Professional Documents
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EG Study Guide 16a
EG Study Guide 16a
These study materials are copyright CPA Australia. They have been provided for your personal use only to
review or proof the study material. You should not reproduce or distribute the materials without permission
from CPA Australia.
CPA PROGRAM
ETHICS AND
GOVERNANCE
Version 16a
Published by Deakin University, Geelong, Victoria 3217 on behalf of CPA Australia Ltd, ABN 64 008 392 452.
First published January 2010, reprinted July 2010, revised January 2011, July 2011,
reprinted January 2012, July 2012, updated January 2013, reprinted July 2013,
updated January 2014, reprinted July 2014, revised January 2015, updated January 2016.
© 2001–2016 CPA Australia Ltd (ABN 64 008 392 452). All rights reserved. This material is: owned or
licensed by CPA Australia and is protected under Australian and international law. Except for personal and
educational use in the CPA Program, this material may not be reproduced or used in any other manner
whatsoever without the express written permission of CPA Australia. All reproduction requests should be
made in writing and addressed to: Legal, CPA Australia, Level 20, 28 Freshwater Place, Southbank, VIC 3006
or legal@cpaaustralia.com.au.
Authors
James Beck Managing Director, Effective Governance Pty Ltd
Courtney Clowes Director, KnowledgEquity
Craig Deegan Professor of Accounting, RMIT University
Patrick Gallagher Director, Governance Tax & Risk Pty Ltd
Alex Martin Manager Financial Policy, Australia and New Zealand Banking Group Ltd
Greg McLeod Senior Investigator, Australian Securities & Investments Commission
Roger Simnett Professor, School of Accounting, University of New South Wales
Jennifer Tunny Senior Research Advisor, Effective Governance Pty Ltd
2016 updates
Jeremy St John Faculty of Business and Economics, Monash University
Thomas Clarke Director, Centre for Corporate Governance, UTS Business School
Roger Simnett Professor, School of Accounting and Centre for Social Impact,
University of New South Wales
Acknowledgments
Steven Delaportas Professor of Accounting, RMIT University
Greg McLeod Senior Investigator, Australian Securities & Investments Commission
Michaela Rankin Associate Professor, Monash University
Tehmina Khan Lecturer, RMIT University
Advisory panel
James Beck Effective Governance Pty Ltd
Prof Thomas Clarke University of Technology Sydney
Dr Mary Dunkley Swinburne University
Alan Greenaway Australian Pharmaceutical Industries
Jennifer Lauber Patterson Frontier Carbon Limited
Mike Sewell Clean Technology Innovation Centre
Marcia O’Neill Consultant
Eva Tsahuridu CPA Australia
Educational designer
Deborah Evans DeakinPrime
Acknowledgment
All legislative material is reproduced by permission of the Office of Parliamentary Counsel, but is not the official or authorised version. It is
subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and publication of Commonwealth
legislation. In particular, s. 182A of the Act enables a complete copy to be made by or on behalf of a particular person. For reproduction
or publication beyond that permission by the Act, permission should be sought.
These materials have been designed and prepared for the purpose of individual study and should not be used as a substitute for
professional advice. The materials are not, and are not intended to be, professional advice. The materials may be updated and
amended from time to time. Care has been taken in compiling these materials but may not reflect the most recent developments and
have been compiled to give a general overview only. CPA Australia Ltd and Deakin University and the author(s) of the material expressly
exclude themselves from any contractual, tortious or any other form of liability on whatever basis to any person, whether a participant
in this subject or not, for any loss or damage sustained or for any consequence which may be thought to arise either directly or indirectly
from reliance on statements made in these materials.
Any opinions expressed in these study materials are those of the author(s) and not necessarily those of their affiliated organisations,
CPA Australia Ltd or its members.
ETHICS AND GOVERNANCE
Contents
Subject outline 1
Module 2: Ethics 75
Subject outline
2 | ETHICS AND GOVERNANCE
OUTLINE
Contents
Introduction 3
Before you begin 3
Important information
Subject description 3
Ethics and Governance: The CPA as a professional
Subject aims
Subject overview 4
General objectives
Module descriptions
Module weightings and study time requirements
Exam structure
Learning materials 7
Module structure
My Online Learning
General exam information 10
Authors 10
SUBJECT OUTLINE | 3
OUTLINE
Introduction
The purpose of this subject outline is to:
• provide important information to assist you in your studies;
• define the aims, content and structure of the subject;
• outline the learning materials and resources provided to support learning; and
• provide information about the exam and its structure.
Subject description
Ethics and Governance: The CPA as a professional
Ethics and Governance is a core component of the knowledge and skill base of today’s
professional accountants. As key business decision-makers, accountants must be proficient in
regulatory regimes, compliance requirements, and governance mechanisms to ensure lawful
and effective corporate behaviour and operations. A better understanding of ethics, corporate
governance frameworks and mechanisms links with the various roles and responsibilities outlined
in other subjects of the CPA Program. From an individual perspective, this subject provides
candidates with the analytical and decision-making skills and knowledge to identify and resolve
professional and ethical issues. The skills and knowledge obtained are also important for
subjects that specialise in the functional disciplines of accounting such as Advanced Taxation,
Financial Reporting, Strategic Management Accounting and Advanced Audit and Assurance.
More than ever, today’s professional accountants are less involved in traditional accounting
functions and are more concerned with leadership and management. Today’s accountants are
leaders in their field providing key support to senior management and are directly involved in
many important decisions. An understanding of ethics and governance is essential to those
in leadership roles, and to those who support their leaders. This subject not only develops an
awareness of corporate governance but also helps members (and those whom they support)
in discharging their stewardship functions.
Subject aims
The subject has three key aims:
1. promoting awareness of the ethical responsibilities of professional accountants, thereby
enabling them to identify and resolve ethical issues or conflicts throughout their career;
2. ensuring professional accountants understand the importance of governance, including their
role in achieving effective governance; and
3. understanding the role of accounting, and of accountants, in providing information about
the social and environmental performance of an organisation.
4 | ETHICS AND GOVERNANCE
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Subject overview
General objectives
This subject provides candidates with the knowledge and skills required of the professional
accountant to operate effectively in a demanding and dynamic global business environment.
It is designed to ensure the development of a range of professional ethics, values and attitudes
among professional accountants.
Module descriptions
The subject is divided into five modules. A brief outline of each module is provided below.
Module 2: Ethics
This module discusses the practical implications of professional ethics based on the notion of the
public interest. The module provides an overview of ethical approaches that guide accountants
to help them consider and resolve complex ethical dilemmas. It also provides a detailed analysis
of the Code of Ethics for Professional Accountants (APES 110) and demonstrates how to apply
this Code when addressing specific ethical issues. The module also describes the factors that
influence ethical decision-making and outlines a structured approach to decision-making that
may lead to better decisions.
SUBJECT OUTLINE | 5
OUTLINE
Module 3: Governance concepts
Module 3 covers the key concepts and principles that underpin corporate governance approaches.
The nature of corporate governance, theories of corporate governance and the key components
generally found in corporate governance frameworks are discussed. This includes consideration of
relationships between companies, boards of directors, managers and various other stakeholders.
Major codes and guidance on corporate governance in countries such as the UK and Australia
are considered, as well as the role and impact of differing cultural approaches to corporate
governance. Governance in other sectors, such as the public sector, is also reviewed. The module
concludes with a discussion of several causes of governance failure that have been identified
and that may arise again in the future, as well as recommendations for improvement.
The module highlights that professional accountants must have a strong understanding of
governance concepts in order to successfully fulfil their duties and obligations and add value
to corporations and entities of all types and sizes.
The module explores some key corporate governance factors relating to corporations and their
boards, shareholders and society at large. Diversity within the corporation and in the boardroom
and its importance for successful decision-making capabilities is addressed. The debate and
mechanisms arising from recent international focus on remuneration practices is considered along
with the growing balance in favour of greater shareholder power over remuneration. The module
also considers a range of operational matters that are important within corporations and in
respect of which day-to-day attention to rules is important—including in relation to employment
conditions and protections. Governance for non-corporate entities is also examined.
The module also covers some of the legal fundamentals that apply within a corporate context
and it considers some key aspects of rules that apply internationally and that are designed
to protect competition and consumers. The module concludes with a brief explanation
of some of the rules that relate to financial market protection and that are, inevitably,
highly consistent internationally.
Do not underestimate the amount of time it will take to complete the subject.
The ‘weighting’ column in the following table provides an indication of the emphasis placed
on each module in the exam, while the ‘proportion of study time’ column is a guide for you to
allocate your study time for each module.
Recommended
proportion of Recommended
Module study time (%) Weighting (%) study schedule
2. Ethics 20 20 Week 2, 3, 4
100 100
Exam structure
The Ethics and Governance exam comprises a combination of multiple-choice and extended-
response questions. Multiple-choice questions will include knowledge, application and problem-
solving questions that are designed to assess the understanding of ethics, governance and
corporate social responsibility content.
Extended-response questions will relate to the case studies provided in the exam. Candidates will
be required to comprehend case facts, recognise and isolate relevant issues, and critically analyse
the facts presented and apply them to the concepts in the study guide to reach a conclusion.
The case studies will predominantly require application and problem-solving.
Strategy, leadership and international business themes may provide contexts for assessment
in the exam.
OUTLINE
Learning materials
Module structure
These study materials form your central reference in the Ethics and Governance subject.
Contents
Each module has a detailed contents list. This list indicates the sequence of the educational
content in the module.
Preview
Each module begins with a preview containing the following sections.
Introduction: The introduction outlines what will be covered in the module and how it relates
to other modules in the subject.
Objectives: A set of objectives is included for each module in the study guide. These objectives
provide a framework for the learning materials and identify the main focus of the module.
The objectives also describe what candidates should be able to do after completing the module.
Teaching materials: This section alerts you to the required teaching material (if any) to which you
should have ready access. It also includes a list of readings which are to be used in conjunction
with the module study material.
Study material
The study material is divided into sections and subsections that will help you conceptualise the
content and study it in manageable portions. It is also important to appreciate the cumulative
nature of the subject and to follow the given sequence as closely as possible.
The purpose of the questions and case studies is to provide you with the opportunity, as you
progress through the subject, to assess your understanding of significant points and to stimulate
further thinking on particular issues. The self-assessment activities are an integral part of your
study and they should be fully utilised to support your learning of the module content throughout
the semester. You are encouraged to spend time reviewing and analysing the module content.
Utilising the self-assessment activities should form one part of your revision for the exam. It is
evident that candidates who achieve good results in the program and in their careers are those
who are able to think, review and analyse situations, and solve problems.
Where applicable, sample answers are included at the end of each module. These provide
immediate feedback on your performance in comprehending the material covered. Your answers
to these questions do not contribute to your final result, and you are not required to submit
your answers for marking.
8 | ETHICS AND GOVERNANCE
OUTLINE
Revision questions. These require you to prepare answers and to compare those answers with
the suggested answers before continuing with the study material. These questions test your
comprehension of specific sections of a module.
Case studies. These are much broader in scope than revision questions. They illustrate practical
problems that an accountant might face. The case studies require you to apply the theoretical
knowledge you studied in the module to a particular situation. To be able to adequately address
issues raised in case studies, a deep understanding of the module content is required. Simply
memorising definitions and lists of technical details is insufficient.
While issues may be relatively clear in some case studies, it is important to realise that often
the case studies will have no correct/incorrect outcomes. The outcomes are quite possibly best
expressed as different viewpoints on problem situations, where viewpoints are supported by
reference to relevant theoretical principles. Moreover, the essence of the case may depend
on interpretation of the relevant concept rather than a simple restatement of that principle or
concept. For this reason, no ‘solutions’ to case studies are provided. Instead, responses to cases
are included in comprehensive case notes. To obtain maximum benefit from your case study
work, and to provide the best preparation for the case scenario section of the subject exam,
it is important to allow adequate time for in-depth analysis of case studies and to thoroughly
work through case materials and prepare a written response to case issues before you check
your responses against the notes/answers provided.
Review
The review section places the module in context of other modules studied and summarises
the main points of the module.
References
The reference list details all sources cited in the study guide. You are not expected to follow up
this source material.
Optional reading
The resources in the ‘Optional reading’ list are useful if you wish to explore a particular topic in
more detail.
Required readings
Readings are provided to assist in the clarification and application of concepts from the study
materials. The content of readings is not directly examinable. However, the concepts covered
by the readings are examinable.
Suggested answers
These provide important feedback on the numbered revision questions and case studies
included in the module learning materials. Consider them as a model for your reference.
To assess how well you have understood and applied the material supplied in the text,
it is important to write your answer before you compare it with the suggested answer.
