Professional Documents
Culture Documents
P1 - Notes Haroon Tabraze
P1 - Notes Haroon Tabraze
Agency theory: Agency is a contract under which one party (the principal) engages
another party (the agent) to perform some service on their behalf. As part of this, the
principal will delegate some decision-making authority to the agent.
Principal: are the share holders, who cannot run management due to:
Wide ownership base, especially in companies listed on stock exchanges
Lack of interest in the management due to limited risk and liability
Possible short term motive of capital gains in stock market (have ability to simply
sell shares if company is in trouble)
Agency Costs: are incurred by Principals to monitor working of their agents (because of
lack of trust)
i.e. Internal and External Audits
Accountability: is the need to explain and justify any failure to fulfill responsibility
Agent is accountable to the Principal (by whom he is employed) when he accepts
to undertake the task given to him
Fiduciary responsibilities:
A fiduciary is expected to be extremely loyal to the person to whom they owe the
duty (Principal);
They must not put their personal interests before the duty, and
Must not profit from their position as a fiduciary, unless the principal consents.
The fiduciary relationship is highlighted by good faith, loyalty and trust.
Stakeholders: any person or group which get affected by the running of the organization
Corporate governance includes the relationships among the many players involved (the
stakeholders) and the goals for which the corporation is governed. The principal players
are the shareholders, management and the board of directors. Other stakeholders
include employees, suppliers, customers, banks and other lenders, regulators, the
environment and the community at large.
Corporate governance deals with issues of accountability and fiduciary duty, essentially
advocating the implementation of guidelines and mechanisms to ensure good behavior
and protect shareholders.
Another key focus is the economic efficiency view, through which the corporate
governance system should aim to optimize economic results, with a strong emphasis on
shareholders welfare.
Agency Costs:
Agency loss is zero when the agent takes actions that are entirely consistent with the
principal’s interests. As the agent’s actions diverge from the principal’s interests, agency
loss increases
Monitoring costs: are expenditures paid by the principal to measure, observe and control
an agent’s behavior. They may include:
Cost to provide data to shareholders (financial statements)
Cost of audits of financial statements,
Cost to hold Annual General Meetings,
Executive compensation contracts, remuneration schemes, incentives and
ultimately the cost of firing managers.
Too much monitoring will reduce managerial entrepreneurship
Bonding Costs: Given that agents ultimately bear monitoring costs, they are likely to set
up structures that will see them act in shareholder’s best interests, or compensate them
accordingly if they don’t. The cost of establishing and adhering to these systems are
known as bonding costs
Residual Loss: Despite monitoring and bonding, the interest of managers and
shareholders are still unlikely to be fully aligned. Therefore, there are still agency losses
arising from conflicts of interest. These are known as residual loss. i.e. Directors
furnishing themselves with expensive cars.
Auditors:
Have their own interest i.e. fee, reputation
When auditor is independent from management, only then he can serve
interest of shareholders
Auditor has to deal with management to conduct audit, and to get his fee, so
he may be perceived not to serve shareholders completely.
For effective monitoring, auditor should be technically competent and up-to-
date with current business approaches.
Agent accountability:
Directors are accountable to the shareholders
Directors should prove that they are discharging their duties efficiently (clean
audit report, good results, compliance with codes)
If shareholders are not satisfied with performance, they can remove the
management
There are number of Codes of Conduct issued by Government and Stock
Exchanges which needs to be complied (voluntarily)
Stakeholder theory:
Companies are large, and should discharge accountability to all stakeholders
(not only shareholders)
Typical stakeholders are employees, customers and suppliers, community,
government, environment, future generations
Stakeholders provide company with a contribution (infrastructure i.e. road)
and expect the company to satisfy their interest (give employment to locals).
"A company is an entity distinct alike from its shareholders and its directors. Some of its powers
may, according to its articles, be exercised by directors; certain other powers may be reserved
for the shareholders in general meeting. If powers of management are vested in the directors,
they and they alone can exercise these powers. The only way in which the general body of
shareholders can control the exercise of powers by the articles in the directors is by altering the
articles, or, if opportunity arises under the articles, by refusing to re-elect the directors of whose
actions they disapprove. They cannot themselves usurp the powers which by the articles are
vested in the directors any more than the directors can usurp the powers vested by the articles in
the general body of shareholders."
Shaw & Sons (Salford) Ltd v Shaw
Duties of Directors
1. Acting in Good Faith: the directors must act "bona fide" in what they consider—not what
the court may consider—is in the interests of the company. Difficult Questions arise i.e. it
may be for the benefit of a corporate group as a whole for a company to guarantee the
debts of a "sister" company. Similarly, conceptually at least, there is no benefit to a
company in returning profits to shareholders by way of dividend
2. Proper Purpose: in many instances an improper purpose is readily evident, i.e. a director
looking to make money for himself, or divert an investment opportunity to a relative; such
breaches usually involve a breach of the director's duty to act in good faith. Greater
difficulties arise where the director, whilst acting in good faith, is serving a purpose that is
not regarded by the law as proper.
3. Unfettered Discretion: Directors cannot, without the consent of the company, fetter their
discretion (in relation to the exercise of their powers), and cannot bind themselves to vote
in a particular way at future board meetings. The company remains bound, if it made a
specific contract, but the directors retain the discretion to vote against taking the future
actions (they may cancel the contract itself.)
4. Conflict of Duty and Interest: A) where a director enters into a transaction with a
company, there is a conflict between the director's interest (to do well for himself out of
the transaction) and his duty to the company (to ensure that the company gets as much
as it can out of the transaction). B) Directors must not, without the informed consent of
the company, use for their own profit the company's assets, opportunities, or information.
C) Directors cannot compete directly with the company without a conflict of interests
arising. Similarly, they should not act as directors of competing companies, as their duties
to each company would then conflict with each other
5. Care and Skill: A director need not exhibit in the performance of his duties a greater
degree of skill than may reasonably be expected from a person of his knowledge and
experience
Companies Act:
Approve interim dividend and recommend final dividend
Approve interim and final financial statements
Approve significant changes in accounting policies
Approval and removal of key staff (company secretary)
Remuneration of Auditors
Recommendation for appointment / removal of auditors
Code Provisions
The board should meet sufficiently regularly to discharge its duties effectively.
There should be a formal schedule of matters specifically reserved for its decision.
The annual report should include a statement of how the board operates, including a high
level statement of which types of decisions are to be taken by the board and which are to
be delegated to management.
The annual report should identify the chairman, the deputy chairman (where there is
one), the chief executive, the senior independent director and the chairmen and members
of the nomination, audit and remuneration committees.
It should also set out the number of meetings of the board and those committees and
individual attendance by directors.
Where directors have concerns which cannot be resolved about the running of the
company or a proposed action, they should ensure that their concerns are recorded in the
board minutes.
On resignation, a non- executive director should provide a written statement to the
chairman, for circulation to the board, if they have any such concerns.
The Company should arrange appropriate insurance cover in respect of legal action
against its directors.
Failures:
In a number of "corporate scandals" of the 1990s, one notable feature revealed in
subsequent investigations is that boards were not aware of the activities of the managers
that they hired, and the true financial state of the corporation.
