provide the necessary
evidence.
Whilst many items will be capable of numerical and/or financial measurement (such as energy consumption or
waste production), others, such as public perception of employee environmental awareness, will be less so.
The third stage is reporting the levels of compliance or variances. The auditors then compile a report to the board
on their findings, detailing the levels of compliance achieved together with any significant breaches they identified.
They would use the evidence gathered to determine and recommend improvements to the internal control
systems.
Areas which can be covered within the environment audit include:





waste management and waste minimization
emissions to air
energy and utility consumption
environmental emergencies
protection of environmentally sensitive areas
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Benefits of an environmental audit
The benefits will vary depending on the objectives and scope of the environmental audit, but include:
-
-
Improved decision making ( as better understanding of legal obligations, environmental risks and their
assessment etc)
Resource consumption. Understanding how the company interacts with its natural environment allows it
to more efficiently use its resource, particularly non-renewables. This clearly demonstrates that the
company is environmentally responsible
Compliance. An environmental audit will provide independent evidence that the organisation is meeting
its specific statutory requirements
Social audits
Ensures policies towards CSR reviewed and assessed.
It involves taking account of the views of the organisation’s stakeholders
1.Consider objectives
2.review org’s action plan
3.review their performance indicators
4.measure whether objectives achieved
What is Environmental Reporting?
Environmental reporting: narrative and numerical info on organization’s environmental footprint.
Narrative: objectives, reasons for not meeting previous targets, specific stakeholder concerns addressed etc
Numerical: report on measures such as emissions in tonnes, resources consumed in litres, land used in square
meters etc.
Ways of Reporting: as a part of annual report, a stand-alone report, on website, in advertising material
Why should a company report its footprints? Better accountability to stakeholders, can address specific
challenges through these reports (esp. oil companies), society’s perception improves esp. when environmental
errors/accidents occur, helps in environmental risk assessment, encourages internal efficiency in operations as a
proper system for information communication and measurement will need to be created.
In broad terms, environmental reporting is the production of narrative and numerical information on an
organisation’s environmental impact or ‘footprint’ for the accounting period under review.
In most cases, narrative information can be used to convey objectives, explanations, aspirations, reasons for failure
against previous years’ targets, management discussion, addressing specific stakeholder concerns, etc.
Numerical disclosure can be used to report on those measures that can usefully and meaningfully be conveyed in
that way, such as emission or pollution amounts (perhaps in tonnes or cubic metres), resources consumed
(perhaps kWh, tonnes, litres), land use (in hectares, square metres, etc) and similar.
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Guidelines for Environmental Reporting
In most countries, environmental reporting is entirely voluntary in terms of statute or listing rules.Because it is
technically voluntary, companies can theoretically adopt any approach to environmental reporting that they like,
but in practice, a number of voluntary reporting frameworks have been adopted. The best known and most
common of these is called the Global Reporting Initiative (or GRI).
Where does environmental reporting occur?
Environmental reporting can occur in a range of media including in annual reports, in ‘stand alone’ reports, on
company websites, in advertising or in promotional media. To some extent, there has been social and
environmental information in annual reports for many years. In more recent times, however, many companies –
and most large companies – have produced a ‘stand alone’ report dedicated just to environmental, and
sometimes, social, issues. These are often expensive to produce, and contain varying levels of detail and
information ‘quality’.
Advantages and Purposes of Environmental Reporting
Environmental reporting is a useful way in which reporting companies can help to discharge their accountabilities
to society and to future generations (because the use of resources and the pollution of the environment can affect
future generations).
In addition, it may also serve to strengthen a company’s accountability to its shareholders. By providing more
information to shareholders, the company’s is less able to conceal important information and this helps to reduce
the agency gap between a company’s directors and its shareholders.
Academic research has shown that companies have successfully used environmental reporting to demonstrate
their responsiveness to certain issues that may threaten the perception of their ethics, competence or both.
Companies that are considered to have a high environmental impact, such as oil, gas and petrochemicals
companies, are amongst the highest environmental disclosers. Several companies have used their environmental
reporting to respond to specific challenges or concerns, and to inform stakeholders of how these concerns are
being dealt with and addressed.
One example of this is the use of environmental reporting to gain, maintain or restore the perception of legitimacy.
When a company commits an environmental error or is involved in a high profile incident, many stakeholders seek
reassurance that the company has learned lessons from the incident and so can then resume engagement with the
company. For the company, some environmental incidents can threaten its licence to operate or social contract. By
using its environmental reporting to address concerns after an environmental incident, society’s perception of its