SUBJECT OUTLINE | 9
OUTLINE
Internet references
At various points in the subject materials you may be directed to references located on the
internet and many of these are on external websites. All the URL addresses cited are tested
prior to the start of the semester to ensure their currency; however, this does not guarantee that
changes have not been made to the websites since the tests were performed. CPA Australia
provides links to external websites as a service to candidates in the CPA Program. CPA Australia
does not own, operate, sponsor or endorse these external websites and makes no warranties or
representations regarding the source, quality, accuracy, merchantability or fitness for purpose
of the content of these external websites; nor warrants that the content of these external
websites is free from any computer virus or other defect or error.
My Online Learning
CPA Australia offers additional study material through My Online Learning to assist candidates
in their study. Your study guide forms your central reference for examinable material. You must
also check My Online Learning for any study guide updates that will be posted there, as these
are considered part of the study guide.
There are many learning resources available to you in My Online Learning, such as self-
assessment questions and online activities. For example, to explain the importance of ethics
and governance in accounting practice there are introductory and expert videos. Modules 2,
3, 4 and 5 are supported by four case studies covering a range of issues and there is also
a Business Simulation that will give you an opportunity to explore an ethical dilemma in a
business situation. We recommend that you take the time to look through these resources
and become familiar with them.
You can access My Online Learning from the CPA Australia website:
cpaaustralia.com.au/myonlinelearning
CPA Program exams are open book. This means that candidates may bring any reference
material into the exam that they believe to be relevant and that may assist them in undertaking
the exam. This may include, for example, the study guide, additional materials from My Online
Learning, readings and prepared notes.
For this subject, candidates are not required to have access to a calculator in the exam.
However, should you wish to bring a calculator, please ensure that the calculator is compliant
with CPA Australia’s guidelines. The calculator must be a silent electronic calculating device
whose primary purpose is as a calculator. Calculators with text-storing abilities are not permitted
in the exam.
The exam is based on the whole subject, including the general objectives, module objectives and
all related content. Where advised, relevant sections of the CPA Australia Members’ Handbook
and legislation are also examinable.
As this exam forms part of a professional qualification, the required level of performance is high.
Candidates are required to achieve a passing scaled score of 540 in all CPA Program exams. Further
information about scaled scores and exam results is available at: cpaaustralia.com.au/cpaprogram.
Authors
James Beck BSc (Hons) RMC Duntroon GAICD
James is Managing Director of Effective Governance.
Effective Governance is a specialist governance firm,
committed to helping boards add value and improve
organisational performance through education, research and
advocacy for good governance. He has substantial experience
in senior management, management consulting and delivery,
which has been established through a strong focus on
his clients over the last 20 years. Over that period he has
gained in-depth knowledge in governance and designing/
implementing strategic solutions to address business
requirements of both government and private clients. As a
partner at PricewaterhouseCoopers, he previously held
the role of Education Leader for five years. James is co-author
of Directors at Work: A Practical Guide for Boards.
SUBJECT OUTLINE | 11
OUTLINE
Courtney Clowes CPA, BCom (Hons) Deakin
Courtney is a director of KnowledgEquity and provides
educational, training and development services to a number
of corporate, government and professional bodies. He is an
experienced author and presenter of professional development
courses, conferences and workshops. Courtney also provides
strategic and business management services to organisations in
a range of industries, including automotive, energy, design and
manufacturing, fast-moving consumer goods, and financial
planning. Such services include detailed analysis of financial
position and performance, reviews of budgeting and strategic
planning processes, cost control strategies and use of financial
information for decision-making.
OUTLINE
Jennifer Tunny BA (Hons) UQ
Jennifer is Senior Research Advisor for Effective Governance.
Effective Governance is a specialist governance firm committed
to helping boards add value and improve organisational
performance through education, research and advocacy for
good governance. Since joining the firm in 2001, Jennifer
has assisted in the preparation of books and academic and
practitioner articles. She has played a key role in research and
in the development and preparation of teaching materials used
in governance training courses throughout Australia. Jennifer
is co-author of Directors at Work: A Practical Guide for Boards.
Since 1996, Greg has also been a part-time lecturer and tutor in
accounting ethics and corporate accounting at RMIT University.
Greg is involved in reviewing and preparing lecture notes and
assessment. For the last 10 years, Greg has been a presenter
for CPA Australia at workshops on accounting ethics.
OUTLINE
ETHICS AND GOVERNANCE
Module 1
ACCOUNTING AND SOCIETY
* CPA Australia gratefully acknowledges the many authors who have contributed to this module.
16 | ACCOUNTING AND SOCIETY
Contents
Preview 17
Introduction
Objectives
Teaching materials
Review 57
Readings 59
Reading 1.1 59
Reading 1.2 63
Suggested answers 65
References 71
Study guide | 17
Module 1:
Accounting and society
STUDY GUIDE
MODULE 1
Preview
Introduction
This module takes an in-depth look at what it means to be a professional accountant.
The terms ‘profession ‘or ‘being a professional’ are well known and regularly used today.
This module examines what it is that sets certain occupations apart from others and why some
are regarded as professions and others are not. It also looks at what expectations being a
member of a profession places on individuals.
The nature of a profession and the attributions of a profession are discussed, along with the
self‑regulatory nature of professions, which is a key to their continued status in society.
The module then looks further into the role that the accounting profession plays in society.
Accounting is of such importance to society that it is considered a social force because it effects
changes on organisations, people and their lives and, consequently, entire societies.
The accounting profession has faced significant challenges in recent history. These have,
to some degree, damaged the credibility of the accounting profession. These challenges will
be considered in this module, along with the steps that have been taken by governments,
regulators and the profession to address them.
The module also considers the work environment, roles and activities that a professional
accountant can work in, and the relationships that are created through these roles. The roles
accountants can hold are diverse, and opportunities exist in many sectors and areas of expertise.
18 | ACCOUNTING AND SOCIETY
Objectives
After completing this module, you should be able to:
• describe the nature and attributes of a profession;
• explain the co-regulatory processes of the accounting profession;
• differentiate the roles, relationships and activities of accountants;
• evaluate the challenges faced by the accounting profession in the global context; and
• explain the importance of soft and technical skills required of accountants.
Teaching materials
MODULE 1
• Readings
Reading 1.1
‘Profile: Roel van Veggel—The sweet sounds of success’
IFAC
Reading 1.2
‘How “soft skills” can boost your career’
J. Jarvis
• The Compiled APES 110 Code of Ethics for Professional Accountants (APESB 2013),
accessed August 2015, http://www.apesb.org.au/uploads/standards/apesb_standards/
compiledt2.pdf.
Module 1 readings are placed after the main text of the module. All readings are important and
must be read in full.
Study guide | 19
MODULE 1
Public interest or self-interest?
Economies and societies require the free flow of accurate information to function efficiently.
The efficiency of market economies is particularly dependent upon disclosure of accurate
financial information. The accounting profession is integral to the process of ensuring people
have access to accurate information. In analysing and presenting information, the professional
accountant needs to be able to clearly distinguish between what information is in the public
interest to be disclosed, and any sense of self-interest. Ultimately, the accounting profession
will only retain its integrity and authority by serving the wider public interest. The ideals of
professionalism and the essential principles of entrepreneurship are compatible when it is
understood that the essential basis of business is trust.
Accounting information is relied on heavily by people who make significant decisions about
the allocation of resources. Accountants, therefore, serve the public interest by creating
and distributing information that conveys a clear and accurate picture of an entity’s financial
performance, financial position and other relevant issues.
Professional accountants also serve the public interest by providing objective, accurate and
appropriate financial and accounting-related advice that is free from bias and based on expertise.
Further descriptions of how accounting, as a profession, serves society are provided later in
this module.
This focus on acting with integrity, objectivity and without bias is linked to the idea of altruism.
The term ‘altruism’ describes action that brings no benefit to an individual and may even be
at their own expense. This view then aligns with the concept that professional accountants
act in the public interest.
However, altruism may not be the driving motivation. Like West (2003), Larson (1977) is
concerned that monopolistic professionals are not motivated by a service ideal or the public
interest. Larson considers there is evidence to suggest that professions and professionals are
about maintaining monopolies and extracting unwarranted wealth and influence from that
position. This could be more accurately described as self-interest or enlightened self-interest,
rather than altruism.
20 | ACCOUNTING AND SOCIETY
Responsible decision-making
When accountants make a decision it is within a systemic framework of principles. These include
governance, accountability and ethics. This means as a member of a profession an accountant
cannot simply make decisions according to personal preferences. The skill and knowledge of
the accountant must be exercised firstly within the governance framework of the profession,
which stipulates certain codes of behaviour. Also, decision-making must be within the relevant
corporate governance framework of the entity concerned, not only in terms of the instruments
and articles of association, but in terms of the policies and strategies that have been formally
approved by the board of directors.
MODULE 1
Also, in conducting accounting work and reaching decisions this must be completed within a
framework of accountability, in terms of the requirements of regulatory authorities, and with the
appropriate disclosure to shareholders and other stakeholders.
Finally, the work of the accountant and any decisions taken must be exercised within a framework
of ethical conduct that informs all aspects of the accountant’s work, which is based on a
commitment to integrity and honesty in the pursuit of professional purposes and client interests.
When all these principles are recognised there is the possibility of effective action and decision-
making as illustrated in Figure 1.1. Within a framework of good governance, corporate
accountability and robust ethics, the accountant’s work will be more authoritative.
Governance
Corporate
Ethics
accountability
Westpac Bank in Australia has, in recent years, consistently performed exceptionally well in
international corporate governance and corporate responsibility indices.
Study guide | 21
Westpac has shown how it is possible to be commercially successful and committed to the
highest standards. The opening statement on corporate governance in the Westpac group
website is:
Corporate governance is about promoting fairness, transparency and accountability by setting
out the rights and responsibilities of the Board, management and shareholders.
Growing evidence links good governance and enhanced shareholder returns. More than just
showing a further commitment to doing the right thing, good governance is a strong indicator of
overall management capability and quality.
Source: Westpac Group 2014, ‘Corporate governance’, accessed August 2015, http://www.westpac.com.
MODULE 1
au/about-westpac/westpac-group/corporate-governance/corporate-governance-overview.
In Westpac’s Corporate Governance Statement of the company there is a clear definition of the
ethical commitments of the bank:
• we act with honesty and integrity;
• we comply with laws and with our policies;
• we do the right thing by our customers;
• we respect confidentiality and do not misuse information;
• we value and maintain our professionalism;
• we work as a team; and
• we manage conflicts of interest responsibly.
Source: Westpac Group 2014, ‘Corporate Governance Statement’, accessed August 2015,
http://www.westpac.com.au/docs/pdf/aw/Corporate_Governance_Statement.pdf.
The focus of each of the principles is to provide a set of guiding principles to help us make the
right decisions ensuring we uphold the reputation of the Group.
In explaining how the bank’s ‘Principles for Doing Business’, which underpin its commitment to
sustainability and the community, Westpac’s annual report states:
• we believe our success depends on the trust and confidence placed in us by our customers,
people, shareholders, suppliers, advisers and the community;
• we believe in maintaining the highest level of governance and ethical practice while protecting
the interests of our stakeholders;
• we believe in putting our customers at the centre of everything we do;
• we believe our people are a crucial element of a successful service business;
• we are committed to managing our direct and indirect impacts on the environment;
• we believe being actively involved in our community is fundamental to the sustainability of our
business; and
• we believe our suppliers should be viewed as partners in our sustainability journey.
Source: Westpac 2014 Interactive Annual Review & Sustainability Report, accessed September 2015.
http://www.westpac.com.au/about-westpac/investor-centre/financial-information/annual-reports/.
In fact, all four of the large Australian banks CBA, ANZ, NAB and Westpac have adopted very
robust standards for corporate governance, accountability and business ethics. They have built
these principles into their fundamental business models, and this could be part of the reason why
Australian banks have enjoyed substantial commercial success over recent decades and fared
relatively well during the global financial crisis (GFC).
22 | ACCOUNTING AND SOCIETY
However, the fact that each of the Australian banks have experienced some issues of governance,
accountability and ethics from time to time (particularly in the area of financial advice), and
financial institutions in other advanced countries have experienced much greater problems,
is a reminder that all corporations need to remain vigilant in these endeavours.
It is often the case that examples of good corporate governance, accountability and ethical
conduct are drawn from leading corporations of the advanced industrial countries. However,
these principles are, if anything, even more essential if enterprises are to succeed in emerging
economies. In a report titled Corporate Governance Success Stories, the International Finance
Corporation (2010) demonstrates how critical these principles are to successful businesses in the
MODULE 1
Enlightened self-interest
Inevitably, in a market economy the economic self-interest of a profession will be an important
driver of behaviour. However, this should never be allowed to outweigh the primary commitment
to the public interest. The term ‘enlightened self-interest’ suggests that both purposes may be
served together; that is it is possible to be committed to the public interest and yet possess a
degree of self-interest. The phrase sometimes employed is ‘doing well by doing good’.
