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ACCA P1
Professional Accountant
Arnold Xu
Arnoldxu@FTGedu.com
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Principals Agents
Views
-Capitalists
-Expedients
-Proponents of
social contract
-Social
ecologists
Governance,
IC, Audit,
ERM
Law, regulation, professional codes, professional values,
personal ethics
Ethical theories, consequentialism, CMD
Stakeholders
-Shareholders
-Staff
-Lenders
-Customers
-Government
-Public
-Future
generations
Directors/accountants
National/local
government
Health authorities
Professional bodies
Schools/colleges
Duties
-Performance
-Competence
-Conflicts of
interests
-Confidentiality
-Accountability
Power
Interests
Investments
Objectives
SOX, Combined Code
NED, AC, RC, NC
Risk Committee
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Safeguards
Governance,
IC, Audit,
ERM
Risks
-Financial
-Operational
-Reputation
-Legal
Threats
-Self-interest
-Self-review
-Advocacy
-Familiarity
-Intimidation
Identify,
Assess,
Evaluate
ARTA
Integrity
Independence
Objectivity
Confidentiality
Competence
Risk Committee
NED, AC, RC, NC
Law, regulation, professional codes, professional values,
personal ethics
Ethical theories, consequentialism, CMD
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Introduction - Syllabus
A. Governance and responsibility
1. The scope of governance
2. Agency relationships and theories
3. The board of directors
4. Board committees
5. Directors remuneration
6. Different approaches to corporate governance
7. Corporate governance and corporate social responsibility
8. Reporting & disclosure
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Introduction Examinable Models & theories
Corporate Governance
Agency theory (2 Define)
Transaction Costs theory (2 Explain & Analyze)
Stakeholder theory (2 Explain & Analyze)
Ethics
Relativisim& Absolutism ( 2 Explain & distinguish)
Kohlbergs stages of moral development (3 Explain)
Deontological and consequentialist (2 Describe &
distinguish)
American Accounting Association model (2 - Apply)
Tuckers 5 question model-PLFRS (2 - Apply)
Gray, Owen and Adams 7 positions (2 Describe &
evaluate) 6
Chapter 1
Corporate Governance
Concepts & Scope
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KNOWLEDGE CHECKLIST
Business organizations
Agency Theory & Transaction Cost Theory
Agency theory
Agency relationship
Duties of agent
Accountability
Fiduciary duty
Agency cost
Alignment of interest
Close monitoring
Transaction cost theory
stakeholders
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KNOWLEDGE CHECKLIST
Corporate governance
Definition
Concepts
Fairness
Transparency
Independence
Probity
Responsibility & accountability
Integrity
Stakeholders
Relationship
Direct & control
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Corporate Governance Stakeholders 3
Stakeholder
Definition:
Any entity
Affect or be affected
Bi-directional
Power x interest =influence
Source of risks
Debates over stakeholder
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All about stakeholders
Stakeholder
theory
Instrumental Normative
Identification of
stakeholders
Stakeholder
mapping
7 Positions
CSR
Corporate Citizen
Sustainability
Reporting
Tuckers 5 Question
Institutional investors
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Chapter 2
Different Approaches
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KNOWLEDGE CHECKLIST
Models of Business Ownership 2
Approaches to Corporate Governance Guidance 3
Principle vs. Rules based
Impetus for Corporate Governance Code 3
Investor (equity treatment)
Responsive
Major Corporate Governance Codes
Combined Code UK 2
Sarbanes-Oxley US 2
International 2
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Major Corporate Governance Codes 2
Principle Based:
UK Combined Code
OECD (CG concept)
ICGN (Ethics & stakeholders)
Rules based:
Sarbanes-Oxley Act
Other national codes
South Africa Kings report (CSR)
Singapore Code of Corporate Governance
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Chapter 3
Best Practices
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KNOWLEDGE CHECKLIST
Board composition & roles 3
Board structures 3
Directors Remuneration 3
Board committees 3
Communicating & Reporting
AGM 2
Proxy voting 3
Corporate Governance reporting 2
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Information & Professional Development of the Board 3
UK Combined Code
The board should be supplied in a timely manner with
information in a form and of a quality appropriate to enable it to
discharge its duties.
All directors should receive induction on joining the board and
should regularly update and refresh their skills and knowledge.
Information to the Board
Responsibility:
Chairman
Management (provider)
Directors ( seek clarification )
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Induction programme
Contents
Company relationship
People
Products or services
Structure
Constitution
Assets, liab.,
Risks
KPI
Regulations
Meet
Visit
Build relationships
Meet auditor
Customer
Supplier
Shareholder
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Professional Development of the Board 3
Who is responsible?
chairman
CPD programme should be concentrate on
Role of the board
Obligations and entitlements of existing directors
Expected behaviour for effective board performance
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Performance of the Board 2
Board performance evaluation:
Key criteria:
L/T development instead of routine management matters
Who will evaluate?
by external 3rd parties ( e.g. auditors)
by NEDs (for evaluating performance of Chairman)
When
Once a year
Whom to report?
Shareholders
1.Formal, rigorous
2.Board, committees, indi vidual directors
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Performance of the Board 2
What are the criteria?
For the Board
Board composition and meetings
The BOD is collectively responsible for success of the
company
Measures:
Meetings (scheduled, unscheduled)
Attendance record
Updates of roles and responsibilities
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Performance of the Board 2
What are the criteria?
For the Board
Board balance and independence
ED and NED
Chairman Chief Executive Officer
Measures:
Age profile of the directors
Up to date CVs of directors
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Performance of the Board 2
What are the criteria?
For the Board
Mission and strategy
Measures:
BSC: non-financial +financial targets
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Performance of the Board 2
What are the criteria?
For the Board
Board appointment and re-election
Formal, transparent procedure
Submitted for re-election at regular intervals
Measures:
NC, Length of tenure of each directors
Re-election interval (maximum 3 years)
Succession policy
Combined code:
All directors should be subject to election by
shareholders at the first AGM after their
appointment,
and to re-election thereafter at intervals of no
more than three years.
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Performance of the Board 2
What are the criteria?
For the Board
Directors' remuneration
Measures:
RC, composed by independent NEDs
Performance targets achieved >performance related
pay
1. Combined Code:
2. Levels of remuneration for directors should be sufficient
to attract, retain and motivate directors of the quality
required to run the company successfully but should
not be more than is necessaryfor purpose
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Performance of the Board 2
What are the criteria?
For the Board
Information and professional development
Info to the Board >timelyand appropriate
All directors >induction training and CPD
Measures:
management a/c information >directors
Training courses
No. of new directors? Attendance?
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Performance of the Board 2
What are the criteria?
For the Board
Accountability
Balanced & understandable assessment of position and prospects in
the annual report and other public statements
Maintain a sound system of IC
Measures:
IC assessed ?
IA examines IC ?
AC (composition, meetings)
IC recommendations from EA
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Performance of the Board 2
What are the criteria?
For the Board
Communication
Dialogue with institutional shareholders
Use AGMto communicate with private investors and
encourage their participation
Measures:
Meet with major shareholders
Other communications?
Shareholders attendance at AGM
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Performance of the Board 2
What are the criteria?
For the chairman
Effective leadership
Relationships and communications with shareholders
Relationships and communications within the board
Board agenda - enable board members to raise issues and
concerns
Company secretary - used appropriately and maximum
value
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Performance of the Board 2
Individual directors
Chairman & CEO
Separate appraisal carried out by NEDs
All directors on the Board
Criteria:
independence >objective
preparedness >knowledge, relationship
practice >questioning, education
committee work >process, enthusiasm
development of the organization >suggestion, innovation
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Performance of the Board 2
Board Meetings
Agenda:
Balance between L/T & S/T issues
Every director >opportunity to propose
Supporti ve information:
Informative, Risks and alternatives identified
Distributed in good time
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Legal & regulatory issues over the Board 2
Appointment
Removal
Rights
Responsibility
Remuneration
Directors
- Fees and expenses
- Emoluments and
compensation for
loss of office
Legal duties
- Skill
- Attend board meetings
-Delegation and
communication
Conflict and disclosure
of interests
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Time-limited
appointments
Removed or
disqualified
Not offering
himself for
re-election
Resignation
Company
Dissolution
Death
Legal & regulatory issues over the Board 2
Departure from office
written
notice
NEDs:
After 2 x 3 period >explain to
SH
After 9 >annual re-election
By companys constitution
By court
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Legal & regulatory issues over the Board 2
Insider dealing/trading
What is?
A criminal offence by using insider information to buy or
sell shares in a stock market
A breach of agents duty
Insider information
Information that is specific and precise,
Not yet been made public >if made public >significant
effect on share price
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BOARD STRUCTURE 3
Good board structure
1. Independence
2. Size
3. Committees and functions
4. Diversity
Division of responsibility in BOD
CEO Chairman
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BOARD STRUCTURE 3
Bad board structure
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BOARD STRUCTURE 3
CHAIRMAN AND CEO
UK Combined Code
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 companys
business. No one individual should have unfettered powers of
decision.
A chief executive should not go on to be chairman of the same
company. If exceptionallya 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.
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BOARD STRUCTURE 3
CHAIRMAN AND CEO
1.Different roles
Chairman: Head of the BOD
CEO: leading the management team
Pros for separation
Chairman (representative of Shareholders) manager role
No single person can do BOTH job well
Can Board make CEO truly accountable for management?
CEO is the head of board
Removes possibility of self-interest >act in the interest of
shareholders
NEDs report their concern over CEO to Chairman
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BOARD STRUCTURE 3
CHAIRMAN AND CEO
Possible Cons for separation
2 leaders >conflict
Greater power to the CEO
Motivating tools
What if CEO =Chairman ?
Strong independent element
E.g. senior independent NED
Available to shareholders to answer concerns that have not
be resolved through normal channels
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BOARD STRUCTURE 3
CHAIRMAN AND CEO
Role of Chairman
Run the board and set its agenda
Information to board members
Effective communication with shareholders
Manage the board (meeting and NED)
Induction program for new directors
CPDof individual directors
Performance evaluation (directors and committees annually)
Encourage active engagement by all the members of the
board
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Accountability of Board and CEO
Board
Shareholders
Executive
management
Financial markets
Regulatory bodies
Supervision of management
And stewardship of the company
Management of the company
& stewardship of its operations
Other stakeholders
Employee etc
Chairman
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BOARD STRUCTURE 3
CHAIRMAN AND CEO
Role of CEO
Senior executive in charge of management team
Answerable Board
Responsibility:
UK Combined Code
Major Responsibilities of CEO
Business strategy and management
Investment and financing
Risk management
Board committees (recommendation)
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BOARD STRUCTURE 3
Role of NED
Who are they?
NEDs have no executive (managerial) responsibilities
non-executive director
Focuses on what they are not rather than what they are
Equivalent terms:
Outside director
Used in the US and elsewhere but NOT in the UK
independent director appears in Higgs Review
ALL NEDs could, or need to, be independent
UK Combined Code
The board should include a balance of ED and
NEDs (and in particular independent NEDs)
such that no individual or small group of
individuals can dominate the boards decision
taking.
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BOARD STRUCTURE 3
Role of NED
SENIOR INDEPENDENT DIRECTOR
UK Combined Code
The board should appoint one of the independent NED to be
the senior independent director.
Be available to shareholders
When normal channels of chairman, chief executive or
finance director has failed
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BOARD STRUCTURE 3
Role of NED
SENIOR INDEPENDENT DIRECTOR
Debate over Senior Independent Director:
Pros:
Important > relationship b/w major shareholders and the board
Address shareholder concern
Chair meetings b/w NEDs where chairman does not attend
Unless being appointed as chairman > functions as Deputy Chair
Cons:
Unnecessary or divisive >shareholders may make use of own connections
with NEDs, or contact the chairmen of board committees if they have
concerns
Construct the case for having an independent Director on
the Board
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BOARD STRUCTURE 3
Role of NEDs
Strategy:
Constructively challenge and contribute to the development of strategy.
Performance (scrutiny)
Scrutinise the performance of management in meeting agreed goals and
objectives and monitor the reporting of performance.
Risk
Satisfy themselves that financial information is accurate and that financial
controls and systems of risk management are robust and defensible.
People
Responsible for determining appropriate levels of remuneration of
executive directors and have a prime role in appointing, and where
necessary removing, senior management and in succession planning
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BOARD STRUCTURE 3
Requirement & Provisions for NEDs in the Board
Number of NEDs
UK Combined Code
At least half the board, excluding the chairman >independent
NEDs
Smaller company >at least 2 independent NEDs
NYSE:
Listed company >MAJ ORITY of NEDs ( >50% of the board)
Singapore:
At least 1/3 >independent NEDs
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BOARD STRUCTURE 3
Pros & Cons for NEDs in the Board
Advantages
External experience and knowledge
Provide wider perspective
Comfort factor for 3rd parties (e.g. investors, creditors)
Well-suited roles played by NEDs
Dual nature of NEDs role
Full board members >same knowledge
Strong, independent element on the board
Compliance with relevant CG codes
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BOARD STRUCTURE 3
Pros & Cons for NEDs in the Board
Problems
Lack independence
Prejudice over recruitment of NEDs
High-calibre NEDs tends to work in best-run companies
Difficult to impose views on the board
Corrective roles may be beyond the capabilities of NEDs
Limited time to devote in company affair
May damage companys performance
Weakening board unity
Stifle entrepreneurship
Debate over CSR:
NED was for political reasons > represent others interest
> not in best interest of shareholders
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BOARD STRUCTURE 3
Remuneration of NEDs
UK Combined Code
No share options to NEDs
In practice
Bonus scheme for NEDs could be problematic:
Too small >lack of motivation >observe bottom line
Too generous >conflict of interest >not act in the best
interests of shareholders
Why?
Fear of challenging ED
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BOARD STRUCTURE 3
Remuneration of NEDs
Recommendations:
Sufficient to attract high quality and motivated NEDs >shareholders
benefit
Payment:
Cash or shares
No share options
Linked to L/T performance rather than financial performance of current
period
Balanced performance measures
Encourage broader view of CG
Shareholders' prior approval of any bonus scheme
NEDs' bonuses >determined by Shareholder, NOT by ED
Incentive for NED to achieve specific objectives or tasks outside normal
duties as NED
Paid immediately
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BOARD STRUCTURE 3
Supervisory board
only non-executive members
Management board
Executive members only
Board of directors
Executive &
non-executive members
Two-tier structure Unitary structure
Executive committee
committees committees
Supervisory board
Composition:
Workers representatives
Shareholders
representatives
Management board
Composition:
-Appointed by Supervisory
Board
-Entirely of managers
Policy boards
- L/T strategic issues
Functional boards
-Main senior executives with
functional role
Monocratic boards
-Few responsibilities
-More symbolic role
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BOARD STRUCTURE 3
Unitary or Multi-tier?
Arguments for & against
Unitary Boards
Advantages:
Equal legal responsibility >NEDs involvement
Same meeting
Decision-making +information
More balanced decision >all directors involved
Presence of NEDs >scrutinizing and challenge >better
decision-making
Enhance relationship between different types of directors
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BOARD STRUCTURE 3
Unitary or Multi-tier?
Arguments for & against
Unitary Boards
Disadvantages:
Overloaded NEDs >manager +monitor
Time pressure for NEDs >meeting and understand
No EE in management board
Division b/w shareholders and directors >AGMonly place
for shareholders
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BOARD STRUCTURE 3
Unitary or Multi-tier?