Most boards largely rely on management to report information to them, thus allowing
management to place the desired 'spin' on information, or even conceal or lie about the
true state of a company.
Boards of directors are part-time bodies, whose members meet only occasionally and may
not know each other particularly well. This unfamiliarity can make it difficult for board
members to question management.
CEOs tend to be rather forceful personalities. In some cases, CEOs are accused of
exercising too much influence over the company's board.
Directors may not have the time or the skills required to understand the details of
corporate business, allowing management to obscure problems.
The same directors who appointed the present CEO oversee his or her performance. This
makes it difficult for some directors to dispassionately evaluate the CEO's performance.
Directors often feel that a judgment of a manager, particularly one who has performed
well in the past, should be respected. This can be quite legitimate, but poses problems if
the manager's judgment is indeed flawed.
All of the above may contribute to a culture of "not rocking the boat" at board meetings.
Strategy Role: contribute to development of strategy of the company; challenging the strategy
produced by Executive Directors and offering advice
Scrutinizing Role: Review the performance of management. Hold management accountable for its
decisions taken and results obtained.
Risk Role: Ensure Company has adequate system of internal controls and system of risk
management in place.
Board Balance:
The board should include a balance of executive and NED's (and in particular independent non-
executive directors) such that no individual or small group of individuals can dominate the
board's decision taking.
a) The board should identify in the annual report each NED it considers to be independent.
b) The board should determine whether the director is independent in character and
judgment and whether there are relationships or circumstances which are likely to affect,
or could appear to affect, the director's judgment.
c) The board should state its reasons if it determines that a director is independent
notwithstanding the existence of relationships or circumstances which may appear
relevant to its determination, including if the director:
has been an employee of the company or group within the last five years;
has, or has had within the last three years, a material business relationship with
the company either directly, or as a partner, shareholder, director or senior
employee of a body that has such a relationship with the company;
has received or receives additional remuneration from the company apart from a
director's fee, participates in the company's share option or a performance-related
pay scheme, or is a member of the company's pension scheme;
has close family ties with any of the company's advisers, directors or senior
employees;
holds cross-directorships or has significant links with other directors through
involvement in other companies or bodies;
represents a significant shareholder;
or has served on the board for more than nine years from the date of their first
election.
d) Except for smaller companies, at least half the board, excluding the chairman, should
comprise NED's determined by the board to be independent. A smaller company should
have at least two independent NED.
e) The board should appoint one of the independent NED to be the senior independent
director. The senior independent director should be available to shareholders if they have
concerns which contact through the normal channels of chairman, chief executive or
finance director has failed to resolve or for which such contact is inappropriate.
There should be a clear division of responsibilities at the head of the company between the
running of the board and the executive responsibility for the running of the company's business.
No one individual should have unfettered powers of decision.
The chairman is responsible for leadership of the board, ensuring its effectiveness on all
aspects of its role and setting its agenda.
The chairman is also responsible for ensuring that the directors receive accurate, timely
and clear information.
The chairman should ensure effective communication with shareholders.
The chairman should also facilitate the effective contribution of NED's in particular and
ensure constructive relations between executive and non-executive directors.
Chairman sets agenda of the Board Meeting and chair these meetings
1. The roles of chairman and chief executive should not be exercised by the same individual.
2. The division of responsibilities between the chairman and chief executive should be clearly
established, set out in writing and agreed by the board.
3. The chairman should (on appointment) meet the independence criteria set out below.
4. A chief executive should not go on to be chairman of the same company. If exceptionally
a board decides that a chief executive should become chairman, the board should consult
major shareholders in advance and should set out its reasons to shareholders at the time
of the appointment and in the next annual report.
The chairman should hold meetings with the NED's without the executives present.
Led by the senior independent director, the NED's should meet (without the chairman
present) at least annually to appraise the chairman's performance.
CEO's Responsibility:
1. Take responsibility for the performance of the company
2. Report to the Chairman and Board of Directors
3. Manage Financial and physical resources
4. Build and maintain effective team
5. Put adequate operational, financial, planning and risk management systems
6. Represent the company to major suppliers, customers, professional associations
a) The chairman is responsible for ensuring that the directors receive accurate, timely and
clear information.
b) Management has an obligation to provide such information but directors should seek
clarification or amplification where necessary.
c) The company should provide the necessary resources for developing and updating its
directors' knowledge and capabilities.
d) Under the direction of the chairman, the company secretary's responsibilities include
ensuring good information flows within the board and its committees and between senior
management and NED, as well as facilitating induction and assisting with professional
development as required.
e) The company secretary should be responsible for advising the board through the chairman
on all governance matters.
f) The chairman should ensure that new directors receive a full, formal and tailored induction
on joining the board. As part of this, the company should offer to major shareholders the
opportunity to meet a new non-executive director
g) The board should ensure that directors, especially non-executive directors, have access to
independent professional advice at the company's expense where they judge it necessary
to discharge their responsibilities as directors.
h) Committees should be provided with sufficient resources to undertake their duties.
i) All directors should have access to the advice and services of the company secretary, who
is responsible to the board for ensuring that board procedures are complied with.
j) Both the appointment and removal of the company secretary should be a matter for the
board as a whole.
1. Individual evaluation should aim to show whether each director continues to contribute
effectively and to demonstrate commitment to the role (including commitment of time for
board and committee meetings and any other duties).
2. The chairman should act on the results of the performance evaluation by recognising the
strengths and addressing the weaknesses of the board and, where appropriate, proposing
new members be appointed to the board or seeking the resignation of directors.
3. The board should state in the annual report how performance evaluation of the board, its
committees and its individual directors has been conducted.
4. The NED's, led by the senior independent director, should be responsible for performance
evaluation of the chairman, taking into account the views of executive directors
Re-election of Directors
• All directors should be submitted for re-election at regular intervals, subject to continued
satisfactory performance.
• The board should ensure planned and progressive refreshing of the board.
• All directors should be subject to election by shareholders at the first annual general
meeting after their appointment, and to re-election thereafter at intervals of no more than
three years.
• The names of directors submitted for election or re-election should be accompanied by
sufficient biographical details and any other relevant information to enable shareholders to
take an informed decision on their election.
• NED should be appointed for specified terms subject to re-election and to Companies Acts
provisions relating to the removal of a director.
• The board should set out to shareholders in the papers accompanying a resolution to elect
a NED why they believe an individual should be elected.
• The chairman should confirm to shareholders when proposing re-election that, following
formal performance evaluation, the individual's performance continues to be effective and
to demonstrate commitment to the role.
• Any term beyond six years (e.g. two three-year terms) for a non-executive director should
be subject to particularly rigorous review, and should take into account the need for
progressive refreshing of the board.
• NED may serve longer than nine years (e.g. three three-year terms), subject to annual re-
election. Serving more than nine years could be relevant to the determination of NED's
independence.
Nomination Committee
There should be a nomination committee which should lead the process for board appointments
and make recommendations to the board.
A committee that is a subset of a larger committee is called a subcommittee. [Where the larger
group has a name other than "committee" - for example, "Board" or "Commission", the smaller
group(s) would be called committee(s), not subcommittee(s)]
The nomination committee should make its terms of reference, explaining its role and the
authority available delegated to it by the board.
