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Individual Assignment

BM055-3.5-2
Ethics and Corporate Governance

Name : Chin Kai Wen


Student Id : TP019076
Lecturer Name : Kho Guan Khai
Intake Code : UC2F1001AF
Submission Date : 23 September 2010
Chin Kai Wen TP019076

Table of Content

Introduction.....................................................................................................................3
The Shareholders.............................................................................................................4
The Directors...................................................................................................................6
The executive directors...............................................................................................6
Certain fraud cases......................................................................................................6
Major causes for fraud.................................................................................................7
The independent directors...........................................................................................8
Purpose of recruiting independent directors................................................................9
Function of non-executive directors............................................................................9
The other players...........................................................................................................11
The accountant..........................................................................................................11
The auditors...............................................................................................................12
Conclusion and Suggestion...........................................................................................13
References.....................................................................................................................14
E-Journal...................................................................................................................14
Internet ......................................................................................................................15

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Introduction

Corporate Governance is define as the process and structure used to control and
manage the business and affairs of the organization towards maximising business wealth and
corporate accountability with the ultimate objective of protecting long term shareholder value,
and taking account the interest of stakeholders at the same time. (Zulkafli, Abdul Samad and
Ismail)

Recent corporate fraud (e.g. Enron, WorldCom Tyco, etc.), which wiped out billions
of shareholders’ wealth, had wear down confidence of investors in financial market, damage
external business relationships firm reputation and branding. Thus, many countries such as
United Kingdom uses the corporate governance as a best practice to gain confidence from the
public. On the other hand, USA uses the Sabena Oxley Act (SOX) as a company law in 30
July 2002 to protect investors by improving the accuracy and reliability of corporate
disclosure.

Good governance will ensure that the directors will fully consider the stakeholders’
interest. In order to meet a long-term success, the organisation must comply with the entire
external environmental factor such as law and regulation as well as social responsibility.
However, some employers may seek profit from his employees and even refuse to provide
basic facilities to its workers to reduce expenses. (Mohamad, 2004)

The non-executive directors are responsible to monitor the board of executive


directors. These independent directors are in charge of exposing such cases to the public and
the shareholder if any fraud is detected. For example, the Treadway Commission Report
states that the audit committee re-evaluate the programme that management establishes to
monitor fulfilment with company’s code of ethics. Hence, corporate governance prevents
fraud from occurring to reduce white-collar crime and discover fraud at the early stage.

The corporate governance ensures the independence of non-executive directors


especially the audit committee. Such example is the executive compensation and director
nominees have majority independent directors. Besides the directors, officers and employees
must perform their responsibility efficiently with honesty and well intentioned. There must be
no bias and fraud in the process of transaction of business.

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The Shareholders

The shareholders are the owner of an organization. Conversely, not all shareholders
actively contribute in the day-to-day process of the company. The majority owners are the one
who make decisions on the behalf of the minority shareholders. Besides, the managers of
some firms will also control the company and make all level decisions. (Bhasa, 2004)

Under the law, directors have the fiduciary principals and duties of care to manage the
company. Whether such duties will perform, depend largely upon shareholders’ action to
protect the other stakeholders and the money they invested. The shareholder must be
responsible to provide authority to the directors’ duty and play a role within corporate
governance so that the directors are able to perform their function effectively. (Kirkbride,
Letza and Smallman)

The shareholders must understand the background of all directors especially the
independent directors before employing them. If any of them had involved themselves in the
white-collar crime, the company will be in danger in their hands. Besides, the shareholder
must provide more authority to non-executive director. These directors must have the right to
view the all information of the organisation so they have enough evidence to proof the right
doing of wrongdoing of the managers.

The committee reports such as Cadbury, Greenbury and Turnbull are very informative
for the shareholders to monitor and control the directors. For example, The Cadbury Code
stated that the Board of Directors should not be control by any single party, such as chief
executive officer, chairperson or by a small group of executive directors. The shareholder
should pick the important factor that are most relevant from all the codes and enforce the
company. However, the company should not use that information, which the organisation
cope with, such as all the organisation should be audited despite its size and costs which was
set by SOX. The shareholder will face problem because the burden of auditing fees will use
up a high portion of its turnover.

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On the other hand, all the directors should be given a test base on morality before and
after they are employed. The test may not be in a written form but practically. For example, a
few directors play in an act to show that there is a fraud case going on in the organisation.
Then, they will monitor on how the candidate take action towards those them. Thus, such test
is able to ensure that all the employees are trustworthy and alert. Thus, they are able to trace if
there is any fraud happening in the organisation too.