legitimacy can be managed.
In addition to these arguments based on accountability and stakeholder responsiveness, there are also two specific
‘business case’ advantages. The first of these is that environmental reporting is capable of containing comment on
a range of environmental risks. Many shareholders are concerned with the risks that face the companies they
invest in and where environmental risks are potentially significant (such as travel companies, petrochemicals, etc)
a detailed environmental report is a convenient place to disclose about the sources of these risks and the ways
that they are being managed or mitigated.
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The second is that it is thought that environmental reporting is a key measure for encouraging the internal
efficiency of operations. This is because it is necessary to establish a range of technical measurement systems to
collect and process some of the information that comprises the environmental report. These systems and the
knowledge they generate could then have the potential to save costs and increase operational efficiency, including
reducing waste in a production process.
In conclusion, then, environmental reporting has grown in recent years. Although voluntary in most countries,
some guidelines such as the GRI have helped companies to frame their environmental reporting. It can take place
in a range of media including in ‘stand alone’ environmental reports, and there are a number of motivations and
purposes for it including both accountability and ‘business case’ motives
Bribery and corruption
Corruption:. Corruption can be loosely defined as deviation from honest behaviour but it also implies dishonest
dealing, self-serving bias, underhandedness, a lack of transparency, abuse of systems and procedures, exercising
undue influence and unfairly attempting to influence. It refers to illegal or unethical practices which damage the
fabric of society.
Bribery: The act of taking or receiving something with the intention of influencing the recipient in some way
favorable to the party providing the bribe. In simple words, bribery is giving or receiving something of value to
influence a transaction. Bribery is a form of corruption.
Examples of form of bribery
-
money
tangible gift
granting a privilege
“facilitation payments” paid to foreign government officials in the course of routine business
-
Parties who may be held responsible:
the payer
the recipient
those who knew about the bribe but didn’t report it
people with authority who don’t take actions to prevent bribery
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Why bribery and corruption are problems
Lack of honesty
Conflict of interest
Economic issues
Professional
reputation
Those with authority and responsibility will not be acting impartially and violating a duty of
service.
Their personal interest will conflict with their legitimate duties and responsibilities.
Furthermore, if they are threatened with public exposure, they might take actions that are
not in the best interest of the organization.
Misallocation of resources will occur. Contracts will go to those who paid the bribe rather
than those who are the most efficient.
It brings a bad name to the profession as a whole.
Measures to combat bribery
1. Top-level commitment. The board must foster a culture in which bribery is never acceptable and it is understood
that the achievement of business objectives should never be at the expense of unethical and corrupt behaviour.
2. Proportionate procedures. Procedures should be implemented which are proportionate to the bribery risks
faced by the organisation and its activities. These should also be transparent, practical, accessible, effectively
implemented and enforced by management.
3. Risk assessment. A formal and documented audit of both the internal and external risks of bribery and
corruption should be periodically undertaken. This should be incorporated into the organisation’s generic risk
management procedures and reported upon annually to shareholders.
4. Due diligence procedures. Bribery risks can be mitigated by exercising due diligence. Any personnel operating in
sensitive areas require greater vigilance; this includes all board members and any personnel involved in
procurement and contract work.
5. Communication. Internal and external communications ensure that bribery prevention policies and associated
procedures are embedded into the organisation’s culture and understood by everyone. Employees at all levels
should undertake regularly anti-bribery compliance training so that they remain constantly aware of the risks.
6. Monitoring and review. Internal audit, tasked by the audit committee, should monitor and review bribery
prevention procedures and recommend improvements where necessary.
How can an anti-corruption culture be established?
-
Set a zero tolerance policy and communicate the consequences that employees may face
The senior manager should be involved in development and implementation of bribery prevention
procedures
Training: general training on threat of bribery at the time of induction as well as specific training to those
involved in higher risk activities such as purchasing and contracting
Do not send a conflicting message by focusing on short term profits
Unachievable targets should not be set
A formal code of conduct should be established
Effective recruitment and human resource procedures in areas where bribery is more likely to be a risk.
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Integrated reporting<IR>
The aim is to give investors and shareholders a broader picture of how companies make their money and their
prospects in the short, medium and long term.
Designed to be an approach to reporting which accurately conveys an organisation’s business model and its sources
of value creation over time, the IR model recognises six types of capital, with these being consumed by a business
and also created as part of its business processes. It is the way that capitals are consumed, transformed and
created which is at the heart of the IR model.