9. The chairman should arrange for the chairmen of the audit, remuneration and nomination
committees to be available to answer questions at the AGM and for all directors to attend.
Induction Program:
Contain selected written text, and presentations about the Company structure,
subsidiaries, joint ventures
Gives understanding about markets, people, suppliers, auditors
Annual accounts, interim financials, KPI's, treasury polcicies
Provide them company's vision and mission and an idea about strategy
Outline of director's duties and responsibilities
Advice on share dealing and disclosure of sensitive information
Should not overload the director with excess information
Terms of reference
The following are the terms of reference of the Nomination Committee ('the Nomination Committee') of
HBOS and the HBOS Group.
1. Membership
1.1 Membership of the Nomination Committee will include the Chairman, the Chief Executive, the Deputy
Chairman, the Senior Independent Director, together with at least two further Non-Executive Directors. The
membership will at all times consist of a majority of independent Non-Executive Directors.
1.2 The Chairman of the Nomination Committee will be the Chairman or an independent Non-Executive
Director.
1.3 The Secretary of the Nomination Committee is appointed by the Chairman of the Committee.
A quorum of the Nomination Committee will comprise at least two members, one of whom shall be the
Chairman of the Committee or the Chairman (if different) or one further independent Non-Executive
Director (if the same).
2. Attendance
The Nomination Committee may invite other persons to attend meetings where appropriate to assist in the
effective discharge of the Nomination Committee's duties.
3. Frequency of Meetings
The Nomination Committee will meet as required but at least twice in each year. Any Nomination
Committee member or the Secretary may call for meetings as necessary.
4. Authority
4.1 The Nomination Committee is authorized by the HBOS Board to undertake any activity within its terms
of reference.
4.2 The Nomination Committee is authorized by the HBOS Board to seek appropriate professional advice
inside and outside of the Group as and when it considers this necessary.
4.3 Although normally decisions are reached on a consensus, in the event of a disagreement, decisions on
any matter are made by the majority, with the Chairman of the meeting having a second, casting vote in
the event of a tie. A Nomination Committee member who remains opposed to a proposal after a vote can
ask for his or her dissent to be noted in the minutes.
5. Principal Duties
5.1 ensure that there is a formal, rigorous and transparent procedure for the appointments of new
Directors to the Board;
5.2 review the composition of the HBOS Board and consider and advise the HBOS Board as to any changes,
which may be required to achieve a balanced and appropriately experienced and qualified Board;
5.3 as necessary to make recommendations to the Board on the independence of any existing or proposed
Non-Executive Director in line with the criteria set out in the Board Control Manual under the section
Independent Non-Executive Directors;
5.4 satisfy itself that plans are in place for orderly succession for appointments to the Board and other
senior management (levels 7 and 8) positions, and will search for, consider and make recommendations to
the HBOS Board in relation to the appointment of Directors of HBOS, including the position of Chairman;
5.5 ascertain, when required, the time commitments required of Non-Executive Directors, individually and
collectively to fulfil the duties required;
5.6 make recommendations to the Chairman of HBOS as required in respect of the membership of the
Board Committees of the HBOS Board, and the Chairmanships thereof;
5.7 make publicly available its terms of reference, explaining its role and the authority delegated to it by
the Board;
5.8 be available in the person of the Chairman of the Nomination Committee to answer Shareholders’
questions about the activities of the Nomination Committee at the Annual General Meeting.
5.9 make a statement in the Company's Annual Report and Accounts detailing its activities and the
process it has used to make any recommendations in respect of appointments to the Board;
5.10 for the appointment of a Chairman of the Board, the Nomination Committee should prepare a job
description, including an assessment of the time commitment expected, recognising the need for availability
in the event of crises. A Chairman's other significant commitments should be disclosed to the Board before
appointment and included in the Annual Report. Changes to such commitments should be disclosed to the
Board as they arise and included in the next Annual Report;
5.11 ensure that on appointment to the Board, Non-Executive Directors receive a formal Letter of
Appointment setting out a job description and clearly what is expected of them in terms of time
commitment, committee service and involvement outside Board meetings.
5.12 Appointment (and removal) of Director Trustees and (subject to the requirements of the Pensions
Act 1995) other Trustees of the Group's Pension Schemes in place from time to time in particular, where
necessary, in accordance with the Definition of Independence of Director Trustees set out in the Terms of
Reference of the Nomination Committee
Remuneration Committee
1. The remuneration committee should judge where to position their company relative to
other companies.
2. They should use such comparisons with caution, in view of the risk of an upward ratchet
of remuneration levels with no corresponding improvement in performance.
3. They should also be sensitive to pay and employment conditions elsewhere in the group,
especially when determining annual salary increases
4. The performance-related elements of remuneration should form a significant proportion of
the total remuneration package of executive directors and should be designed to align
their interests with those of shareholders and to give these directors keen incentives to
perform at the highest levels.
5. Executive share options should not be offered at a discount save as permitted by the
relevant provisions of the Listing Rules.
6. Levels of remuneration for NED's should reflect the time commitment and responsibilities
of the role.
7. Remuneration for NED's should not include share options.
8. If, exceptionally, options are granted, shareholder approval should be sought in advance
and any shares acquired by exercise of the options should be held until at least one year
after the NED leaves the board.
9. Holding of share options could be relevant to the determination of a NED's independence.
10. Where a company releases an executive director to serve as a NED elsewhere, the
remuneration report should include a statement as to whether or not the director will
retain such earnings and if so, what the remuneration is.
• The remuneration committee should consult the chairman and/or chief executive about
their proposals relating to the remuneration of other executive directors.
• The remuneration committee should also be responsible for appointing any consultants in
respect of executive director remuneration.
• Where executive directors or senior management are involved in advising or supporting
the remuneration committee, care should be taken to recognize and avoid conflicts of
interest.
• The chairman of the board should ensure that the company maintains contact as required
with its principal shareholders about remuneration in the same way as for other matters.
a) The board should establish a remuneration committee of at least three, or in the case
of smaller companies two, members, who should all be independent NED's.
b) The remuneration committee should make available its terms of reference, explaining
its role and the authority delegated to it by the board.
c) Where remuneration consultants are appointed a statement should be made available
of whether they have any other connection with the company.
d) The remuneration committee should have delegated responsibility for setting
remuneration for all executive directors and the chairman, including pension rights and
any compensation payments.
e) The committee should also recommend and monitor the level and structure of
remuneration for senior management.
f) The definition of "senior management" for this purpose should be determined by the
board but should normally include the first layer of management below board level.
g) The board itself or, where required by the Articles of Association, the shareholders
should determine the remuneration of the NED within the limits set in the Articles of
Association.
h) Where permitted by the Articles, the board may however delegate this responsibility to
a committee, which might include the chief executive.
i) Shareholders should be invited specifically to approve all new long-term incentive
schemes (as defined in the Listing Rules) and significant changes to existing schemes,
save in the circumstances permitted by the Listing Rules.
Remuneration includes base salary (basic), bonuses, economic benefits (other than cash), share
options, pension contributions etc.
