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Corporate Governance
Main Principles
Corporate governance
There are 2 possible systems for trying to get companies to have good corporate
governance:
These are:
1. Rules based
2. Principle based
Rules-based system
In the rules-based system, companies adhere to the rules or pay penalties.
ADVANTAGES
1. Clarity
2. Standardisation
4. Easier compliance with the rules, as they are unambiguous, and can be evidenced
DISADVANTAGES
1. Can create just a "box-ticking" approach
5. Expensive
ADVANTAGES
1. Not so rigid, allows for different circumstances.
4. Can develop own specific CG and Internal controls (For example physical controls over cash will be vital to some
businesses and less relevant or not applicable to others.
DISADVANTAGES
1. The principles are so broad that they are of very little use as a guide to best corporate government practice
2. Not easier compliance as with the rules, as they are ambiguous, and can not be evidenced
The principle of comply or explain means that companies have to take seriously the general principles of relevant
corporate governance codes.
Compliance is required under stockmarket listing rules but non-compliance is allowed based on the premise of full
disclosure of all areas of non-compliance.
It is believed that the market mechanism is then capable of valuing the extent of non-compliance and signalling to the
company when an unacceptable level of compliance is reached.
On points of detail companies could be in non-compliant as long as they made clear in their annual report the ways in
which they were non-compliant and, usually, the reasons why.
This meant that the market was then able to punish non-compliance if investors were dissatisfied with the explanation (ie
the share price might fall).
In most cases nowadays, comply or explain disclosures in the UK describe minor or temporary non-compliance.
Some companies, especially larger ones, make full compliance a prominent announcement to shareholders in the annual
report, presumably in the belief that this will underpin investor confidence in management, and protect market value.
Remember though that companies are required to comply under listing rules but the fact that it is not legally required
should not lead us to conclude that they have a free choice.
The stock market takes a very dim view of most material breaches, especially in larger companies.
Typically, smaller companies are allowed (by the market, not by the listing rules) more latitude than larger companies.
This is an important difference between rules-based and principles-based approaches.
Smaller companies have more leeway than would be the case in a rules-based jurisdiction, and this can be very important
in the development of a small business where compliance costs can be disproportionately high.
Rules
Rules-based control is when behaviour is underpinned and prescribed by statute of the countrys legislature.
Compliance is therefore enforceable in law such that companies can face legal action if they fail to comply.
US-listed companies are required to comply in detail with Sarbox provisions.
Sarbox compliance can also prove very expensive.
The same detailed provisions are required of SME's as of large companies, and these provisions apply to each company
listed in New York.
National differences
Developing countries
In developing economies - there are normally many SMEs. For these companies extra regulations would be very costly
So, perhaps for them the option to comply or explain is better.
This would allow those who seek foreign investment to comply more fully than those who don't want it and are prepared to
explain why
Developing countries may not have all resources that are needed for full compliance (auditors, pool of NEDs, professional
accountants, internal auditors, etc).
To help compliance, international standards help nations become competitive.
The OECD (Organisation for Economic Cooperation & Development) was established in 1961.
It is made up of the industrialised marketeconomy countries, as well as some developing countries, and provides a forum in
which to establish and coordinate policies.
The ICGN (International Corporate Governance Network) was founded in 1995 at the instigation of major institutional investors,
represents investors, companies, financial intermediaries, academics and other parties interested in the development of global
corporate governance practices
So whats all this nonsense about then hey?? Well, for a company to be run well, and in the best interests of its shareholders, is a
bit like all good relationships. They are built on solid foundations of trust and so on so thats my little heartwarming story
over back to the boring stuff oh but please remember these need memorising as they are a common question!
Responsibility
Willingness to accept liability for the outcome of governance decisions.
Clarity in the definition of roles and responsibilities.
Conscientious business and personal behaviour.
Accountability
Answerable for the consequences of actions.
Honesty/Probity
Not simply telling the truth but also not being guilty of issuing misleading statements or presenting information in confusing or
distorted way.
Truthful
Not misleading
Integrity
A person of high moral virtue. Adheres to a strict moral or ethical code despite other pressures.
It is an underlying principle of corporate governance and it is vital in all agency relationships.
Straightforward dealing.
Transparency/ Openness
Means openness (say, of discussions), clarity, lack of withholding of relevant information unless necessary.
Disclosure, including voluntary disclosure of reliable information.
Importance of transparency:
Independence
Independence of NEDs.
Independence of the board from operational involvement.
Reputation
Personal reputation for moral virtues.
Organisation reputation for moral virtues.
Accountancy profession reputation for moral virtues.
These are the most prominent group in corporate governance (and often the most annoying).
Seriously though they have a massive part to play in making sure the company is well run and directed (hence the name!)
Executive or non-executive
The numbers and split of executives to NEDs will partly depend upon the regulatory regime of the country.
NEDs are independent and are not involved in the day to day running of the business
Non executives
Investors and regulators prefer there to be more NEDs, due to their independent scrutiny of the company.
Remember that the execs should be working in the best interests of the shareholders and its partly the NEDs job to ensure they
do
Legal responsibilities
So here we are looking at the legal side of what they need to do to help run and direct the company well (corporate governance)
In a unitary board structure (the one where theres just one board - see later sections), all directors share legal responsibility for
company activities and all are accountable to the shareholders.
Notice that directors are all responsible for each others decisions - this is important - it means everyone is looking to ensure each
other does the job well (see collective responsibility below)
In most countries, all directors are subject to retirement by rotation, where they either step down or offer themselves for
reelection (by the shareholders) for another term in office.
This gives shareholders a chance to not re-elect rubbish directors!
Collectively responsible
Directors are collectively responsible for the companys performance, controls, compliance and behaviour.