Definition: <IR> demonstrates how organisations really create value:
It is a concise communication of an organisation’s strategy, governance and performance
It demonstrates the links between its financial performance and its wider social, environmental and economic
context
It shows how organisations create value over the short, medium and long term
Integrated reporting is about integrating material financial and non-financial information to enable investors and
other stakeholders to understand how an organisation is really performing. An integrated report looks beyond the
traditional time frame and scope of the current financial report by addressing the wider as well as longer-term
consequences of decisions and action and by making clear the link between financial and non-financial value. It is
important that an integrated report demonstrates the link between an organisation's strategy, governance and
business model
An Integrated Report should be a single report which is the organization’s primary report – in most jurisdictions
the Annual Report or equivalent.
What does integrated reporting mean for companies?
The IIRC defines the following guiding principles for preparing integrated reports which it argues should:
Convey
a
company's
strategic focus
Designed to be an approach to
reporting which accurately
conveys an organisation’s business
model and its sources of value
creation over time, the IR model
recognises six types of capital,
with these being consumed by a
business and also created as part
of its business processes. It is the
way that capitals are consumed,
transformed and created which is
at the heart of the IR model.
P1 Knowledge Summary
IR is designed to make visible the capitals
(resources and relationships) on which the org
depends, how the org uses them and its impact
upon them!
Financial capital: This comprises the pool of
funds available to the business, which includes
both debt and equity finance. This description
of financial capital focuses on the source of
funds.
Manufactured capital. This is the humancreated, production-oriented equipment and
tools used in production or service provision,
such as buildings, equipment and
infrastructure. Manufactured capital draws a
distinction is between inventory
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(as a short-term asset) and plant and
equipment (tangible capital).
Human capital: Is understood to consist of the
knowledge, skills and experience of the
company’s employees and managers, as they
are relevant to improving operational
performance.
Intellectual capital. This is a key element in an
organisation’s future earning potential, with a
close link between investment in R&D,
innovation, human resources and external
relationships, as these can determine the
organisation’s competitive advantage.
Natural capital. This is any stock of natural
resources or environmental assets which
provide a flow of useful goods or services, now
and in the future.
Social and relationships capital. Comprises the
relationships within an organisation, as well as
those between an organisation and its external
stakeholders, depending on where social
boundaries are drawn. These relationships
should enhance both social and collective wellbeing.
Provide information that
"connects the dots" across
all types of risk they face
from
financial
to
environmental and social
Interrelatedness between the factors that affect the ability to create value
Be
responsive
and
inclusive to stakeholders
and their concerns
Quality of relationships with key stakeholders and how their legitimate needs and
interests are taken into account
Contain concise, reliable
and material information.
Which should be consistent over time and comparable with other organisations
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Benefits of <IR>
Increasingly, businesses are expected to report not just on profit but on their impact on the wider economy,
society and the environment. Integrated reporting gives a ‘dashboard’ view of an organisation’s activities and