Basic Salary:
• It is usually set in relation to peer groups (industry specific, equal size ventures)
• High basic salary gives a guaranteed payment without any regard to performance.
• High basic salary may reduce incentive for any improvements
• Low basic salary with performance bonuses, urges board to work with more productivity
• If the basic salary is too low, it will de-motivate the board
Legal issues:
• Compensation commitments (including pension) should be considered for the case of early
termination
• Compensation package should not reward poor performance
Ethical issues:
• In high profile corporate failures, directors were perceived to receive excessive
remuneration in relation to their performance
• In underperforming, or privatized utilities, public perception of excess pay rises
Activity 1
Flick plc (quoted on LSE) is planning to acquire 20% stake in UUL (also listed on LSE). Flick plc is
considered to be adhering to the principles of good corporate governance.
UUL is predominantly a family owned concern, with 51% shares vested with the Johnson family.
Mr. Johnson is the Chairman board of directors, while Mr. Smith (son of Mr. Johnson) is the CEO.
There are 8 members in the board of director of UUL (including Chairman and CEO), of which 5
belong to the Johnson family and work as full time paid directors. Other 3 directors are
representative of Global Bank Limited, which leads the consortium of the lender institutions.
Required:
1. Comment on the board structure of UUL? Does it comply with the Code?
2. How can Flick plc insist on putting their director on the board? Describe whether
the director should be a paid director or NED?
3. What role does a NED play in a company? Describe?
4. What effect will the acquisition have on Flick plc, if it acquires UUL in current state,
without any change? Consider the case where Flick plc requires more funds for the
acquisition.
The system by which companies are directed and controlled, in the interests of shareholders and
stakeholders
Fairness: sense of equality in dealing with internal and external stakeholders, and ability to reach
equitable judgment in a given ethical situation
Openness / transparency: transparent relationship with shareholders to reduce their agency cost.
Development of systems and procedures to form an appropriate culture in organization
Independence: between executive and non-executive directors and from personal influence of
one party
Probity / honesty: honestly reporting financial position, and providing perception of honesty to all
stakeholders
Judgment: Ability to reach conclusions after weighing issues and giving them consideration
Integrity: Highest standard of honesty and observing strict moral and ethical code.
Non-Profit Organizations:
• Stakeholders are fund providers, regulators, general public
• Volunteer trustees manage alongwith paid or unpaid management team
• Donors demand information – accountability
This obligation is seen to extend beyond the statutory obligation to comply with legislation and
sees organizations voluntarily taking further steps to improve the quality of life for employees
and their families as well as for the local community and society at large.
Criticism to CSR:
• Free market operation: Company's principal motive is to maximize profit. Company does
not have moral responsibility for its actions
• Image building: Companies put up CSR programs to build their image only
Stakeholders:
Traditional stakeholders were four parties: investors, employees, suppliers, and customers.
Stakeholder theory argues that there are other parties involved, including governmental bodies,
political groups, trade associations, trade unions, communities, associated corporations,
prospective employees, prospective customers, and the public at large. Sometimes even
competitors are counted as stakeholders.
A sound system of internal control reduces, but cannot eliminate, the possibility of poor judgment
in decision-making; human error; control processes being deliberately circumvented by
employees and others; management overriding controls; and the occurrence of unforeseeable
circumstances.
Risk Management:
The process by which executive management, under board supervision, identifies the risk arising
from business and establishes the priorities for control and particular objectives.
Code Provisions:
• The board should, at least annually, conduct a review of the effectiveness of the group's
system of internal controls and should 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 board should establish an audit committee of at least three, or in the case of smaller
companies' two, members, who should all be independent non-executive directors.
• The board should satisfy itself that at least one member of the audit committee has recent
and relevant financial experience.
The main role and responsibilities of the audit committee should be set out in written terms of
reference and should include:
• to monitor the integrity of the financial statements of the company, and any formal
announcements relating to the company's financial performance, reviewing significant
financial reporting judgments contained in them;
• to review the company's internal financial controls and, unless expressly addressed by a
separate board risk committee composed of independent directors, or by the board itself,
to review the company's internal control and risk management systems;
• to monitor and review the effectiveness of the company's internal audit function;
• to make recommendations to the board, for it to put to the shareholders for their approval
in general meeting, in relation to the appointment, re-appointment and removal of the
external auditor and to approve the remuneration and terms of engagement of the
external auditor;
• to review and monitor the external auditor's independence and objectivity and the
effectiveness of the audit process, taking into consideration relevant UK professional and
regulatory requirements;
• to develop and implement policy on the engagement of the external auditor to supply
non-audit services, taking into account relevant ethical guidance regarding the provision
of non-audit services by the external audit firm;
• and to report to the board, identifying any matters in respect of which it considers that
action or improvement is needed and making recommendations as to the steps to be
taken.
1. The terms of reference of the audit committee, including its role and the authority
delegated to it by the board, should be made available.
2. A separate section of the annual report should describe the work of the committee in
discharging those responsibilities.
3. The audit committee should review arrangements by which staff of the company may, in
confidence, raise concerns about possible improprieties in matters of financial reporting or
other matters.
4. The audit committee's objective should be to ensure that arrangements are in place for
the proportionate and independent investigation of such matters and for appropriate
follow-up action.
5. The audit committee should monitor and review the effectiveness of the internal audit
activities. Where there is no internal audit function, the audit committee should consider
annually whether there is a need for an internal audit function and make a
recommendation to the board, and the reasons for the absence of such a function should
be explained in the relevant section of the annual report.
6. The audit committee should have primary responsibility for making a recommendation on
the appointment, reappointment and removal of the external auditors.
7. If the board does not accept the audit committee's recommendation, it should include in
the annual report, and in any papers recommending appointment or re-appointment, a
statement from the audit committee explaining the recommendation and should set out
reasons why the board has taken a different position.
8. The annual report should explain to shareholders how, if the auditor provides non-audit
services, auditor objectivity and independence is safeguarded.
GUIDANCEONINTERNALCONTROL
(The Turnbull Guidance)
The guidance is based on the adoption by a company's board of a risk- based approach to
establishing a sound system of internal control and reviewing its effectiveness.
This should be incorporated by the company within its normal management and governance
processes. It should not be treated as a separate exercise undertaken to meet regulatory
requirements
• A company's objectives, its internal organization and the environment in which it operates
are continually evolving and, as a result, the risks it faces are continually changing.
• A sound system of internal control therefore depends on a thorough and regular
evaluation of the nature and extent of the risks to which the company is exposed.
• Since profits are, in part, the reward for successful risk- taking in business, the purpose of
internal control is to help manage and control risk appropriately rather than to eliminate
it.
The board must ensure that the system of internal control is effective in managing risks. It
should consider:
• the nature and extent of the risks facing the company;
• the extent and categories of risk which it regards as acceptable for the company to bear;
• the likelihood of the risks concerned materializing;
• the company's ability to reduce the incidence and impact on the business of risks that do
materialize; and
• the costs of operating particular controls relative to the benefit thereby obtained in
managing the related risks.
1. It is important that risk management and control are not seen as a burden on business,
rather the means by which business opportunities are maximized and potential losses
associated with unwanted events reduced.