So theres no hiding place for them hopefully
Board roles
1. They must comply fully with relevant regulatory requirements that will include legal, accounting and governance frameworks.
2. The board of directors must discuss and agree strategies to maximise the long-term returns to the companys shareholders.
Company secretary
Company secretary
Compulsory
In most countries, the appointment of a company secretary is a compulsory condition of company registration.
This is because the company secretary has important responsibilities in compliance, including the responsibility for the
timely filing of accounts and other legal compliance issues.
So as well as making sure her nails are well manicured it is his/her legal responsibility to ensure all the admin that comes
with PLCs are adhered too.
Even though I joke about this - it is actually a vital role. The legal frameworks are there to try and protect the stakeholders
Loyal to company
His or her primary loyalty is always to the company.
In any conflict with another member of the company (such as a director), the company secretary must always take the side
most likely to benefit the company
Technical knowledge
In many countries he (get me being all modern!) must be a member of one of a list of professional accountancy or company
secretary professional bodies
Sub-board management
Sometimes referred to (ambiguously) as middle management, managers below board level are a crucial part of the governance
system.
It is the employees, led by subboard management, that implement strategies, meet compliance targets and collect the
information and data on which boardlevel decisions are made.
Effectiveness
Depends on the extent to which organisational activities are controlled and coordinated.
Strategic drift can occur, especially in large organisations, when this vital control and coordination is ineffective.
It is the sub management which can prevent the strategic drift by making sure the policies decided by the board are actually
followed through
Employee Representatives
Employee representatives
Stock exchanges
Listing rules are sometimes imposed on listed companies often concerning governance arrangements not covered elsewhere by
company law.
In the UK, for example, it is a stock exchange requirement that listed companies comply with the Combined Code on Corporate
Governance
1. legal
2. regulatory
3. compliance
Steps:
1. In the UK a firm seeking listing must register as a public limited company.
This entails a change in its memorandum and articles agreed by the existing members at a special meeting of the company.
2. The company must then meet the regulatory requirements of the Listing Agency which, in the UK, is part of the Financial Services
Authority (FSA).
These requirements impose a minimum size restriction on the company and other conditions concerning length of time trading.
3. Once these requirements are satisfied the company is then placed on an official list and is allowed to make a public offering of its
shares.
4. Once the company is on the official list it must then seek the approval of the Stock Exchange for its shares to be traded.
In principal it is open to any company to seek a listing on any exchange where shares are traded.
5. The London Exchange imposes strict requirements and invariably the applicant company will need the services of a sponsoring
firm that specialises in this type of work.
3. Enhances its credibility as investors and the general public are aware that by doing so it has opened itself to a much higher degree
of public scrutiny than is the case for a firm that is privately financed.
2. There is also a much more public level of scrutiny with a range of disclosure requirements.
3. Financial accounts must be prepared in accordance with IFRS or FASB and with the relevant GAAP as well as the Companies Acts.
4. Under the rules of the London Stock Exchange companies must also comply with the governance requirements of the Combined
Code
Shareholders
Now time for the big boys the most important external actors in corporate governance.
They do, after all, own the business that we are looking to run and direct properly.
Other Investors include fixedreturn bondholders
Agency relationship
The shareholders are the principals . They expect agents (directors) to act in their best economic interests
An agency relationship is one of trust between an agent and a principal which obliges the agent to meet the objectives placed
upon it by the principal.
As one appointed by a principal to manage, oversee or further the principals specific interests, the primary purpose of agency is
to discharge its fiduciary duty to the principal
Agency costs
So lets look at some examples of costs of monitoring and checking on directors behaviour
1. Attending relevant meetings (AGMs and EGMs)
2. Studying company results
3. Making direct contact with companies
Types of Investor
Small investors
Individuals who hold shares in unit trusts, funds and individual companies.
They typically buy and sell small volumes and tend to have fewer sources of information than institutional investors.
They also often have narrower portfolios, which can mean that agency costs are higher, as the individuals themselves
study the companies they have invested in for signs of changes in strategy, governance or performance.
Institutional investors
The biggest investors in companies, dominating the share volumes on most of the worlds stock exchanges.
Examples include Pension funds, insurance companies and unit trust companies each fund being managed by a fund
manager.
Fund managers have some influence over the companies so need to be aware of the performance and governance of
many companies in their funds, so agency costs can be very large indeed.
Auditors
The most obvious role of audit in corporate governance is to report to shareholders that the accounts are accurate (a true and
fair view is the term used in some countries.
A qualified audit report is an important signal to markets about the company.
Other services
These sometimes include social and environmental advice and audit.
Examples
The control of monopolies
Non Corporates
"Non corporate" Corporate Governance
For a nationalised rail service, for example, some loss-making route services may be retained in order to support economic
development in a particular region.
Such service delivery objectives are often underpinned by legislation.
Management serve the interests of the taxpayer who, though, are likely to seek objectives other than long run profit
maximisation.
This causes a problem however. The taxpayer/electorate does not have one simple goal (like shareholders have that of
profit maximisation).
So public servants, elected and non-elected, try to interpret the taxpayers best interests
So there will be a problem of establishing strategic objectives and monitoring their achievement.
The millions of taxpayers and electors in a given country are likely to want completely different things from public sector
organisations.
Some will want them to do much more while others, perhaps preferring lower rates of tax, will want them to do much less
or perhaps not to exist at all.
This can be called the problem of fitness for purpose.
It is normal to have a limited audit of public sector organisations to ensure the integrity and transparency of their financial
transactions, but this does not always extend to an audit of its performance or fitness for purpose.
This change means competition. It changes the skills needed by executive directors, so is usually accompanied by a
substantial internal culture change
In exchange, a charity must demonstrate its benevolent purpose and apply for recognition by the countrys charity
commission or equivalent.