But if enlightened self-interest leads to actions that are not the right and ethical thing, but that
will further a person’s own interests—this is not acceptable professional behaviour. There is a
careful balance to be maintained between serving the public interest and pursuing self-interest,
and it is the public interest that is paramount. Can the public interest and self-interest really be
integrated in a form of ‘enlightened self-interest?
This concept of enlightened self-interest is described by Lee (1995) as protecting the public
interest in a self-interested way, and is also explained in the following quote, which shows how
enlightened self-interest and the public interest may be integrated:
The accounting profession would account for its existence in relation to the efficiency benefits for
society as a whole, arising from the existence of an institutionally organised body of accounting
knowledge … In return for their monopoly position concerning the right to practise particular
accountancy and auditing functions, accountants would see themselves as serving the public
interest (Robson & Cooper 1990, p. 379).
Ideals of accounting—entrepreneurialism
and professionalism
Some argue that professions never really had a public interest or service ideal (Johnson 1972;
Abbott 2014). Others believe it may have existed in the past, but has been abandoned for a
more lucrative role as ‘partner in business’ (Saravanamuthu 2004). Carnegie and Napier (2010)
identify the ideals of accounting professionalism as comprising ‘the four Es’ of education, ethics,
expertise and entrepreneurship. According to these authors, placing too strong an emphasis
on entrepreneurship, especially where it involves a de-emphasis on any of the other ideals,
may result in a ‘de-professionalisation’ of accounting. This de-professionalisation may occur
because the pursuit of commercial opportunities moves an accountant away from integrity,
objectivity and professional behaviour in order to achieve commercial success.
Study guide | 23
Accountants are often in a position of power that can create an ‘ethics versus profits’ dilemma.
Examples of accountants pursuing self-interested outcomes at the expense of their ethical or
professional standards have been linked to the corporate collapses of the early 2000s, and more
recently when we consider the failures of organisations, such as Lehman Brothers in the GFC
of 2008–2009. In these cases of systemic failure it was clearly demonstrated in all of the official
reports by the US Congress, UK parliament and others that not only had financial executives
failed, but all of the associated professionals and regulators had some responsibility in allowing
MODULE 1
the failures inherent to develop into a crisis (US FCIC 2011; UK HCTR 2009).
These points identify the potential conflicts that members of a profession may face, where
they must, at times, choose between their own self-interest, and the public interest and their
responsibility as members of a profession.
We will further consider why trust in professions is so important and look at the key attributes
of the accounting profession. An in-depth analysis of these attributes will emphasise the
co‑regulating nature of the profession and how, as a result, professions are able to continue
maintaining their status and valued role in society today.
What is a profession?
A profession is defined in the Oxford Dictionary as an occupational area or vocation that
‘involves prolonged training and a formal qualification’.
A profession is based on a high level of competence and skills in a given area, which are
learnt through specialised training and maintained by continuing professional development.
Members of professions are expected to behave ethically and in the best interests of society.
There is a difference between the concept of a ‘profession’ as defined by the established
professional associations, which carry many obligations and attributes (see list), and the wider
reference to somebody being ‘professional’, which simply means they complete their work with
dedication and skill (attributes to be highly valued in any occupation).
The key attributes listed below, combined together as a group, provide valuable guidance in
recognising the existence of a profession (elements of these attributes were originally derived
from Greenwood, and have since been developed further. The existence of these attributes
tends to confirm the existence of a profession:
• systematic body of theory and knowledge;
• extensive education process for its members;
• ideal of service to the community;
• high degree of autonomy and independence;
• code of ethics for its members;
• distinctive ethos or culture;
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Source: Adapted from Greenwood, E. 1957, ‘Attributes of a professional in social work’, in S. Loeb
(ed.) 1988, Professional Ethics in Accountancy, Wiley, Santa Barbara, California.
It must be noted, however, that there is no clear distinction between an occupation and a
profession. It is suggested that there is a continuum of the degree to which these attributes are
displayed so that professionals are only distinguished from non-professionals by a higher level
of standards
Another feature of a profession is that it often leads to greater status and wealth for its members.
This is often a result of the members’ specialised skills and the level of monopoly control.
Monopoly control describes the situation where members of the profession control who is
allowed to work in the industry by establishing licensing rules and regulations. This creates
protection against competition. An example of this exclusivity is the requirement under the
Corporations Act 2001 (Cwlth) where a company auditor must be a member of a professional
accounting body (such as CPA Australia).
Early authors argued that professions exist primarily to serve society, and this view persists today.
In this view, often called the ‘service ideal’, it is accepted that professions should both serve
society and act in the public interest.
The services provided by professions are so important that high levels of expertise are required.
This expertise calls for extensive educational programs focused on the development of
intellectual skills, knowledge and experience, with an emphasis on lifelong updates.
Self-regulation
Most of the time professions are given permission to provide services to the public through
some regulatory process. For example, in many countries only doctors of medicine are allowed
by law to prescribe certain drugs.
Once accorded the relevant permissions, it is common for the professions to have a substantial
degree of independence or autonomy. This means they have a greater level of authority to set
their own rules and regulations, and have less detailed government regulation.
Autonomy allows members of a profession to be judged by their informed peers, rather than
by regulators whose knowledge is inevitably more limited and may have a bias resulting from
less experience.
Autonomy also enables internal penalties, or sanctions, for matters that a legal process might
ignore or not be able to identify (e.g. ethical breaches of a professional code of conduct that are
not legal breaches).
It is also common for professions to apply internal sanctions in addition to legal sanctions, if a
member has been found in breach of the law and has brought the profession into disrepute.
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From self-regulation to a co-regulatory process
Members provide services to society in their field of expertise and society benefits from the
service provided. Society trusts the profession to act in its best interest and values the service
provided. There is a potential negative outcome from this autonomy if the profession fails to
properly demonstrate self-control and self-regulation and does not hold its members to account
when they act inappropriately. If members of a profession act in an unethical way, they are
seen not to be acting in the best interest of society. If this is allowed to continue through lack
of self‑regulation, trust in the profession will be eroded and the value and the status of the
profession will be destroyed.
Due to a large number of corporate failures and the poor conduct of some accountants,
this erosion of trust has occurred in the accounting profession. As a result, some of the authority
to self-regulate has been removed from the accounting profession. Regulations from external
sources are also in place, so the profession has moved from a situation of self-regulation to
co‑regulation, with regulation shared between the profession and external sources. Examples of
co-regulation include the involvement of the Australian Financial Reporting Council, which is a
government body, and the regulations within the Corporations Act, which have given auditing
and accounting standards the force of law. This issue is discussed in more detail later.
What is a professional?
The term ‘professional’ refers to the members of a profession and much of the previous
discussion about professions is directly relevant to this question. A professional is a person
who has a significant level of training and a high level of competence and skills in an area.
They behave in an ethical and appropriate manner and apply their skill and judgment in areas of
importance. The process of becoming a professional is sometimes described as the development
from a technician (i.e. someone who has technical knowledge about how to perform specific
tasks in a given area), to someone who uses their knowledge and experience in that area to make
judgments of importance to the public interest. The description of a profession that has been
used so far in this module is often called the ‘traditional’ or ‘functional’ view of professionalism.
As discussed, professions are recognised as offering important advantages to society by
undertaking complex tasks and functions on its behalf. In return, the professions are accorded
a privileged position in society.
Later in this module we will examine in more detail each of the attributes of a profession as they
apply to the accounting profession.
26 | ACCOUNTING AND SOCIETY
Not everybody believes professions are necessarily so valuable—and for some, the concept of
the ‘service ideal’ has often been replaced by visible greed. One common perception is that
professionals are self-serving monopolists whose professional bodies exist principally to maintain
membership exclusivity. Denial of entry of non-members into an industry or occupation maintains
the monopoly.
An extreme example of this would be the case of Andersen (previously Arthur Andersen, one of
the world’s largest professional accounting firms) in relation to the failure of HIH Insurance. We find
ourselves immediately questioning the motivations of Andersen’s partners. Andersen was the
auditor of HIH, which was, until its failure, Australia’s largest insurance company. Its failure was
rapid and spectacular and took place at about the same time Enron failed in the US in 2001/2002.
(This was the accounting firm that also audited Enron and WorldCom that both experienced major
bankruptcies, which were not flagged in their audit reports. As a result of a court case against
Andersen’s role in the Enron failure, Andersen itself was put out of business, despite the shell
company winning the case on appeal). These three cases of HIH, Enron and WorldCom were the
most graphic illustrations of corporate failure in this period, and Arthur Anderson featured in each
of them (McLean and Elkind 2004; Jeter 2003; Westfield 2003).
There were a number of unacceptable financial and management practices at HIH, including a
series of illegal transactions resulting in numerous people being convicted and jailed.
Examples such as this have a highly negative impact on the reputation of the accounting
profession.
Therefore, it is not surprising, as West points out, that ‘images of altruism, ethical service and
self-regulation were supplanted by a portrayal of professions as self-interested collectives’
(West 2003, p. 21).
Study guide | 27
Ultimately, the way the public regards a particular profession will control the rights granted to the
profession and the professionals working within it. Public trust regarding any profession is vital.
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If a profession loses credibility in the eyes of the public, the consequences can be severe for
the public, the profession and the profession’s members.
In the wake of the early 2000s collapses of Enron, WorldCom and HIH Insurance, and the
demise of the global accounting firm Arthur Andersen, the accounting profession worldwide
experienced the effects of a credibility crisis. The international bank failures during the GFC also
caused doubt about the credibility of accounting standards and the reliability of the professional
work of accountants. Institutional failure, business collapses and widespread doubt about the
integrity of financial information hurt all levels of society.
So how can a profession sustain its relevance, credibility and the public’s trust?
Source: Adapted from Greenwood, E. 1957, ‘Attributes of a professional in social work’, in S. Loeb
(ed.) 1988, Professional Ethics in Accountancy, Wiley, Santa Barbara, California.
As you read through this section you should consider what it will mean for you to be a professional
and member of the accounting profession.
Thus, theory construction by means of systematic research becomes an essential basis for the
development of a profession and for professional practice.
28 | ACCOUNTING AND SOCIETY
The educational process for accountants is one of lifelong learning that commences with the first
study of accounting. The International Federation of Accountants (IFAC) has issued International
Education Standards that outline the core competencies all aspiring accountants must satisfy in
order to be recognised as a member of the profession, and of a professional body.
All IFAC member bodies must abide by the requirements in these standards when designing the
content and assessment of their education programs. The aim of the standards is to ensure an
equivalent level of competence and knowledge for all members of the accounting profession.
The standards cover technical knowledge, soft skills and professional competence, and they
provide a framework for professional bodies to assure the quality of their education programs.
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Importantly, their knowledge and skills will be further enhanced by the accumulation of
knowledge and experience through mentoring, professional development and continuing
education programs. Throughout their careers, all professionals must maintain their knowledge
and skills.
As part of the commitment to lifelong learning for the accounting profession so as to ensure
all members possess current knowledge and skills, IFAC has issued a standard prescribing the
requirements for ongoing professional development. All CPA Australia members must undertake
ongoing professional development throughout their careers.
According to Buckley (1978), society grants the professions monopoly power over professional
affairs and the power to use this monopoly power as they see fit, as long as the power is used
in the public interest. Any profession that deliberately and consistently breaches this trust does
so at its own risk. This trust is an important part of the philosophical notion of a ‘social contract’.
As Wilensky (1964, p. 140) observes, ‘any profession that abandons the service ideal will very
quickly lose the moral claim to professional status’.
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Continued erosion of public trust by unethical behaviour may lead ultimately to extreme
governmental intervention in the profession’s affairs, with consequent reduction of autonomy,
authority and reputation. Therefore, each member of a profession has a responsibility, and an
obligation, to behave in a manner that maintains the reputation of the profession.
The Compiled APES 110 Code of Ethics for Professional Accountants (APESB 2013) specifies
the fundamental principles of acceptable professional conduct for professional accountants.
These are reviewed in detail in Module 2.
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• the well-being of society;
• the pursuit of excellence; and
• community service.
Community service
Many accountants offer their time and skills free of charge to the community. This is sometimes
described as pro bono, a Latin term meaning ‘for the good’, which indicates the provision of
unpaid work for the public good. Various kinds of pro bono work may include:
• membership of finance committees for church groups, charities and schools;
• providing financial counselling and other advice to people referred by community welfare
groups; and
• holding honorary positions on hospital and university boards.