2. Companies set themselves strategic and business objectives, then manage risks that
threaten the achievement of those objectives.
3. Internal control and risk management should supplement entrepreneurship, but not
replace it.
4. Increased shareholder value is the reward for successful risk taking and the role of
internal control is to manage risk appropriately rather than to eliminate it.
Risk can be defined as real or potential events which reduce the likelihood of achieving business
objectives. Or, put another way, uncertainty as to the benefits. The term includes both the
potential for gain and exposure to loss.
Internal control is one of the principal means by which risk is managed. Other devices used to
manage risk include:
• The transfer of risk to third parties,
• Sharing risks,
• Contingency planning and the withdrawal from unacceptably risky activities.
Of course companies can accept risk too. Getting the balance right is the essence of successful
business – to knowingly take risk, rather than be unwittingly exposed to it.
Example: the objective of a coal miner is to maximize coal output. More digging, means more
output, resulting in a risk of mine collapse, resulting in injury and delayed outputs.
Pit props (wooden supports) can manage risk of mine collapse. Too many props (over control)
can delay digging, and few props (under control) will not be able to manage the collapse.
Cost of control should be balanced against the benefits, including the risk it is designed
to manage.
When SONY was designing its WALKMAN, the CEO stated that in order to achieve 50% reduction
in size, he would be willing to accept higher level of failure in R&D projects, and he had to visibly
demonstrate its acceptance.
Control can help minimize errors, but cannot provide absolute assurance that they will
not occur.
A control system cannot be designed to provide protection with certainty.
The system of control should be embedded in the operations of the company and
should form part of its culture.
People, who are accountable to achieve objectives, should also be accountable to maintain
effective controls to achieve those objectives. By making individuals accountable, likelihood of
effective operation of controls increases.
Activity 2
A photocopier salesman was offered a bonus for meeting a particular sales target. The copiers
were sold with a standard three years warranty. The salesman was able to provide the purchaser
extended warranty cover by inaccurately putting dates on the warranty card. This gave him
advantage over his competitors in selling, and he sold the required number of copiers every
month.
Board responsibilities
• Effective monitoring on a continuous basis is an essential component of a sound system of
internal control. The board cannot, however, rely solely on the embedded monitoring
processes within the company to discharge its responsibilities.
• It should regularly receive and review reports on internal control.
• Internal controls considered by the board should include all types of controls including
those of an operational and compliance nature, as well as internal financial controls
• The board should define the process to be adopted for its review of the effectiveness of
internal control.
• This should encompass both the scope and frequency of the reports it receives and
reviews during the year, and also the process for its annual assessment.
• When reviewing reports during the year, the board should:
a) consider what are the significant risks and assess how they have been
identified, evaluated and managed;
b) Assess the effectiveness of the related system of internal control in managing
the significant risks, having regard, in particular, to any significant failings or
weaknesses in internal control that have been reported;
c) Consider whether necessary actions are being taken promptly to remedy any
significant failings or weaknesses; and
d) Consider whether the findings indicate a need for more extensive monitoring of
the system of internal control.
Management Responsibilities:
• The reports from management to the board should, in relation to the areas covered by
them, provide a balanced assessment of the significant risks and the effectiveness of the
system of internal control in managing those risks.
• Any significant control failings or weaknesses identified should be discussed in the reports,
including the impact that they have had, could have had, or may have, on the company
and the actions being taken to rectify them.
• It is essential that there be openness of communication by management with the board
on matters relating to risk and control.
Internal Audit
Internal audit is one of the most influential and value added service available to the Board. The
scope of internal auditing within an organization is broad and may involve internal control topics
such as:
• Efficacy of operations,
• Reliability of financial reporting,
• Deterring and investigating fraud,
• Safeguarding assets, and
• Compliance with laws and regulations.
Internal auditors are not responsible for the execution of company activities; they advise
management and the Board of Directors (or similar oversight body) regarding how to better
execute their responsibilities.
Code provisions:
• Companies which do not have an internal audit function should from time to time review
the need for one.
• The need for an internal audit function will vary depending on company specific factors
including:
a) Scale, diversity and complexity of the company's activities,
b) number of employees, and
c) Cost/benefit considerations
d) any trends or current factors relevant to the company's activities, markets or
other aspects of its external environment, that have increased, or are expected
to increase the risks faced by the company
e) Internal factors such as organizational restructuring or from changes in
reporting processes or underlying information systems.
f) adverse trends evident from the monitoring of internal control systems
g) an increased incidence of unexpected occurrences
• Senior management and the board may desire objective assurance and advice on risk and
control
• An adequately resourced internal audit function (or its equivalent where, for example, a
third party is contracted to perform some or all of the work concerned) may provide such
assurance and advice.
• There may be other functions within the company that also provide assurance and advice
covering specialist areas such as health and safety, regulatory and legal compliance and
environmental issues
• If the company does not have an internal audit function and the board has not reviewed
the need for one, the Listing Rules require the board to disclose these facts.
Independence requirements:
• Internal auditors should be independent of executive management and should not have
any involvement in the activities of the system they audit.
• Head of internal audit should directly report to a senior independent non-executive
director, or the audit committee
• The head of the internal audit should have direct access to the chairman
• The audit committee should approve appointment, termination and remuneration of the
internal audit head.
that the company pays in proportion to the overall fee income of the firm, office and
partner, and other related regulatory requirements
9. The audit committee should develop and recommend to the board the company’s policy in
relation to the provision of non-audit services by the auditor.
10. The audit committee’s objective should be to ensure that the provision of such services
does not impair the external auditor’s independence or objectivity.
11. In this context, the audit committee should consider:
a. whether the skills and experience of the audit firm make it a suitable supplier of
the non audit service;
b. whether there are safeguards in place to ensure that there is no threat to
objectivity and independence in the conduct of the audit resulting from the
provision of such services by the external auditor;
c. the nature of the non-audit services, the related fee levels and the fee levels
individually and in aggregate relative to the audit fee;
d. the criteria which govern the compensation of the individuals performing the audit.
12. The audit committee should set and apply a formal policy specifying the types of non-
audit work:
a. from which the external auditors are excluded;
b. for which the external auditors can be engaged without referral to the audit
committee;
c. for which a case-by-case decision is necessary.
13. In determining the policy, the audit committee should take into account relevant ethical
guidance regarding the provision of non-audit services, and in principle should not agree
to the auditor providing a service if:
a. the external auditor audits its own firm’s work;
b. the external auditor makes management decisions for the company;
c. a mutuality of interest is created;
d. the external auditor is put in the role of advocate for the company.
14. The annual report should explain to shareholders how, if the auditor provides non-audit
services, auditor objectivity and independence is safeguarded.
9. At the end of the annual audit cycle, the audit committee should assess the effectiveness
of the audit process. In the course of doing so, the audit committee should:
a. review whether the auditor has met the agreed audit plan and understand the
reasons for any changes, including changes in perceived audit risks and the work
undertaken by the external auditors to address those risks;
b. consider the robustness and perceptiveness of the auditors in their handling of the
key accounting and audit judgments identified and in responding to questions from
the audit committees, and in their commentary where appropriate on the systems
of internal control;
c. obtain feedback about the conduct of the audit from key people involved, e.g. the
finance director and the head of internal audit; and
d. review and monitor the content of the external auditor’s management letter, in
order to assess whether it is based on a good understanding of the company’s
business and establish whether recommendations have been acted upon and, if
not, the reasons why they have not been acted upon.