Multi-tier Boards
Advantages:
Separation b/w monitors and those being monitored
Supervisory/policy board
Guard & Deterrent (similar to IA)
Stakeholders needs >by supervisory board
Shareholder involvement and EE participation (appointment
and supervision of directors)
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BOARD STRUCTURE 3
Unitary or Multi-tier?
Multi-tier Boards
Disadvantages:
Confusion over authority >lack of accountability
Theory practice
Management board may restrict info passed to
supervisory board
Independence of supervisory board
Representatives of shareholders >interfere
NED?
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BOARD STRUCTURE 3
Trends and futures
UK & US
Increasing criticismover two-tier board structure
Advocates on NEDs role in the board
Germany and J apan
Under pressure of globalisation of capital markets and
cross-boarder M& A
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Board representation: Weight and influence of
different stakeholders on the board
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Shareholders
employees
employees
United Kingdom US
Continental Europe
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DIRECTORS REMUNERATION 3
Purpose & general guideline:
Adequate remuneration to attract individuals with sufficient
calibre
Motivate individuals to achieve performance levels
High-performing directors should be rewarded
>but how much is enough?
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DIRECTORS REMUNERATION 3
Setting of Directors remuneration
By remuneration committee
Role
general policyon remuneration of executive directors
specific remuneration packages for each director
Composition
INDEPENDENCE (3 NEDs)
Staffed by NEDs > ED can NOT set on own salaries
3 No
no personal interest
no conflicts of interest
no day-to-day involvement in running the business
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DIRECTORS REMUNERATION 3
Remuneration Policy
pay scales
proportion of rewards
period for performance related payments become payable
proportion of performance related, balance b/w L/T & S/T
transparency of directors remuneration (pension rights)
Benchmarking with similar companies >applied with caution
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DIRECTORS REMUNERATION 3
Remuneration Policy
Determine the Performance Measures
Problems:
Wrong measure applied
Myopia (short-term focus)
Remunerated with time delay ( reward for the past)
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DIRECTORS REMUNERATION 3
Remuneration Policy
Determine the Performance Measures
Other considerations:
Link variety of strategic goals and targets together
Profit based
EPS
Problem: S/T, manipulation, risk-taken
Market based
TSR
Problem:
Market fluctuation
Individual performance
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TSR
Total Shareholder Return
Capital Gain + Total Di vidend over the period
Initial investment (Opening SP)
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DIRECTORS REMUNERATION 3
Remuneration Policy
Determine the Performance Measures
Other considerations:
Link variety of strategic goals and targets together
Internal based
Measures: financial +non-financial
Problems:
Intangible
Benchmark
Compliance
Environmental
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DIRECTORS REMUNERATION 3
Remuneration Policy
Determine the Performance Measures
Other considerations:
Remuneration for different levels of directors
Loss of management (confidentiality)
Additional and basic
Flexibility
Difficult to distort
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Basic
salary
Performance
related
Shares
Share
options
DIRECTORS REMUNERATION 3
Remuneration Package
1. UK Combined Code
2. Levels of remuneration should be sufficient to attract,
retain and motivate directors of the quality required to
run the company successfully, but a company should
avoid paying more than is necessary for this purpose.
3. A significant proportion of executive directors
remuneration should be structured so as to link
rewards to corporate and individual performance.
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DIRECTORS REMUNERATION 3
Components
Basic salary
Determined by employment contract (experience, market
rate)
Not related to performance
Performance related bonuses
Cash bonus (may have a cap)
Transaction bonuses
Shares
Award shares and exercise after period of service
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DIRECTORS REMUNERATION 3
Components
Share options
a) What is
A right to purchase shares at a specified exercise price over
a specified time period in the future
At the exercising day, if share price >exercise price, follow
exercise price
Initiatives and Problems
A mechanism to align interest of management with that of the
shareholders
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DIRECTORS REMUNERATION 3
Share options
Conditional based on achievement of certain conditions
Market based:
Share price
Target share price relative to an index of market prices
Non-market based:
Revenue / Profits
Increase in EPS
Non-financial targets (IPO, number of EEs)
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DIRECTORS REMUNERATION 3
Share options
Initiatives and Problems
Vesting period
UK Combined Code:
Not less than 3 years
Encourage for longer holding period
Grants >in phase
Performance criteria
A matter of debate
Benchmark to a group of comparable companies
What will the directors do to protect own interests?
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DIRECTORS REMUNERATION 3
Benefits in kind
Transport, health provisions, life assurance, holidays,
expenses, loans
Concerns:
Cost & benefit
Compared with EEs package
Loans
Abuse of loan (WorldCom case)
Loans to directors of listed companies >prohibited
(some jurisdiction)
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DIRECTORS REMUNERATION 3
Pensions
Pension contributions
UK Combined Code
Only basic salary is pensionable
Pension consequences and associated cost need to be
considered
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DIRECTORS REMUNERATION 3
Service Contracts & Termination Payments
Length of service contract
Most CG >less than 12 months
Compensation for terminating service contract
Continue to pay
Cease payment when directors finds new job
Paying shares
1.UK Combined Code:
2.The remuneration committee should carefully consider what compensation
commitments (including pension contributions and all other elements) their
directors terms of appointment would entail in the event of early termination.
The aim should be to avoid rewarding poor performance. They should take a
robust line on reducing compensation to reflect departing directors
obligations to mitigate loss.
3.Notice or contract periods should be set at one year or less. If it is
necessary to offer longer notice or contract periods to new directors
recruited from outside, such periods should reduce to one year or less after
the initial period.
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DIRECTORS REMUNERATION 3
Remuneration Disclosures
Annual report:
Remuneration policy
Arrangement for individual directors
Other disclosures
Duration of directors contracts
Notice periods and termination payments
Details of external remuneration consultants employed by
RC
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DIRECTORS REMUNERATION 3
Voting on Remunerations
Shareholders
Approve remuneration policy >voting on remuneration
statement +remuneration packages
However
Legally binding contract b/w Co. & directors
Shareholders can not force a breach of contract
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BOARD COMMITTEES 3
Sub-board committees responsible for supervising specific
aspects of governance.
Main board committees
Internal Audit Committee
Remuneration Committee
Nomination Committee
Risk Committee
Operation of committee system does not discharge the
responsibility of board on the specific areas
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COMMUNICATING & REPORTING 2
Board shareholders (institutional)
AGM >forum
Annual Report and Accounts
Shareholder has the right to appoint a agent (proxy) to act on
their behalf at company meetings
Board should maintain a regular dialogue with
shareholders, particularly institutional shareholders
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COMMUNICATING & REPORTING 2
AGM
Guidelines:
Company
Notice >20 working days before meeting
Business presentation +Q&A session
Chair of key sub-committees >available to answer questions
Shareholders
Vote separatelyon EACH substantial separate issue (no bounding of
issues)
Propose a resolution at AGM relating to reports and accounts
Institutional investors
Provide details of their vote in the AGM
Eliminate impediments to cross-border voting
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CORPORATE GOVERNANCE REPORTING
Importance of Reporting
Reduce information asymmetry
Helps to address key difficulties of agency
relationship
Principles vs. Compulsory
Principle based : London Stock Exchange
Compulsory: NYSE
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CORPORATE GOVERNANCE REPORTING
Whether complied throughout
the accounting period
Non-compliance >explained
Narrative statement
LSE
Statement of compliance
how applied
explanations on detail
Supplementary Disclosures
balanced and detailed information
based on judgement
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CORPORATE GOVERNANCE REPORTING 2
Reporting Requirements
1. Explain responsibilities for preparing accounts
2. Report on going concern status
3. Information on BOD
4. Brief reports on
i. remuneration
ii. audit
iii. nomination committees
5. Relations with auditors
6. Statement >reviewed effectiveness of IC, risk management
7. Statement >relations and dialogue with shareholders
8. Statement >company is a going concern
9. Substantiality report
10. Operating and financial review (OFR)
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CORPORATE GOVERNANCE REPORTING
Voluntary Disclosure 2
Any disclosure above mandated minimum
CEOs report
Social/environmental report
Additional risk or segmental data
General guidelines:
Transparent & planned process >communicated to everyone
responsible for preparing the information
Consultation within business, shareholders and other key groups
All relevant information >taken into account
Comprehensive, consistent and subject to review
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Q 1 Remuneration package
(a) As a consequence of the corporate governance codes, there is
increasing disclosure in the accounts of listed companies of
the procedures for determining the remuneration of directors,
and the actual remuneration.
The following statements are quoted from recent accounts:
'The (two) non-executive directors constitute the remuneration
committee.'
'No member of the committee has a personal financial interest,
other than as a shareholder, in the matters to be decided.
There are no conflicts of Interest arising from cross
directorships....'
'The Chairman has a service contract with a notice period of
three years. This was originally drawn up in 20X2 and was
considered at that time to afford protection for the Group
against the loss of the services of a key executive. ....the
Board does not intend to seek to varythe terms.'
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Q 1 Remuneration package
Answer:
'The (two) non-executive directors constitute the remuneration
committee.
Membership:
Wholly by NEDs >ED cant decide on own salary
Number of NEDs
Significant number of NEDs (recommended)
At least 3 (Combined Code)
2 for small company
Reliance on NEDs
Overloaded >insufficient attention
Minimum number of NEDs at least 3
15
85
Q 1 Remuneration package
Answer:
'No member of the committee has a personal financial interest,
other than as a shareholder, in the matters to be decided.
There are no conflicts of Interest arising from cross
directorships....
Independence
All NEDs should be independent
No share option
No performance-related pay
No pension scheme
Cross-directorship
Agreement on set higher salary for each other
86
Q 1 Remuneration package
'The Chairman has a service contract with a notice period of
three years. This was originally drawn up in 20X2 and was
considered at that time to afford protection for the Group
against the loss of the services of a key executive. ....the
Board does not intend to seek to vary the terms.
Answer:
Lengthy contract
Good: retain key management
Bad:
Financial disincentives to remove >high compensation costs
Shareholders right to remove directors >undermined
Service Contracts
Combined Code: for 1 year only
87
Q 1 Remuneration package
(b) Required:
Analyze and explain the motivational effect on the Chief
Executive of each elements of the remuneration package, and
of the total package. (14 marks)
88
Q 1 Remuneration package
(b) Under contractual remuneration arrangements, the Chief
Executive of X Group received in 20X6, as disclosed in the
annual report and accounts:
Salary 516,000
Bonus 50,000
Employee profit-sharing scheme 8,000
Benefits 21,000
He has a three-year rolling contract. The Group contribution to
his pension scheme was 85,000.
The bonus is determined by the remuneration committee, and is
non-pensionable. It is based on the committee's assessment of the
annual performance of the company and the individual's contribution
thereto. The bonus may not exceed 25% of salary. Participation in
the employee profit-sharing scheme is limited to 8,000. The
benefits relate to the use of a company car and accommodation.
89
Q 1 Remuneration package
In addition to the above, the contract provides that the Chief
Executive can receive, as part of his remuneration package,
the following.
(i) A conditional allocation of ordinary shares, which may be
approved annually by the Remuneration Committee, based on
a percentage of salary not exceeding 50%.
Shares are held by trustees during the measurement period of
three years.
Vesting (formal ownership and possession) of the shares is
subject to a performance test at the end of the period. The test
involves ranking the total shareholder return (TSR) against
those of other top 100 companies (FT-SE 100).
(1) An upper quartile ranking will produce 100%vesting, a
lower quartile zero.
(2) The calculation of intermediate points is linear.
90
Q 1 Remuneration package
The shares required are purchased in the market. Conditional
allocations are expected to be at 50%of salary (the maximum).
(ii) Share options may be granted, at the market price at the
date of grant. The maximum share options granted in a three-
year period can not exceed four times annual salary.
These can not be exercised for three years, and can be
exercised only if the percentage growth of the TSR of the
company equals or exceeds that of the average of the FT-SE
100 companies.
16
91
FTSE 350 Total Shareholder Return*
2. Imperial Tobacco 305.3%
3. Man Group 303.9%
4. Hit Entertainment 268.9%
5. Lonmin 259.2%
6. Grainger Trust 233.0%
7. RPS Group 230.3%
8. Enterprise Inns 230.1%
9. McCarthy & Stone 228.7%
10. Wimpey (George) 226.0%
11. Holiday Break 197.7%
12. PZ Cussons 179.0%
13. Interim Capital Group 178.0%
*Source: Datastream- Total Shareholder Return, period covering 5 years fromJ an/98 J an/03
1. J ardine Lloyd Thompson 376.9%
14. Persimmon 177.6%
15. BHP Billiton 171.9%
16. PZ Cussons A 168.8%
17. Inchcape 165.0%
18. British American Tobacco 162.8%
19. Gallaher Group 161.1%
20. Wembley Group 154.9%
21. Alba 154.1%
22. Signet Group 150.6%
23. Schroder Ventures 135.2%
24. Smith & Nephew 132.3%
25. Royal Bank of Scotland 128.5%
92
Q 1 Remuneration package
Answer:
Salary: 516,000
Substantial
Implication:
One of the highly-paid & highly sought-after directors
May increase in line with companys growth
Motivating
93
Q 1 Remuneration package
Answer:
Bonus: 25 % x 516,000 =129,000
Relate to performance of Co.
Criteria ?
Assessment of Remuneration Committee
Implication:
Company politics >de-motivational ?
Based on annual performance >S/T view?
94
Q 1 Remuneration package
Answer:
Employee profit-sharing scheme 8,000 (Max)
Insignificant
However, average performance will get the bonus
Other benefits, pension contribution 85,000
Substantial
Unlikely linked to performance >limited motivation
95
Q 1 Remuneration package
Answer:
Conditional Allocation of Shares
50% of salary >significant
3 year time scale >related to TSR >not S/T focus
Motivational
However
Penalized by market?
If group perform well, but sector performed bad >CEO
penalized
96
Q 1 Remuneration package
Answer:
Share Option
Not exceeding 4 times of salary >lucrative
Strong motivational
However >based on market >out of control of CEO
Current position of the company?
Average >reasonable target
Low >mission impossible?
Recommendation:
Sliding scale approach instead of all or nothing
17
97
Q 1 Remuneration package
Answer:
Total Package
Motivation depend on how CEO controls
Internal
External
Share grant +share option
Very lucrative
Encourage L/T perspective
However
Fixed proportion >substantial already
If CEO ambitious >higher performance
People are usually motivated by success itself
98
Chapter 4
Internal Control
Framework
99
Introduction - Syllabus
B Internal control and review
1. Management control systems in corporate governance
Propose
Assess
2. Internal control, audit and compliance in corporate
governance
Internal audit independence 2 - Assess
3. Internal control and reporting 2
4. Management information in audit and internal control
Communication of info 3
100
COSO
- A process,
- Effected by BOD, management and other personnel
- reasonable assurance . achievement of objectives in the
following categories:
Effectiveness and efficiency of operations
Reliability of financial reporting
Compliance with applicable laws and regulations
Purpose of Internal control system 2
101
Purpose of Internal control system 2
Importance of Internal Control
Achieve objectives
Underpin investor confidence
Risk awareness and control
Information on internal operations and compliance
Performance (expose and improve underperformed)
Reporting
Information for internal and external reporting
102
Purpose of Internal control system 2
Key stages involved in a Control System
1. Identification of system objectives
2. Setting targets for system objectives
3. Measuring achievements/outputs of the system
4. Comparing achievements with targets
5. Identifying what corrective action might be
necessary
6. Implementing corrective action
18
103
Importance of Internal control system 3
Turnbull Proposal
A company's system of internal control has a key role in
the management of risks that are significant to the
fulfilment of its business objectives.