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The Directors

There are two types of directors in an organisation, namely executive directors and
non-executive directors.

The executive directors

Executive directors were selected by the majority vote of shareholders. The executive
directors functions as senior manager of a business. They design, develop and implement
strategic plan to achieve the objective of the organization. These directors involve in a day-to-
day operation of the organisation. They have the authority to control over all staff and became
the link between the employees and shareholders. Moreover, a financial report will be
produce by the board of directors at least once a year for the shareholders to review. (Role of
the Executive Director)

As a leader of a large organisation, the executive directors should set a very good
example to their employees in terms of morality and efficiency in the process of serving the
company. They should be ethical and do not abuse their authority in the company. Such
violation of power includes using the company’s asset privately, accepting “commissions”
from the contractors and many others. However, current white-collar crimes show that most
organisations lack of corporate governance.

Certain fraud cases

One of the most recent cases is the fraud case of Enron, which started in early 1991.
The company was able to borrow substantial loan without disclose in the financial report and,
thus ,able to continue its business as usual. Many years later, the company accumulated a debt
of more than $350 million dollars but these amounts of loans were recorded in the accounts of
their assets or liabilities from an affiliate entity. (Doost, 2003) Later, this case was exposed in
the late 2001 and all the managers were sent to prosecution. (Azul, 2004)

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Bernard Ebbers, former CEO of WorldCom, was once a celebrated CEO of the last
decade. However, the economy was slow and WorldCom was unable to expand its business.
Thus, he was in a personal financial difficulty as he bought a large quantity of the company’s
stock as a security. In order to maintain the stock price above the critical level and reduce his
liability, Ebbers falsified the finances. Later, in July 2002 where the company unable to bear
the liability and went for liquidation, it was found that $104 billion of assets were overrated.
This amount was twice of the Enron’s case. (Martin, 2005)

Parmalat, a dairy-foods producer created a fraud account in Bank of America where


the branch is in Cayman Island in 1998. Its financial report stated that it had 38% of assets,
which is $4.9 billion in this bank. 15 years later, the falsified account was disclosed and the
organisation’s liability was as high as $16.2 billion. Thus, it was forced to wind up in 27
December 2003. (Celani, 2004)

Major causes for fraud

The fraud cases can happen easily when shareholders only depend on the directors.
The non-executive directors or external auditors were not employed to audit the day-to-day
operation of the executive directors. Thus, this lose control system allows the directors to
abuse their authorities. The shareholders might think that the auditing job is a waste of
resources, fund and time. However, they must understand that they should invest in an
organisation, which will maximise their wealth, and the directors must work in an ethical
manner. These investors are the only one who can control, monitor and give pressure the
directors. A large company involves the other stakeholders beside shareholder too. If the
organisation collapses, many stakeholders especially the innocent employees who will be
jobless and both directors and shareholders is to be blame.

The director’s salary is based on performance. When the organisation does not gain
much profit or is at a loss, the directors will be under pressure. They are afraid that their
salary will be deducted. Thus, they will cook the book so the shareholders will be satisfied.
Minor window dressing such as buying less than 5% of the company’s shares and preparing
cheques before the Annual General Meeting (AGM) is allowable. Conversely, extensive
window dressing will consider as fraud. For example, after purchasing MCT”s IPR&D,

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WorldCom reported a loss of $3.2 billion. This figure was less than half of the actual loss they
had, which was $7 billion. (Kokoszka, 2003)

After a month of hard work to maximise the company’s wealth, a director may seek
that his salary is only a small amount from the profit. The rest of the money is the assets of
the shareholder. He may think that the amount of money should belong to him as he had
worked it. Thus, he had self-interest on the company’s wealth. For example, every time he
provides a business to a supplier, the other party may inject the goods price and give him
some “commission” as a reward.

The independent directors

An independent director or non-executive director is the member of a separate board


in a two-tier structure. This board of director does not involve in the management team.
Moreover, they serve the organization two three-year terms. In UK, the generally legal duties
allocated to the company by executive and non-executive directors are equal. (Higgs, 2003)

These non-executive directors must be independent in terms of character and


judgment, and no relationship that can influence their decision. A company must consist of at
least three independent directors. Either one of them must be from an accounting background
while the other one must from the finance background too. They are required to meet as a
group at least once a year without the chairpersons or executive directors. Besides, they
should record after each time such meeting incurred; it must be recorded in the annual report
after it had occurred. (Higgs, 2003)

Besides, an audit committee must consist of all independent directors to oversight the
company’s financial statement, financial reporting and internal accounting and financial
control. The members are drawn from the company’s board of directors. However, the
independent directors may not be an audit committee member. The rest of them are
responsible to provide advices and ideas to the executive directors and communicate with the
shareholders.