Then there is the agency problem between the donors and the charity.
Will the donations be used fully for the purpose?
Hence the need for very strong regulation
Some charities voluntarily provide full financial disclosures and this places increased pressure on others to do the same.
A common way to help to reduce the agency problem is to have a board of directors overseen by a committee of trustees
(sometimes called governors).
The trustees here act in a similar way to NEDs, and will generally share the values of the charities purpose
Charities can exhibit their effectiveness by using a social or environmental audit-type framework, including a regular and
transparent report on how the charity is run and how it has delivered against its stated objectives.
This increases the confidence and trust of all of the main stakeholders: service users, donors, regulators and trustees and
reduces the agency problem
Purpose
Agents
Principals
Typical
governance
arrangements
Public listed
companies
Maximisation
of long-term
shareholder
returns
Directors
Shareholders
Executive board
monitored by nonexecutive directors
and non-executive
chairman.
Public sector
Implementation
of government
policy
Various
layers of
service and
departmental
managers
Ultimately,
taxpayers and,
in a
democracy,
voters (the
two are often
similar)
Complex political
structures seeking
to interpret the
wishes of taxpayers
and the best way
to deliver services
Charities and
voluntary
organisations
Achievement of
benevolent
purposes
Directors and
service
managers
Donors and
other
supporters
provide the
Ideally, an
executive board
accountable to
independent
provide the
resources.
Service users
or consumers
benefit from
charities.
independent
trustees. Open to
interpretation and
abuse in some
jurisdictions,
however.
Agency
Agency is defined in relation to a principal. What?! Well all this means is an owner (principal) lets somebody run her business
(manager).
The agent is doing this job on behalf of someone else.
Footballers, film stars etc all have agents. They work on behalf of the star. The star hopes that the agent is working in their best
interest and not just for their own commission
Agency Costs
A cost to the shareholder through having to monitor the directors
General
Transaction costs occur when dealing with another party.
If items are made within the company itself, therefore, there are no transaction costs
Company will try to keep as many transaction as possible in-house in order to:
reduce uncertainties about dealing with suppliers
avoid high purchase prices
manage quality
Are the transaction costs (of dealing with others and not doing the thing yourself) worth it?
The 3 factors to take into account as to whether the transaction costs are worthwhile are:
1. Uncertainty
Do we trust the other party enough?
The more certain we are, the lower the transaction / agency cost
2. Frequency
how often will this be needed
3. Asset specificity
How unique is the item
The more unique the item, the more worthwhile the transaction / agency cost is
This can be applied to directors who may take decisions in their own interests also:
1. Uncertainty - Will they get away with it?
2. Frequency - how often will they try it?
3. Asset specificity - How much is to gain?
Responsibilities of..
Board committees
Importance of committees
Many companies operate a series of board sub-committees responsible for supervising specific aspects of governance.
Nominations committee
Advises on:
Looks at continuity and succession planning, especially among the most senior members of the board.
Ensure that each director is fairly but responsibly rewarded for their individual contribution in terms of levels or pay and the
components of each directors package.
It is likely that discussions of this type will take place for each individual director and will take into account issues including
market conditions, retention needs, long-term strategy and market rates for a given job.
Reports to the shareholders on the outcomes of their decisions, usually in the corporate governance section of the annual
report
Board Of Directors
In the UK listed companies have to state in their accounts that they comply with the
following regulations:
1. Separate MD & chairman
2. Minimum 50% non executive directors
(NEDs)
3. Independent chairperson
4. Maximum one-year notice period
5. Independent NEDs (three-year contract, no share options)
Unitary Board
This does not mean that all are equal in terms of the organisational hierarchy, but that all are responsible and can be held
accountable for board decisions.
Advantages
1. NEDs are empowered, being accorded equal status to executive directors.
2. The presence of NEDs can bring independence, experience and expertise
3. Board accountability is enhanced as all directors are held equally accountable under a cabinet government arrangement
4. Reduced likelihood of abuse of power by a small number of senior directors
5. Often larger than a tier of a two-tier board so more viewpoints are expressed and more robustly scrutinised
6. All participants have equal legal responsibility for management of the company and strategic performance
Disadvantages
1. A NED or independent director can not be expected to both manage and monitor
2. The time requirement on NEDs may be onerous
Two-tier boards
The board is split into multi-tiers, separating the executive from directors.
These are predominantly associated with France and Germany.
This two-tier approach can take the form of a:
Supervisory board
Appoints, supervises and advises members of the management board.
A separate chairman coordinates the work and members are elected by shareholders at the AGM
Has no executive function.
factors like age, race, gender, educational background and professional qualifications of the directors to make the board less
homogenous.
In implementing policies on board diversity, both the companys chairman and the
nomination committee play a significant role.
The chairman, being the leader of the board, has to facilitate new members joining the team and to encourage open
discussions and exchanges of information during formal and informal meetings.
The nomination committee should give consideration to diversity and establish a formal recruitment policy concerning
the diversity of board members with reference to the competencies required for the board, its business nature as well as its
strategies.
The committee members have to carefully analyse what the board lacks in skills and expertise and advertise board
positions periodically.
NEDs
1. Strategy role
NEDs are full members and thus should contribute to strategy. They may challenge any aspect of strategy they see fit, and offer
advice
2. Scrutiny role
NEDs should hold executive directors to account for decisions taken.They should represent the shareholders interests
3. Risk role
NEDs should ensure the company adequate internal controls and risk management systems
This is often informed by prescribed codes (such as Turnbull) but some industries, such as chemicals, have other systems in place,
some of which fall under International Organisation for Standardisation (ISO) standards.
4. People role
NEDs should oversee issues on appointments and remuneration, but might also involve contractual or disciplinary issues.