A sound system of internal control contributes to
safeguarding the shareholders' investment and the
company's assets.
1. Internal controls should include all types of controls
including
Operational and compliance
Internal financial controls
104
Importance of Internal control system 3
Turnbull Proposal
What is a Sound system of Internal Control
Embedded in operations and form part of its culture;
Capable of responding quickly to evolving risks
Within the company
In business environment
Procedures for reporting immediately to management
Significant control failings or weaknesses identified
+
Corrective action being undertaken
105
Importance of Internal control system 3
Combined Code Requirements on Internal Control
The board should maintain a sound system of internal
control to safeguard shareholders' investment and the
company's assets.
The directors should, at least annually, conduct a review
of the effectiveness of the group's system of internal
control and should report to shareholders that they have
done so.
The review should cover all material controls, including
financial, operational and compliance controls and risk
management systems.
106
Importance of Internal control system 3
Combined Code Requirements on Internal Control
For listed companies, the BOD should
Assess howthe company has applied code
requirement to main a sound system of internal
control
Revieweffectiveness of internal control
Reporting on these matters to shareholders in the
annual report and accounts
107
Importance of Internal control system 3
Roles and responsibilities over internal control
Board of Directors
Responsible for the company's system of internal control
Set policies
Seek regular assurance on effective operation
Ensure effectiveness of IC in managing risks
108
Importance of Internal control system 3
Roles and responsibilities over internal control
Management
Implementing role
Identify and evaluate the risks >consideration by the board
Design, operate and monitor IC
CEO
- Ultimately responsible & assume "ownership" of the system
- Sets the "tone at the top" >control environment
- Provide leadership and direction to senior managers
- Reviewsenior managers control over the business
19
109
Importance of Internal control system 3
Roles and responsibilities over internal control
Senior Management
Assign responsibility >responsible personnel
All EEs
Some responsibility >accountability for achieving objectives
Collectively establish, operate and monitor
Produce information & communicate
Defined in everyone's J D
110
Importance of Internal control system 3
Roles and responsibilities over internal control
Internal Auditors
Evaluating
Monitoring
External parties
EA >NO responsibilities, NOR being part of IC
111
INTERNAL CONTROL FRAMEWORK 3
SOX Requirements on Internal Control
Statutory requirement
Sox 404
Audit and reporting of internal control systems
Management (CEO & CFO)
Understand IC
Evaluate effectiveness (design + operating)
Written assessment at Y/E on effectiveness >included in annual return
External Auditor
Opinion on managements assessment
Test & Verify>assessment is correct
Express an opinion on F/S of the company
112
INTERNAL CONTROL FRAMEWORK 3
SOX Requirements on Internal Control
Statutory requirement
Sox 404
Audit and reporting of internal control systems
113
Sample Auditors Report - Microsoft
In our opinion, such consolidated financial statements present fairly,
in all material respects, the financial position of Microsoft
Corporation and subsidiaries as of J une 30, 2007 and 2006, and the
results of their operations and their cash flows for each of the three
years in the period ended J une 30, 2007, in conformity with
accounting principles generally accepted in the United States of
America.
We have also audited, in accordance with the standards of the
Public Company Accounting Oversight Board (United States), the
effectiveness of the Companys internal control over financial
reporting as of J une 30, 2007, based on the criteria established in
Internal Control Integrated Framework issued by the Committee of
Sponsoring Organizations of the TreadwayCommission and our
report dated August 3, 2007, expressed an unqualified opinion on
management's assessment of the effectiveness of the Companys
internal control over financial reporting and an unqualified opinion on
the effectiveness of the Company's internal control over financial
reporting.
DELOITTE & TOUCHE LLP
114
INTERNAL CONTROL FRAMEWORK 3
Internal Control Framework
Control Environment
Control
Procedures
Culture, infrastructure
+
Attitude of management
Detailed control in place
20
115
INTERNAL CONTROL FRAMEWORK 3
COSO
1. Effectiveness and efficiency of Operations
2, Reliability of Financial reporting
3. Compliance with applicable laws and regulations
Key Concepts
Internal control is a process. It is a means to an end, not an end in itself.
Internal control is effected by people. Its not merely policy manuals and
forms, but people at every level of an organization.
Internal control can be expected to provide only reasonable assurance,
not absolute assurance, to an entitys management and board.
Internal control is geared to the achievement of objectives in one or
more separate but overlapping categories.
116
INTERNAL CONTROL FRAMEWORK 3
COSO
4 Objective Categories
Strategic development
Operations
Reporting
Compliance
5 components of internal control
Control Environment
Risk assessment
Control Activities
Information and Communication
Monitoring
Added
117
COSO ERM Framework
118
COSO
Control Environment
Sets the tone, influencing control consciousness
Foundation >discipline and structure
Control environment factors
Integrity
Ethical values and competence
Philosophy and operating style
Assigns authority and responsibility and organizes and
develops its people
Attention and direction provided by the BOD
119
COSO
Control Environment
Importance of Control Environment
Strong control environment
Does not, by itself, ensure the effectiveness of the
overall IC system
Major influence only
- Establishment of business objectives
- Structuring of business activities
- The way business followed to deal with risks
120
COSO
Risk Assessment
Assessment of external and internal risks pertain to the entity
Identification and analysis of relevant risks to achievement
of the objectives
Basis for determining how the risks should be managed
Risk assessment >ongoing
21
121
COSO
Control Acti vities
Control activities occur
throughout the organization, at
ALL levels and in ALL functions
Typical activities (SOAPMAPS)
Supervision
Organization
Authorization
Personnel
Management
Arithmetical & Accounting
Physical
Segregation of duties
122
COSO
Information and Communication
Information must be identified, captured and communicated in
a form and timeframe that enable people to carry out their
responsibilities
Information:
IS reports
Operational, financial and compliance-related information
For planning and control of the business
Information sources:
Internally generated data
External events, activities and conditions necessary for informed
business decision-making and external reporting
123
Tactical
Strategic
Operational
Information & Communication
Planning
Controlling
124
COSO
Monitoring
A process that assesses the quality of the system's
performance over time
Ongoing monitoring (in the course of operations)
Separate evaluations
Internal control deficiencies >upstream
Serious matters >top management & the board
A combination of the two
125
COSO
Relationships:
All 5 components must be in place to achieve either one of 3
objectives.
Advantages:
Focused on a wide concept of IC
Not just limited to financial control
126
COCO
COCO framework
Criteria of control
Canadian Institute of Chartered Accountants
Importance of feedback and continuous improvement in
control systems learning process
Definition of Internal Control:
Internal Control is those elements of an organization
(including its resources, systems, processes, culture,
structure and tasks) that, taken together, support people in
the achievement of the objectives.
22
127
Purpose
A sense of direction.
What are we here for?
Commitment
A sense of identity
and values.
Do we want to do
a good job?
Capability
A sense of competence.
What action do we need to
take?
Monitoring and
Learning
A sense of evolution.
What Progress?
What Next?
ACTION
COCO
128
COMPONENTS OF INTERNAL CONTROL 3
Major Classifications:
Corporate, management, business process, transaction,
Administrative, accounting
Prevent, detect, correct
Discretionary and non-discretionary
Voluntary and mandated
Manual and automated
Application and general IS controls (Covered in F8)
Financial and non-financial
129
INTERNAL CONTROL AND RISK MANAGEMENT
3
Turnbull Proposal
The board must further ensure that the system of internal
control is effective in managing those risks in the manner
which it has approved.
In determining its policies with regard to internal control, and
thereby assessing what constitutes a sound system of internal
control in the particular circumstances of the company,
Factors to be considered by the Board
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 materialising;
The company's ability to reduce the incidence and impact on
the business of risks that do materialise; and
The costs of operating particular controls relative to the benefit
thereby obtained in managing the related risks.
Risk management is ONGOING process!
130
Cost & benefits of internal control 2
Benefits & measurements:
Helps to achieve objecti ves
not ensure achievement (factors out of management
control)
Helps to reduce fraud and errors
cant eliminate ( inherent limitation of internal control)
Helps to improve effecti veness and efficiency
how to quantify
The Cost of implementing a specific control should NOT
exceed the expected Benefit of the control.
131
Cost & benefits of internal control 2
Cost
Tangible costs
salary, additional expenditures
Opportunity costs
management time spend on monitoring and supervision
Intangible costs
Reduced flexibility, responsiveness, creativity
Does control stifle initiative?
132
Cost & benefits of internal control 2
Practical Difficulties for Cost & Benefit analysis:
How to estimate potential monetary loss or gain in the event of
control failure or absence
How to assess effect of control
E.g. how much a control can save?
Many benefits are non-monetary
E.g. improved morale or reputation
23
133
Exam Questions on IC
Pilot Paper
- Sound system of internal control (optional Q)
Dec 07 (Q 1)
- Importance of internal control
- Recommendation of control procedures (application)
J un 08 (Q1)
- IC over subcon (application)
134
Chapter 5
Internal Control - Internal Audit
No prior Exam Question on this area!
135
KNOWLEDGE CHECKLIST
Internal Audit
Need for Internal Audit function 1
Roles of Internal Audit 1
Independence of internal audit 3
Source of internal auditor
Relationship with external auditor
IIAs standards over internal auditor 3
Internal audit reports
Assess the performance of internal audit 3
Audit Committee 2,3
Roles and functions
Relationship with IA & EA 2
Roles in internal control 3
136
Need for Internal Audit function
Factors:
Scale, diversity and complexity of companys activities
Number of EE
Cost/benefit considerations
Changes in organizational structures, reporting process or
underlying IS
Changes in key risks
Problems with internal control system
An increased number of unexplained or unacceptable
events
Combined Code:
Companies which do not have an internal audit
function should from time to time review the need for
one
137
Definition of internal audit 1
Appraisal or monitoring activity
Within an entity
Service to the entity
Examine & Report to management & directors
Accounting & internal control systems
UK APB
138
Typical Tasks 1
INTERNAL REVIEW
Internal
audit
External
auditors/
consultants
OR
Types of assignment Performed by
Operational
Systems
Value for
money
Financial
24
139
Roles of Internal Audit 1
Review of accounting and internal control system
Reviewdesign
Monitoring operation
Risk assessment
Detailed testing
Recommending cost effective improvements
Financial +non-financial controls
Examination of financial and operating information
Review of IS over financial and operation
Detailed testing of transactions, balances and procedures
140
Roles of Internal Audit 1
Review of 3Es of the operations
Review of Compliance with
Review controls over safeguarding of assets
Review of implementation of corporate objectives
Review effectiveness of planning
Relevance of standards and policies
CG procedures and operation of particular procedures
141
Roles of Internal Audit 1
Risk management
Identification of significant risks (F, O)
Monitoring overall risk management policy and risk
management strategies
Insufficient ERM
Effective ERM
Recommend
Audit & improve
142
Independence of internal audit 3
1. Independent of the
activities they audit
2. Independent reporting line
3. Objectivity (state of mind)
1. Independent mental
attitude
143
Independence of internal audit 3
Recommended Principles for Internal Auditor
Integrity
Objecti vity
In gathering, evaluating, and communicating information
Balanced assessment
Impartial, unbiased attitude and avoid conflicts of interest
Confidentiality
Not disclose without appropriate authority >unless
whistleblowing!
Competency
IA: ethics, public interest, duty of agent
144
Independence of internal audit 3
Recommended Principles for Internal Auditor
Management of IA
CIA
TOR (scope of work)
Planning, supervising, control
CPD
25
145
Threats to Independence 3
Invol vement in system design
Overfamiliarity
Close professional or personal relationship with managers
and staff under audit
Reporting relationships
Independent of line management ( finance director)
Should report to board or AC
146
Threats to Independence 3
Dealing with threats to independence
No audits over previously worked department
No post-implementation audits on new systems if
involved in designing and implementation
Defined scope of responsibilities, unrestricted access
to records, assets and personnel
Rotation of staff over different audit areas
147
Independence of internal audit 3
Consulting and safeguards
Problems:
Too much efforts on
consultancy projects
Involved in operational
concerns >
independence ?
Unrealistic expectation:
Reliance on IA for
solution
involvement of
operational staffs
Safeguards
No management responsibility
Clearly defined TOR:
Resources
Prioritize
Additional resources
Include recommendation work on IC as
IAs responsibility
Different staff
Serious control weaknesses discovered in
consultancy >high risk >regular review
148
Sourcing Internal Audit
Internal Auditor
Internal
Outsourced
Fresh perspective, experience
Independence >no operational
problems
No prejudices and bias
No training cost or ongoing cost
More flexible >provided when
needed
Problem:
Independence
Cost
Confidentiality
Staff change
149
Internal Audit Report
No formal reporting requirement
Standard Report Format
Executive Summary
Background
Objectives
Major outcomes
Key risks identified
Key action points
Summary of work left to do
Body of the Report
List of Findings
Potential impact of issues
Recommended approaches
Managements response
Agreed actions and deadlines 150
Assess the performance of internal audit 3
Assessment Criteria
Professional proficiency
Scope of work
Performance of audit work
Management of internal audit
Independence of internal audit
Authority of internal audit
26
151
Assess the performance of internal audit 3
Quality control of IA
Internal Audit function should
Establish QC policies and procedures
All audits conducted in accordance with internal standards
Communicate >to IA
Factors affecting the policies
Size and nature of dept.
Geographic dispersion
Organization
Cost-benefit considerations
152
Assess the performance of internal audit 3
Quality control of IA
Responsibility
Chief audit executive (CAE)
Develop & maintain QA and improvement program
Continuously monitors its effectiveness
Internal
External
153
Assess the performance of internal audit 3
Annual Review of Internal Audit
By whom:
Board or
AC
Criteria:
Scope of work
Operational IC
Risk assessment and management process
Compliance with laws, regulations and policies
Safeguarding of assets
Reliability of information
Value for money
Organizations objectives and goals
Sources of info: internal audit plan
154
Assess the performance of internal audit 3
Annual Review of Internal Audit
Criteria:
Authority
TOR
IA reports >adequately considered & actions taken
Independence
Adequate safeguards
Reporting line
Removal of head of IA
No operational responsibility
No system design, installation and other operational task
by IA
155
Assess the performance of internal audit 3
Annual Review of Internal Audit
Criteria:
Resources
Sufficient resources available for IA to carry out all
necessary work
Human
Hardware
Knowledge, skill and experience
156
Audit Committee 2, 3
Composition:
Combined Code:
The board should establish an audit committee of at least three,
or in the case of smaller companies two, members.
All members
Independent NED
The board should satisfy itself that at least one member of
the audit committee has recent and relevant financial
experience
27
157
Audit Committee 2, 3
Appointment
Chairman of BOD member of audit committee
By board
Taking recommendation from NC (where there is one)
In consultation with the AC chairman
Period
Up to 3 years
Extendable by no more than 2 x additional 3 year periods,
so long as members continue to be independent.