True professionals bring the same care and skill to such volunteer work as they bring to assignments
they are paid for. Note that as a member of the accounting profession, an accountant is held to the
same level of responsibility for all their work, whether it is paid or unpaid.
➤➤Question 1.1
Discuss whether acts of public service are considered as purely political actions designed to
maintain the profession’s status in the eyes of the community.
30 | ACCOUNTING AND SOCIETY
Example 1.1: C
o-regulatory approach to setting accounting
standards in Australia
In Australia, accounting standards are developed by the Australian Accounting Standards Board (AASB)
and auditing standards are developed by the Auditing and Assurance Standards Board (AUASB). Until
recently, these boards were created and controlled by the professional accounting bodies in Australia.
There are three major professional accounting bodies in Australia: CPA Australia; the Chartered
Accountants Australia and New Zealand (previously the Institute of Chartered Accountants (ICAA));
and the Institute of Public Accountants (IPA).
This has now changed, and the AASB and AUASB report to the Australian Financial Reporting Council
(FRC), which is a government body. While the professional bodies have a number of their members on
the AASB and AUASB boards, they no longer have the complete regulatory control they had previously.
This has been a natural evolution of accounting standard setting, where a stronger regulatory framework
has been required. The professional accounting bodies are still very involved, but their involvement
is tempered by overarching regulation and FRC control.
The member must be allowed to use their professional judgment free from the direction or
influence of others, and detached from the risk of financial gain (or loss) as a result of the advice
provided. The member must also be free from fear of reprisals. In other words, the professional
person’s judgment should be autonomous in the literal sense of the term (i.e. governed by
their own professional rules and laws and not influenced by inappropriate outside interests).
Autonomy in this sense implies a self-principled, ethical and responsible approach by
the member.
For a professional accountant in public practice, the specific attribute of independence becomes
more important in relation to the concepts of objectivity and integrity. At times the accountant
may be torn between meeting the requirements of the client to report in a given way and
maintaining their own ethical compass and professional obligations.
The ethics of the professional accountant can be tested in these circumstances, and maintaining
independence and autonomy from the client will help the professional accountant ensure the
most appropriate position is adopted.
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A complex set of regulatory structures and practices have been developed around the public
accounting profession. These regulatory structures and practices attempt to define the technical
and ethical responsibilities that accountants owe to their employers, clients, third parties and
the public.
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The regulatory structures of CPA Australia include:
• a system of accreditation for accounting degree programs to ensure that the relevant body
of knowledge is acquired by future members;
• a membership qualification process by way of examination and required practical experience;
• a requirement for high levels of continuing professional education;
• a code of ethics that must be complied with; and
• a disciplinary process to address member misconduct.
A brief overview of the code of ethics is provided in the following commentary. Later in this
module, we discuss the role of the Accounting Professional and Ethical Standards Board and the
disciplinary procedures designed to enforce compliance with accounting and auditing standards.
The Compiled APES 110 Code of Ethics for Professional Accountants (APESB 2013), various
other APES statements and the Constitution of CPA Australia provide a guidance and discipline
framework for members of CPA Australia. Relevant legislation, such as corporate law and
accounting standards regulation, also provides a framework that members of CPA Australia
must follow.
Professional ethics in its simplest form is behaviour that is consistent with the APESB Code
of Ethics, and behaviour that contravenes the Code is considered unprofessional. The Code
attempts to deter unethical behaviour or, alternatively, promote desirable behaviour by
stipulating acceptable and unacceptable conduct.
As part of working in a global market, we find that in different cultures and nations, different
behaviours are seen as acceptable or unacceptable. This raises challenges for professional
accountants, in fact all professionals, because there is a need to be true to the ethical guidelines
of a profession without causing others to feel that their behaviour is unethical. An example of this
is the payment of bribes, which in some countries is seen as unethical and corrupt, but in others
is a part of business dealings that is sometimes tolerated (albeit a part of business dealings that
invariably leads to the undermining of the economies in which it takes place, and to inefficiency
and nepotism replacing business dealings based on quality, efficiency and capability).
32 | ACCOUNTING AND SOCIETY
The norms of a professional group comprise both formal and informal characteristics.
New members become familiar with the professional culture in a variety of ways. Creating a
culture and a sense of belonging are very important in maintaining a professional organisation
that is kept vital by new and interested membership—a key part of the ongoing value of the
profession itself.
Symbols of a profession may include its insignia, emblems, certification and titles (e.g. ASA,
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CPA or FCPA). Culture and ethos stem from formal history, significant milestones, jargon,
stereotypes and folklore.
To succeed in their chosen profession, a new member needs to learn about the culture and ethos
of the profession, and to become part of the culture and ethos. A key to evolutionary growth
is that new members must contribute to the ethos and the culture of the profession to ensure
change happens in ways that are desirable for the community and the profession.
For CPA Australia members our ethos has the word ‘integrity’ as its foundation. This word is at
the heart of CPA Australia’s image, and is seen on our corporate logo.
Since many non-professional occupations insist on practical experience, and since problem-
solving is by no means absent from those occupations, it is important to try to understand what
distinguishes professional judgment from decisions involving technical judgments only.
A major difference, as Schön (1983, p. 17), expresses it, is that professional people must have an
‘awareness of the uncertainty, complexity, instability, uniqueness, and value conflict’ that surround
many of the problems they tackle in practice. This reference to ‘value conflict’ identifies that
complex social values can regularly apply to decisions.
Professionals must choose the outcome that professionally best meets the social ideal of
professions—rather than merely the best outcome for the client at that moment. It is certain
that professionals will make many technical judgments based on technical skills. However, it is
the expectation that professionals can also judge values and make judgments regarding values
(based on professional ethical wisdom) that distinguishes the work of a professional within
a profession.
To emphasise the previous point, Schön also stated that professionals are required to develop
competency in professional judgment, artistry and intuition. These competencies are not only
required in applying knowledge and skills to problem-solving, but also (and Schön would argue,
more importantly) to finding and defining the right problem to be solved. The emphasis on
problem-setting rather than on problem-solving, in turn, requires professionals to communicate
skilfully with their clients and/or employers in order to identify and solve the right problems.
The complexity of understanding the nature of problems may not seem obvious at first, but this
understanding is an essential component in gaining the wisdom required to make values-based
professional judgments. The exercise of professional judgment in the accounting profession is
important for all accountants, irrespective of their work environment or geographic location.
Study guide | 33
One area of concern for professionals is the distinction between a judgment made in error—
a mistake—and a negligently formed judgment.
Many interesting questions regarding the professional judgment of accountants have occurred
in the area of auditing. This is because judgment, and negligence in respect of judgment,
have been tested in the courts, proving the ongoing social impact of the judgments of auditors.
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• deciding whether reasonable assurance or limited assurance is possible;
• ensuring that the budget for the audit is sufficient;
• deciding on an audit plan—including details such as whether in any area, ‘sufficient
appropriate audit evidence’ has been identified and whether such additional procedures
as are required have been undertaken; and
• deciding whether the evaluation of the results is appropriate and ensuring that the
conclusions are soundly based on the evidence examined and that appropriate action has
been taken. It is also important to consider whether the appropriate level of management
has been informed and an appropriate opinion expressed to the relevant authority or,
where applicable, a modified audit report is required.
➤➤Question 1.2
Discuss four situations where accountants may apply professional judgment in the course of
their work.
The governing body of a profession, therefore, has an important enabling role and should:
• speak for the profession as a whole, particularly on those matters of public policy that may
adversely affect the profession’s independence and autonomy;
• ensure that those who enter the profession have the requisite standard of education and
that those practitioners already within the profession continue to keep themselves up to
date with developments in accounting theory and practice;
• encourage the setting and monitoring of high standards of professional conduct;
• apply disciplinary sanctions if standards of professional conduct are not observed.
The power to discipline, therefore, requires the governing body to have the power to
control its members’ activities. Any breach of professional conduct is judged and acted on
by professional peers without public interference, although members who may have acted
illegally may face public prosecution in the courts; and
• ensure high standards of performance and conformance by the professional body itself—
including establishing policies and strategies and appropriate codes of conduct within
the organisation.
34 | ACCOUNTING AND SOCIETY
The governing body must be credible and effective in the eyes of both the members and the
public. Even though the attributes of a profession may be clearly evident, the community’s
view about whether or not a profession deserves to be regarded as a profession is shaped to a
significant extent by how the profession (and its members) actually behave.
The Accounting Professional and Ethical Standards Board (APESB) is an independent body
that sets the professional standards for accountants. The APESB was the result of an initiative
of CPA Australia and Chartered Accountants Australia and New Zealand (CAANZ), which at the
time was called the Institute of Chartered Accountants in Australia (ICAA). The roles of the APESB
are discussed in detail below.
Background
Earlier we highlighted that a high degree of autonomy is an important characteristic of a
profession, and noted how this attribute has been challenged by the regulators with the removal
from the profession of the powers to set accounting and auditing standards. As we have seen,
these powers are now in the hands of the Australian Accounting Standards Board (AASB) and the
Australian Auditing and Assurance Standards Board (AUASB) respectively. These two boards in
turn report to the Australian Financial Reporting Council (FRC).
In regard to auditing standards, the CLERP 9 legislation (Corporate Law Economic Reform
Program (Audit Reform and Corporate Disclosure) Act 2004 (Cwlth)) reconstituted the AUASB as
a body corporate under the Australian Securities and Investments Commission Act 2001 (Cwlth).
Consequently, the AUASB reports to the FRC and not to the professional accounting bodies.
Auditing standards have the force of law under the Corporations Act, which means registered
auditors have a legal duty to comply with auditing standards issued by the AUASB. The AUASB’s
power to approve legally enforceable standards means that all references to ethical requirements
in auditing standards will attract legal status. However, the AUASB has acknowledged that,
while this will result in professional standards having the force of law, it will not reduce or limit
the profession’s own disciplinary activities.
Once professional standards acquired the force of law for auditors, the profession sought a
more rigorous and transparent process for setting ethical requirements. On 4 November 2005,
CPA Australia and the ICAA announced the establishment of the Accounting Professional and
Ethical Standards Board (APESB), an independent ethical standards board to review and set the
code of ethics and professional standards. The formation of the APESB effectively transferred
the setting of professional and ethical standards from the professional accounting bodies to an
independent body.
CPA Australia, CAANZ (previously the ICAA) and the Institute of Public Accountants (IPA)
(formerly known as the National Institute of Accountants) are all members of the APESB.
Members of these three professional associations are required to abide by APESB standards.
The profession acknowledges that, in order to increase public confidence, it needs to open the
professional standard-setting process to greater public scrutiny. While the standards previously
released by CPA Australia and the ICAA were of a high standard and enforced through
appropriate due processes, the profession has an ongoing interest in improving the public’s
perception of its professional standards. Any appearance of self-interest should be removed
and the standards should be written by an independent board.
Study guide | 35
The APESB comprises a technical board and a secretariat to enable it to fulfil this role. The technical
board consists of eight members, including two members from CPA Australia. It comprises
representatives from the public sector, corporate sector, audit profession, academia and the
general public.
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six months of issue;
• referring matters to the secretariat for research, direction and amendment;
• seeking comment on exposure drafts for proposed standards from the public, the professional
bodies and their members; and
• monitoring the effectiveness of professional and ethical standards.
Standard setting
The institutional arrangements for standard setting involve the FRC with oversight responsibility
for the AASB, which deals with standard setting in the private and public sector, and the AUASB,
which deals with the setting of auditing standards.
Practice reviews
To hold a Certificate of Public Practice, members must demonstrate compliance with quality
control standards by annually providing a signed assurance that the established quality control
requirements are being met and by undergoing a practice review. Reviewers appointed by
CPA Australia visit public accounting firms and meet with Certified Practising Accountants (CPAs)
who are partners or principals of these firms. The reviews occur on a five-year cyclical basis. If the
findings of the review are unsatisfactory, the practitioner is required to take remedial action within
an agreed timeframe. Serious deficiencies will result in the instigation of disciplinary procedures.
APES 320 Quality Control for Firms establishes the basic principles of and provides guidance
for a system of quality control that provides reasonable assurance that a firm and its personnel
comply with professional and regulatory requirements. Under this statement, the elements of a
system of quality control include policies and procedures addressing:
• Leadership responsibilities for quality within the firm—policies and procedures to
promote an internal culture that recognises quality is essential in performing engagements.
• Ethical requirements—policies and procedures to provide reasonable assurance that
the firm and its personnel comply with relevant ethical requirements as contained in the
profession’s code of ethics.