Independence
The Code states as a principle that the board should include a balance of NEDs and executives.
The board should ensure any NED is truly independent in character and judgement by:
not having a material business relationship with the company in the last 3 years
Cross directorships
When two (or more) directors sit on the boards of the other.
In most cases, each directors second board appointment is likely to be non-executive.
This can compromise the independence of the directors involved. For example, a director deciding the salary of a colleague who,
in turn, may play a part in deciding his own salary
It is for this reason the cross directorships are explicitly forbidden by many corporate governance codes
Advantages of NEDs
Disadvantages of NEDs
1. Lack of trust can affect board operations
2. Quality: there may not be many appropriately qualified NEDs around
3. Liability: Poor remuneration and liability in law might reduce potential NEDs further
Role of CEO
Role of CEO
1. To lead the company and to protect shareholder interests above all others
2. To develop and implement polices and strategies capable of delivering superior shareholder value
3. To assume full responsibility for all aspects of the companys operations
4. To manage the financial and physical resources of the company, monitor results, and ensure that effective operational and
risk controls are in place
5. To oversee the management team, co-ordinating the interface between the board and the other employees in the company,
and assisting in the appointment of directors to the board
6. Communicating effectively with significant stakeholders including the companys shareholders, suppliers, customers and
state authorities
2. The chairman represents the company to investors and other outside stakeholders/constituents.
3. Effective communication with shareholders
The public face of the organisation So, the chairmans roles include communication with shareholders.
This occurs in a statutory sense in the annual report and at annual and extraordinary general meetings.
4. Finally, the co-ordinating of NEDs and facilitating good relationships between them and executives
5. Ensuring the board receives accurate and timely information
Allows chairman to inform shareholders about issues Legal rights and responsibilities of Directors (Breach of responsibility
can leave director open to criminal prosecution)
Disclosures
1. risk disclosure
2. social and environmental reporting
Others
The accounts
Press releases
AGM
Shareholder approval is signalled by the passing of resolutions in which shareholders vote in proportion to their holdings.
It is usual for the board to make a recommendation and then seek approval of that recommendation by shareholders.
The dividend per share, for example, is recommended by the board but only paid after approval by the shareholders at the AGM.
Institutional shareholders may employ proxy voting if they are unable to attend in person.
The chairman should arrange for the chairmen of the audit, remuneration and nomination committees to be available to answer
and for all directors to attend.
Notice of the AGM to be sent to shareholders at least 20 working days before the meeting
a shareholder mandate for a particular strategic move, such as for a merger or acquisition.
Other major issues that might threaten shareholder value may also lead to an EGM such as a whistleblower disclosing
information that might undermine shareholders confidence in the board of directors
They also occur for many irregular events for special issues such as takeovers
The issue is basically too serious to wait for the next AGM
Proxy Voting
Ensures that shareholders unable to attend meetings can still vote
The Combined Code 2006 requires that:
After a vote has been taken the number of proxy votes should be stated in terms of:
Individual Directors
Directors Rights and Duties
These are:
Rights
The first thing to understand is that directors do not have unlimited power. They are limited by:
1. Articles of association
These prescribe how directors operate including the need to be re-elected every 3 years
2. Shareholder resolution
This can stop the directors acting for them
3. Provisions of law
Eg health and safety or the duty of care.
4. Board decisions
Boards make decisions in the interests of shareholders not directors
Fiduciary Duties
1. Act in good faith:
as long as directors motives are honest
duties
remuneration details
constraints
Induction
Depends on their background
It is important, for effective participation in board strategy development, not only for the board to get to know the new
director, but also for the director to build relationships with the existing board and employees below board level.
Induction Process
Highly tailored to the individual but will include the following
1. Company structure
2. Company values
3. Company strategy
4. Markets and key players
Objectives of CPD
1. Maintain sufficient skills and ability
2. To communicate challenges and changes within the business environment
3. Improve board effectiveness
4. Support personal development of directors
Conflicts of Interest
Key areas
Directors contracting with their own company (However, the articles may allow if disclosed)
Insider dealing/trading
Here a director uses information (not known publicly) which if publicly available would affect the share price
Trading in own shares with this knowledge is fraud
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.
If, for example, they are made aware of a higher than expected performance, it would be classed as insider dealing to buy
company shares before that information was published.
Director's Remuneration
Director's Remuneration
These include:
2. Short and long-term bonuses and incentive plans which are payable based on pre-agreed performance targets being met;
3. Share schemes
which may be linked to other bonus schemes and provide options to the executive to purchase predetermined numbers of shares
at a given favourable price;
4. Pension and termination benefits including a pre-agreed pension value after an agreed number of years service and any
golden parachute benefits when leaving;
5. Pension contributions
are paid by most responsible employers, but separate directors schemes may be made available at higher contribution rates than
other employees.
6. Other benefits in kind such as cars, health insurance, use of company property, etc.
Balanced package
This is needed for the following reasons:
A reward package that only rewards accomplishments in line with shareholder value substantially decreases agency costs
and when a shareholder might own shares in many companies, such a self-policing agency mechanism is clearly of benefit.
Typically, such reward packages involve a bonus element based on specific financial targets in line with enhanced company
(and hence shareholder) value.
Director's removal
Retire by Rotation
At AGM, every 3 years
Termination
1. Death
2. Resignation
3. Not seeking re-election (see above)
4. Bankruptcy
5. Disciplinary procedures
Disqualification
The reasons can be:
Wrongful trading - allowing the company to trade while knowing its insolvent
Stakeholders
CSR is a concept whereby organisations consider the interests of society by taking responsibility for the impact of their activities
on wider stakeholders.
Milton Friedman
Only humans have moral responsibilitiesnot companies
Eg.