158
Audit Committee 2, 3
Meetings of AC
Frequency and timing decided by
AC chairman
Company secretary
Frequency depend on role and responsibilities required >not less
than 3 meetings
Timing:
Key dates within FR and audit cycle
Attendance
OnlyACs chairman +members of committee
Non-members >subject to audit committees decision
Audit lead partner +FD
159
Audit Committee 2, 3
Meetings of AC
Meet with EA & IA >at least annually
Chairman of AC should maintain close contact with key people
involved in the companys governance
Board chairman
CEO, FD
EA lead partner
Head of IA
160
Audit Committee 2, 3
Resources
Remuneration
Component:
Remuneration paid to all NED
+
Further remuneration for the additional responsibilities
Skills, experience and training
1 x recent and relevant financial experience +professional qualification from
one of the professional accountancy bodies
Other member x experience of corporate financial matters
Induction programme for new member
CPD
Ongoing and timely training
161
Audit Committee 2, 3
Relationship with the board
Board responsible for
Role and extent of work
Reporting line
TOR
Annual reviewof audit committees effectiveness
Disagreement with board
Allow adequate time for discussion
Unresolved >report to the shareholders in annual report
162
Audit Committee 2, 3
Review annual
a/c and IC
Monitor and
review
effectiveness of
IA function,
Appoint/remove
CAE
Liaise with EA
whistleblowing
28
163
Audit Committee 2, 3
Communication with Shareholders
Annual
Report
AGM
Separate section for AC
Work of AC
Summary of role
Names and qualifications of all
members
Number of meetings
Report on how AC has discharged its
responsibilities
Non-audit services & safeguards
Chairman should answer
AC activities and
Matters within the scope of audit
committees responsibilities.
164
Chapter 6
Risk Management
Identification of Risk
165
KNOWLEDGE CHECKLIST
Risk concept 2
Nature of risks
Risk & return
Risk and Corporate Governance 2
Strategic and Operational Risks 2
Business Risks 2
166
RISK CONCEPT
Nature of Risks
Definition:
A condition
in which there exists a possibility of deviation
From
a desired outcome that is expected or hoped for
167
RISK CONCEPT
Nature of Risks
Risk and Hazard
Risk is Probability
Likelihood that it will actually cause harm or injury
Hazard is Consequences
Something with the potential to cause harm or injury
Relationship:
Risk is often used as generic term to cover Hazard as
well.
168
RISK CONCEPT
Nature of Risks
Types of Risk
Speculative risks
Consequences >
either good or harm
Example?
Business entity
Pure risks
Only consequence is
harmful
Usually can be dealt with
insurance
Example?
Negative Risk
- Downside
29
169
RISK CONCEPT
Risk & return
Risk management
Minimizing but not eliminate
Residual or remaining risk
Still be in presence >cost and benefit considerations
170
Different Attitudes to Risk
Definition
People have asymmetrical
views on risk
Types
Risk Seeking
Risk Neutral
Risk Averse
171
Different Attitudes to Risk
For a business
Profit is a reward for risk taking
Risk management
Avoid risks ( surprises)
Form integral part of business strategy
Enable business focusing on key value drivers
172
RISK AND CORPORATE GOVERNANCE
Links:
Risk taken shareholder return achieved
Risk taken directors remuneration
Should we link directors remuneration with risks taken?
Corporate Governance requirements :
Directors should
Establish appropriate control mechanism to deals with risks
organization face
Monitor risks by regular review and a wider annual review
Disclose risk management processes in the accounts
173
Business strategy
Risk appetite
Risk attitude Risk capacity
Risk
strategy
Risks
Residual
risk
amount of risk willing to accept
overall approach to
risk
risk averse
risk seeking
risk neutral
maximum risk a
business can
accept
174
STRATEGIC AND OPERATIONAL RISKS
Strategic Risk
Fundamental and key
decisions that directors
take about the future of
the organization
Business risk
Non-business risk
L/T financing
Operational risk
Risk of loss due to
People, processes,
infrastructure or
technology
operational impact,
Outside environment
Out of control of entity
Long term perspective
Internal environment
Controllable by entity
Day to day basis
30
175
STRATEGIC AND OPERATIONAL RISKS
Strategic risk
Responsibility
BOD
Vision, info, skill
Risk management
Accept
New product in New mkt
Reduce in long run
Redesign
Avoid
High impact
Slim prospect
Operational risk
Responsibility
BOD>
Risk Committee>
Risk management
function>
Line MGR >EE
Risk management
Transfer
H (impact) L (probability)
Reduce
L (impact) H (probability) 176
STRATEGIC AND OPERATIONAL RISKS
Operational risk
Staff
Competence, labor
Technology
Fraud
Processes/procedure
Outsourcing
Language/translation
Security
Staff welfare
177
BUSINESS RISKS
Financial Risk
Risk that affect the entitys going concern status
Structure of finance, fraud and misuse of financial resources
Long term risks
Currency risk
Interest rate risk
Short-term risks
Credit risk
Liquidity risk
178
BUSINESS RISKS
Financial Risk
Currency Risk
Possibility of loss or gain due to future changes in exchange rates
1. Transaction Risk
Exchange rate movements
2. Translation Risk
B/S values of foreign assets and liabilities >prevailing
exchange rate at Y/E
3. Economic Risk
Intl competitiveness (imp & exp)
Hedging strategies
Internal
Domestic currency invoicing
Netting
Leading and lagging
External
Forward market hedges (buying or selling currency forward)
Money market hedge (exporter)
Borrow the foreign currency
Sell the foreign currency in the spot market
Lend the domestic currency
Futures or options
179
BUSINESS RISKS
Financial Risk
Interest Rate Risk
Risk of volatility in interest rate that may affect companys cost of
debts
How to deal with the risk?
-Forward rate agreement
-Swaps:
- Reduce each partys financial risk
180
BUSINESS RISKS
Financial Risk (short-term)
Credit Risk
The risk that a counterpartymay not pay amounts owed when
they fall due.
How to management (exporter case):
Documentary credits
Bills of exchange
Export credit insurance
Export factoring and forfeiting
31
181
BUSINESS RISKS
Financial Risk (short-term)
Liquidity Risk
Risk of loss due to a mismatch between cash inflows and outflows
182
BUSINESS RISKS
Financial Risk (short-term)
Finance providers Risk
Risks to the entity for providing finance for others
Risk of default on debt payment
Risk of low or no return on investment
Dividend
Capital gain
183
BUSINESS RISKS
Legal and Political Risk
Risks
Financial or other penalties
Compliance costs
Loss of reputation
Typical regulations:
Health and safety
Environmental legislation
Trade descriptions
Consumer protection
Data protection
Employment issues
184
BUSINESS RISKS
Political Risk
The risk that there will be a change in the political framework of
the country
Government policies:
Limitations on equity
Restrictions / interference with operations
Discriminatory taxation or tariffs
Non-tariff barrier
Profit repatriation
Wage fluctuations
Fiscal and monetary policies
185
BUSINESS RISKS
Political Risk
How to manage?
Avoidance
Insurance
Negotiate the environment
Structure the investment
R&D
Supplies of key components or materials
Global trademarks
Local stakeholders
186
BUSINESS RISKS
Country risk
Risk that a foreign currency will not be available to allow
payments due to be paid because of a lack of foreign currency or
the government rationing that which is available
32
187
Tactical
Strategic
Operational
BUSINESS RISKS - Information
Planning
Controlling
Strategic
Tactical
Operational
188
Tactical
Strategic
Operational
Information Requirement
Planning
Controlling
ESS
DSS
ES
MIS
TPS
KWS
189
BUSINESS RISKS
Technological Risk
Physical damage risks
Fraud risk
Data and system integrity risk
Denial of service attack
Internet risk
190
BUSINESS RISKS
Health & Safety Risk
Environmental Risk
Fraud Risk
191
BUSINESS RISKS - Fraud risks
Opportunities
Weak Board of Directors
Weak Internal Controls
Attitudes/Rationalizations
Lack of a Code of Conduct
Disregard for Financial
Reporting
Incentives/Pressures
Tight Debt Covenants
Unrealistic Analyst
Expectations
192
BUSINESS RISKS
Trading Risk
Risk with trading both internationally and domestically
Physical risk
Trade risk
Liquidity risk
Disruption risk
Cost and resource wastage risk
Product risk
33
193
BUSINESS RISKS
Reputation risk
Loss of reputation as a result of the adverse consequences of another risk
A genuine emerging issue after a series of accounting scandals
Affected stakeholders >power, interest
Poor customer service
Failure to innovate
Poor ethics
Non-cooperation from suppliers and customers
Inability to recruit high-quality staff
Fall in demand because of consumer boycotts
Increased public relation costs
Increased compliance cost
Loss of market value
194
Chapter 7
Risk Management - Risk Assessment
195
KNOWLEDGE CHECKLIST
Risk Analysis 2
Risk Identification
Risk Assessment
Risk Profiling
Risk Quantification
Risk Consolidation
Risk & Stakeholders 3
Role of the Board in Risk Management 3
196
Risk Analysis 2
Risk analysis involves identifying, assessing, profiling,
quantifying and consolidating risks.
Other terms may be used to describe these stages
Identify
Assess
Profiling
Quantifying Consolidating
197
Control It
Share or
Transfer It
Diversify or
Avoid It
Risk
Management
Process
Level
Activity
Level
Entity Level
Risk
Monitoring
Identification
Measurement
Prioritization
Risk
Assessment
Risk Analysis
198
Risk Analysis 2
1. Risk Identification
A continuous process to identify newrisks and changes in
existing risks
Involves identifying risk conditions
Method:
Physical inspection
Enquiries (e.g. QC procedures)
Check documents, correspondence
Brainstorming sessions
Checklist
Benchmarking (internal and external)
34
199
Risk Analysis 2
2. Risk Assessment
Understand the extent of impact of potential events
Assesses risks from 2 perspectives:
Likelihood
What is the likelihood of an incident occurring?
Impact
If an accident occurs, what would be the magnitude of its
consequence?
200
Risk Analysis 2
3. Risk Profiling (Prioritisation)
After evaluation of
Likelihood of occurrence
Impact
Analyzed further into a prioritized risk list
Which risks need the most urgent attention
201
Low
High
High
I
M
P
A
C
T
PROBABILITY
High Risk
Medium Risk
Medium Risk
Low Risk
Risk Analysis 2
Likelihood/consequence matrix
Loss of key customers
Failure of computer
system
Loss of senior staff
Loss of sales to competitor
Loss of sales due to macro-
eco factors
Lost of low level staff
Lost of unimportant
supplier
Can we quantify? 202
Risk Management
Response to risks
Control
Share Mitigate & Control
Accept
High Risk
Medium Risk
Medium Risk
Low Risk
Low
High
High
I
M
P
A
C
T
PROBABILITY
Strategic
issues
203
Risk Analysis 2
3. Risk Profiling (Prioritisation)
Likelihood/consequence matrix
Qualitati ve way of assessing impact of risk
High Risks >more urgent attention >Strategic Decisions
Low Risks >less urgent
Attention:
Risk profile varyin different businesses
Risk can evolve due to environmental changes
204
Risk Analysis 2
3. Risk Profiling (Prioritisation)
CIMA
Factor affecting location of risk in a risk map
Strategic objective affected
Type of risk ( pure risk or speculative risk?)
Direct and indirect impact of risk
Likelihood of risk
Cost of responses
Organizations environment
Constraints within the organization
Organizations abilityto respond to events
Analyze and locate the risks in the map and
give reasons
35
205
Question 14 Risk Map
Required
Prepare a 2 X 2 risk map, with one risk identified in each
quadrant of the map.
Explain your reasons for assessing the probability and impact
of the risk as high or low in each case.
206
Question 14 Risk Map
BC Freight is a freight-forwarding business. It sends
containers of freight from Heathrowto airports around the
world. It specialises in consolidating the freight of different
shippers into a single container, to obtain the benefit of lower
freight charges for large shipments. The prices that BC
charges its clients cover a share of the airline flight costs and
insurance, and provide a margin to cover its running costs and
allow for profit. To make a satisfactory profit, BC needs to fill
its containers to at least 75%, and at the moment is achieving
an average' fill' of 78%.
International trade and commerce have been growing in the
past year, although at a slow rate.
BC's management is aware that airline flight costs are likely to
rise next year due to higher fuel costs, and because several
major airlines that have been suffering large losses will be
hoping to increase their prices.
207
Question 14 Risk Map
Step 1:
What are the risks?
A. Container not filled to B/E level
B. Increasing airline freight costs
C. Downturn in international trade
D. Some major airline may go out of business
208
Low
High
High
I
M
P
A
C
T
Likelihood
High Risk
Medium Risk
Medium Risk
Low Risk
Step 2:
Rank the impact and likelihood
Downturn in
international trade
Container not filled
to B/E level
Increasing airline
freight costs
Major airline may go
out of business
209
Risk Analysis 2
4. Risk Quantification
Risk can be further analyzed by quantifying
Consequences
Probability
Expected Value
EV = Probability of Occurrence x Impact
210
Risk Analysis 2
4. Risk Quantification
Risk can be further analyzed by quantifying
Consequences
Probability
Fire at
office
(0.2)
Likelihood of
damage
(0.8)
No alarm or sprinkler
system
80% of equipment may
be lost
$10,000
0.2 x 0.8 x
$10,000
=
$1,600
36
211
Risk Analysis 2
4. Risk Quantification
Results from quantification
Average or expected result or loss
( $1,600)
Frequency of losses
Predictable by studying available records
Confidence margin improved by including likely effects of changed
circumstances
Non-recurrence events >difficult to predict
Chances of losses
(0.16)
Largest predictable loss
($10,000)
No calculation required in EXAM!
212
Risk Analysis 2
4. Risk Quantification
Tools and techniques for quantifying risk:
Scenario planning
Sensitivity analysis
Decision trees
Computer simulations
Software packages
Analysis of existing data
213
Risk Analysis 2
5. Risk Consolidation
Divisional or subsidiary level >aggregated at corporate level
Group level risk >Board set up risk management system:
Identify changes in risks
Monitor risks regularly
Wider annual review(IC, ERM)
Categorization also helps to develop and implement
common control for certain group of risks
Example?
Shared service
214
Examiners Definition of Risk Assessment
5 components in risk assessment stage:
1. Identifynature and extent of the risks facing the company
2. Decide whether risks are acceptable (Cost of control such risk
and benefit to the business if risks are to be controlled)
3. Quantify risk by determining the likelihood (probability) of the
identified risks materialising
4. Examine businesss ability to reduce the impact of risks that do
materialise
5. Understanding of the costs of operating particular controls to
review and manage the related risks
Bad debts
Control?
L/C
Cash on delivery
Discount/factoring
30% of AR >
bad debts
Sufficient working
capital?
Legal action?
Cost:
Charges
Loss potential
customers
215
RISK & STAKEHOLDERS 3
Customers
Employees
Managers
Directors
Shareholders
Impact of Business Risk Stakeholder
Identify stakeholders
Describe their claims
What are their actions & effects on business risks?