performance in this broader context.
Systems and Accountability. The need to report on each type of capital would create and enhance a system of
internal measurement which would record and monitor each type for the purposes of reporting. So the need to
report on human capital, for example, would mean that the company must have systems in place to measure,
according to the IIRC guidelines, ‘competences, capabilities and experience and their motivations… including
loyalties *and+… ability to lead, manage and collaborate’. These systems would support the company’s internal
controls and make the company more accountable in that it would have more metrics upon which to report.
Decision-making. The connections made through <IR> enable investors to better evaluate the combined impact of
the diverse factors, or ‘capitals’, affecting the business. This in turn should result in better investment decisions by
the shareholders, and more effective capital allocation by the firm.
Reputation. The greater transparency and disclosure of <IR> should result in a decrease in reputation risk, which in
turn should result in a lower cost of, and easier access to, sources of finance.
Harmonisation. <IR> provides a platform for standard-setters and decision-makers to develop and harmonise
business reporting. This in turn should reduce the need for costly bureaucracy imposed by central authorities.
Communications. The information disclosed, once audited and published, would create a fuller and more detailed
account of the sources of added value, and threats to value (i.e. risks), for shareholders and others. Rather than
merely recording
financial data in an annual report, the IR guidelines would enable the company to show its shareholders and other
readers,
how it has accumulated, transferred or disposed of different types of capital over the accounting period. So it
would have
to report, for example, on the social capital it has consumed, transformed and created. It might include, for
example, the jobs it has created or sustained in its supply chain and the social value of those jobs in their
communities, or how it might operate a system of cultural values for its employees. In addition and in the same
way as for added value, IR would help the organisation to identify, assess and manage its key risks, with this
bringing further benefit to shareholders and others.
Relationships. The information will lead to a higher level of trust from, and engagement with, a wide range of
stakeholders. This emphasis on stakeholder engagement should lead to greater consultation with stakeholder
groups and enable the company to handle their concerns more effectively.
Challenges in IR
– Progress towards IR will happen at different speeds in different countries as regulations and directors duties
vary across the globe
– Directors liability will increase as they will be reporting on the future and on evolving issues
– A balance will need to be created between benefits of reporting and the desire to avoid disclosing competitive
information
– It will take time to convince management to overcome focus on short term rewards.
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Public sector governance-to be covered through the technical article
A simpler summary of the technical Article – Public Sector
Public Sector: This helps to deliver goods/ services that cannot be/ should not be provided by ‘For Profit’
businesses.
Operated (at least partially) by the STATE (a self-governing autonomous region)
STATE
Executive
Government
Legislature
Forms, passes laws
(elected)
Judiciary
Secretariat
Enforces laws
Administration
(independent of
government)
(education, health,
defence, foreign
affairs, tax collection,
immigrations, prisons)
Principal: Mainly Tax payers (funders) and Service Users (pupils in schools, patients in hospitals)
Often the two are the same! But when not, there is a debate about how much state funding is to be allocated to
which public sector organisation/ area.
Objectives: Social purpose, good VFM
Value for Money:



Economy: Budget & Time
Efficiency: Acceptable return on money/ resources invested in a service
Effectiveness: Extent to which an organisation delivers what it intended to deliver
rd
3 Sector Organisations: These organisations do not make profit and do not deliver services on behalf of the State.
They exist to provide benefits that cannot be easily provided by profit making business or the public sector.
NGO: Example ‘Doctors without borders’



Privately funded
Board of Directors is overseen by trustees
Have a stated purpose/ terms of reference
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Quasi-Autonomous NGO (QuANGO):



Funded by the Government but are semi-independent of the government
No political interference
‘Weak’ reporting
Lobby Groups:



Organised attempt to influence government policy or drafting of statute law
Try to ‘lobby’ and get politicians to vote in the legislature in their favour
Best funded are best heard
Stakeholders:
Public Sector:


Tax payers do not have a choice in paying tax
Tax payers have different objectives and views
Private Sector:

Customers who willingly engage with the organisation
Stakeholder Claims: Assessment of validity depends on political stance. Therefore some may be unrecognised.
National





Sub-National
Below national



Public Sector Organisations at various levels
Based in capital city; divided into Central Government departments such as treasury,
interior department, foreign office, defence, education
Led by a political minister of governing party. (In democratic countries, policies of
these departments will then reflect the expectations of the society)
National government policies made and co-ordinated centrally by head of government
Each department’s head (the minister) ensures government’s overall strategic
objectives are achieved by issuing instructions on formulation and implementation of
policies
Ministers are ‘advised’ or ‘helped’ by civil servants/ permanent government
employees
Some countries are sub-divided into regional authorities/ regional assemblies/ states/
municipalities/ local authorities/ department (whatever term used!)
Selected powers given by national government due to belief that these areas are best
handled by local people, due to knowledge, efficiency or cost effectiveness
E.g. of powers: panning of roads, new housing permission, utilities, local schools,
rubbish collection etc.
Local Schools: Have more statistics, can do better ‘need analysis’, budgetary
compliance, teaching quality, results monitored
Led by elected representatives and advised by permanent officials
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Supranational

A multi national organisation where power is delegated to the organisation by the
government of member states
E.g. European Union, World Trade Organisation, World Bank
Strategic Objectives:
Private Sector Organisation:


Answerable to Shareholders
Objectives are therefore according to Shareholders expectations
Public Sector organisation:




Help to achieve higher government policy objectives
Autonomy given to individual organisations varies
Economy: Specified budget and time
Efficiency: As government funded, resource utilisation is important
Effectiveness: Must achieve objectives for which it was established
Criticised normally for over spending or underperforming
Governance Arrangements:
Accountability:



A reporting system
An oversight body
No market mechanism for performance measurement (like the ones listed companies have)
Oversight Body:



A board of governors, a council of reference, a board of trustees, an oversight board
Ensures organisations run for the benefit of users and protects the interest of the funders (taxpayers)
Roles:
a) Comply with government rules
b) Organisation is well run, performance targets met (audits can be done)
c) Budget negotiations and monitoring performance against budgets/ other financial measures
d) Appoint senior officials, monitor management performance
e) Reports upwards to local or central authorities
Public Sector Organisation – nature of democratic control, political influence & policy implementation
Debate about: how they should be operated by law, how constituted, state size, the role of its institutions etc.
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Left Leaning Government: prefer a larger state sector, more state spending, more public sector employment
Right Leaning Government: prefer more to be achieved in private sector, less by government
Policy objectives change with governments, which affect size and importance of public sector
Health Services: some want this entirely funded by taxpayers and others think people should pay (e.g. through
insurance)
University Education: some say that state should pay it, others think students’ should


In some countries, economies restricted through privatisation
In some cases, a previous public sector monopoly supplier turned into a public listed company
Arguments for Privatisation:
Private sector has profit motive and competition, so it can deliver better value to customers
Arguments against Privatisation:
State should control more of the economy plus some services like utilities, airlines, transport etc. are too
important to be subject to market forces
Changes from Public Sector to Private:



Cultural changes
Structure and governance changes
Equally important and so common features between the two are: strategic leadership, clear thinking and
effective strategy implementation
Shareholder Rights and Responsibilities
PUBLIC INTEREST
All professionals, including professional accountants, have a primary duty to the public interest. Professionals
enjoy a privileged position of high esteem in society, and in return, it is important that they act in such a way as to
maintain that position of trust. This includes a commitment to high social values such as human welfare, fairness,
justice, integrity and probity, and the wellbeing of society.
The International Federation of Accountants (IFAC) in its code of ethics states that the accountancy profession
accepts its responsibility to act in the public interest. This means that a professional accountant’s responsibility is
not just to meet the needs of an employer or client but to act in a manner that is for the good of the profession
and society.
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Public interest does not have a set definition.
To act in the public interest is to recognise a fiduciary duty to the benefit of society rather than just a duty to one
particular party.
Public interest concerns the overall welfare of society as well as the sectional interest of the shareholders in a
particular company. It is generally assumed, for example, that all professional actions, whether by medical, legal or
accounting professionals, should be for the greater good rather than for sectional interest.
THE ROLE OF THE ACCOUNTANT IN SOCIETY
Accountants are responsible for acting in the public interest.
This means that accountants need to act in accordance with an agreed set of professional values, always maintain
the highest levels of integrity, and deal fairly with all parties they engage with. Accountants, along with other
professionals in society, are expected to demonstrate unswerving support for these professional values and be
beyond reproach, and act independently at all times.
This may involve disclosing confidential client information to the authorities if it is in the public interest to do so,
e.g. if the client is involved in fraudulent or criminal activities.
In addition, accountants have the skills to be able to provide benefit for society as a whole. This may be that they
are involved in the development of new reporting requirements that will enhance financial reporting. For
example,many governments do not require environmental and social reporting. It is the accounting profession that
has promoted this reporting as voluntary information that should be disclosed alongside the annual report.
Accountants have a role to play in influencing the distribution of power and wealth in society. They may use their
skills to help set up social security systems to distribute state benefits to those in need. They have a wealth of skills
which are readily transferable so can assist governments in designing new financial reporting rules and tax regimes
that may benefit those less well off.
Ethical responsibilities of a professional accountant
Responsibilities to employer: An accountant’s responsibilities to his or her employer extend to acting with
diligence, probity and with the highest standards of care in all situations. In addition, however, an employer might
reasonably expect the accountant to observe employee confidentiality as far as possible.
The responsibilities also include the expectation that the accountant will act in shareholders’ interests as far as
possible and that he or she will show loyalty within the bounds of legal and ethical good practice.
Responsibilities as a professional: In addition to an accountant’s responsibilities to his or her employer, there is a
further set of expectations arising from his other membership of the accounting profession. In the first instance,
professional accountants are expected to observe the letter and spirit of the law in detail and of professional
ethical codes where applicable (depending on country of residence, qualifying body, etc.). In any professional or
ethical situation where codes do not clearly apply, a professional accountant should apply
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‘principles-based’ ethical standards (such as integrity and probity) such that they would be happy to account for
their behaviour if so required. Finally, and in common with members of other professions, accountants are