Shareholders demand a good return
Employees want fair employment
Customers seek good quality products
2. Legal
Legal responsibility to operate within the laws of society e.g.. Health and safety
Laws codify society's moral views
3. Ethical
Ethical responsibility to act fairly e.g..Do not put profits before ethical norms
4. Philanthropic
Philanthropic responsibility to give to charities, sponsor art events etc
This framework is used to attempt to understand the influence that each stakeholder has over an organisations strategy.
The idea is to establish which stakeholders have the most influence by estimating each stakeholders individual power over and
interest in the organisations affairs.
The stakeholders with the highest combination of power and interest are likely to be those with the most actual influence over
objectives.
Interest
is how much the stakeholders care
Influence
= Power x Interest
However it is very hard to effectively measuring each stakeholders power and interest.
The map is not static; changing events can mean that stakeholders can move around the map
Definition
Freeman,1984 defined a stakeholder as:
Any group or individual who can affect or [be] affected by the achievement of an organisations objectives.
This definition shows important bi-directionality of stakeholders - that they can be affected by - and can affect - an
organisation.
1. shareholders
2. management
3. employees
4. trade unions
5. customers
6. suppliers
7. communities
Stakeholder Theory
Business are now so large and pervasive they are accountable to more than just direct shareholders; they are also accountable to
other stakeholders
STAKEHOLDER CLAIMS
A stakeholder makes demands of an organisation.
Some shareholders want to influence what the organisation does (those stakeholders who want to affect) and the others are
concerned with the way they are affected by the organisation.
Some stakeholders may not even know that they have a claim against an organisation, this brings us to the issue of..
1. trade unions
2. shareholders
3. employees
4. customers
5. suppliers
being remote from the organisation (eg producer groups in distant countries).
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?
The example is an environmental pressure group
Categories of Stakeholder
2. External stakeholders
Will include customers, competitors, suppliers, and so on.
Some will be more difficult to categorise, such as trade unions that may have elements of both internal and external membership
2. Wider stakeholders
Less affected and may typically include government, less-dependent customers and the wider (non local) community
An organisation may have a higher degree of responsibility and accountability to its narrower stakeholders.
2. Secondary stakeholders
Those that the organisation does not directly depend upon for its immediate survival
Do not influence the organisation
2. Passive stakeholders
Are those who do not normally seek to participate in an organisations 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 organisations strategy.
Will normally include most shareholders, government, and local communities.
2. Involuntary stakeholders
Involuntary stakeholders have their stakeholding imposed and are unable to detach or withdraw of their own volition.
Do not choose to be stakeholders but are so nevertheless
Includes local communities, the natural environment, future generations, and most competitors.
1. Legitimate
Those with an active economic relationship with an organisation will almost always be considered legitimate.
For example suppliers, customers
2. Illegitimate
Those 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.
Theory
Stakeholder Theory
Stakeholder Theory
A business is a citizen of society, enjoying its protection, support and benefits so it has a duty to recognise a plurality of
claims
each other in respect of taking account of each others concerns and opinions.
The normative view argues that organisations should accommodate stakeholder concerns 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.
Internal Control
Objectives of Internal Control
To ensure the orderly and efficient conduct of business in respect of systems being in place and fully implemented.
To safeguard the assets of the business. Assets include tangibles and intangibles
at the operational level, controls are aimed at ensuring that the organisation does things right.
However, internal control systems are only as good as the people using them.
No system is infallible
Responsibility for internal control is not simply an executive management role.
Though they should set the tone
All employees have some responsibility for monitoring and maintaining internal controls
These are:
Principles of internal control embedded within the organisations structures, procedures and culture.
The United States Securities and Exchange Commission (SEC) guidelines are to disclose in the
annual report as follows:
A statement of managements responsibility for establishing and maintaining adequate internal control over financial
reporting for the company.
This will always include the nature and extent of involvement by the chairman and chief executive, but may also specify
the other members of the board involved in the internal controls over financial reporting.
The purpose is for shareholders to be clear about who is accountable for the controls.
A statement identifying the framework used by management to evaluate the effectiveness of this internal control.
Managements assessment of the effectiveness of this internal control as at the end of the companys most recent fiscal
year.
This may involve reporting on rates of compliance, failures, costs, resources committed and outputs (if measurable)
achieved.
Internal Audit
Internal Audit - What and When
Internal Audit
What is Internal audit?
Internal audit is a management control, where all other controls are reviewed
The department is normally under the control of a chief internal auditor who reports to the audit committee.
2. Follow up Visits
Many organisations also require internal audit staff to conduct follow-up visits to ensure that any weaknesses or failures
have been addressed since their report was first submitted.
This ensures that staff take the visit seriously and must implement the findings.
3. Examine Information
Internal audit may also involve an examination of financial and operating information to ensure its accuracy, timeliness
and adequacy.
In the production of internal management reports, for example, internal audit may be involved in ensuring that the
information in the report is correctly measured and accurate.
Internal audit needs to be aware of the implications of providing incomplete or partial information for decision-making.
Audit Committee
Audit Committee & Internal Control
Playing a more supervisory role if necessary, for example reviewing major expenses and transactions for reasonableness
Audit committee must oversee the relationship between external auditors and the company
Key roles
So the role is to OVERSEE the external audit relationship, I want you to therefore visualise windscreen wipers when you think of
audit committee and external audit.
Visualise the committee as windscreen wipers - helping the external auditors to see things more clearly.
This will help you understand their key role in this respect:
I independence is maintained
As part of the overseeing internal controls the audit committee must also oversee the internal audit function
This time I want you to appreciate the difference between how an audit committee would deal with an external auditor
compared to an internal one.
To make that distinction clear for your memory - understand that the internal audit department work for the same company as
the committee.
They share the same goals therefore. In fact picture the internal auditor as one man only.