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Purpose of recruiting independent directors

The non-executive directors aid the board by providing knowledge, objectivity,


judgment and balance that may not be available if there are only full time executive directors.
(Clarke, 1998) For example, both executive directors and independent director will argue on
which material they should take order. Each of them will make comments on different
viewpoints of the product in terms of pricing, functions and quality and make the best
decision. Thus, the company will able to save cost on the purchase and reduce bias. However,
some shareholders may dislike appointing independent directors as the company may take a
longer time to make a decision.

The independent directors monitor and ensure the performance of the executive
directors and the management of the company is up to standard required. (Clarke, 1998) For
example, these directors make sure that all their staffs had sufficient training so they are able
to excel in their performance. If the employees could not achieve the requirement, the non-
executive director may take action on the human resource department.

Function of non-executive directors

The external directors provide ideas to broaden the strategic view of board of
directors. Thus, they aid in expanding the company’s vision and mission. According to
Cadbury, he understands the importance to think outside the box and encourages all his
employees to do so. (Clarke, 1998)

These directors act as a bridge between the directors and internal directors. They have
to ensure that the executive directors are interested to work with the company to maximise the
shareholder’s wealth. As a watchdog and whistleblower, they are also responsible on
monitoring the boards to detect if there is any breach of duties. On the same time, these
directors aid in resolving conflicts between the interest of shareholders and executive
directors, such as directors remuneration, usage of company’s fund on investment, the
company’s expenses and many others. (Clarke, 1998) Thus, meetings between shareholders
and non-executive directors on appointment should be held in order to aid these directors to
communicate and has a better understanding on the views of major investors. (Higgs, 2003)

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Each non-executive director has his own clear role in appointing, monitoring,
replacing the Chief Executive Officer (CEO) and evaluating the executive team. If the
shareholders or the board of independent director loose confident on the chief executive, he
may need to step down. Then, the non-executive director may need to replace him if
necessary and important decisions were needed. Furthermore, although the failure of
governance is aware when the necessary checks and balances are absent, the shareholders are
still unable to judge whether to board is working well at work. This is because it is hard to
measure the performance of the board. Yet, they still can understand the basic information
from the board’s structure and past performance of each individual. (Clarke, 1998)

Besides monitoring the internal environment, the outside director must understand the
external surroundings too. They must be alert that some significant change on the external
environment such as public expectation might affect the organisation in large. Thus, such
problem must be brought to the meeting. (Clarke, 1998)

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The other players

The accountant

Accounting is a professional skill. The accountants play an important role in the


organisation. They are responsible to record all the transactions, budgeting and performance
monitoring as well as prepare financial statements for all the decision makers (such as
directors, shareholders, creditors, etc.). Thus, they must ensure that all the record in the
accounts must be accurate.

According to research, most accountants use virus protection, firewalls and password
protection. The growth of internet and e-commerce that rises in the computer networks, had
increase the exposure to fraud. Accountant should ensure only legitimate users can access to
the computer network and prevent intruders by using these computer systems. (Bierstaker,
Brody, and Pacini, 2006)

Besides, the accountants may use bank reconciliation, which involve comparing the
record transactions and balances to the bank’s record of transaction and balances to combat
fraud. They are able to notify the amount of cash available in the account and who along with
when and how much did the company pays its creditors.

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The auditors

In the past, the role of auditor was only verification of accounts. It was the managers’
duty to implement appropriate internal control system along with preventing and detecting
fraud. As time passes, auditor is now responsible to report to shareholder the entire dishonest
act that taken place. However, auditors are not expected to discover all fraud took place in the
organization because they are not the guarantor. On the other hand, they must conduct the
audit will reasonable skill and care in all conditions. (Alleyne and Howard, 2005)

In the process of auditing the financial account, the auditor uses the sampling and
testing techniques. Thus, the result will only provide an assurance of the content of financial
statements. They are unable to detect fraud that involves unrecorded transactions, theft or
other uncertainties. Nevertheless, they must reduce all the risk on checking the financial
information because it might be material to the financial statement.

Beside, the external auditor should audit the internal control to reduce the amount of
substantial testing. The component of internal control includes control environment, entity’s
risk assessment process, information and communication, control procedure, and monitoring.
Yet, the process of carrying out audit on organisation’s internal control is restricted by the
management override personnel errors and collusion.