• Acceptance and continuance of client relationships and specific engagements—policies
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and procedures to ensure that it will only undertake or continue with engagements where it
has considered the integrity of the client, is competent to perform the engagement and can
comply with the ethical requirements.
• Human resources—policies and procedures to ensure there are sufficient personnel
with the capabilities, competence and commitment to the ethical principles needed to
perform engagements in accordance with professional standards and regulatory and legal
requirements.
• Engagement performance—policies and procedures to provide reasonable assurance that
engagements are performed in accordance with professional standards and regulatory and
legal requirements.
• Monitoring—policies and procedures necessary for ongoing evaluation of the firm’s
system of quality control, including a periodic inspection of completed engagements and
documentation.
If you have worked for a public practice firm, reflect on the way that it approached quality control.
For example, what was covered in your induction program? What procedures and manuals were
used consistently?
➤➤Question 1.3
A merger is being finalised between your public practice and a firm that provides
bookkeeping services. As the partner in charge of quality control, you have not quite
finalised your due diligence on the policies and procedures designed to provide reasonable
assurance that the firm and its personnel comply with relevant ethical requirements.
You are confident that the bookkeeping firm’s policies and procedures are robust, but
you have not yet completed a review of them. You nevertheless assume that there are
no issues, as the firm being acquired only provides bookkeeping services.
A few months after the merger is completed, you receive a phone call from one of
your clients. Your client is concerned because an employee of your firm who performs
bookkeeping services for them has an interest in a business that is one of their major
competitors.
Your client is particularly disturbed because they are in the middle of extremely
confidential business negotiations. The client wants guarantees that your employee will
not have access to any confidential information. You agree to investigate your client’s
concerns (Sexton 2009).
Identify and describe the quality assurance and ethical issues arising from this scenario.
Study guide | 37
Professional discipline
Professional and ethical standards aim to ensure that members of the accounting profession
work to the highest level of professionalism, providing a quality of service that achieves credibility
among the general public and gains their confidence. Members often face personal, financial and
other pressures that threaten their integrity and test their judgment. Unfortunately, in response to
such pressures, some members prioritise self-gain and overlook their duty to protect the interests
of third parties and the trust bestowed upon members by the public. It should be noted that no
profession is totally free of unscrupulous members.
Joining CPA Australia means committing to upholding the reputation of the CPA designation by
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adhering to the obligations spelt out in CPA Australia’s Constitution and By-Laws, the Code of
Professional Conduct and applicable regulations. To ensure all members uphold these standards,
CPA Australia has a formal process that enables complaints about members to be heard and
evaluated and, where appropriate, disciplinary actions to be taken.
Investigations and disciplinary processes are guided by the principles of procedural fairness
(the right for a member to put forward their case), confidentiality, independence and the right
to appeal.
CPA Australia has undertaken to act in the public interest and has an obligation to ensure that
complaints about members are investigated thoroughly, in an impartial and timely manner,
at all times striving to preserve the rights of members while acknowledging the public interest
concerns of complainants.
Investigation and disciplinary procedures form an essential adjunct to the Code of Professional
Conduct. CPA Australia has placed due importance on the area of co-regulation and professional
discipline by establishing an elaborate set of rules and procedures to handle disciplinary matters.
You should now read these parts of the Constitution and By-laws. You can access these documents
via the following links:
cpaaustralia.com.au/~/media/corporate/allfiles/document/about/cpa-australia-constitution-2014.pdf
cpaaustralia.com.au/~/media/corporate/allfiles/document/about/by-laws-effective-17-october-2014.
pdf?la=en
The process for dealing with member conduct is started when a complaint is made. A complaint
may be raised by any person including members of the public, members of CPA Australia or
the General Manager Professional Conduct of CPA Australia.
Types of complaint identified in the Constitution of CPA Australia (clause 39) include:
• obtaining admission as a Member by improper means;
• breaching the Constitution, By-Laws or Code of Professional Conduct;
• dishonourable practice or conduct that is derogatory to CPA members;
• failing to observe a proper standard of professional care, skill or competence;
• becoming insolvent; and
• being found to have acted dishonestly in any civil proceedings.
38 | ACCOUNTING AND SOCIETY
The complainant should first attempt to resolve the matter directly with the CPA Australia
member. Where this initial resolution attempt is unsuccessful, the complainant must lodge a
written complaint providing all necessary details, supported by documentary evidence.
All complaints are reviewed by CPA Australia’s General Manager Professional Conduct (the MPC).
The MPC will determine whether the complaint is relevant and if it is, a file will be opened to
address the issue. The complaint will be allocated to a professional conduct officer (PCO).
The PCO will contact the member against whom the complaint has been made and provide
details of the nature of the issue. The member will be asked to provide an explanation.
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Once the PCO has completed the investigation, a report will be given to the MPC to enable a
recommendation to the chief executive officer (CEO) of CPA Australia as to whether there is
a case to answer.
The CEO must determine whether there is a case to answer based on the MPC’s recommendation
and any relevant external advice. If the member is assessed as having a case to answer, the CEO
must refer the complaint to either the Disciplinary Tribunal or to a One Person Tribunal (OPT),
depending on the circumstances.
The member and complainant will be notified by the MPC that there is a case to answer and the
MPC will refer the case to an investigating case manager (ICM). The ICM will prepare written
particulars of the case and present the complaint at the hearing that will be conducted.
After the hearing of the case, a determination (decision) will be made and the member and
complainant will be advised of the outcome.
It should be noted that the formal complaints process does not investigate issues relating to
fees. Fees charged by members are a commercial matter between members and their clients.
However, the complaints process will consider cases where members are in breach of their
professional obligations, such as those included in the Code of Professional Conduct and APS 12
Statement of Financial Advisory Service Standards. Where the client’s concern relates to the
size of the fee, the client may consider contacting an organisation that mediates commercial
disputes. There is usually a cost involved in using mediation services.
Study guide | 39
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• employers;
• clients;
• employees (if business owners or managers); and
• their peers.
Peers may include work colleagues, other accountants in professional networks and other
accountants who work for the same client in a different aspect of accounting. Maintaining
good-quality professional relationships is an essential part of being a successful professional
accountant.
Many factors influence how an individual will behave in their workplace. These factors include
culture, standards and ethical evaluations. Other variables that impact on an accountant include:
• personal moral development;
• family influences and personal relationships, including those at work;
• the organisational level (business structure and relationships with superiors and
subordinates, etc.);
• laws and regulations; and
• professional aspects (including professional expectations and professional ethics).
These all have an impact on the way problems and issues are dealt with by an individual in the
workplace. A threat to, or excessive pressure on, any of these areas has the potential to result in
unprofessional conduct.
Start-ups
CPAs must be equipped with a range of skills to function as business leaders. Further, our
professional capabilities are mobile, enabling us to work in different geographic locations and
in various work environments.
The public practice environment can be grouped into three types of firms and practices.
These firms are PwC (PricewaterhouseCoopers), Deloitte, Ernst & Young and KPMG. These firms
each have more than 150 000 employees globally and annual revenues in excess of AUD 20
billion each.
It is worth noting that these firms manage the vast majority of audits for all publicly listed
companies and many private companies.
Smaller accounting firms tend to be used by small and medium enterprises (SMEs), which often
have no statutory audit requirements. Accordingly, these practices usually undertake compliance
work that is less related to audit (e.g. tax returns, standard accounting).
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While Big Four firms, and to some extent second-tier firms, offer services that include consulting
and legal divisions, the range of accounting activities for an accountant in public practice are
similar, irrespective of the size of the practice.
The types of roles within public practice work environments include those shown in Table 1.2.
Area Activity
Assurance and audit Financial statement attestation, in which the firm examines and attests
to a company’s financial statements, or other assurance services such as
assessing procedures and controls relating to privacy and confidentiality,
performance measurements, systems reliability, information security and
outsourced process controls.
Taxation services Covers company and individual taxation, fringe benefits tax (FBT), goods
and services tax (GST), capital gains tax (CGT) and international tax issues.
Forensic accounting Specialised area that involves engagement for legal issues including fraud,
disputes or litigation.
Internal audit services Systematic, disciplined approach to evaluating and enhancing risk
management, control and governance processes.
Business advising Assisting business managers to more successfully achieve value. The tasks
involved are varied, often reflecting that businesses have internally
recognised weaknesses or identified that objective external evaluations
and contributions can be valuable. It can also extend to advice on business
re engineering, restructuring, takeovers and mergers.
Role Responsibilities
Board member Elected to the Board of Directors to oversee the activities of the
company or organisation.
Finance director or chief financial Formulation, management and review of the financial and strategic
officer direction of the company or corporate group.
Financial accountant Preparation of general purpose financial reports, the annual report
and special purpose financial reports as required. May supervise a
team of accountants.
Risk manager Quality and risk management responsibility for the business.
Strategic management accountant Preparation of budgets and forecasts, performance measures for
analysing and improving organisational performance.
Company secretary Reporting and regulatory compliance and ensuring, with the chair,
the efficient functioning of the board of directors.
During their career a professional accountant may remain in a particular role or may move
through various functional roles and then on to management levels within the finance area.
Often, professional accountants move into general management roles as a result of the wide
capabilities and skills they acquire during their career.
Professional accountants are also often found on the boards of companies as directors or
company secretaries.
Even with changes in the roles performed and challenges faced, which generally become more
complex as more senior roles are accepted, a CPA must continue to maintain the service ideal
and continue to comply with professional ethical requirements.
Study guide | 43
So what is an SME?
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depending on the country (IFAC 2010, p. 10).
The accounting functions within an SME are broadly the same as in a large business environment.
However, an SME-employed accountant may have to complete more detailed work because
there will be fewer (if any) support staff. Also, the number of areas they need to cover may be
wider but have less complexity compared to a large business environment.
At the same time, because they will know the business and typically be very close to the
ownership (in fact, may even be an owner) and senior management, the professional accountant
in an SME will also often be involved in a range of business decision activities.
It is important to note that in very small SMEs, often no accountants will be employed and
therefore there will be total reliance on an external public accounting practice to perform all
accounting functions.
➤➤Question 1.4
Outline four possible accounting-related roles with an SME and, for each role, identify the tasks
that could be undertaken in that role.
IFAC research
The Professional Accountants in Business Committee (PAIB Committee) of IFAC ‘provides
leadership and guidance on relevant issues pertaining to professional accountants in business
and the business environments in which they work’ (IFAC 2013).
The PAIB Committee in 2005 developed an information paper titled The Roles and Domain of the
Professional Accountant in Business. This paper provides a description of the contemporary roles
that are filled by professional accountants in business (PAIB).
44 | ACCOUNTING AND SOCIETY
Activity Examples
Control Financial control, budgeting and forecasting, and the reduction of waste
through process analysis.
Source: Adapted from The Roles and Domain of the Professional Accountant in Business, Professional
Accountants in Business Committee, p. 4, published by the International Federation of Accountants
(IFAC) in 2005 and is used with permission of IFAC, accessed October 2015, https://www.ifac.org/
publications-resources/roles-and-domain-professional-accountant-business.
We can link these IFAC activities to the roles identified earlier and the different sizes of
private sector businesses. For example, the measurement activity in a large business may be a
management accountant measuring the performance of international freight supplier contracts.
In a small business, the measurement activity may be the financial controller determining a
breakeven sales figure.
In 2008, the PAIB Committee released another information paper titled The Crucial Roles of
Professional Accountants in Business in Mid-sized Enterprises (IFAC 2008). Understanding the
role of accounting in these enterprises is vital for the success of the enterprises and of economies
reliant on such enterprises.
For the paper, IFAC interviewed various accountants in mid-sized enterprises (MEs). The MEs
were chosen because they all had employed accountants, so the multi-dimensional role of
the professional accountant as an employee could be explored. The report summarises the
interviews as follows:
Study guide | 45
Generating Value
The PAIBs featured in this report have identified numerous responsibilities that directly affect the
current and future success of the mid-sized enterprises in which they work …
Their most prevalent duties hinge on helping their companies to generate value by:
• establishing a common ‘performance language’ throughout the company so that everyone’s
activities are aligned with the vision and goals leadership has set;
• upholding business integrity;
• creating, implementing and improving management information systems to bolster strategy,
planning, decision-making, execution and control activities;
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• managing costs through rigorous planning, budgeting, forecasting and process improvement
efforts;
• managing risk and handling business assurance;
• measuring and managing performance; and
• communicating financial and other performance information to internal and external
stakeholders, including regulatory authorities, lenders, bankers and investors in a manner
that fosters trust
Source: This text is an extract from The Crucial Roles of Professional Accountants in Business in Mid‑sized
Enterprises, p. 6, Professional Accountants in Business Committee, published by the International
Federation of Accountants (IFAC), New York in 2008 and is used with permission of IFAC.