216
RISK & STAKEHOLDERS 3
Wider Community
Banks
Government
Supplier
Impact of Business Risk Stakeholder
37
217
ROLE OF THE BOARD IN RISK MANAGEMENT 3
Strategic level risk and attitude and approach to risk
Driving risk management and provide resources to managers
Ensure that risk management supports strategic objectives
Determine acceptable level of risk
Communication of risk management strategy throughout
organisation and embedded in all activities
Reviews, identifies and monitors progress risk management
plans
Determine which risks will be accepted which cannot be
managed, or which it is not cost effective to manage, i.e.
residual risk
218
ROLE OF THE BOARD IN RISK MANAGEMENT 3
Turnbull Guidance
The board is responsible to develop internal control to
management risks facing the business
Factors to consider when determining policies on internal
control
Nature and extent of risks facing the company
Extent and categories of risk which it regards as acceptable
for the company to bear
The likelihood of the risks materializing
The companys ability to reduce the incidence and impact
on the business of risks that do materialize
Cost and benefit consideration for operating particular
controls
219
Chapter 8
Risk Management
Dealing with Risks
220
KNOWLEDGE CHECKLIST
Risk Management Systems 3
COSO ERM
Reducing Risk 2
Embedding risk awareness
Diversification
Risk Avoidance/retention/transference
Risk Avoidance & retention 2
Risk transference
Risk Attitude and Strategy 3
221
KNOWLEDGE CHECKLIST
Risk Management Responsibilities 3
Role of Risk Committee
Risk Management Group
Role of Risk Manager
Risk Auditing
Others involved in Risk Management
Information on Internal Control & Risk 2
Information requirement of directors
Review of Internal Control
Reporting on Internal Control and Risk Management
222
KNOWLEDGE CHECKLIST
Controlling Risk
Targeting risk
Risk Manager
Risk Committee
Risk Audit
Risk Avoidance
/Retention/Transfer
Reducing Risk
Embedding Risk
Diversification
Risk Avoidance
Risk Retention
Risk Transfer
Risk Attitude
Reporting on Internal Control & Risk
38
223
RISK MANAGEMENT SYSTEMS
a process, effected by an entity's board of directors,
management and other personnel,
applied in strategy setting and across the enterprise,
designed to identify potential events that may affect the
entity,
and manage risks to be within its risk appetite,
to provide reasonable assurance regarding the
achievement of entity objectives.
Source: COSO Enterprise Risk Management Integrated Framework. 2004.
224
RISK MANAGEMENT SYSTEMS
Benefits/Purpose of ERM
Aligning (risk appetite = strategy)
Enhancing risk response decisions
Framework for determine risk responses ARTA
Reducing operational surprises and losses
Identifying and managing multiple and cross-enterprise risks
Interrelated impacts > integrated responses
Seizing opportunities
Improving deployment of capital
Risk management helps an entity get to where it wants
to go and avoid pitfalls and surprises along the way.
225
RISK MANAGEMENT SYSTEMS
Fundamental concepts
A process >ongoing and flowing through an entity
Effected by people at every level
Applied in strategy setting
Applied across the enterprise >entity-level portfolio view of risk
Designed to identify>manage risk within its risk appetite
Reasonable assurance
Geared to achievement of objectives in one or more separate
but overlapping categories
226
Internal Control Vs. ERM
RISK MANAGEMENT SYSTEMS
Internal Environment
ObjectiveSetting
Event Identification
RiskAssessment
RiskResponse
Control Activities
Information&Communication
Monitoring
E
n
tity
-
L
e
v
e
l
D
iv
is
io
n
B
u
s
in
e
s
s
U
n
it
S
u
b
s
id
ia
r
y
Internal Environment
Objective Setting
Risk Response
Event Identification
Strategic
227
RISK MANAGEMENT SYSTEMS
Entity objectives can be viewed in the
context of four categories:
Strategic
Operations
Reporting
Compliance
8 components for
- Whole entity
- Each objective
- Individual unit
228
RISK MANAGEMENT SYSTEMS
Internal Environment
Set the tone at the top
Philosophy regarding risk management.
Risk culture
Objecti ve setting
Objectives =risk appetite
Event Identification
Identify events that affect strategy & achievement of objectives
Internal or
External
39
229
RISK MANAGEMENT SYSTEMS
Risk Assessment
Assesses risks:
Likelihood
Impact
By a combination of
Qualitative +Quantitative methodologies
230
RISK MANAGEMENT SYSTEMS
Risk Responses
Identifies and evaluates possible responses to risk
Evaluate response by
Entitys risk appetite
Cost vs. benefit consideration
Effectiveness of a response in reducing impact and/or
likelihood
Selects and executes response
231
RISK MANAGEMENT SYSTEMS
Control Acti vities
Policies and procedures >risk responses
Information and Communication
Policy & responsibility
Communication lines
232
RISK MANAGEMENT SYSTEMS
Monitoring
Effectiveness of the other ERMcomponents is monitored
through:
Ongoing monitoring activities
Separate evaluations
A combination of the two
233
RISK MANAGEMENT SYSTEMS
Limitations
Strategic and operational objective >external events outside
entitys control
ERM >help to react timely >reasonable assurance only
Human judgment
Cost-benefit consideration
Human failures
Controls can be circumvented by collusion
Management override
234
ERM Vs. Internal Control
A strong system of internal control is essential to
effective ERM
Internal control
An integral part of ERM
COSO ERM framework encompasses internal control
40
235
Reducing Risk 2
Reducing Risk
Di versification
Embedding
Risk - systems
Embedding
Risk - culture
Risk Awareness
236
Reducing Risk 2
Risk awareness
Strategic Level
Continued monitoring of
risk
Operational Level
Daily operation
Monitoring risk that affect
tactical managers
Tactical Level
237
Reducing Risk 2
Embedding Risk in Systems
Ensuring that the risk management is included within the
control systems of an organization
Who shall lead?
Board
Procedures
1. Identify existing controls
2. Monitor operating effectiveness
3. Improve and refine the controls as required
4. Document evidence of monitoring and control operation
Use performance indicators or
Independent assessment by IA or EA
238
Reducing Risk 2
Embedding Risk in Culture
Culture is the pattern of basic assumptions that a given group
has invented, discovered, or developed,
in learning to cope with its problems of external adaptation and
internal integration,
and that have worked well enough to be considered valid and,
therefore, to be taught to newmembers as the correct wayto
perceive, think and feel in relation to these problems. (Schien)
the way we do things round here
239
Reducing Risk 2
Embedding Risk in Culture
Factors affecting embedding of risk management in Culture:
Open or closed culture?
Open to new ideas, procedures and change
Overall commitment >to risk management policies
Attitude to IC
Tension or benefits?
Governance
Pressure from external stakeholders
Risk management is part of culture ?
Taken for granted?
Discuss the factors to consider when embedding risk
management into culture of an organization, and
explain its suitability to the Company in scenario.
240
Reducing Risk 2
Di versification
Risk pooling and diversification > portfolio theory
Di versifying/spreading risk
Di versifying risk
Financial management techniques/market
Spreading risk
Portfolio management
41
241
Reducing Risk 2
Di versification
Risk can be diversified in terms of
Financial management
risk by use of financial tools (hedging techniques)
Expanding operations >different countries, product
Market/ product management
Spread risk according to portfolio of companies held
within a group > supply chain
Neutralize
only!
242
Reducing Risk 2
Diversification
Diversifying/spreading risk
Spreading risk by portfolio management
Spread risk by expanding portfolio of companies held > integration
Linking with other companies in supply chain or
Diversification into other areas
Backward integration
Inputs into the organisation (raw materials, machinery and labor)
Forward integration
Outputs (distribution, transport, servicing and repairs)
Horizontal integration
Competitor or directly complement
Example:
Travel agent >selling travel insurance and currency exchange services
Unrelated diversification
No clear relationship to present portfolio
Completely different market
243
Reducing Risk 2
Diversification
Diversifying/spreading risk
Problems with portfolio theory
Individual decision makers attitude to risk
How to measure ?
Data requirement
Relationships b/w investments
Capital Asset Pricing Model
244
Reducing Risk 2
Di versification
Di versifying/spreading risk
CAPM :
No consideration of relationships between that investment and
all other possible investments
Onlyconcerned with one relationship
Relationship with market portfolio
Beta
Only considers >systematic risk
Unsystematic risk >eliminated by diversification
245
Contingency plan
Identifying post-loss needs of the business
Plan in advance and review regularly to cope with
changes
Contents
Definition of Responsibilities
Priorities
Backup and stand-by arrangements
Communications with staff
Public relations protocol
Risk assessment
Recoveryplan
Reducing Risk 2
246
Loss control
Careful advance planning to control losses
2 major aspects
i. Physical
- installing physical devices
- regular inspection & maintenance
ii. psychological
- awareness and commitment
e.g. individual managers accountable for losses
under control
Reducing Risk 2
42
247
RISK AVOIDANCE/RETENTION/TRANSFERENCE
Risk avoidance:
A risk strategy by which the organization literally avoids risk
Risk retention:
Risk strategy by which an organization retains that particular
risk within the organization
Risk Avoidance
Where an organization has a lowrisk appetite
High likelihood +transference impracticable :
Risky new project
Divestment of subsidiaries
248
RISK AVOIDANCE/RETENTION/TRANSFERENCE
Risk Retention
Where risk is deemed to be minimal or where other risk
strategies such as transference are too expensive
Self-insurance
249
RISK AVOIDANCE/RETENTION/TRANSFERENCE
Risk Transference
Transfer to external parties: (Supplier, customer, insurers)
Lead to other risk
Transfer to internal departments:
Problems
Available instruments and methods:
Hold harmless agreements or indemnity
Limitation of liability
Risk sharing
Insurance policy
J oint venture
250
Risk Attitude and Strategy 3
An organizations attitude to risk is determined by its:
Risk appetite of the management
Risk capacity: how much risk the organization can accept
Risk capacity reached >low-risk activities
High risk capacity >risky projects
Overall >portfolio of projects with different risk level
251
Risk Attitude and Strategy 3
Factors affecting the Risk Appetite of the Board
Products
Some products are of higher risk >limited risk appetite
Some products are of lower risk >higher risk appetite
252
Risk Attitude and Strategy 3
Factors affecting the Risk Appetite of the Board
Business objectives
Enter into newmarket >higher risk
Increase share in existing market >lower risk
Board members personal preference
Depends on personal attitude and experience
Changes in market
Dynamic market >have to accept more risks
Reputation of business
Good reputation ?
43
253
Business strategy
Risk appetite
Risk attitude Risk capacity
Risk
strategy
Risks
Residual
risk
amount of risk willing to accept
overall approach to
risk
risk averse
risk seeking
risk neutral
maximum risk a
business can
accept
254
Risk Management Responsibilities 3
The board has for risk management as an essential part of its
corporate governance responsibilities
Responsibility below board level will depend on the extent of
delegation to line managers and whether there is a separate
risk management function
The Board (overall responsibility )
255
Risk Management Responsibilities 3
Risk Management Committee
What is:
Sub-committee appointed by the Board to oversee risk
identification and management of risk.
Audit committee will take this responsibility in absence of such
a committee. (Combined Code)
Composition:
Can be staffed by ED
Where there are doubts about EDs competence and good faith
>staffed by NEDs
256
Risk Management Responsibilities 3
Risk Management Committee
Which one is better?
Argument for a Risk Committee- separate risk function
ACs main responsibility >liaise with EA and concerns
mostly with financial risks
Audit Committee > monitoring role
Risk Committee >take the lead in driving changes in
practice
Practice:
Most companies >established risk committee
Appointed by the Board and report back to the Board
Good CG >larger organizations will normally have a risk
management committee
257
Risk Management Responsibilities 3
Risk Management Committee
Major roles of Risk Committee
Raising risk awareness
Risk management
Processes in place to identify, report and monitoring risks
Updating risk profile of the organization
Reporting to the Board
Making recommendations on risk appetite of the organization
258
Risk Management Responsibilities 3
Role of Risk Manager
Usually a member of Risk Management Committee
Reporting directly to the Committee and the Board
Skills:
Technical: credit, market and operational risk
Soft: leadership and persuasive skills
Supported and monitored by the Risk Management Committee
More operational role than strategic role
44
259
Risk Management Responsibilities 3
Risk Auditing
Roles:
Assists overall risk monitoring process
Providing an independent view of risks and controls
Who:
Both IA and EA
260
Information on Internal Control & Risk 2
Information requirement of directors
Sources of information:
Own efforts
Report from subordinates
Lines of communication
Normal communication channels
Whistleblowing
Reports from control functions
Reports on activities
Exception reporting
Feedback from customers
261
Information on Internal Control & Risk 2
Review of Internal Control
Board should review risks and effectiveness of internal controls
regularly. They should also carry out annual review that looks
more widely at risks faced and control systems and how these
issues should be reported.
Regular review
Regularly receive and review reports and information on
IC
IC to deal with risks
Actions taken & results
Annual Review
More wide-ranging than regular review
262
Information on Internal Control & Risk 2
Reporting on Internal Control and Risk Management
Turnbull Guidance:
The board should, as a minimum, disclose that
There is an ongoing process for identifying, evaluating
and managing the significant risks faced by the company,
That it has been in place for the year under review and up
to the date of approval of the annual report and accounts,
That it is regularly reviewed by the board and accords
with the guidance
263
Information on Internal Control & Risk 2
Reporting on Internal Control and Risk Management
Annual accounts
Internal Control
Required by CG code for listed companies
Overview of IC +how directors maintain those systems
Risk
Summary of how the board have addressed some risks
Environmental risk (CSR)
264
Information on Internal Control & Risk 2
Reporting on Internal Control and Risk Management
Auditors
Internal Control
Any material deficiencies in the IC
Risk
Only those result in a material error in the F/S
SOX >different!
45
265
Information on Internal Control & Risk 2
Reporting on Internal Control and Risk Management
Audit committee
Internal Control
Internal reporting
Report control weakness to the Board
External reporting
Where no actions from the board
Serious issues (similar to whistleblowing)
Risk
Focus on internal rather than external
266
Ethics
&
CSR
267
KNOWLEDGE CHECKLIST
Chapter 9,10,11
Corporate Code
Purpose
Effectiveness
Social &
Environmental issues
Professional Code
ACCA
Threats &
safeguards
Footprints
Sustainability
Environmental
Management
System
Social &
Environmental
Audit 268
Chapter 9
Professional Ethics
Theories & Models
269
Exam Structure
Question on Ethics:
- Theory based
- Pilot paper question 3 (discuss approaches to ethics)
- Case study
Ethical dilemma for accountant or corporate
Accountant
7 questions
CMD
Deontological
IFAC codes
Absolutism & relativism
Corporate
5 questions
CMD
Stakeholder analysis 270
KNOWLEDGE CHECKLIST
Ethical theories
Relativism and absolutism 2
Kohlbergs stages of human moral development 3
Deontological and teleological/consequentialist, Pluralism 2
46
271
ETHICAL THEORIES
Ethics
What is right & wrong
How conducts of individual and business should be judged as
good or bad
Morality:
What is good (right) and bad (wrong) as accepted by societyor
a culture
Ethical theories
Attempt to set morality of society
Ethics is about the study of attempts to question, analyse
and justifya system of standards and principles.
Ethical theories are developed to assist these attempts.
Can ethics be determined by objective, universal principles.
272
ETHICAL THEORIES
Relati vism and absolutism 2
Relativism:
Non-cognitivism
There are a wide varietyof ethical beliefs and practices
What is correct in a given situation will depend on the
CONDITIONS at that time
Absolutism:
Cognitivism
Unchanging and immutable set of moral >hold true in ALL
situations
The standard beliefs and practices will be common to ALL
societies
Pragmatic
Dogmatic
273
ETHICAL THEORIES
Kohlbergs stages of human moral development 3
Reasoning process behind moral judgements
Those processes changed as individual matured from a
child to an adult
Applied to tackle ethical dilemmas by an individual
274
self-interest,
external
rewards and
punishment
Do what is
expected of
them by
others
Autonomous
decision-
making based
on internal
perspectives
of right/wrong
ethics
275
ETHICAL THEORIES
Kohlbergs stages of human moral development 3
3 main levels x 2 stages:
Pre-conventional
1.1 Obedience and punishment
Right >reward
Wrong >punishment from authority
1.2 Instrumental purpose and exchange
Right >is there fairness in exchanges? Any immediate
interests ?