Risk management
• Risk management is the human activity which integrates recognition (identification) of
risk, risk assessment (analysis), development of strategies to manage it (planning), and
monitoring of risk using managerial resources.
• The strategies include transferring the risk to another party, avoiding the risk, reducing
the negative effect of the risk, and accepting some or all of the consequences of a
particular risk.
• Some traditional risk managements are focused on risks stemming from physical or legal
causes (e.g. natural disasters or fires, accidents, death and lawsuits). Financial risk
management, on the other hand, focuses on risks that can be managed using traded
financial instruments.
• Objective of risk management is to reduce different risks related to a preselected domain
to the level accepted by society. It may refer to numerous types of threats caused by
environment, technology, humans, organizations and politics.
Strategic Risks
These are risks associated with adopting a particular strategy
• A company aiming to achieve growth by acquisitions have more risk compared to the
company growing through slow and gradual increase in sales
• Developing new products is more risky than to enhance the existing ones.
• Strategic risks should be identified by the senior management
Operational Risks
These are risks arising from business operations
• Potential loss in business (through failed or inadequate internal processes, people and
systems)
• Risk of fraud by employee
• Poor quality of production / lack of production (stock out)
Activity 3
A new mobile phone company has recently launched operations. What are its strategic and
operational risks?
Activity 4
A telecommunication company has announced to launch WiFi based service. WiFi is a new
technology, which enables voice and data to be exchanged on wireless network, at speeds upto
1GB per second. This speed limit has been tested in labs only, and a commercial deployment is
yet to be made. Equipment manufacturers (phone sets, computer cards) are in the R&D stage
and hope to start commercial production by middle of 2008. Price and quality of equipment is not
yet confirmed.
Activity 5
Due to power shortage, and rising fuel prices, Government of Pakistan has decided to provide
incentives to the alternative power generation sector. Electricity can be generated through wind,
and solar processes. Cost of generating equipment is three times the cost of conventional
generating equipment (using fossil fuel). Due to rapid R&D in the sector, it is estimated that cost
of alternative energy equipment will decrease by 1/3rd by end of 2008.
Activity 6
A young designer, just out of Fashion College, has decided to launch her own clothing line. She
perceives the current fashion to change within the next 6 months, and believes if she launches
her clothing line now, she will have a head start.
Generic Risk: that affects all businesses in the market. i.e. increase in interest rate will affect all
business with borrowings.
Sector Specific Risk: that is specific to an industry sector. i.e. environmental legislation effecting
oil exploration companies
Activity:
For each event listed below, rate the potential financial severity and the probability or frequency
of the event at this time in your life. We are concerned only with negative financial impacts. Use
these definitions to help you rate the severity of an event:
Let's look at one event as an example. If you are a young parent with pre-school children, you
are the major breadwinner in your family, and you have no life-threatening health problems,
then you will probably rate the financial impact of your death as a 1 or 2 (ignoring for the
moment any life insurance you have) and the probability a 3 or 4. However, if you are 90, in poor
health, and have no financial dependents, you will likely consider the financial severity of your
death either a 3 or 4 and the probability a 1 or 2.
a) Bear the financial risk and do not seek to reduce it. For example, continue driving car
without taking any insurance.
b) Transfer the risk to another party. For example take insurance for the car.
c) Reduce or control the risk. For example wear seat belts / drive at slow speed (reduce injury)
d) Remove the risk and avoid it entirely. For example you sell the car and use public transport.
Reporting by Directors:
a) Overall responsibility of maintaining control systems
b) Appoint internal auditors and internal audit committee to review and maintain internal
controls
c) Internal auditors test controls on regular basis and report their findings to the board
d) Review the report on internal controls and suggest improvements
e) Report to shareholders that a review of internal control has been done
Reporting by Auditors:
a) Identify and document internal controls
b) Test those controls
c) Report material deficiencies in the audit report
• In most companies board will establish Risk Management Committee (based on size)
• Where no such committee is formed, audit committee will perform similar duties
Risk Manager:
• Is a member of Risk Management Committee, and reports directly to the committee and
the board
• His role is more operational rather than strategic
• Policies are set by the Risk Management Committee and implemented by the risk manager
⇒ Risk and uncertainty are so pervasive in our lives that we deal with them all the time.
⇒ Risk management already exists, in some form, before risk managers and auditors
come along to try to "implement" it.
Embedding risk management system within the Culture and Values of Organization
Culture is:
• Commonly held and relatively stable set of attitudes, values and norms
• Basic assumptions and beliefs that are shared by members of an organization.
Diversifying Risk
• Spreading risk effectively reduces it
• Operational risk may be diversified by producing in different geographical regions
• Poor performance of one division / product may be offset by good performance of the
other
• Diversification only works where returns are negatively correlated (move opposite)
• Financial risk can be diversified by investing in different sectors or by hedging (it can
decrease potential for loss, along with potential for gain).
Activity 7
A service department has been challenged to improve its performance by a certain amount on
various metrics. The improvement cannot be achieved without innovation as new resources are
not available.
To meet this challenge, a plan is devised with over 30 improvement actions, some more specific
than others. The plan is extensively circulated and the plan document is formally approved at a
high level.
A monitoring group meets regularly to assess progress against the plan and deal with problems.
Measures of progress have been identified. Actions have been prioritized rigorously.
What risk managing activities do you see here, and what could be improved?
Answer to activity 7:
a. The plan has been documented (reducing risk of miscommunication), has been
reviewed widely, and has formal approval;
b. There is a monitoring group that meets regularly and they have measures of progress
(needed because things may not go according to plan); and
c. Actions have been prioritized (reflecting an awareness of uncertainty as to how many
of the actions can be carried out).
d. Bearing in mind that innovation was required, group seems over-confident that their
improvements will be effective and that their prioritization is correct.
e. More should have been said in the plan about using experience to find out as early as
possible which actions appear to be effective, and to generate improved actions
f. The monitoring group is only assessing progress against the plan, and this again
reflects an assumption that the plan is correct. Progress should be assessed against
the most recent forecasts and revised plans that reflect what has been learned so far.
Relativism:
• There are many sets of moral rules. Rules change over time.
• An action is right or wrong depends on the moral norms of the society in which it is
practiced. Different societies have different rules.
• The same action may be morally right in one society but be morally wrong in another.
• For the ethical relativist, there are no universal moral standards (standards that can be
universally applied to all peoples at all times).
• The only moral standards against which a society's practices can be judged are its own.
• It is the opposite of moral absolutism
Absolutism:
• It is the view that moral rights are absolute and never change
• There is one set of rules which is always true.
• Moral rights will hold true in all situations and are common to all societies.
• Moral “truth” of once society can be imposed on another
Directors, auditors have a set of rules to follow (legislation). They may choose to interpret
it differently (relativism).