The report continues with specific observations about the importance of continuing self-
development by the employed accountants—especially regarding communication.
Study Reading 1.1 ‘Profile: Roel van Veggel—The sweet sounds of success’, which is an excerpt from
‘The Crucial Roles of Professional Accountants in Business in Midsized Enterprises’ (IFAC 2008).
As you review this reading, identify three areas where you have added value in your own workplace.
➤➤Question 1.5
Refer to Reading 1.1.
How did Roel van Veggel add value to Andre Rieu’s business?
The risks involved in offering financial advice are many. It is vital to remember Adam Smith’s words:
this is ‘other people’s money’. That is, any risks involved in the proposed investment strategy are
borne by the client, not the adviser. Moreover, if, as a financial adviser, the accountant becomes
too close to certain investment funds, this poses the risk of the adviser acting out of self-interest
rather than the client’s interest. The financial advice industry has been associated with these
dilemmas on frequent occasions, which has led to a number of government inquiries into the
financial advice industry both in Australia and overseas, most recently as part of a comprehensive
examination of the current cost, quality, safety and availability of financial services, products and
capital for users, in the Australian Government’s Financial System Inquiry Final Report (2014).
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The dilemmas of self-interest conflicting with public service are most serious in the field of
financial advice. The occupation of financial adviser has expanded considerably in recent
decades as more people have accumulated wealth that they wish to invest wisely. Since
accountants have extensive financial skills and knowledge, some accountants have been drawn
into providing financial advice, often at the request of their clients.
Regrettably, internationally there has been a series of scandals in which there has been widespread
selling of inappropriate investment products, unacceptably high fees, and sometimes corrupt
practices. This has not only occurred with individual financial advisers, but in the past with financial
advisers working for the insurance industry in the UK, and the major banks in Australia.
Clearly the role of financial adviser carries significant responsibilities and risks beyond those
normally encountered in the accounting profession. It is essential for any accountant engaging
in financial advice to be fully aware of the responsibilities and risks involved, and to maintain a
sense of objectivity regarding the best interests of the client receiving the advice.
Regulation of financial advisers is achieved by Regulatory Guide 146, issued by ASIC, which details
minimum levels of training, competence and experience to those giving financial advice.
The survey reported that 97 per cent of SMEs purchase accounting services (i.e. taxation advice
and financial statement preparation) from an external accountant (CPA Australia 2005, p. ii).
Importantly, 67 per cent of SMEs identified business advice as a key service available from
external advisers. CPA Australia’s survey found that 76 per cent of SMEs at some stage relied
on external accountants as business advisers. However, the survey found that reliance on
accountants for business advice was very limited in extent and overall effect. Only 6.5 per cent
of SMEs were found to place any substantial degree of reliance on their external accountant
for general business advice (including managerial accounting advice). This is disappointing and
the survey therefore indicates that external accountants have an important role in conformance
(i.e. compliance) but have not been much valued in improving performance (i.e. profitability).
Five years later, and at an international level, IFAC (2010) found the same general trend. IFAC also
clarified that it is important for external accountants (small to medium practices) to recognise the
real opportunities—for the businesses they advise and for their own practice growth—that exist
in the greater provision of profit-oriented business advice rather than accepting the current
overwhelming dominance of compliance advice.
Study guide | 47
➤➤Question 1.6
Why have SMEs not relied in the past on their external accountants for business advisory services?
Comment on whether this might be changing or needs to change.
Reflecting on your own organisation or one with which you are familiar, consider whether it relies on
external accountants for advice. If not, what may have prevented this from happening?
Public sector
The public sector includes a wide range of government and regulatory bodies. It includes the
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national government and lower levels including state, territory and local government. Where
governments provide for-profit services, they often set up particular entities called government
business enterprises (GBEs) or state-owned enterprises (SOEs). Governments are characterised
by the breadth of their powers in comparison with the private sector, such as the ability to
establish and enforce legal requirements.
Governments and their agencies require economic, finance, accounting and audit staff for their
operations and qualified professionals can build successful careers. Often people are drawn
to the government sector because of the potential for greater work–life balance, training and
development and career progression and because they wish to ‘make a difference’.
Over recent years there have been significant cultural changes with a shift towards a more
corporate model of best practice and ‘value for money’ approaches. As in the private sector,
the public sector highly values commercial know-how, analytical thinking and leadership and
stakeholder management abilities.
Accounting roles within the public sector are quite similar to those in the private and business
sector, with the requirement for financial reporting, internal audit, risk management and strategic
management accounting of key importance.
NFPs can vary in size from very large charitable institutions to local sports clubs. The principal
sources of income for their operations are usually receipts from members and supporters,
grants, donations and fundraising. Some NFPs also supplement revenue with trading activities.
Although profitability is not their core purpose, NFPs require sound financial management to
ensure that they are sustainable, can demonstrate positive social impact and can continue
to meet their objectives.
The NFP sector, sometimes called the community or third sector, is diverse and growing.
In Australia, the NFP sector encompasses 600 000 organisations contributing an estimated
AUD 43 billion, making it larger than the communications industry, agriculture or tourism
(Office for the Not-for-Profit Sector 2013).
As the complexity of tendering and accountability requirements grow in this sector, so does the
need for professionally qualified staff to enhance efficiency and effectiveness.
48 | ACCOUNTING AND SOCIETY
Keeping the organisation in good financial shape, meeting the reporting requirements of a
myriad of stakeholders, understanding the grants process, constructing and monitoring budgets,
tendering for outsourced government services, diversifying revenue streams through new models
of investment and social enterprise and meeting best practice volunteer management are all part
of the daily mix for a finance professional working in an NFP.
have a duty to use those capabilities to improve and enhance society. We can call this a positive
(or active rather than passive) social impact. Does accounting have a positive social impact?
Can that impact be negative in some circumstances? Is it possible that accounting may even
change society?
One aspect of accounting is the important role of reporting to investors, owners, management
and other users. This reporting may be designed principally to inform users about events that
occurred in the past, by way of annual, half-yearly and quarterly reports, and also some types of
historical reports within organisations.
Some people might think that this reactive information is passive. However, as a result of this
historical accounting information (created under applicable accounting standards), investors,
governments, managers and other stakeholders make decisions with significant social
consequences. Reporting, which is reactive in respect of events, is the active foundation for
a variety of outcomes—and these outcomes actively change social circumstances and entire
societies. An example of this may be the preparation of the half-yearly results for a publicly
listed company. If the results are poor, there is an obligation for the company to announce this
to the public. Investors may then choose not to go ahead with a plan to purchase shares in the
company. If financial results for a large number of companies are poor, society may interpret
this as a sign that the economy is failing.
Examples such as these show that implementing accounting systems and their constructs
have a forceful social impact and social and economic consequences, so accountants need
to understand and apply vast ‘professional capabilities’ to achieve appropriate reporting in
each circumstance. These professional capabilities include relevant technical knowledge,
soft (sometimes called ‘social’ or ‘interpersonal’) skills and extensive experience to avoid
adverse consequences due to poor or inaccurate reporting.
Beyond reporting about the past, accounting is commonly used within organisations to provide
information to support managers in decision-making. Such information is future-oriented and is
designed to facilitate, support and even to cause change. For example, a strategic management
accountant designing information to support a new manufacturing plant is change-focused,
as is an accounting ‘regulator’ working on new laws or new accounting standards designed to
create changes.
If the reporting is right, then the social impact, arguably, will be good, as markets and decision-
makers are informed appropriately. If the reporting is wrong, then the social impact will
almost certainly be negative.
Arguably, even perceptions about accounting can create significant social impact—so
communications regarding accounting need to be professional and balanced.
People who are not familiar with accounting may see depreciation as a technically accurate
adjustment to reflect the decline in values of non-current assets. However, in reality there is a
broad scope for choice in depreciation methods.
The depreciation method and estimated residual life or productive capacity will have an impact
on several measures, including reported profits and asset balances, and therefore remuneration
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and bonus plans that are linked to profits or return on investment.
From these points, we can conclude that the choice of depreciation method and residual life
of the asset is not a ‘value-free’ or technical choice, but one that may have a significant impact
on different people. Because the different outcomes may have positive or negative effects,
they have a social and behavioural impact on accountants, managers and users of financial
reports, including lenders, owners and the broader community. This may create a situation
where an accountant is pressured to report an artificial result.
Accounting is often perceived as neutral—a set of black and white tasks performed in a
mechanical manner—but this understates its influence. Rather, the activities of accountants
and the use of accounting information, including the decisions that are made based on
the outputs of accountants, have a decisive impact on the social functioning of individuals,
groups and entities. The impact is far wider than at first might be apparent.
It is important for accountants to understand the potentially broad social impact of accounting
at the micro and the macro level. At the macro level, this extends to all types of business,
public organisations and social institutions, and society generally. At the micro level, we must
understand the potential impact that accounting can achieve on the motivation and behaviour
of managers and employees within an organisation.
The motivational effects of performance measurement are discussed in more detail in the
‘Strategic Management Accounting’ subject of the CPA Program.
50 | ACCOUNTING AND SOCIETY
Our technical actions and behaviours as accountants are under scrutiny. The way we act and the
work we perform have a significant impact on organisations and society. As such, when we fail to
perform our work to an adequate standard and organisations experience trouble and distress,
the credibility of the profession is called into question.
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Accountants and auditors who have not performed their roles effectively are seen as responsible
for the failures and inaccuracies that have led to the decline in credibility. The view is that the
accounting profession did not fulfil its service ideal role as it did not prevent these situations by
giving appropriate advice to managers and/or making appropriate disclosures.
Following the many corporate collapses of the late 1980s and the market collapse of October
1987, many efforts were made to make accounting standards more consistent—and these
efforts continue today.
Despite these efforts, there have been a number of high-profile corporate failures in the
past 15 years, including Enron, WorldCom and Lehman Brothers (US), Babcock & Brown
and HIH Insurance (Australia), Parmalat (Italy), and Equitable Life Assurance Society (UK).
These failures have again placed the accounting profession under extensive scrutiny.
Creative accounting
‘Creative accounting’ means using the choices available to present information in ways that
do not clearly represent reality, and which provide a distorted and often favourable view of the
organisation.
Many accounting issues from the 1980s remain unresolved, including practices such as
capitalisation of interest expenditure, financial instrument valuation and risk management,
formation expenditure being treated as an asset, mining exploration expenses regularly
being capitalised and related party transactions. The words of Chambers, writing in 1973,
are still current:
If due to the optional accounting rules available to them, the company managers and directors are
able to conceal the drift (in financial position), shareholders and creditors will continue to support,
and support with new money, companies that are weaker than their accounts represent them to be
(Chambers 1973, p. 166).
Study guide | 51
Chambers could just as easily have been writing about 2001 and 2002 or about the valuation of
sub-prime debt and complex financial instruments from 2007 to 2009.
The GFC also saw auditors become subject to increased scrutiny (e.g. see Durkin & Eyers 2009;
Eyers 2009). GFC corporate failures have demonstrated valuation failures especially in relation to
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financial instruments and these valuation failures have raised questions about the role and value
of auditing (Sikka 2009; Sikka, Filling & Liew 2009; Woods et al. 2009).
In view of the massive financial bail-outs of many prominent corporations around the globe,
Sikka observed that:
Many financial enterprises have sought state support within a short period of time of receiving
unqualified audit opinions. This raises questions about the value of company audits, auditor
independence and quality of audit work, economic incentives for good audits and the knowledge
base of auditors (Sikka 2009, p. 868).
Sikka, Filling and Liew (2009), for example, expressed a perennial view of the basic auditing
model, that is, it is ‘flawed since it makes auditors financially dependent on companies’.
Consequently, according to Sikka’s view, auditors will not give objective independent professional
judgments because their incomes depend on the survival of the audit ‘target’. Case Study 2.2
in Module 2, ‘Arthur Andersen’, explores this issue in detail.
It has been proposed that the GFC was at least in part caused by ineffective accounting
standards for complex financial instruments. The role of risk, along with the failure of the various
decision-makers to understand risk and the true nature of ‘complex financial instruments’,
has also been a key factor. The fact that accounting standards did not help has been a matter
of professional concern for accountants.
It is worth noting that IFAC commissioned a study in 2002 to look at the loss of credibility in
financial reporting and approaches to resolving the problem.
Case Study 1.1 demonstrates several of these issues as they relate to the collapse of ABC Learning.
Sydney yesterday that in mid-2008, as the group battled mounting debts, the company’s
internal accountants were instructed to prepare a cashflow statement for the rest of the year.
The document was to be given to the company’s syndicate of banks as part of negotiations
to extend financing and keep ABC Learning afloat.