required to act in the public interest.
The Global reporting Initiative (GRI)
It is a reporting framework which arose from the need to address the failure of the current governance structures
to respond to the changes in the global economy.
It aims to develop transparency, accountability, reporting and sustainable development.
Its vision is that reporting on economic, environmental and social importance should become as routine as
financial reporting.
Contents of such a report
1.
2.
3.
4.
5.
Vision and strategy(with regards to sustainability)
Profile (organizational structure and operations)
Governance structures and management systems
GRI content index ( to state where the info listed in the guidelines is located in the report)
Performance indicators
Shareholders have the following rights:
 The right to sell their stock.
 The right to vote in general meeting.
 The right to certain information about the company.
 The right to sue for misconduct
 Certain residual rights in the case of liquidation.
Responsibilities
The unique nature of the ownership of a share may suggest that shareholders have a limited responsibility for
corporate action. However, this responsibility still exists and can be seen in:
Shareholder democracy: the concern here is whether shareholders, particularly institutional shareholders, can use
their position to influence greater corporate accountability.
Shareholder activism: buying shares in a company gives you the right to have a voice at the AGM and so make
other shareholders aware of company policies and challenges.
Ethical investment: is the use of ethical, social and environmental criteria in the selection and management of
investment portfolios’ of company shares.
XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX
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P1 Past papers index-Dec 2016 attempt
Chapter
Topic
Mapping
1
Concepts underpinning corporate gov.
2
Non-Executive Directors
2
Chairman and CEO
June 16-Q2c
June 14-Q1a
June 11-Q3b
June 12-Q2a
Dec 10-Q3a,b
Dec 09-Q1c
June-15 Q1di
Dec 14-Q3
Dec 11-Q2b
Dec 09-Q2c
2
2
Nomination Committee
Remuneration Committee
3
Induction
3
CPD
3
3
4
Appraisal
Diversity, Appointment, Removal and other
miscellaneous topics
Unitary and two-tier boards
5
Agency theory
6
Stakeholders
June 16-Q1a
June-15 Q2a,c
Dec 14-Q1a
June 14-Q1c
Dec 12-Q4b,c
June 12-Q1d
Dec 10-Q1a
June 10-Q1a,b
7
Codes of corporate governance
7
Insider/outsider structures
June 14-Q4c
Dec 13-Q2 ( prepare Sarbanes Oxley from here as well)
June 13-Q4a
Dec 12-Q2
Dec 11-Q2a,c
June-15 Q1a
June 12-Q4a
June 10-Q4a
P1 Knowledge Summary
Dec 13-Q3a
Dec 13-Q1c
June 13-Q4b,c
Dec 11-Q3a
June 10-Q2
June 12-Q4b
Dec 09-Q2a
June 16-3a
Dec 14-Q4c
June 12-Q4b
June 12-Q3a,c
Dec 13-Q3b
Dec 13-Q4a
June 12-Q4c
Dec 09-Q2b
June 16-Q2a,b
June 13-Q3b
Page 94
8
Disclosures and other communication with
shareholders
June 14-Q2c
Dec 11-Q3-c
June 11-Q1c
Dec 10-Q3c
9
Internal Controls
Dec 15 Q1-d
June 13-Q1c
Dec 12-Q3a,b
June 12-Q1c
Dec 11-Q1ci
June 11-Q1a
Dec 09-Q1b
10
Internal Audit & Audit Committee
11
Reporting on internal controls &
Management information
June-15 Q3
Dec 14-Q4a,b
Dec 13-Q1d
June 13-Q2
June 11-Q3c
Dec 12-Q3c
Dec 10-Q1c
June 10-Q3
Dec 09-Q1d
12
Risk management
June 16-Q4a
Dec 15 Q3
June-15 Q1-c,dii
Dec 14-Q1c
June 14-Q1d
June 14-Q2a,b
Dec 13-Q1b
Dec 13-Q4b
June 13-Q1a
June 13-Q3a,c
Dec 12-Q1b and d
June 12-Q1a
June 12-Q2b,c
Dec 11-Q1cii,iii,iv
Dec 11-Q3b
June 11-Q2
Dec 10-Q4
Dec 09-Q4
13
Ethical theories
13
Kohlberg’s Levels of Moral Development
Dec 15 Q4-a
June 13-Q1d
Dec 10-Q1b
June 16-Q3b
June-15 Q4a
June 14-Q4a,b
June 11-Q1b
P1 Knowledge Summary
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14
Corporate Social Responsibility
Dec 15 Q2-a,b
June-15 Q2b
Dec 14-Q1di and ii
Dec 13-Q3c
Dec 11-Q4
June 11-Q1d
15
Code of ethics
June 16-Q3c
Dec 15 Q1-c
June 14-Q1b
June 14-Q3a,c
Dec 12-Q1c
June 12-Q3b
Dec 11-Q1a
16
Ethical decision making
17
Bribery and corruption
Dec 12-Q4a
June 12-Q1b
Dec 09-Q1a
Dec 09-Q3
Dec 15 Q4-b
Dec 14-Q1b
18
Sustainability
19
Integrated reporting
20
Public sector
21
Public interest and other generic topics
P1 Knowledge Summary
June 16-Q4b,c
June-15 Q4b,c
June 14-Q3b
Dec 13-Q1a
June 13-Q1b
Dec 12-Q1a
Dec 11-Q1b
Dec 10-Q2
June 10-Q1d
Dec 15 Q2-c
Dec 14-Q1diii
June 16-Q1d
Dec 15-Q1a,b
Dec 14-Q2
June 11-Q3a
June 10-Q1c
June 16-Q1b,c
June-15 Q1b
Dec 13-Q4c
June 11-Q4
June 10-Q4b,c
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