After all the head of IA is in fact appointed by the audit committee.
Remember though that he works for the same company as the audit committee.
So they like him. In fact they often say We are Him!.
This will help you memorise those key roles..
Key roles
W ork plan reviewed
E ffectiveness assessed
E fficiency of IA ensured
H ead of IA appointed
I ndependence preserved
M onitor IA
Risk
Identifying Risks
Categories of risk
1. Strategic risks
Refers to the positioning of the company in its environment.
Typically affect the whole of an organisation and so are managed at board level
2. Operational risks
Refers to potential losses arising from the normal business operations.
Are managed at risk management level and can be managed and mitigated by internal controls.
3. Financial risks
= are those arising from a range of financial measures.
The most common financial risks are those arising from financial structure (gearing), interest rate risk, liquidity
4. Business risks
The risk that the business won't meet its objectives.
If the company operates in a rapidly changing industry, it probably faces significant business risk.
5. Reputation risk
Any kind of deterioration in the way in which the organisation is perceived
When the disappointed stakeholder has contractual power over the organisation, the cost of the reputation risk may be material.
6. Market risk
Those arising from any of the markets that a company operates in, such as where the business gets its inputs, where it sells its
products and where it gets its finance/capital
Market risk reflects interest rate risk, currency risk, and other price risks
7. Entrepreneurial risk
8. Credit risk
Credit risk is the possibility of losses due to non-payment by creditors.
4 step process:
1. Identify Risk
Make list of potential risks continually
2. Analyse Risk
Prioritise according to threat/liklihood
4. Monitor Risk
Assess risks continually
Related risks
Related risks
These are risks that vary because of the presence of another risk.
This means they do not exist independently and they are likely to rise and fall in importance along with the related one.
Risk correlation is a particular example of related risk.
Positively Correlated
Risks are positively correlated if one will fall with the reduction of the other and increase with the rise of the other.
Negatively correlated
They would be negatively correlated if one rose as the other fell.
Example
Often environmental and reputation risks are positively correlated - the more attention spent on how the business
interacts with the environment means their environmental risk is lower and also their reputation risk
Risk Analysis
Risk Analysis
Risk Analysis
Risk Attitudes
Risk Attitudes
1. Risk Appetite
This determines how risks will be managed.
Some will be risk averse and some will be risk seekers, younger companies often need to be risk seekers and more established
companies risk averse
2. Risk Capacity
Risk capacity indicates how much risk the organisation can accept.
The overall strategy of an organisation will therefore be affected by risk strategy, risk appetite and risk capacity.
ALARP
(As low as reasonable practicable)
A risk is more acceptable when it is low (and less acceptable when it is high).
Risks cannot be completely eliminated, so each risk is managed so as to be as low as is reasonably practicable because we
can never say that a risk has a zero value.
For example, It would be financially and operationally impracticable to completely eliminate health and safety risks
This does not mean becoming complacent, so we maintain a number of controls that should reduce the probability of the
risks materialising,
TARA
There are four strategies for managing risk and these can be undertaken in sequence. It is sometimes called the TARA framework.
1. Transfer
This means passing the risk on to another party which, in practice means an insurer or a business partner such as a supplier or a
customer
2. Avoid
This means asking whether or not the organisation needs to engage in the activity where the risk is.
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
the risk.
3. Reduce
This means diversifying the risk or re-engineering a process to bring about the reduction.
It can also include Risk sharing.
This involves finding a party that is willing to enter into a partnership so that the risks of a venture might be spread
4. Retain
This means believing there to be no other feasible option. Such retention should be accepted when the risk and return
characteristics are clearly known
Embedded Risk
Embedded risk
How?
Introduce risk controls into the process of work and the environment in which it takes place.
So that people assume such measures to be non-negotiable components of their work experience.
Risk management becomes unquestioned, taken for granted, built into the corporate mission and culture and may be used
as part of the reward system.
Risk Monitoring
Risk Manager
3. Monitor overall exposure and specific risks. Strategic risk monitoring could occur frequently
4. Assess the effectiveness of risk management systems
Risk Audits
Risk Audit
Features
1. Complicated
It can be a complicated and involved process. Some organisations employ teams of people to monitor and report on risks.
2. Voluntary
Risk audit is not a mandatory requirement for all organisations but, importantly, in some highly regulated industries (such as
banking and financial services), a form of ongoing risk assessment and audit is compulsory
Process
1. Identify risk
Management must be aware of potential risks
They change as the business changes
So this stage is particularly important for those in turbulent environments
Uncertainty can come from any of the political, economic, natural, socio-demographic or technological contexts in which the
organisation operates.
2. Assess risks
The probability and the impact of the risk needs assessing
( sometimes not possible to gain enough information about a risk to gain an accurate picture of its impact and/or probability)
This strategy is often, from share portfolio management to terrorism prevention.
Businesses then come up with strategies to deal with the risks (TARA) but thats for a different part of the syllabus
In a risk audit, the auditor now reviews the organisations responses to each identified and assessed risk.
Disadvantages
Impaired independence and overfamiliarity
Ethics
Professional
Professions and the Public Interest
Profession
Has two essential and defining characteristics:
1. A body of theory
2. Knowledge which guides its practice and commitment to the public interest
Professionalism
Professionalism may be interpreted more as a state of mind while the profession provides the rules that members of that
profession must follow.
Over time, the profession appears to be taking more of a proactive than a reactive approach. This means seeking out the public
interest and positively contributing towards it
The Public Interest
Providing information that society as a whole should be aware of in many cases public interest disclosure is used to establish
that disclosure is needed although there is no law to confirm this action
A professional accountant
Society accords professional status to those that both possess a high level of technical knowledge in a given area of expertise
(accounting, engineering, law, dentistry, medicine) on the understanding that the expertise is used in the public interest.