These are planes of moral adequacy conceived by Lawrence Kohlberg to explain the development
of moral reasoning. His theory holds that moral reasoning, which is the basis for ethical behavior,
has six identifiable developmental constructive stages - each more adequate at responding to
moral dilemmas than the last.
who commits it gets punished. The worse the punishment for the act is, the more
'bad' the act is perceived to be. Employee take ethical decision because they will
get rewarded, or they think company will punish them.
2. Self-interest orientation
Right behavior being defined by what is in one's own best interest. Stage two
reasoning shows a limited interest in the needs of others, but only to a point where
it might further one's own interests. Employee covers a colleague in understanding
that colleague will cover him when required
Level 2 (Conventional): Persons who reason in a conventional way judge the morality of
actions by comparing these actions to societal views and expectations
Level 3 (Post-Conventional): Realization that individuals are separate entities from society
now becomes salient. One's own perspective should be viewed before the society.
• Individuals move from stage 1 to 6, as they mature from a child to adult. Each level is
further divided into two levels.
• Higher levels provide more ethical methods of reasoning
• Most individuals operate at level 3 and 4, and decisions are made in accordance with what
the individual perceives others to believe and expect from him.
• Whistleblowers would be at the last level (6).
A woman was near death from a special kind of cancer. There was one drug that the doctors
thought might save her. It was a form of radium that a druggist in the same town had recently
discovered. The drug was expensive to make, but the druggist was charging ten times what the
drug cost him to produce. He paid $200 for the radium and charged $2,000 for a small dose of
the drug. The sick woman's husband, Heinz, went to everyone he knew to borrow the money, but
he could only get together about $ 1,000 which is half of what it cost. He told the druggist that
his wife was dying and asked him to sell it cheaper or let him pay later. But the druggist said:
"No, I discovered the drug and I'm going to make money from it." So Heinz got desperate and
broke into the man's store to steal the drug for his wife.
Should Heinz have broken into the laboratory to steal the drug for his wife? Why or why not?
Stage one (obedience): Heinz should not steal the medicine because he will consequently be put
in prison which will mean he is a bad person. Or: Heinz should steal the medicine because it is
only worth $200 and not how much the druggist wanted for it; Heinz had even offered to pay for
it and was not stealing anything else.
Stage two (self-interest): Heinz should steal the medicine because he will be much happier if he
saves his wife, even if he will have to serve a prison sentence. Or: Heinz should not steal the
medicine because prison is an awful place, and he would probably languish over a jail cell more
than his wife's death.
Stage three (conformity): Heinz should steal the medicine because his wife expects it; he wants
to be a good husband. Or: Heinz should not steal the drug because stealing is bad and he is not a
criminal; he tried to do everything he could without breaking the law, you cannot blame him.
Stage four (law-and-order): Heinz should not steal the medicine because the law prohibits
stealing, making it illegal. Or: Heinz should steal the drug for his wife but also take the
prescribed punishment for the crime as well as paying the druggist what he is owed. Criminals
cannot just run around without regard for the law; actions have consequences.
Stage five (human rights): Heinz should steal the medicine because everyone has a right to
choose life, regardless of the law. Or: Heinz should not steal the medicine because the scientist
has a right to fair compensation. Even if his wife is sick, it does not make his actions right.
Stage six (universal human ethics): Heinz should steal the medicine, because saving a human life
is a more fundamental value than the property rights of another person. Or: Heinz should not
steal the medicine, because others may need the medicine just as badly, and their lives are
equally significant.
Approaches to ethics
1. Deontological approach:
a) is an approach to ethics that focuses on the rightness or wrongness of actions themselves,
as opposed to the rightness or wrongness of the consequences of those actions
b) It is sometimes described as "duty"- or "obligation"-based ethics, because deontologists
believe that ethical rules "bind you to your duty.
c) Action is only right or wrong when morals for taking the action are known
d) For example to end starvation, someone may suggest to kill all people.
• Act only according to that maxim by which you can also will that it would become a
universal law. (exploitation of labor – managers in developed countries may not want
themselves to be exploited elsewhere)
• Act in such a way that you always treat humanity, whether in your own person or in the
person of any other, never simply as a means, but always at the same time as an end.
(child labor – right of children to safe upbringing being ignored)
• Act as though you were through your maxims a law-making member of a kingdom of
ends.
2. Teleological approach:
a) Teleological' theories are those that are concerned with outcomes or consequences.
b) The rightness of an action is determined by its consequences
c) A teleologist, explains the rightness of actions in terms of the goodness of the state of
affairs that occurs because of that action.
d) If some action genuinely brings about greater good in the world, then it is a right action,
and this rightness is independent of the nature of the action or the intentions of the
person carrying out the action.
e) As long as outcome is right, action itself is irrelevant
Egoism:
a) A view stating “what is best for me”? Egoist will pursue his own goal and interests
b) Egoist will also do what appears to be right in society
Utilitarianism
a) A view stating “what is good for most of people”?
b) Action is right if it does the greatest amount of good to greatest number of people
c) It is highly subjective, because it introduces concept of utility – economic value of action
Social Responsibility:
a. Social responsibility is an ethical or ideological theory that an entity whether it is a
government, corporation, organization or individual has a responsibility to society.
b. This responsibility can be "negative," in that it is a responsibility to refrain from acting
(resistance stance) or it can be "positive," meaning there is a responsibility to act
(proactive stance).
c. It involves an idea that it is better to be proactive toward a problem rather than reactive to
a problem
d. While primarily associated with business and governmental practices, activist groups and
local communities can also be associated with social responsibility, not only business or
governmental entities. Social responsibility is voluntary; it is about going above and
beyond what is called for by the law (legal responsibility).
Businesses can use ethical decision making to strengthen their businesses in three main ways:
a) The first way is to use their ethical decision making to increase productivity.
This can be done through programs that employees feel directly enhance their benefits
given by the corporation, like better health care or a better pension program.
When the company is perceived to feel that their employees are a valuable asset and
the employees feel they are being treated and such, productivity increases.
b) A second way is by making decisions that affect its health as seen to those stakeholders
that are outside of the business environment.
Customers and Suppliers are two examples of such stakeholders.
For example, when people realized that some bottles of Tylenol contained cyanide they
quit buying Tylenol, stocks dropped and Johnson & Johnson lost a lot of money. But
they chose to loose even more money and announced a major recall of their product.
They lost money to be socially responsible, but in the long run they gained the trust of
their customers.
c) A third way that business can use ethical decision making to secure their businesses is by
making decisions that allow for government agencies to minimize their involvement with
the corporation.
For instance if a company is proactive and follows the EPA guidelines for admissions on
dangerous pollutants and even goes an extra step to get involved in the community
and address those concerns that the public might have; they would be less likely to
have the EPA investigate them for environmental concerns.
“A significant element of current thinking about privacy, however, stresses "self-
regulation" rather than market or government mechanisms for protecting personal
information”.
Most rules and regulations are formed due to public outcry, if there is not outcry there
often will be limited regulation.
4) Social ecologist: recognition of the overall concern for environment that companies have
caused.
a. Companies can help in eliminating the problems caused by them, if possible.
b. Policies and procedures change in areas where resources are used.