The original cashflow statement, referred to in court as ‘the first cut’, showed the group did
not expect to receive any ‘compensation fees’ paid to ABC Learning Centres from childcare
centre operators and developers from June to December 2008.
However, after it was reviewed by former chief executive and founder Eddy Groves, a ‘second
cut’ of the statement showed there could be $44.79 million in fees received over that six-
month period.
The court was told there were other substantial changes made to the ‘first cut’, including an
increase in the value of childcare payment receipts from parents in that time (Murdoch 2010).
In May 2013 the former CFO was charged with providing false or misleading documents to the
company’s auditors.
Auditor failure
Pitcher Partners were the auditors for ABC Learning during the 2007 period. However, due to the
company’s overseas expansion, Pitcher Partners indicated it would no longer conduct the audits
so Ernst & Young took over the audit work for the 2008 financial year. Ernst & Young then made the
radical decision to reject the previous accounts based on, amongst other issues, a disagreement with
particular accounting treatment of revenue items.
In August 2012, Simon Green, the company’s former Pitcher Partners auditor was suspended from audit
work for five years It was Green’s failure to adequately and properly perform his duties as an auditor
when conducting the audit of the 2007 financial report that led to this suspension. Specifically, Green
did not obtain enough evidence to confirm the correct treatment of fees, which led to an overstatement
of fees, nor to establish whether the company was a going concern (Kruger 2012).
As we look at corporate failures over the last 30 years, it appears that too often the
independence and professional ethics of accountants failed. Instead, professionals left behind
their standards in the hope of becoming part of an economic revolution related to booming
share market growth. The decade beginning with the failures of 2001 to 2002 has seen the
profession come under scrutiny to an extent never previously seen.
The credibility of accounting as a profession of value has been very much ‘on the line’.
Arguably, there has been a diminution of public trust in the profession’s service ideal and a
reduction in its former degree of autonomy and independence. We now consider the response
of the professions and government to restore credibility to financial accounting, auditing and
the accounting profession itself.
Study guide | 53
MODULE 1
Accounting standards are backed by law. Accounting standards are externally created and
enforced by regulations, meaning non-compliance by a professional accountant can mean both
disciplinary action from their professional body and legal penalties.
Auditors must apply the code of ethics. The Compiled APES 110 Code of Ethics for
Professional Accountants also has legislative application to auditors.
FRC responsible for auditor independence. The FRC now has direct responsibility for
monitoring the effectiveness of auditor independence. This reduction in autonomy is likely to
lead to greater comfort in the community and less opportunity for abuse by auditors. As a result,
this change should help to restore and maintain professional auditor credibility in the future.
Enhanced regulation. New laws, regulations and guidance have also been developed globally,
including the Sarbanes–Oxley Act 2002 in the US, COSO 2004 (discussed in more detail in
Module 3), and the extensive process leading to the CLERP 9 Act in Australia.
Adoption of international standards. Since 2004, many countries have adopted, or are in
the process of adopting, common international standards on accounting, auditing and
professional ethics.
➤➤Question 1.7
Outline reasons why the four key issues identified by IFAC (2003) would reduce the profession’s
credibility. What strategies may be useful at reducing or eliminating these problems in future?
The reduction of the profession’s autonomy (in terms of setting its own rules and guidelines)
is one change that is leading to restored credibility, as externally enforced legislation and
rules provides greater protection and comfort to users of accounting information and society
in general.
Individual accounting bodies, such as CPA Australia, have also been active with various
initiatives in support of improved financial reporting, enhanced auditing standards and more
effective governance. The Corporate Governance Council of the Australian Securities Exchange,
the OECD and the UK Financial Reporting Council have also undertaken much work.
To restore credibility the underlying problems must be identified and practical measures put in
place to reduce or eliminate them. The measures described above aim to reduce the likelihood
of past issues being repeated.
If these aims are met, they will help alleviate society’s concerns and provide reassurance that
these issues will not happen again. Success will require the utmost application of all the relevant
professional capabilities that a professional accountant must possess.
54 | ACCOUNTING AND SOCIETY
Capability considerations
So far, we have been discussing the broader accounting profession, what it means to be a
professional and the issues the profession has been facing. Professional accountants are
expected to understand their professional responsibilities and apply themselves diligently
to achieve and maintain these standards. As such, they have a role to play in improving the
credibility of the profession, ensuring the public interest is served, and making sure clients,
employers and the broader community benefit from their skills, knowledge and decision-making.
The CPA Program is a large component of developing technical knowledge to attain professional
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status. However, it is also important to develop a broader range of skills. The pathway to
becoming a CPA includes professional mentoring and achieving rigorous technical knowledge
requirements, combined with broader business knowledge and soft skills including communication
and leadership. Managing oneself is fundamental to successfully achieving professional status,
and so personal effectiveness becomes another foundation for a successful career.
Leaders are required to develop the strategy, drive the change and align the organisation’s
structure, resources and culture with strategy. Leadership requires vision, energy and drive
from the professional accountant, the desire to be strategic and to be a key contributor to the
improvement and strategic growth of the organisation. As business leaders, and as professionals,
accountants must exercise a high degree of competence and due care, and have a professional
obligation to service ideals.
We discussed earlier that professional competence requires not only strong technical accounting
skills, knowledge and experience, but also the desire to actively enhance our professional
expertise and insights through the acquisition of diverse new skills, knowledge and experience.
Professional capabilities arise over a relatively long time frame, through the steady accumulation
of all the relevant skills, knowledge and experience. As the professional accountant enhances
their skills, knowledge and experience, they enhance what they can offer society, and in particular
their readiness to be leaders in society.
As mentioned earlier in this module, the skills, knowledge and experience of a professional
accountant can be broken into the two key categories of technical skills and soft skills.
Both are vitally important and it is a mistake to concentrate on one at the expense of the other.
Professional capabilities are not simply skills, knowledge nor experience on their own. Rather,
professional capabilities arise over a relatively long timeframe through the steady accumulation
of all the relevant skills, knowledge and experience. There is no clear definition of when we
become professional, but arguably an individual can be regarded as professional when that
individual has sufficient capabilities to make complex and difficult professional judgments and
effectively advise others in respect of those judgments.
Study guide | 55
MODULE 1
The degree of TSKE required varies according to the tasks being undertaken by the accountant.
For example, an accountant functioning as a company secretary (called ‘public officer’ in some
jurisdictions) for a publicly listed entity must have a strong awareness of financial reporting
requirements and the local stock exchange listing rules.
Some accountants will have TSKE regarding internal audit, external audit and forensic
accounting. Technical requirements will depend on the field of work and the level of detailed
skills and knowledge required.
SSKE is primarily (some might say is all) about people and related issues. More specifically,
professional accountants need well-developed social skills and capabilities, including the
ability to:
• listen;
• understand complex and difficult issues and their role in the decisions and information
needs of others;
• communicate effectively (both verbally and in writing);
• discuss and debate without hostility—a vital aspect of interpersonal skills;
• persuade and convince based on logical and reasonable argument—another vital aspect
of interpersonal skills and an important part of leadership;
• manage time;
• meet deadlines; and
• build and improve our capabilities.
Professional career progression, advancement and promotion within employment, along with
higher status in the profession (as a person becomes a CPA and then an FCPA), are all functions
of demonstrated improvement in TSKE and SSKE capabilities.
Staff from the University of North Carolina (Blanthorne, Bhamornsiri & Guinn 2005) reported that
TSKE are relatively more important in the early years of professional accountants’ actual careers
but, as time passes, and TSKE and SSKE improve and as some CPAs move to partnership (and/or
senior management) level, SSKE becomes relatively more important in career progression.
56 | ACCOUNTING AND SOCIETY
In fact, Blanthorne, Bhamornsiri and Guinn (2005) found that CPA firms, when selecting
candidates for early career promotions, regarded technical skills of candidates as the most
important evaluation criterion (ranked first on a list of six ranked appointment criteria).
However, when seeking promotion later in their careers (promotion to partnership level),
the research found that technical skills moved to fifth place in the six items.
Further, the ‘interpersonal’ soft skill moved from its previous third place (for early career
appointments) to first place, with leadership in second place and communication in third place
for partner appointments.
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This demonstrates that accountants need to have a strong foundation of technical skill, but that
building relationships, interacting with staff and clients, and leadership skills are required to
further their careers.
Reading 1.2, ‘How “soft skills” can boost your career’, is from 2005 and is still relevant. It is valuable
in further discussing attributes of soft skills and how these can be important in successful career
development. You should study this now.
The Career Guidance System provides an interactive tool on the CPA Australia website at:
cpaaustralia.com.au/cps/rde/xchg/cpa-site/hs.xsl/career-guidance.html.
Review
In this module, we have explored what it means to be a professional accountant. We also
considered the signals that exist when professions are under challenge. More importantly,
we learned that both as individuals and as part of the overall profession of accounting, we have
a responsibility to respond to these challenges. It is our responsibility to ensure that society
genuinely benefits from our profession.
Throughout this module, it has been apparent that professional accounting capability extends far
beyond the important tasks of preparing accounts and financial reporting. We observed various
MODULE 1
illustrations of accounting as a social force. Accountants must be aware of professional ethical
responses required in a variety of detailed circumstances. These include how we should:
• deal with staff and staff problems;
• build and maintain our soft and technical professional capabilities and ethical responses in a
variety of challenging workplaces;
• be able to analyse and interpret complex financial information, even in contexts of change,
uncertainty and ambiguity; and
• advise managers and build value.
As always, we must conduct ourselves appropriately so that our professional role and reputation
are never diminished.
The real task is to remain constantly professional in all circumstances. To do this, professional
accountants must be enquiring, innovative, measured and courageous in making correctly
balanced professional judgments. More than anything else, it is the consistent ability to make
good professional judgments in the right way that should be our fundamental goal.
By understanding all that accountants do and consistently acting professionally, we will ensure
that our many various roles bring value to society.
MODULE 1
Reading 1.1 | 59
Readings
READINGS
MODULE 1
Reading 1.1
Profile: Roel van Veggel—the sweet sounds of success
International Federation of Accountants
When Roel van Veggel was asked to consider working for globally renowned Dutch violinist and
conductor André Rieu, his immediate reaction was, ‘Does he want me to carry his violin?’
Actually, Van Veggel’s finely tuned finance and accounting skills attracted Rieu’s interest.
Their ensuing collaboration during the past seven years has helped Rieu focus more energy on
performing for audiences, leading the highly talented musicians in his orchestra and conceiving
new ways to make classical music more accessible to his fast‑growing worldwide audience.
‘André has a unique vision with regard to where he wants to take his orchestra and music,’
says Van Veggel, André Rieu Group CFO. ‘It’s my role to inform him about the risks involved in
executing his vision and to identify ways to manage these risks.’
Because he successfully fulfils his primary (CFO) responsibilities, Van Veggel’s role has expanded
beyond the traditional boundaries of the chief financial officer in a mid-sized enterprise (ME).
In addition to serving as a trusted advisor to his CEO and the business, he has taken on business-
executive duties by managing the fastest-growing and largest source of revenue, concert touring.
These combined activities explain why Van Veggel possesses perhaps the most musical title
among any professional accountant in business (PAIB): ‘CFO and Concert Tour Director.’
60 | ACCOUNTING AND SOCIETY
Van Veggel then joined a private importer of Swiss watches as its finance director. The move was
well-timed: the company’s growth during Van Veggel’s tenure resulted in its becoming part of
MODULE 1
the Swatch Group, one of the largest watchmakers in the world. During his eight years with the
Swatch Group, Van Veggel again accumulated a variety of PAIB experience, including financial
reporting, post-acquisition integration and staffing management activities, that helped tune
him up for his current role.
When Rieu recruited Van Veggel, the André Rieu Group was already a thriving company
contending with the same challenges that most fast-growing MEs encounter. Rieu’s talent,
success and rocketing global popularity helped sell more than 23 million CDs since his
breakthrough album, ‘From Holland with Love,’ was first released in 1994. His concerts currently
rank as the 16th top-grossing act in the world, and he stages about 120 concerts annually.
The quick growth required new staffers and new investments to support a heavier touring
schedule; however, accounting and some other support processes were struggling to keep
pace. Van Veggel was hired to instill more sophisticated financial management capabilities and
controls in the organization.
‘I joined the company, in large part, because it was completely unique,’ he recalls. ‘You don’t
see anything like it in the accounting textbooks. And I soon realized that you can create your
own job. You’re expected and encouraged to look for potential needs throughout the company;
if you see a challenge you can address, you pick it up.’
One of the challenges that provided the greatest allure to Van Veggel was an issue that
commonly confronts finance executives in fast-growing entities: injecting greater finance and
accounting discipline into managing growth, but doing so without stifling the founder’s vision,
creativity and success.