276
ETHICAL THEORIES
Kohlbergs stages of human moral development 3
3 main levels x 2 stages:
Conventional
2.1 interpersonal according and conformity
What is expected by peers and those close to them
2.2 Social accord and system maintenance
What is expected by the society?
47
277
ETHICAL THEORIES
Kohlbergs stages of human moral development 3
3 main levels x 2 stages:
Post - Conventional
3.1 Social contact and individual rights
Right and wrong =basic rights, values and contracts of society
3.2 Universal ethical principles
Decisions based on self-chosen ethical principles
Which level will be a normal business manager lies on ?
Which level will be a whistle blower lies on?
278
ETHICAL THEORIES
Kohlbergs stages of human moral development 3
Criticisms:
Gender bias
Too much emphasis on rights and justice compare with
other theories
Different moral reasoning in different situations >no
sequence of stages
279
ETHICAL THEORIES
Approach to ethics
Deontological
Consistency
Human dignity
Universality
Teleological
Utilitarianism Egoism
280
ETHICAL THEORIES
Deontological and teleological/consequentialist 2
Deontological approach:
Non- consequentialist theory
Motivation or principle !
Right or wrong of action >based on morals for taking that
action
3 maxims/tests
An action is morally rightif it satisfies ALL three:
281
ETHICAL THEORIES
Deontological and Teleological/consequentialist 2
Deontological approach:
1. Consistency
Act only according to that maxim by which you can at the same time
will that it should become a universal law
Action can only be right if everyone follow the same
underlying principle
Example:
Is murder immoral?
Yes
Because if everyone murders >no human life at all !
Exploitation of 3rd world labor -
managers in EU may not want this to
become a universal law (do they want
to send their children to work?)
282
ETHICAL THEORIES
Deontological and Teleological/consequentialist 2
Deontological approach:
2. Human dignity
Act so that you treat humanity, whether in your own person or in
that of another, always as an end and never as a means only
Everybody uses others in some way, but others should not
be simply seen as a provider of goods and services
Must respect their own needs and expectations
Use of child labor - human dignity of
children?
Their right to a safe and accident free
upbringing may be ignored
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283
ETHICAL THEORIES
Deontological and Teleological/consequentialist 2
Deontological approach:
3. Universality
Act only so that the will through its maxims could regard itself at the
same time as universal lawgiving
Whether an action is deemed to be moral or suitable when
viewed by others, not by the person undertaking that action
Example:
Will you feel uncomfortable if your immoral activities was put on a
website with photos and contact details ?
Use of child labour how about
disclosing the fact in newspapers?
284
ETHICAL THEORIES
Deontological and Teleological/consequentialist 2
Teleological approach:
Consequentialist theory
Goal is important ! NOT the means of getting there
Right or wrong depends on consequences or outcomes of
that decision
2 versions:
Egoism: what is best for me
Utilitarianism: what is best for the greatest number
285
ETHICAL THEORIES
Quiz:
Explain the teleological and deontological views of the
following actions:
1. Animal testing
1. Deontological
Dignity >animal dignity affected
Teleological
Pain suffered by animal reduce pain to many humans
2. Murder of a serial killer
1. Deontological
Consistency >can everyone kill?
Teleological
Murder 1 >prevent more people being killed 286
ETHICAL THEORIES
Quiz:
Explain the teleological and deontological views of the
following actions:
3. Whistleblowing
1. Deontological
Allowed
Universality ?
You make others uncomfortable
Will you find another job if you whistleblowed?
Teleological
Good to society >harm to the individual business
Whether an action is deemed to be moral
or suitable when viewed by others, not by
the person undertaking that action
287
ETHICAL THEORIES
Pluralism
A condition in which there is diffusion of power among the
societys many groups and organizations.
A pluralistic society >power widely decentralized
Accept: there are different views on morality
Suggest: a consensus can be reached in certain situations
Morality as social phenomenon
Weakness:
Diversified groups pursue their own self-interests >how to
balance and prioritize ?
stakeholder analysis
288
Quiz 2 - DEONTOLOGICAL ETHICS
A recent newspaper report explained that a toy re seller was recalling over
500,000 toys because they were unsafe.
Following use of the toys, it was discovered that some magnets attached to
each toy could become dislodged and accidentally swallowed by children.
Swallowing a number of magnets could produce digestion problems and in
extreme cases death.
Subsequent investigation by the Trading Standards Authority (TSA)
identified that these toys were produced in a country where the use of child
labour is common, where this was not the case in the country of sale.
Also the manufacturer did not always provide safe conditions for the
workers. Workers were also paid on a piece rate which meant theyhurried
to complete each toy, and the magnets were not always properly attached
to the toy.
The reason for the lack of safety and poor working conditions was ascribed
to pressure from the toy re-seller to provide toys at a low price. The toy re-
seller indicated that low prices were expected by its customers, and that the
use of child labour had not been publicised.
Required:
Applythe theory of Kant to the above situation evaluating whether the use
of child labour is acceptable
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289
Quiz 2 - DEONTOLOGICAL ETHICS
Answer:
- 3 maxims:
- Maxim 1: consistency
- Maxim 2: Human dignity
- Maxim 3: Universality
- Country of manufacturing
- Country of sale
290
Quiz 2 - DEONTOLOGICAL ETHICS
Answer:
- Country of manufacturing:
- Use of child labor >accepted
- Poor working condition >limit production costs
- Poor quality products >danger to health in country of
sale
- Whether use of child laborneed to pass 3 maxims in BOTH
- Country of manufacturing
- Country of sale
291
Quiz 2 - DEONTOLOGICAL ETHICS
DEONTOLOGICAL ETHICS
Answer:
- Consistency:
- Country of sales >use of child labor unacceptable
- So cant be followed in the country of manufacturing
- Both maker and seller are at fault
- Human dignity
- Need to consider needs and expectation of child worker
- Country of sale:
- Consumer dont want their child suffering the same
- Failed
292
Quiz 2 - DEONTOLOGICAL ETHICS
DEONTOLOGICAL ETHICS
Answer:
- Universality
- Toy-seller comfortable when consumer know the
fact?
- Consumer is against child labor in country of
sale
- Toy-seller kept information secret >implies its
morally wrong
- Failed
293
Chapter 10
Professional Ethics
Dealing with Ethical Dilemma
294
KNOWLEDGE CHECKLIST
Ethical behavior 2
Professions & Public Interest
Profession & professionalism 2
Public interest 2
Role of accountant 3
Professional Code of Ethics 3
Content
Pros & Cons for principles-based ethical guidance 2
Ethical threats and safeguards
Framework for ethical conflict resolution
50
295
KNOWLEDGE CHECKLIST
Decision making framework
American Accounting Association Model 2
Tuckers 5-question model 2
296
ETHICAL THEORIES
Factors affecting the decision made by professional
accountants:
Personal ethical stances
Laws and regulations
Professional ethical code
The environment where the accountant is in
297
PROFESSIONAL CODE OF ETHICS 3
Ethical behavior
Factors affecting accountants ethical stance
issue related
factors
context
related factors
Moral
intensity
Moral
framing
Concentration of effect
Proximity
Temporal immediacy
Magnitude of
consequence
Social consensus
Probability of effect
how the issue is
actually represented
in workplace
System of reward
Authority
Bureaucracy
Work roles
Organizational group
norms and culture
National and cultural
context
298
ETHICAL THEORIES
Making a decision over ethical dilemma invol ves
Consideration of stakeholders
Possible impact on these identified stakeholders:
1. Who are the stakeholders?
2. What are the relevant facts of the case?
3. What are the governing concepts, values and cultural practices?
4. What are the alternative actions available for the key parties?
5. How should a professional accountant act on the case? Why?
6. How should such action be supported and reported?
299
PROFESSIONS & PUBLIC INTEREST
Profession & professionalism
Profession : 2
A body of theory and knowledge which is used to support the
public interest
Professions are established primarily to serve society
300
PROFESSIONS & PUBLIC INTEREST
Profession & professionalism
Professional Value
Society>
Grant profession its rights
Expects certain professional values
Competence
Objectivity
Integrity
Confidentiality
Disciplines to discharge of their duties
=due care +professionalism
51
301
PROFESSIONS & PUBLIC INTEREST
Profession & professionalism
Professionalism: 2
Taking action to support the public interest
Actions can be either reactive or proactive
Public interest: 2
Collective well-being of the community of people and
institutions the professional accountants serves,
Clients, lenders, governments, employers, employees,
investors, business and financial community
And others who rely on the work of professional
accountants
(IFAC)
302
PROFESSIONS & PUBLIC INTEREST
Profession & professionalism
Professional Ethics:
An application of ethical theories in the ethics environment of a
profession.
The study, analysis and justification of the moralityof actions
and situations using well founded ethical theories and values
in a professional setting
303
PROFESSIONS & PUBLIC INTEREST
Profession and Public interest
- Proactive & reactive
Public interest and Human Rights
Contradictory
Action of an individual >adversely harms other members of
society
Actions of the state >adversely affect some or all members
of society
304
PROFESSIONS & PUBLIC INTEREST
Public interest & professional accountant 3
Professional accounting bodies >developed professional
codes >professional values of professional accountant
Professional accountant
Auditing
Management
Employee
Or consultant
Both Accountant +Professional person
305
PROFESSIONS & PUBLIC INTEREST
Role of accountant
Skills & expertise Duties & Values
Lack of confidence by society
Stakeholders?
Impact on
them?
306
PROFESSIONS & PUBLIC INTEREST
Role of accountant 3
Influence of Accounting
Overall influence of accounting professional may be limited by:
Extent of organisational reporting
Conflicts of interest in providing services
Long term relationship with clients
Overall size of accountancy firms
Large firm more economy of scale >good for public interest?
Large firm >quality may drop >restrict size of firm?
Large firm >necessary for audit of MNCs
Focus on growth and profit
Competition between big 4 >cut costs >impair quality?
Factors affecting ethical decision making of accountants?
52
307
PROFESSIONS & PUBLIC INTEREST
Role of accountant 3
Influence of Accounting
Accountants role in society:
Maintain the status quo
Become involved in change
Contribute to public interest
308
PROFESSIONS & PUBLIC INTEREST
Role of accountant 3
Influence of Accounting
Accountants and Public interest
Ethical guidance requirement >act IN the public interest
Problems
Lack of disclosure may be AGAINST public interest
Or disclosure of information may harm the public interest
309
PROFESSIONS & PUBLIC INTEREST
Role of accountant 3
Influence of Accounting
Accountants and Public interest
Lack of disclosure
Decrease accountability or limit decision making of the
public
Lack of enforcement of laws
Impair health and safety of the public
Disclosure
Adversely affect economic interests of public
Not providing information on illegal actions of
companies >harm the interests of stakeholders
A criminal will not be caught and continue a
crime (e.g. money laundering)
310
PROFESSIONAL CODE OF ETHICS 3
Content
IFAC Code of Ethics for Professional Accountant
A distinguishing mark of the accountancy profession is
-Its acceptance of responsibility to act in the public interest.
-Therefore, a professional accountants responsibility is not
-Exclusively to satisfy needs of individual client or employer.
-But acting in the public interest
-A professional accountant should observe and comply with the
ethical requirements of this Code.
311
PROFESSIONAL CODE OF ETHICS 3
Part A :
Fundamental principles +conceptual framework
Conceptual framework
Guidance used to identify threats to compliance with fundamental principles
Parts B:
Professional accountant in public practice
Application of conceptual framework in specific situations
Examples of safeguards to address threats
Examples of situations where safeguards are not available > avoided
Part C
Professional accountants in business
Also applicable to Professional accountants in public practice
312
PROFESSIONAL CODE OF ETHICS 3
Fundamental Principles
Integrity
Straightforward and honest in all relationships
Objectivity
No bias, conflict of interest or undue influence of others to override
judgments
Professional competence & due care
Continuing duty to maintain professional knowledge and skill to provide
competent professional service
Act diligentlyand in accordance with applicable technical and professional
standards
Confidentiality
Respect confidentiality of information >not disclose to third parties without
authority
Unless : legal or professional right or duty to disclose
Not use it for personal advantage or third parties
Professional behavior
Comply with relevant laws and regulations and not discredits the profession
53
313
PROFESSIONAL CODE OF ETHICS 3
Principles-based vs. rules-based 2
Rule - based
Principle - based
Ethical rules for member
to follow
- Members are aware of
the rules
- Comply with them
Fundamental ethical
principles that members
must follow
Ensure members are
aware of the principles
Members to identifyand
address threats to
compliance with the
principles >mitigate each
threat
314
PROFESSIONAL CODE OF ETHICS 3
Principles-based vs. rules-based 2
Rule - based
Principle - based
Practice:
Inappropriate >can NOT cover
every eventuality
Adopted by most professional
institutes
Advantage:
Easy to check compliance
Easy to amend
Advantage:
Recognize that NOT every threat can be
simply listed
Allows for subjective judgment >member
apply principles
Prevent members interpreting legalistic
requirements narrowly > encourage
compliance
Applicable in rapidly changing environment
Prohibitions may be made in addition to
principles to deal with particular threats
Prescribe minimumstandards of behavior
expected
Examples to illustrate how principles applied
315
PROFESSIONAL CODE OF ETHICS 3
Principles-based vs. rules-based 2
Rule - based
Principle - based
Disadvantages:
Incomplete rules
No room for individual
judgment
Disadvantage:
Interpretation
International codes >can NOT fully
capture regional variations in beliefs
and practice
Illustrative examples >interpreted as
rules to follow in ALL similar
circumstances
Difficult to enforce legallyunless
blatant >Most codes are voluntary
and therefore less effective
Think of relativism & absolutism
316
PROFESSIONAL CODE OF ETHICS 3
Threats to fundamental principles
Self-interest threats
Financial or other interests of a professional accountant or of an
immediate or close family member;
Self-review threats
When a previous judgment needs to be reevaluated by professional
accountant responsible for that judgment;
Advocacy threats
When a professional accountant promotes a position or opinion to the
point that subsequent objectivity may be compromised;
Familiarity threats
When, because of a close relationship, a professional accountant
becomes too sympathetic to the interests of others;
Intimidation threats
When a professional accountant may be deterred from acting
objectively by threats, actual or perceived
317
PROFESSIONAL CODE OF ETHICS 3
Withdraw
Safeguards:
1. Safeguards created by profession, legislation or regulation
Entry requirement: educational, training and experience
CPDrequirements
CG regulations
Professional standards
Professional or regulatory monitoring and disciplinary
procedures
External reviewby a legally empowered 3rd party of the
reports, returns, communications or information produced
by a professional accountant
318
PROFESSIONAL CODE OF ETHICS 3
Safeguards:
2. Safeguards in the work environment (Engagement-specific)
Additional professional accountant >reviewor advise
Consulting an independent 3rd party (e.g. AC, professional
regulatory body or another professional accountant)
Rotating senior personnel
Discussing ethical issues with those in charge of client
governance
Disclosing to those charged with governance the nature of
services provided and extent of fees charged
Involving another firmto perform or re-perform part of the
engagement
54
319
PROFESSIONAL CODE OF ETHICS 3
Safeguards:
3. Safeguards by Individual
Complying with professional standards
Maintaining records of contentious issues
Mentoring
Contacting professional bodies with queries
320
PROFESSIONAL CODE OF ETHICS 3
Threats to fundamental principles
Self -interest
Financial interest
Close business relationship
Potential employment with a client
Partner on client board
Family and personal relationship
Gifts & hospitality
Loans & guarantees
Overdue fees
Percentage or contingent fees
Undue dependence on total fees from a client
Lowballing
Recruitment
321
PROFESSIONAL CODE OF ETHICS 3
Threats to fundamental principles
Self -interest
Lowballing
Maintain records of staff and time budget
Comply with applicable standards
Recruitment
Not make management decisions
Present finding only
322
PROFESSIONAL CODE OF ETHICS 3
Threats to fundamental principles
Self-review
Recent service with an assurance client
General services
Preparing a/c records and F/S
Valuation services
Taxation services
Internal audit services
Corporate finance
Other services
323
PROFESSIONAL CODE OF ETHICS 3
Threats to fundamental principles
Advocacy
What is
Involved in clients dispute or as their advocate
Allowed if it did not result in misleading information being given
Example:
Commenting publiclyon future events in particular circumstances,
having made assertions without detailing the assumptions;
Where information is incomplete or advocating an argument which is
unlawful;
Promoting shares in a listed entity when that entity is a F/S audit
client;
Acting as an advocate on behalf of an assurance client in litigation or
disputes with third parties
Use separate
teams
Disclose to AC
Withdrawal
324
PROFESSIONAL CODE OF ETHICS 3
Threats to fundamental principles
Familiarity
Family and personal relationship b/w client/firm
Recent service with assurance client
Employment with assurance client
Long association with assurance clients
Safeguards:
Rotation of senior staff
2nd partner review
Internal quality control review
55
325
PROFESSIONAL CODE OF ETHICS 3
Threats to fundamental principles
Intimidation
Actual and threatened litigation
Safeguards:
Disclose to AC
Remove from assurance team
Additional professional accountant review
Resign
Second opinion
Safeguards:
Communication between auditors
326
Conflicts of interest
Member Vs. Client
Client Vs. Clients
Not accept/continue if
significant conflicts
exist
If conflict identified
disclose
Safeguards:
notify & obtain permission from
client
notify & obtain permission from
all relevant parties
use separate teams
prevent leak of information
confidentiality agreements for
partners and staff
independent partner review
advise client to obtain
independent advice
PROFESSIONAL CODE OF ETHICS 3
327
PROFESSIONAL CODE OF ETHICS 3
Ethical problems for accountant working in business
Conflict of duties to different staff superiors
Discovering an illegal act or fraud perpetrated by company
Discovering a fraud or illegal act perpetrated by another EE
Pressure from superiors
Take certain viewpoints, or
Not reporting unfavorable findings
328
PROFESSIONAL CODE OF ETHICS 3
Framework for ethical conflict resolution
I. IFAC recommendation
II. American Accounting Association Model ( 7 Questions)
7 questions:
1. What are the facts of the case?
2. What are the ethical issues in the case?
3. What are the norms, principles and values related to the case?
4. What are the alternative courses of action?
5. What is the best course of action that is consistent with the norms,
principles and values identified in Question 3?
6. What are the consequences of each possible course of action?
7. What is the decision?
III. Tuckers 5 question model
IV. Kohlbers CMD theory
Profitable?
Legal?
Fair?
Right?
Sustainable or
environmentally sound?
329
PROFESSIONAL CODE OF ETHICS 3
Obtain
Relevant facts
IFAC recommendation
Ethical issues
involved
Fundamental
principles
Established
internal
procedures
Alternative
course of
action
-Comply with fundamental principle?
-Weigh the consequences of each
alternative
Decide course of action
unresolved
Consult within firm
No result
Consult within those charged
with governance
Document
unresolved
Consult professional body
Withdraw
unresolved
330
ETHICAL THEORIES
Application of Ethical Decision making
American Accounting Association Model
A series of questions regarding application of ethics
Starts from a ethical dilemma conclusion of an ethical decision for the
specific situation
7 questions:
1. What are the facts of the case?
2. What are the ethical issues in the case?
3. What are the norms, principles and values related to the case?
4. What are the alternative courses of action? (brainstorming)
5. What is the best course of action that is consistent with the norms,
principles and values identified in Question 3?
6. What are the consequences of each possible course of action?
7. What is the decision?
56
331
ETHICAL THEORIES
Application of Ethical Decision making
Case study
An auditor uncovers an irregular cash payment and receives
an unsatisfactory explanation for it from the clients finance
director. He suspects the cash payment is a bribe paid to
someone but cant prove it. The client then offers to pay the
auditor a large amount of money if he pretends not to have
noticed the payment. The amount of money offered by the
client is large enough to make a significant difference to the
auditors wealth. Should the auditor take the money?
Required:
Apply AAAs 7 question model and make a decision over
possible actions
332
ETHICAL THEORIES
Application of Ethical Decision making
1. What are the facts of the case?
Auditor: uncovered possible bribe
Client: offer a bribe to ignore or overlook it
2. What are the ethical issues in the case?
Accept bribe?
accept >illegal, negligent of professional duties
3. What are the norms, principles and values related to the
case?
Auditors:
Independent, reasonable assurance on T&F of F/S
Entrusted with task of assuring F/S
Any failure or loss of objectivity >failure of duty to shareholders
333
ETHICAL THEORIES
Application of Ethical Decision making
4. What are the alternative courses of action? (brainstorming)
Option 1 : accept bribe >ignore irregular cash payment
Option 2 : refuse bribe >take appropriate actions
5. What is the best course of action that is consistent with the
norms, principles and values identified in Question 3?
Which =norms, standards?
Refuse bribe
Report irregular payment
Report bribe for auditor
334
ETHICAL THEORIES
Application of Ethical Decision making
6. What are the consequences of each possible course of
action?
Option 1:
Accept bribe >increase in wealth >better life
Risks >professional and legal trouble (being uncovered) >guiltiness
In debt to the client >client disclose bribe?
Option 2:
Refuse bribe
Impact on client >future clientauditor relationship
Maintain and enhance reputation +social standing of auditors >public
confidence
Serve best interest of shareholders
7. What is the decision?
335
ETHICAL THEORIES
Application of Ethical Decision making
Tuckers 5-question model
Used to make ethical decisions
Conceptually slightly different from 7 Questions
Not all 5 criteria are relevant to every ethical decision
More useful for corporate (e.g. Question 1: profitable?)
Used for discussion and debate over different stakeholders
claims and interests before reaching the conclusion
Used after 7 questions >correctdecision made ?
336
ETHICAL THEORIES
Application of Ethical Decision making
Tuckers 5-question model
Is the decision:
1. Profitable?
2. Legal?
3. Fair?
1. To whom? >which stakeholder?
4. Right?
rightor wrong>depends on ethical position adopted
Deontological Teleological
5. Sustainable or environmentallysound?
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337
ETHICAL THEORIES
Application of Ethical Decision making
Case Study
Big Company is planning to build a new factoryin a developing country.
Analysis shows that the new factory investment will be more profitable than
alternatives because of the cheaper labour and land costs.
The government of the developing country has helped the company with its
legal compliance, which is now fully complete, and the local population is
anxiously waiting for the jobs which will, in turn, bring much needed
economic growth to the developing country.
The factory is to be built on reclaimed brownfield land and will produce a
lower unit rate of environmental emissions than a previous technology.
Required:
Apply Tuckers 5 Question in analyzing the possible decisions
338
ETHICAL THEORIES
Application of Ethical Decision making
1. Profitable?
Yes >superior return
because of the cheaper labour and land costs
2. Legal?
Yes >government >happy to attract investment >helped with its legal
issues
3. Fair?
Yes
Stakeholder ?
Workforce of developing country >anxiously waiting for the jobs
Other ? >didnt mention
339
ETHICAL THEORIES
Application of Ethical Decision making
4. Right?
Yes >help developing country with much needed
economic growth
No counter-arguments mentioned
5. Sustainable or environmentally sound?
Yes >environmental advantage
Conclusion:
Passes ALL 5 criteria
340
ETHICAL THEORIES
Application of Ethical Decision making
Further Analysis
Some more information has emerged about Big Companys
new factory in the developing country.
The brownfield land that the factory is to be built on has been
forcefully requisitioned from a community (the Poor
Community) considered as second class citizens by the
government of the developing country.
The Poor Community occupied the land as a slum and now has
nowhere to live.
341
ETHICAL THEORIES
Application of Ethical Decision making
1. Profitable?
Yes >superior return
2. Legal?
Government of developing country >no effective laws
However, legal structures in host country ? Treatment of
poor Community?
342
ETHICAL THEORIES
Application of Ethical Decision making
3. Fair?
Stakeholders:
Employment >ok
Poor community >unfair (New job provided vs. cost of homes)
Decision based on makers view
4. Right ?
Ethical assessment
Rights of Poor Community vs. economic benefits
Obtain other info
Legality of Poor Communitys occupation of site
Options for rehousing once construction on site has begun
5. Environment ?
Ok
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343
Quiz 1
Tuckers five question model
An accountancy firm normally provides CPD training for its
staff using an external training provider. This means that staff
members have to travel to the traning venue but then receive
training in a classroom environment.
In an attempt to decrease costs, the training manager has
decided to provide training in-house using computer-based
training. Training can be undertaken at a time to suit each
member of staff, although some unpaid late afternoon and
evening use of the CBT will be expected.
Required
Explain Tuckers five question model and assess the change
in training method against this model. (9 marks)
344
Quiz 1
Answer:
Profitable?
Firm: reduce expenditure
Staff: unhappy with treatment >resign >cost for
replacement ?
Legal?
Yes : meet requirement for CPD
Training hours monitored by computer software
345
Quiz 1
Answer:
Fair?
Stakeholders?
Difficult to determine
Fair: all staff has access to training
Unfair: may involve unpaid O/T
Right?
Yes >provide training to staff
Sustainable or environmentally sound?
Environmentally sound >reduce travel time >less
resource consumption
346
Quiz 2 - Kohlberg
Kohlbergs Model
As a newly qualified certified accountant, you are assisting in the preparation
of the accounts of MATTI plc. Part of your duties involves calculating the
provision for inventory.
Part way through this calculation, the senior accountant notices that you are
providing against inventory lines which have not sold any units for the last six
months. "That provision will adversely affect profit by 520,000he notes.
"The company cannot afford that additional fall in profit and anyway,
provision for those items has not been made in this way before; we normally
wait and see what the scrap value will be in 12 months time."
The senior accountant states that the provision must not be entered into the
accounting system.
Required:
Apply Kohlberg's levels of Cognitive Mental Development, provide an
example of a decision and the rationale behind it for each level of
development.
347
Quiz 2 - Kohlberg
Answer:
1.1 pre-conventional ( obedience and punishment)
Example:
Follow advice
If no >punished by senior
1.2 pre-conventional ( Instrumental purpose and exchange)
Example:
Follow advice
In future >will get benefits
Late work permitted
Leave early
Promotion? 348
Quiz 2 - Kohlberg
Answer:
2.1 conventional ( Interpersonal accord & conformity)
Example:
Follow advice
Other EE do the same
If not follow
Other may do the same to the senior
May be rejected by the group
2.2 conventional ( Social accord & system maintenance)
Example:
May still follow
Need to discuss with senior >why provision need not to be made?
Make suggestion that in similar company same provision was made
59
349
Quiz 2 - Kohlberg
Answer:
3.1 post-conventional ( Social contract and individual rights)
Example:
Make provision
Contact AC or discuss with FD
Will insist on making the provision
3.2 post-conventional ( Universal ethical principles)
Example:
Make provision >actively seeks method to do it
If no provision
Resignation ?
350
Quiz 2 - Kohlberg
Z's son needs a drug costing 40,000 to improve the quality of
his son's life, and potentially stop him from dying. Z lives in a
state where healthcare requirements are provided almost
exclusively by the state.
Z has a discussion with M, a doctor. M informs Z that the
hospital budget (which is set by the state) cannot afford this
amount of expenditure on one individual. M advises Z to try and
obtain the money privately, Z informs M this is not possible.
Z takes a job as a hospital cleaner and one night breaks into the
hospital storeroom and steals the drug. Z's son recovers from
his illness.
Required:
Using Kohlberg's model of CMD, explain the actions of Z and M.
351
Quiz 2 - Kohlberg
Answer:
Z:
Unethical?
Motivated >improve his sons life
Knows that stealing is wrong
basic human right to have good quality of life>health
authority cant deny the drug
unethicalstealing >now justified >for his sons moral
rights
At 3.1 social contract and individual rights
352
Quiz 2 - Kohlberg
Answer:
M:
EE of hospital >follow rules of hospital
No enough funds to pay for drug >accept and insist on
rules
At stage 1.2 or 2.1
1.2
Expect exchange from hospital for following policy
2.1
Act in expectation of peers >all doctor wont
break hospital policies
How about evaluating the case using deontological &
teleological theory?
353
Q 19 Internal Auditor
You are a manger in the internal audit department of TB1, a
large listed company employing 7,000 staff in your country
including an internal audit department of 30. during the course
of the audit of the computer-based financial control systems,
you have discovered that 1.1 billion of revenue expenditure
has been treated as capital spending. You have reported this
finding to the head of internal audit and then to the chief
accountant, but as far as you are aware, no action has been
taken by the company. The external audit is due to commence
in 7 days, and you have been instructed by the head of internal
audit not to disclose this information to the external auditors.
Required:
a) Explain the composition and the role of the audit committee in a
listed company (8 marks)
b) Discuss reasons why whistleblowing has become more
important in recent years ( 6 marks)
c) Evaluate the alternative actions available to you now, and how
these may conflict with ACCA ethical guidance. (11 marks)
354
Q 19 Internal Auditor
Required:
b) Discuss reasons why whistleblowing has become
more important in recent years ( 6 marks)
Answer:
(i) Accessibility of Information
(i) Easy to access information by EE (IA)
(ii) Treatment of blowers
(i) Traitor >retaliatory action
(iii) practice
(i) Help to disclose frauds and scandals
60
355
Q 19 Internal Auditor
Required:
c) Evaluate the alternative actions available to you now, and how
these may conflict with ACCA ethical guidance. (11 marks)
Answer:
Dilemmas: integrity vs. confidentiality
Actions: disclose
BOD / chairman
EA
AC
Solution:
Report to AC
356
Q 19 Internal Auditor
Required:
c) Apply CMDto recommend possible actions
Answer:
Preconventional
No disclosure
Conventional
Depends on working environment & culture
Post conventional?
Whistleblow!
357
Q 19 Internal Auditor
Required:
c) Apply Deontological / teleological to recommend possible
actions
Answer:
Deontological
Consistence: everybody disclose?
Human dignity: embarrass others?
Universality: in others view?
Teleological
Egoism
Utilitarianism
358
Q 19 Internal Auditor
Required:
c) Apply AAAs 7 question to recommend possible actions
Answer:
1. What are the facts of the case?
IA: overstatement of profit
Head of IA: conceal the fact
2. What are the ethical issues in the case?
Disclose?