In the case of Enron, Arthur Anderson was supposed to act as a watchdog and
gatekeeper for the shareholder. Besides, they should look after the shareholder’s wealth too.
However, Enron’s fraud case was not exposed because Anderson wanted to continue the
business with it from the other services to increase profits. The consultation revenue for
Enron is as high as $13.5 million, which is 25.96% of total income. Therefore, external
auditor are not allow to provide other services after this incident. (Doost, 2003)

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Conclusion and Suggestion

An auditor should produce a true and fair view financial report for the shareholder to
review. However, the auditors are often being control by the management level. Before the
report was sent to the shareholders, it must be authorise by the directors. Thus, auditors were
given pressure if the report is unfavourable to the executive directors. Such pressure includes
changing auditors, reducing auditing fees and backstabbing on the auditors. However, such
problem will not exist if the company had a powerful audit committee, which was
recommended in the Corporate Governance Best Practice. The independent directors from the
audit committee could have helped the external auditors to provide a strong and transparent
report.

The Greebury committee states that directors should be paid by yearly basis but not
performance. Moreover, the executive pay should not be excessive but sufficient to attract,
retain and motivate them. Such practice is similar to Singapore where the entire government
servant has very high paid. The high salary is to make the directors find that the pay is more
than enough and prevent them greediness and doing fraud. On the other hand, if the directors
are pay on performance, they will manipulate the financial statement if the company is
making lost. Such problem will happen when they will not get a good pay for that period like
the example for the case study of HIH insurance.

After the Enron case, many researchers found out that the independent of the auditors
must not only be physical but also metal. Its auditor, Arthur Andersen, did not expose Enron’s
fraud because the auditing company do not want to lose another business on financial
consultant for this client. Thus, all auditors are prohibited from doing non-audit service for the
company whom they are responsible to the audit. Besides, Sarbanes-Oxley also listed some
service that the auditors are not allowed but not limited to provide. Such services are
bookkeeping, financial information systems design, internal audit outsourcing services,
actuarial services etc.

In this world of fast moving technology, white-collar crime rate is increasing


tremendously. People are trying to use many ways to commit crime. Thus, many best
practices have been suggested and certain laws were replaced to compete crimes.

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References

E-Journal

• Alleyne, P and Howard, M, 2005, An exploratory study of auditors’ responsibility for


fraud detection in Barbados, Managerial Auditing Journal [online],
<http://www.emeraldinsight.com/journals.htm?issn=0268-
6902&volume=20&issue=3&articleid=1463715&show=pdf> [Accessed 30 August 2010]

• Bhasa, M P, 2004, Understanding the corporate governance quadrilateral , Corporate


Governance [online], 4(4), pp 7-15, <http://www.emeraldinsight.com/journals.htm?
issn=1472-0701&volume=4&issue=4&articleid=873209&show=pdf > [Accessed 30
August 2010]

• Bierstaker, J.L., Brody, R.G. and Pacini, C., 2006, Accountants’ perceptions
regarding fraud detection and prevention methods [online], Managerial Auditing Journal,
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6902&volume=21&issue=5&articleid=1556584&show=pdf> [Accessed 11th August
2010]

• Clarke, T, 1998, The contribution of non-executive directors to the effectiveness of


corporate governance, Career Development International [online], 3/3, pp118-124,
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• Doost, R K, 2003, Enron, Arthur Andersen and the Catholic Church: are these
symptoms of a more chronic problem? , Managerial Auditing Journal[online], 18(8),
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• Keinath, A K, and Walo, J C, 2009, Audit Committee Responsibilities: Focusing on


Oversight, Open Communication and Best Practices, The CPA Journal [online],
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September 2010]

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• Kirkbride, J, Letza, S and Smallman, C, 2009, Minority shareholders and corporate


governance: Reflects on the derivation action in the UK, the USA and in China,
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• Petra, S T, 2005, Do outside independent directors strengthen corporate boards?


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• Celani, C., 2004, The Story Behind Parmalat’s Bankruptcy [online],


<http://www.larouchepub.com/other/2004/3102parmalat_invest.html> [Accessed 22
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[Accessed 30 August 2010]

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• Higgs, D, 2003, Review of the role and effectiveness of non-executive directors


[online], <http://www.dti.gov.uk/files/file23012.pdf> [Accessed 3 September 2010]

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• Kokoszka, R J, 2003, Recognizing the signs: internal auditors can help organizations
avoid the risks associated with inappropriate earnings management by understanding the
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