The body of knowledge is gained through passing examinations and gaining practical expertise over time. Acting in the public
interest means that the professional always seeks to uphold the interests of society and the best interests of clients (subject to
legal and ethical compliance).
1. Integrity
The highest levels of probity in all personal and professional dealings. Professionals should be straightforward and honest in all
relationships.
2. Objectivity
Professionals should not allow bias, conflicts of interest or undue influence to cloud their judgements or professional decisions.
4. Confidentiality
Professionals should, within normal legal constraints, respect the confidentiality of any information gained as a result of
professional activity or entrusted to them by a client.
5. Professional behaviour
Professionals should comply fully with all relevant laws and regulations whilst at the same time avoiding anything that might
discredit the profession or bring it into disrepute.
Responsibilities to employer
Acting with diligence, probity and care in all situations.
Absolute discretion of all sensitive matters both during and after the period of employment.
To act in shareholdersinterests 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
To observe the letter and spirit of the law in detail and of professional ethical codes where applicable
If no codes, apply principles-basedethical standards (such as integrity and probity) such that they would be happy to
account for their behaviour if so required.
Accounting has a large potential impact on the public - the working of capital markets and hence the value of tax
revenues, pensions and investment rests upon accountantsbehaviour.
The stability of business organisations and hence the security of jobs and the supply of important products also depends
Ethical threats
Ethical threats
You are an ASS IF you get caught doing any of these ;-)
A dvocacy
S elf-interest
S elf-review
I ntimidation
F amiliarity
Safeguards against these threats:
1. Be professional
CPD; Corporate governance regulations; professional monitoring and discipline
3. Individual ethics
comply with profession standards; mentoring, contact ACCA if in doubt, whistle-blowing
Bribery
= "the offering, giving, receiving or soliciting of any item of value to influence the actions of an official or other person in
charge of a public or legal duty."
1. Offer
2. Promise or
3. Give an advantage
... to someone who you want to act improperly.
Being bribed
The recipient is also guilty.
If a person in your business bribes another personal to give your business an advantage - the business is guilty then too.
Small and medium-sized enterprises will inevitably have fewer resources to counter bribery than larger companies.
Make sure that all senior managers and directors understand that they could be personally liable.
It is important that senior management lead the anti-bribery culture of the business, especially if it wants to take
advantage of the adequate procedures defence to the offence of failing to prevent bribery.
Risk assessment
1. Make sure the risks that the business may be exposed to, are understood.
For example, certain industry sectors (such as construction, energy, oil and gas, defence and aerospace, mining and financial
services) and countries present a greater risk as employees are more likely to engage in bribery in these areas.
2. Review how potential customers are entertained, especially those from government agencies or state-owned enterprises or
charitable organisations.
Routine or inexpensive corporate hospitality is unlikely to be a problem, but have clear guidelines in place that everybody
understands.
Ensure background checks are carried out on any agents or distributors before engaging them.
If the business operates in a high-risk industry sector or country, consider introducing a compulsory training programme for
all staff.
Corruption
= "the abuse of entrusted power for private gain".
Ethical Codes
Ethical Codes
C ompany Values
S ourcing of products/ materials done ethically
Content
1. Introduction
(Background and disciplinary measures)
2. Fundamental Principles
(Summary)
3. Conceptual Framework
(How principles are applied)
4. Detailed Application
(Specific circumstances)
Principles
1. Integrity
2. Objectivity
3. Professional Competence
4. Confidentiality
5. Professional BehaviourLimitations of Codes
Limitations
They can convey the (false) impression that professional ethics can be reduced to a set of rules contained in a code.
Personal integrity is needed also emphasised.
Ethical codes do not and cannot capture all ethical dilemmas that an accountant will encounter.
Regional variations mean that such codes cannot capture important differences in emphasis in some parts of the world.
The moral right cannot be prescribed in every situation.
Professional codes of ethics are not technically enforceable in any legal manner
2. Moral Judgement
It is immoral to do so as the money is not mine
3. Intent
I should put the petty cash where it belongs
4. Be Moral!
Ensure I do put it back and not buy myself a coffee!
Context Related
Certain behaviours are always rewarded or punished
It is the norm for this action to happen
Depends on culture and religion
Deontological ethics
It originates from the Greek word deon, meaning "duty or obligation" (logos, "science").
It is based on the concept of duty.
e.g. an obligation to tell the truth, not to harm others
An action is considered morally good because of some characteristic of the action itself, not because the product of the action
(consequence) is good
This derives from the Greek word teos, meaning "end", since the end result of the action is the sole determining factor of its
morality.
A decision is right or wrong depends on its consequences or outcome.
As long as the consequences of the action taken are more favourable than unfavourable, then the action can be considered as
morally right.
1. Egoism
The quality of the outcome refers to the individual (what is best for me?).
2. Utilitarianism
The quality of outcome in terms of the greatest happiness of the greatest number (what is best for the majority?).
Consequentialist ethics are therefore situational and contingent, and not absolute.
Deontological ethics
1. This is where the means are judged more important than the ends.
2. The rightness of an action is judged by its intrinsic virtue
3. Morality is seen as absolute and not situational. An action is right if it would, by its general adoption, be of net benefit to society.
Lying, for example, is deemed to be ethically wrong because lying, if adopted in all situations, would lead to the deterioration of
society.
Teleological ethics
1. This is where the ends are judged more important than the means.
2. An act is right or wrong depending on the favourableness of the outcome (consequences)
3. In the teleological perspective, ethics is situational and not absolute.
Absolutism vs Relativism
Absolutism
Right and wrong are objective qualities that can be rationally determined and do not change regardless of the person,
culture or environment
Believes that there are eternal rules that guide all decision making in all situations.