Disclose >breach duty of confidentiality
Conceal >integrity
3. What are the norms, principles and values related to the case?
IA:
Professional: integrity, objectivity, competence and due care
Report to those charged with governance
Report to external parties
Employee: act in best interest in shareholders
359
Q 19 Internal Auditor
Required:
c) Apply AAAs 7 question to recommend possible
actions
Answer:
4. What are the alternative courses of action? (brainstorming)
Option 1 : disclose >loss job/ isolated/ retaliated
Option 2 : conceal >failure to observe ethical
standards
5. What is the best course of action that is consistent with
the norms, principles and values identified in Question 3?
Which =norms, standards?
Disclose to internal or external parties
360
Q 19 Internal Auditor
Required:
c) Apply AAAs 7 question to recommend possible actions
Answer:
6. What are the consequences of each possible course of
action?
Option 1:
Disclose >punished/ loss job
Option 2:
Conceal >exchange from head of IA
Harm shareholders interest
7. What is the decision?
61
361
Chapter 11
Professional Ethics
Ethics & Social Responsibility
362
KNOWLEDGE CHECKLIST
Ethical & Social Responsibility Stances 2
Seven positions on social responsibility
Other constructions of personal & corporate ethical stance
Variables determining cultural content
Corporate Ethics 3
Key areas of corporate code of ethics
Purpose of code of ethics
Effectiveness of code of ethics
363
KNOWLEDGE CHECKLIST
Corporate Social Responsibility 3
Impact of CSR on strategy and CG
Corporate citizenship
Social & Environmental Issues
Environmental and social footprint 3
Sustainability & Environmental accounting 3
Environmental management systems 3
Social & environmental audit 3
364
All about stakeholders
Stakeholder
theory
Instrumental Normative
Identification of
stakeholders
Stakeholder
mapping
7 Positions
CSR
Corporate Citizen
Sustainability
Reporting
Tuckers 5 Question
365
ETHICAL & SOCIAL RESPONSIBILITY STANCES
Views
Stockholder Stakeholders
Shareholders
Agents: moral +legal
duty shareholders
Corporate citizen
Protected, benefit from
society
Shareholder +stakeholder
366
ETHICAL & SOCIAL RESPONSIBILITY STANCES
Organizations should have some social responsibility
Together with social responsibility +social accountability
(accountable for their actions)
There may be a difference between
How the world is NOW
How it SHOULD be
7 positions on social responsibility> show alternative views
on the difference
62
367
Pristine capitalist
Social ecologist
Expedients
Shareholders rule
Proponents of social
contract
Socialist
Radical feminist
Deep ecologist
All stakeholders
ETHICAL & SOCIAL RESPONSIBILITY STANCES
Seven positions on social
responsibility 2
Environmental
CSR
Sustainability
A full recognition of each stakeholders (voiceless,
unrecognized) claim >would NOT allow business to
continue
368
ETHICAL & SOCIAL RESPONSIBILITY STANCES
Variables determining cultural
content 2
Economic: profitability
Legal: compliance with laws
Ethical: doing what is right
Philanthropic: doing what is
desired
Cultural difference exists in different
areas and countries
Ethics and CSR will be different in
different culture
US culture tends to focus on
economic factors
European culture tends to
focus on legal factors
Economic responsibilities
+
Legal responsibilities
+
Ethical responsibilities
+
Philanthropic responsibilities
= Total CSR
369
CORPORATE ETHICS 3
Application of ethical values to business behavior
From board strategies to relations with suppliers
Goes beyond legal requirements > discretionary
In practice, disclose in CSR report
370
CORPORATE ETHICS 3
Key areas
Purpose and values of business
Employees
Customer relations and advertising
Shareholders or other providers of funds
Suppliers and supply chain issues
Community and charitable involvement
Implementation
Issue and application of the code
Review and updates
371
CORPORATE ETHICS 3
Purpose of code of ethics
Provides framework for conflict resolution
Provide guidelines for similar ethical disputes and methods of resolution
Provide the boundariesacross which it is ethically incorrect to go beyond
However, in placeeffective
Limitations:
All the ethical issues covered ?
Interpretation ?
Lack of effective punishment for breaching the code
Irrelevancy
Fails to illustrate the ethical problems that EE encounter
Lack of organization-wide commitment
Inconsistent with prevailing organizational culture
372
CORPORATE ETHICS 3
Effectiveness of code of ethics
Factors limiting effectiveness of corporate and professional
codes:
Imposed without communication to explain its purpose >
lead to resentment, particularly amongst EEs
'in place effective >reminders needed to enforce it
Lack of punishment on breach of code, especially by senior
management
How to make it effective?
63
373
CORPORATE ETHICS 3
Recommend or advice how to improve effectiveness of code:
Participation >encourage 'buy in
Disciplinaryactions for breach of the code
Publicityof breaches and actions taken >promoting
compliance
What is on the student newsletter?
Identity and values program(promote positive values)
Ethical training >change culture
Procedures for reporting and investigating ethical concerns
Ethical office/department
374
CORPORATE SOCIAL RESPONSIBILITY 3
Impact of social responsibilities on strategy and CG
- Objectives and mission statements
- Ethical code of conduct
- CSR and social accounts
- CG
375
CORPORATE SOCIAL RESPONSIBILITY 3
Corporate citizenship
Corporate citizenship
The business strategythat shapes the values underpinning a companys
mission and the choices made each day by its executives, managers, and
employees as they engage with society.
Three core principles define the essence of corporate citizenship, every
company should apply them in a manner appropriate to its distinct needs:
Minimizing harm
Maximizing benefit
Being accountable and responsive to stakeholders
Corporate accountability:
Whether the organization is in some way answerable for the
consequences of its actions beyond its relationship with shareholders
376
CORPORATE SOCIAL RESPONSIBILITY 3
Corporate citizenship
3 perspectives/citizenship (by Matten et al)
Limited view(philanthropic view)
Equivalent view (economic +legal +ethical +philanthropic =
Total CSR)
Extended view
Active social +political citizenship
377
SOCIAL & ENVIRONMENTAL ISSUES 3
Impact of business activities on environment and society:
Economic activityis onlysustainable where its impact on society and
environment is sustainable
Measurement of sustainability
Empirical (quotients) or subjective
Environmental footprint
Sustainability in terms of resources used by economic activity
Unsustainable: resources used >provision
Social footprint
Sustainability in 3 areas of capital >economic activities are
sustainable only when 3 areas are satisfied:
Social capital
Human capital
Constructed capital
378
SOCIAL & ENVIRONMENTAL ISSUES 3
Environmental Footprint 3
Business operate at a net cost to the environment
Environmental footprint >attempt to evaluate size of impact
by economic activities on the environment
(i) Resource consumption (inputs)
- Energy, feedstock, water, land use, etc.
(ii) Harm to the environment by economic activities
- Emissions, effluents
- Spillages, waste
(iii)Measurement >either qualitative, quantitative or
replacement terms
64
379
SOCIAL & ENVIRONMENTAL ISSUES 3
Environmental Footprint 3
Examples (Detergent manufacture)
(i) Production
Improving chemical formula to decrease amount of
chemical used
(ii) Transportation from manufacturing plant to consumer
Manufacturing in fewer locations
Better logistical networks
(iii)Packaging for the product
Cardboard rather than plastic packaging
Decrease weight of packaging >resource use and
transportation costs
380
SOCIAL & ENVIRONMENTAL ISSUES 3
Social Footprint 3
Evaluate sustainability in 3 areas
1. Social capital
Social networks and mutually-held knowledge
2. Human capital
Personal health, knowledge, skills, experience and other
resources required for individual to take effective actions
3. Constructed capital
Physical infrastructures in society (road, utilities)
Supply of social capital = results < 1
Need for social capital
unsustainable
381
SOCIAL & ENVIRONMENTAL ISSUES 3
Sustainability & Environmental Accounting
Definitions:
Sustainable development is development that meets the
needs of the present without compromising the ability of
future generation to meet their own needs
Sustainability is an attempt to provide the best outcomes for
human +natural environments both now +into indefinite
future
Relates to continuityof economic, social, institutional and
environmental aspects of human society +non-human
environment
Affects every level of organisation (local neighborhood +
entire planet)
L/T maintenance of systems according to environmental,
economic and social considerations 382
SOCIAL & ENVIRONMENTAL ISSUES 3
Sustainability & Environmental Accounting
How to measure?
Full cost accounting
Calculating total cost of company activities
Environmental +economic +social costs
TBL accounting
Expanding the traditional company reporting framework
Environmental +financial performance
383
SOCIAL & ENVIRONMENTAL ISSUES 3
Sustainability & Environmental Accounting
3 Perspective covered by Sustainability:
1. Economic perspective
Earth is a finite system >economic growth limited
Sustainability for organisation >ensure L/T growth >in
existence for the foreseeable future
Examples of unsustainable activities:
Short-termism (e.g. increase in share price)
Paying bribes
Creative accounting and underpayment of taxes
384
SOCIAL & ENVIRONMENTAL ISSUES 3
Sustainability & Environmental Accounting
3 Perspective covered by Sustainability:
2. Social perspective
Business impact on communities >may change their
social make-up
Concept of social justice
Income gaps and wealth & poor b/w nations
Examples of social justice failure:
Rich consuming countries and poorer manufacturing
countries,
Urban richand rural 'poor'
65
385
SOCIAL & ENVIRONMENTAL ISSUES 3
Sustainability & Environmental Accounting
3 Perspective covered by Sustainability:
3. Environmental perspective
Impact on environment >deterioration and eventual loss
of some resources
Effective management of environmental resources >
available for future generations
Limiting use or replacing those resource the medium to long term
Examples:
Use of non-renewable resources including oil, gas and coal
Long term damage to environment from CFCs
Can future generations enjoy the same standard of living?
386
SOCIAL & ENVIRONMENTAL ISSUES 3
Sustainability & Environmental Accounting
Sustainability Report
Initiated by GRI (Global Reporting Initiative)
Develop transparency, accountability, reporting and sustainable
development.
Reporting on E, E, S >routine and comparable as financial reporting
Recommended format:
Vision and strategy
Profile
Governance structure and management systems
GRI content index
Performance indicators
Integrated
Economic
Environmental
Social performance indicators
387
SOCIAL & ENVIRONMENTAL ISSUES 3
Sustainability & Environmental Accounting
Environmental Accounting
Full cost accounting
Include all costs of action, decision or manufacture of a
product into a costing system
FCA
=actual costs incurred +additional costs of those actions
Aim
Internalize all costs (including those incurred outside )
Elements:
388
Disposal cost +associated
environmental damage
Cost incurred to elimination
environmental effect
Environment
focused
costs
Tier 4
Cost of non-callback of
faulty cars
Cost of poor environmental
management (loss of goodwill,
reputation risk)
Less
tangible
costs
Tier 3
Contingent liability(fines) Liability
costs
Tier 2
time lost from traffic queues
additional cost of pollution
from cars
Overheads (cost of management
system and safety)
Hidden costs Tier 1
initial outlay on a factory
Basic capital and revenue costs Usual costs Tier 0
Example ( car manufacturer) Items Costs
389
SOCIAL & ENVIRONMENTAL ISSUES 3
Sustainability & Environmental Accounting
Environmental Accounting
Full cost accounting
Advantage:
Knowledge of full environmental footprint
Reducing environmental footprint
Assist in decision-making by allowing comparison b/w
different investment options
Enhance publicity
390
SOCIAL & ENVIRONMENTAL ISSUES 3
Sustainability & Environmental Accounting
Environmental Accounting
Full cost accounting
Disadvantage:
Data requirement
Determination of cost (which to use? Correction or prevention?)
Quantifyimpact of activities into financial terms
Wider perspective results more useful FCA ( industry or geographical
area)
Difficulty in including social costs ( definition and measurement)
Additional cost give worse impression
Compliance burden
66
391
SOCIAL & ENVIRONMENTAL ISSUES 3
Sustainability & Environmental Accounting
Environmental Accounting
TBL
Normal financial reporting framework of a company to
include environmental + social performance
Triple 'P' :
People
Planet
Profit
392
The Global Fishbowl companies can not hide!
SOCIAL & ENVIRONMENTAL ISSUES 3
393
SOCIAL & ENVIRONMENTAL ISSUES 3
(People) (Planet) (Profit)
Social Environment Economics
-Shareholders + EE+
community
-Profit not primary goal
- Fair wages
- Safe working
environment
- Not use child labor
- Surrounding
community >
educational
opportunities or safe
community
Environmental practices
> whether they are
sustainable
- Reduce 'ecological
footprint' by managing
consumption and energy
usage
1. For example:
1. efficient production
process
2. Avoid resource
depletion
example: fish stocks
-'normal' bottom line
-A non-TBL company
> maximize
shareholder return
- A TBL company >
balance
394
SOCIAL & ENVIRONMENTAL ISSUES 3
Environmental management systems 1
EMAS and ISO 14000
Establishing and maintaining environmental management
systems (EMS)
Difference:
ISO 14000: focused on internal systems
EMAS: focuses on standard of reporting and auditing of
that reported information
Application:
Refer to the standards in CSR reports
395
SOCIAL & ENVIRONMENTAL ISSUES 3
Social & environmental audit
Purpose:
A process that enables an organization to
Assess and demonstrate its social, economic and
environmental benefits and limitations, and
Check whether it is fulfilling the wider requirements of
being a good corporate citizen
Types:
Social audits
Environmental audits
396
Exam Structure
Analysis of Pilot Paper
Pilot paper
Q 1 ( 50 marks)
a) CG (CG problems) - Evaluate & explain 10
b) Risk identification Identify & explain 15
c) CG (board structure) Construct the case 10 (2 for Prof.)
d) CG (roles of NEDs) Explain & assess 7
e) Ethics (environment reporting) Write a memo 8 (2 for Prof.)
67
397
Exam Structure Analysis of Pilot Paper
Pilot paper
Q 2 CG
Remuneration committee (R.C.)
Remuneration package
Application (Ethics approach)
Q 3 Ethics (Discursive)
Professional code
CG - integrity
Ethics
Deontological vs. consequentialist
Q4 Internal control
Internal control
Reputation risk
Ethics (responsibilities of accountant)
CG - instrumental vs. normative
Ethics - CMD
CG - stakeholders
CG - application
Internal audit
Source of IA
IA independence
IA (objectivity)
CG (Agency cost)
CG (institutional investor)
Risk committee
CG (principle based )
398
Analysis of Pilot paper
CG:
Agency cost
Institutional investor
Comply or explain
Roles of NED
Board structure ( unitary vs. two-tier )
Remuneration committee
Roles of RC
Remuneration package
Stakeholder theory ( normative vs. instrumental)
Stakeholder analysis ( reputation)
399
Analysis of Pilot paper
Internal Control & Risk management
Sound internal control system
Internal audit
Need
Outsourcing
Reporting line
Objectivity
Reputation risk
Risk identification and assessment
Risk committee
400
Analysis of Pilot paper
Ethics:
Integrity (D)
Deontological vs. consequentialist (D)
Principle-based ethical codes (D)
CMD
Ethical responsibility of accountant
Environmental footprint & reporting
401
Important Areas Dec 2008
Board structure (unitary, multi-tier)
Directors remuneration
Audit committee
IA independence, assessment of IAs performance
Ethics
Ethical decision making (scenario)
7 questions +5 questions
Deontological vs. consequentialist
Public interest vs. Duty of agents +ethical dilemma