5) Socialist: Capital should not be allowed to dominate society and human life, and its
influence should be decreased.
a. Change the system where capitalists manipulate resources (workers) & make profit
b. Economic system becomes secondary objective, primary objective being welfare
6) Radical feminist: Business run on masculine views (aggression, achievement).
a. Introducing feminist views of compassion, co-operation
b. Radical change in the structure of society in order to move to feminist views
7) Deep ecologist: Human beings do not have more rights to resources than other life forms
a. Environmental considerations have to be accounted for
b. Business cannot run if it destroys environment
Shaper of society:
Businesses have power to change society by applying their positioning power (increase
in fast food chains have changed eating habits)
Individuals cannot change society by themselves, however they can exert force if they
act in a group.
Organizations must strive to improve the society (R&D in solar powered cars).
a) Economic considerations:
i. These relate to ability of organization to stay in business and give returns
ii. In some countries emphasis is on profitability and interest of shareholders
iii. In some countries, loss making companies may be bailed out by
governments in the interest public
b) Legal considerations:
i. An organization will follow the laws of the jurisdiction in which it operates.
ii. In some countries, government role is minimized, giving wider liberty to
organizations to operate
iii. Some governments impose laws even when they are perceived to be
excessive (minimum wages, working hours)
c) Ethical considerations:
i. It is what society expects from the organizations
ii. In some countries businesses are perceived to operate ethically
iii. In some countries environmental activists and consumer societies are very
active and vocal
d) Philanthropic:
i. These are activities which organizations do because they believe it will be
for welfare of people
ii. In some countries individuals and organizations have shown big
philanthropic acts
iii. In some countries, governments provide funding for most of the welfare
schemes (partly due to large tax collections)
Profession:
It is an occupation, vocation or career where specialized knowledge of a subject, field,
or science is applied
It is usually denoted to occupations that involve prolonged academic training and a
formal qualification
Professions are usually regulated by professional bodies that may set examinations of
competence, act as an licensing authority for practitioners, and enforce adherence to
an ethical code of practice.
Professions are at least to a degree self-regulating, in that they control the training
and evaluation processes that admit new persons to the field, and in judging whether
the work done by their members is up to standard.
This differs from other kinds of work where regulation (if considered necessary) is
imposed by the state, or where official quality standards are often lacking
A profession tends to dominate, police and protect its area of expertise and the
conduct of its members, and exercises a dominating influence over its entire field
which means that professions can act monopolist
Professional:
It is a worker required to possess a large body of knowledge derived from extensive
academic study (usually tertiary), with the training almost always formalized.
Professionals usually have autonomy in the workplace—they are expected to utilize
their independent judgment and professional ethics in carrying out their
responsibilities
This holds true even if they are employees instead of working on their own. Typically a
professional provides a service (in exchange for payment or salary), in accordance
with established protocols for licensing, ethics, procedures, standards of service and
training / certification.
Public interest:
The public interest refers to the "common well-being" or "general welfare."
While nearly everyone claims that aiding the common well-being or general welfare is
positive, there is little, if any, consensus on what exactly constitutes the public
interest.
There are different views on how many members of the public must benefit from an
action before it can be declared to be in the public interest
It is also possible that in some cases advancing the public interest will hurt certain
private interests.
There is risk of "tyranny of the majority" in any democracy, since minorities' interests
may be overridden.
One view is that individuals are free to act, as long as they do not harm others
Actions of a majority of shareholders may affect the minority shareholders
Actions of the organization itself may harm the public i.e. pollution
iii. Advising on the contents of company law for increased creditor protection
Corporate ethics
• It includes many areas from board strategies to how company negotiates with
employees and suppliers
• Many companies provide details of their ethical approach in a CSR report
• Corporate ethics will cover the following
i. Purpose and value of business: it provides reason of continuing the business
(mission statement)
ii. Employees: policies regarding rights of employees in relation to working
conditions, recruitment, development and training, rewards, health and safety,
retirement, redundancy, and discrimination
iii. Customer relations: policies regarding responsibility towards customers (past,
current and future) in relation to product quality, pricing, after sales service
iv. Shareholders and investors: investors require a fair return on their investment
and the company must commit to provide timely and accurate information to
enable investors to make their decisions
v. Suppliers: policies relating to settling invoices, co-operating with suppliers to
maintain quality, not using bribery to secure contracts, and attempting selection
of suppliers on basis of ethical criterion i.e. 'not using child labor'
vi. Society / community: explaining in the CSR report how the company complies
with law, how it protects obligations relating to environment, policy on making
donations (to educational or charitable organizations)
Fundamental Principles:
1. Integrity: straightforwardness / honesty / fair dealing / not misleading
2. Objectivity: unbiased / not involving conflict of interest
3. Competence: Professional knowledge / skills. Due care
4. Confidentiality: information of clients not to be disclosed without authority
5. Professional behavior: comply with laws / regulations, avoid actions to discredit
profession (marketing, treating people with courtesy)
Conflict of Interest:
1. Framework is needed because it is impossible to define all situations where threats to
fundamental principles exist
2. Different assignments create various threats requiring mitigating actions
3. Framework uses guidance (principles based) to identify threats
4. This approach is preferable to rules based approach
5. where conflict arises in application of fundamental principle, code of ethics provides
guidelines on how to resolve those conflicts
Potential threats
• Acceptance of gifts and hospitality form the audit client or its directors
5. Intimidation threats: where auditor receives some sort of threat
• Threat of replacement over a disagreement
• Pressure to reduce extent of work to be performed in order to reduce fee
• Dominant personality in a senior position, controlling dealings with the auditor
Conceptual Framework
a) Provides initial set of assumptions / values / definitions which are agreed upon by
all stakeholders
b) It is easy to understand
c) Provides generalized guidance
Ethical Threats: situation where a person / organization is tempted not to follow code of ethics
a) Requirements of employer to act contrary to rules / regulations
b) Pressure to prepare false / misleading information
c) Employee misleading his employer about his level of expertise / experience
(including time planning)
d) Employee or his close family members holding financial interest in the company
e) Incentives (inducements) offered to encourage unethical behavior
f) Pressure on employee to offer inducements to other accountants / employees
g) Pressure on employees to disclose confidential information
h) Whistle blowing situations
Moral intensity:
1. Concentration of efforts: how many people are affected by the decision
2. Proximity: Relationship between decision maker and the people who are affected
by his decisions
3. Timing: How soon the consequences of decision will arise
4. Magnitude: what will be the magnitude of consequences of the decision
5. Consensus: How other people perceive the decision to be
6. Probability: likelihood of the consequences happening in result of the decision
Economic activity:
1. Social footprint: sustainability in three areas is measured
a. Social capital: social network and mutually held knowledge
b. Human capital: Individual skills and knowledge
c. Constructed capital: physical infrastructure
2. Environmental footprint: measures sustainability in terms of:
a. Resources consumed by the company
b. Harm brought to environment due to pollution by the company
Environmental reporting
a) Resource consumption and pollution should be measured (quantitatively or
qualitatively)
b) Transparency, openness and responsibility dictates that environmental footprint
should be measured and reported
c) External stakeholders should be aware of the impact on environment by the
company
d) Investors should be aware of the potential loss arising from environmental
legislation happening in future