A Dogmatic approach means accepting without discussion or debate and is an example of absolutism
Relativism
A relativist will adopt a pragmatic approach and decide, in the particular situation, what is the best outcome.
This involves a decision on what outcome is the most favourable and that is a matter of personal judgment.
2. Conventional
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.
The more compliant you are with norms, the moral you see yourself as being.
Views the moral right as being compliant with legal and regulatory frameworks / norms of society
3. Post-Conventional
At the postconventional level, morality is understood in terms of conformance with perceived higher or universal ethical
principles.
Postconventional assumptions often challenge existing regulatory regimes and social norms and so postconventional behaviour can
often be costly in personal terms.
Morality is conformance with higher or universal ethical principles.
Assumptions often challenge existing regulatory regimes and social norms and so is often costly in personal terms.
Suggests a logical, seven-step process for decision making, which takes ethical issues into
account.
1. Establish the facts of the case. To ensure there is no ambiguity about what is under consideration.
2. Identify the ethical issues in the case, by asking what ethical issues are at stake.
3. Identify the norms by placing the decision in its social, ethical, and professional behaviour context.
Professional codes of ethics are taken to be the norms, principles, and values.
4. Identify alternative courses of action by stating each one, without consideration of the norms, in order to ensure that each
outcome is considered, however inappropriate it might be.
5. What is the best course of action that is consistent with the norms.
Then it should be possible to see which options accord with the norms and which do not.
Tucker's Model
Is the decision:
profitable?
legal?
fair?
right?
sustainable or environmentally sound?
This model can require more thought than when using the AAA model in some situations.
It might be the case that not all of Tuckers criteria are relevant to every ethical decision.
The reference to profitability means that this model is often more useful for examining corporate rather than professional or
individual situations.
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.
These are
1. Pristine Capitalists
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
2. Expedients
Also believe in maximising shareholder wealth, but recognise that some social responsibility may be necessary
So, 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
4. Social ecologists
Recognise that business has a social and environmental footprint and therefore bears some responsibility in minimising the
footprint it creates.
An organisation might adopt socially responsible policies because it feels it has a responsibility to do so.
5. Socialists
Those that see the actions of business as manipulating, and even oppressing other classes of people.
Business is a concentrator of wealth in society and so the task of business, social, and environmental responsibility is very large
much more so than merely adopting token policies
Business should recognise and redresses the imbalances in society and provides benefits to stakeholders well beyond the owners
of capital.
6. Radical feminists
Also seek a significant readjustment 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 would be better if society and business were based instead on connectedness, equality, dialogue, compassion, fairness, and
mercy (traditionally seen as feminine characteristics).
7. Deep ecologists
The most extreme position, strongly believing that humans have no more intrinsic right to exist than any other species
The worlds ecosystems of flora and fauna are so valuable and fragile that it is immoral for these to be damaged simply for the
purpose of human economic growth.
Economic Sustanability
Economic sustainability is the term used to identify various strategies that make it possible to utilise available resources to best
advantage.
The idea is to promote usage of those resources that is both efficient and responsible, and likely to provide long-tem benefits.
In the case of a business operation, economic sustainability calls for using resources so that the business continues to function
over a number of years, while consistently returning a profit.
Economic sustainability forces a company to look on the internal and external implications of sustainability management.
There is some consensus that sustainability is desirable for individual businesses to prevent the devastating and inefficient
impacts of corporate premature death, and to enable and protect social and environmental initiatives, which tend to be the
product of more mature businesses.
Economic sustainability can be seen as a tool to make sure the business does have a future and continues to contribute to the
financial welfare of the owners, the employees, and to the community where the business is located.
The social and environmental accounting movement began in the mid-1980s, when it was argued that there was a moral case
for businesses, in addition to reporting on their use of shareholders funds, to account for their impact on social and natural
environments.
How, though for example, could you attribute a cost to the loss of species habitat when building a new factory?
The full cost, then, should include the cost to the environment.
Social Audit
A process that enables an organisation to assess and demonstrate its social, economic, and environmental benefits and
limitations.
Also measures the extent to which an organisation achieves the shared values and objectives set out in its mission
statement.
Provides the process for environmental auditing
Environmental audit
This allows an organisation to produce an environmental report dealing with the concerns above
This is generally voluntary
It means organisations must start collecting appropriate data:
agreed metrics (what should be measured and how)
performance measured against those metrics
and reporting on the levels of variance.
Entirely voluntary?
Not always as stakeholder pressure may demand it
Most large organisations collect a great deal of data, many have environmental and produce an annual environmental report.
Social and environmental issues in the conduct of business and of ethical behaviour
Economic activity is only sustainable where its impact on society and the environment is also sustainable.
Sustainability can be measured empirically or subjectively
Environmental Footprint
Measures a companys resource consumption of inputs such as energy, feedstock, water, land use, etc.
Measures any harm to the environment brought about by pollution emissions.
Measures resource consumption and pollution emissions in either qualitative, quantitative or replacement terms.
Together, these comprise the organisations environmental footprint.
A target may be set to reduce the footprint and a variance shown.
Not all do this and so this makes voluntary adoption controversial
Sustainable development
The development that meets the needs of the present without compromising the ability of future generations to meet their own
needs.
Energy, land use, natural resources and waste emissions etc should be consumed at the same rate they can be renewed
Sustainability affects every level of organisation, from the local neighborhood to the entire planet.
It is the long term maintenance of systems according to environmental, economic and social considerations.
EMAS
EMAS compliance is based on ISO 14000 recognition although many organisations comply with both standards
EMAS focuses on the standard of reporting and auditing of that reported information.
Many companies refer to the standards in their CSR reports
ISO 14000
ISO 14000 focuses on internal systems although it also provides assurance to stakeholders of good environmental
management.