‘So many mid-sized companies become successful because the founder has a great idea that
really takes off,’ explains Van Veggel. ‘When the company just starts out, the founder hires a
handful of people to help with the details. All of a sudden, they have a mid-sized company,
yet the same people are doing the accounting. And now they have a range of challenges that
they did not anticipate when they joined the company.’
His first move after he came aboard was to revamp the organization’s financial information
systems. The bulk of the existing accounting department’s time and energy was devoted to
accounts payable—processing the invoices and cutting checks. A more sophisticated finance
and accounting system would equip the business with greater visibility into its costs and revenue.
The company’s revenue comes from three sources: touring, CDs and video specials that it sells
to television stations and releases on DVD.
Reading 1.1 | 61
While the company understood that touring represented its largest source of revenue, Van Veggel
wanted to gain a far more detailed understanding of what drove revenue and costs. ‘We were not
really focusing on what a concert costs, and that is our core business,’ he explains. ‘I changed the
entire system so it could follow what was truly happening and inform us where our costs were,
how we could save money and what it would cost us to expand into new markets.’
Second, Van Veggel beefed up the accounting department by hiring specialists. ‘Just as a
Dutch soccer coach always takes his best players along to a new club, I took my best accounting
players with me to my new company,’ he notes. Those professionals included a payroll specialist
(to help manage the complexities of compensating international musicians), an accounts payable
MODULE 1
specialist (whose expertise extends to credit and collections) and a controller (who can manage
the accounting department in The Netherlands while Van Veggel executes his new business
responsibilities around the world).
Third, he sought to open lines of communications on two fronts. Inside the company, he worked
to relay the importance of financial management and controls throughout the company. ‘At any
fast‑growing company, the sales team can sell a ton of wonderful products, but if the finance
team is not collecting the money from those sales, you have a major problem,’ Van Veggel notes.
‘That’s why I think communications within companies represents one of the most important aspects
of a CFO’s job.’ He also strengthened relationships with important external sources, including
auditors and tax authorities in the countries and localities where the company operates. ‘This is
not easy to do when you’re an orchestra that performs in numerous countries,’ he explains.
‘There are so many different regulations and rules that affect us. That’s why it’s important to let
the tax authorities know they have a good contact person within the organization.’
Fourth, and perhaps most important, Van Veggel sought to help Rieu focus less on administrative
issues while providing greater support with regard to strategic decision-making activities.
That objective required Van Veggel to establish credibility with Rieu and his new management
colleagues. ‘At a certain level, the organization and its leaders thought, ‘What do we need him
for? We pay our bills on time,’’ explains Van Veggel. ‘So, as soon as you’ve put in the systems,
processes and people that let you get much more detailed information, you have to show them
the value of your management information.’
To demonstrate the value of his work, Van Veggel immediately showed Rieu which countries
and venues provided higher touring profits and which costs were creating the greatest drag on
profits. He also produced highly accurate forecasts. Equipped with the information, the company
took action. It lowered transportation costs by flying less frequently and upgrading its tour
busses. It increased the number of concerts it performed each year to increase the returns on
its overhead.
And, in an even bigger move, André Rieu Group began promoting its own events in the U.S.
in 2003 since Van Veggel’s analysis indicated that the company could lower costs and increase
concert attendance by doing so.
In addition to his musical talent, Rieu ‘is a superstar in terms of assembling his orchestra and
leading them on a daily basis,’ Van Veggel points out. ‘Our team of 130 people really operates
as a family. Everyone one of us truly enjoys what we do, and that’s because of André’s vision and
leadership.’ By having to spend less time in the back of the office, Rieu can dedicate more energy
to leading his team and performing.
62 | ACCOUNTING AND SOCIETY
After Van Veggel dedicated his first two years with the company to bringing its finance and
accounting capabilities in line with its growth, Rieu asked him to lead the U.S. operations.
While he maintains his CFO title and responsibilities, New York-based Van Veggel also became
responsible for devising and executing André Rieu Group’s U.S. touring. The work includes
negotiating agreements with concert venues and television stations—Rieu’s concerts have been
MODULE 1
‘Touring is our main business,’ he notes. ‘It exerts such a strong influence on our finances
that I need to be closely involved with it.’ This involvement recently expanded: he is now also
responsible for managing all contract negotiations with promoters around the world.
While Rieu may not have wanted Van Veggel to carry his Stradivarius, he has enjoyed the rewards
of asking his PAIB do almost everything else.
Key lessons
• PAIBs are expected to establish greater finance and accounting rigor to more effectively manage
growth without stifling the founder’s vision, creativity and success.
• Help the organization conduct administrative matters more efficiently so it can focus more resources
on executing its vision.
• Communications within companies represent one of the most important aspects of a CFO’s job.
• Financial information systems should report what is truly happening and alert PAIBs to expansion and
cost cutting opportunities.
• Once PAIBs have put in place new information systems, processes and people, the value of those
investments should be clearly demonstrated to the entire management team.
• PAIBs within mid-sized enterprises are expected and encouraged to look for potential needs
throughout the company; if you see a challenge you can address, seize it.
Source: International Federation of Accountants 2008, ‘Profile: Roel van Veggel—The sweet sounds
of success’, The Crucial Roles of Professional Accountants in Business in Mid-Sized Enterprises
(extract), IFAC Information Paper, Professional Accountants in Business Committee, September,
New York, pp. 48–51. Used with permission of IFAC.
Reading 1.2 | 63
Reading 1.2
How ‘soft skills’ can boost your career
Jessica Jarvis
Accountants may be focused on their qualifications, but don’t neglect soft skills. These are
becoming increasingly sought after by employers, and could give you that extra lift up
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the career ladder.
Most of us manage to arrange holidays and a social life around work, but the planning seems to
go out the window when it comes to reviewing our career paths.
Perhaps you have aspirations of progressing to the next level, but no real idea of how to do it or
where to start. Perhaps you’re simply lacking the motivation to do anything about it. Whatever
the situation, if career progression is something you really want to achieve, and you know where
you’d like to go, the next step is knowing what employers want from you.
A CIPD Guide to Career Management points out that few careers adhere closely to the idea
of upward progression through a hierarchical sequence of roles. Some involve sideways moves
within an organisation, or frequent moves in or out of employment in a number of different
companies. Or even phases of self-employment, temporary work and permanent employment.
Qualifications are vital to building a successful career in most professions, but it is also
important to remember the significance of basic skills and talents that do not necessarily
require formal training.
Employers are increasingly interested in essential skills such as communication and interpersonal
skills, time management and even assertiveness.
People can develop their careers by accumulating and transferring job skills from one context to
another, by broadening the range of expertise they apply in each successive job, or by constantly
seeking out novel and challenging situations.
Therefore, anyone who is worried about giving the impression of being a ‘job hopper’ can
actually use the experience to highlight the skills they have developed from a variety of sources.
These skills may seem so basic they are often overlooked, but employers are looking for more
than a qualification, and highlighting your soft skills may make the difference between two
equally qualified candidates.
Time-management
Demonstrating good time management skills means controlling and using your time as efficiently
as possible. There are a number of benefits to be gained from effective time management.
Greater control of your time, improved productivity, an increase in free time, and higher visibility
among peers and superiors can all be achieved by introducing simple techniques and habits such
as effective diary keeping and organised delegation.
64 | ACCOUNTING AND SOCIETY
Listening skills
Good communication is a two-way process, and listening is an essential aspect of this. Listening
is an activity that is often taken for granted as it is assumed we all do this as part of a natural
communication process. However, listening is more than just hearing what others are saying.
Real listening means giving your full attention, and really understanding what is being said.
The ability to listen well to others often means that they will reciprocate and listen to you—
and respond when you are speaking.
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Assertiveness
Assertive skills can bring a number of benefits to the individual and, therefore, the organisation.
Handling confrontation will become easier and produce satisfactory results, stress will be reduced
and self-confidence increased, behaviour will be more tactful (which will improve image and
credibility), and individuals will be able to disagree more convincingly in a way that maintains
the effectiveness of the relationship.
However, influencing positively will help you achieve more of what you want and build relationships
based on openness, trust understanding and mutual respect. It also boosts personal credibility.
This is a skill that involves both good listening and assertiveness; thereby improving your abilities
in a variety of communication skills areas.
These ‘softer’ skills are all highly transferable to any organisation or role, and at all levels. So it is
important to demonstrate them through your work achievements, abilities and personal qualities.
Thinking about them will help you to decide what you are good at and what you need to develop
further. Looking at your soft skills will also help you to identify some realistic career options,
and work out what steps you need to take to start moving your career in that direction.
Source: Jarvis, J. 2005, ‘How “soft skills” can boost your career’, AccountancyAge, 28 April,
used with permission, accessed October 2015, http://www.accountancyage.com/aa/feature/
1789970/how-soft-skills-boost-career.
Suggested answers | 65
Suggested answers
SUGGESTED ANSWERS
MODULE 1
Question 1.1
Many authors’ views are described in Module 1; the variety of views shows that there is a wide
range of interpretations about the actions of professional accountants in terms of serving
the public interest. At one end are those whose motives are selfish, and whose overarching
desire is to establish a monopoly group that maintains a position of prestige and power
within the community. At the other end are those who believe that many professionals have
a genuine desire to contribute to society, without the need for significant monetary reward or
political power.
In such a large profession, it is likely that there are many individuals who fit into the different
categories that have been described. While we often hear about the disgraceful and/or harmful
actions and outcomes from corporate collapses and failures, there are many untold examples of
selfless efforts and sacrifices that provide a significant contribution to the community.
Question 1.2
The following examples illustrate many situations where accountants might apply professional
judgment, although this list is not exhaustive. Your answer may have included four of the following:
• making decisions about workflows and staff recruitment needs;
• making staff selection decisions and choosing accounting team member roles;
• advising clients on business decisions;
• advising managers on accounting information relevance for business decisions;
• identifying environmental cost parameters and advising management of them, and devising
reporting mechanisms;
• planning for all types of professional assignments;
• interpreting accounting standards and other professional pronouncements;
• identifying business and audit risks;
• making assumptions in forecasts and estimates;
• placing quantitative assessments on future liabilities for clients and others;
• providing overall opinions on the adequacy of internal control, the reliability of accounting
records and the sufficiency of audit evidence;
66 | ACCOUNTING AND SOCIETY
Question 1.3
This situation highlights the importance of implementing an appropriate system of quality
control. Policies and procedures developed by individual firms need not be complex or time-
consuming to be effective. However, APES 320 Quality Control for Firms requires firms to
address each of the following elements of a system of quality control:
• leadership responsibilities for quality within the firm;
• ethical requirements;
• acceptance and continuance of client relationships and specific engagements;
• human resources;
• engagement performance; and
• monitoring.
Although we have not yet studied ethics (see Module 2), it is useful to assess your current
understanding of ethics. You may like to review this question and solution after completing
Module 2 to identify how your study of that module changes your approach to the question.
Ethical requirements are featured in the Compiled APES 110 Code of Ethics for Professional
Accountants and, as we shall see in more detail in Module 2, they address the fundamental
principles of professional conduct:
• integrity;
• objectivity;
• professional competence and due care;
• confidentiality; and
• professional behaviour.
Policies and procedures must be in place to identify and evaluate circumstances and relationships
that create threats to compliance with the fundamental principles. Appropriate action must be
taken to eliminate or reduce these threats to such a level that compliance with the fundamental
principles is not compromised.
Therefore, professional accountants must identify any actual and/or perceived conflicts of
interest, not only between their clients but also between their clients and their employees and
to manage these conflicts in accordance with any ethical requirements. The firm’s personnel
already have an obligation to observe at all times the confidentiality of information acquired as
a result of professional and business relationships and not to disclose such information without
proper and specific authority from the client or employer or unless there is a legal duty to
disclose. Nonetheless, in this case, it would have been prudent to ensure that the employees
providing bookkeeping services were also free of any conflicts of interest.
Suggested answers | 67
Policies and procedures addressing the ethical requirements need to be communicated to all
personnel and reinforced by the firm’s leaders and through education and training, monitoring
and a process for dealing with non-compliance. It is important that policies and procedures
that address ethical requirements are continually reviewed and take into account changes
in circumstances, including staff changes, client acquisitions and structural changes such
as mergers.
The trust and confidence of clients are crucial to any ongoing professional relationship,
and avoiding real, potential or perceived conflicts of interest builds this trust. It is, therefore,
necessary for professional accountants to ensure that there are appropriate policies and
MODULE 1
procedures to address their clients’ concerns and to respond to clients’ concerns to restore
any loss of trust.
Question 1.4
There are many roles that a CPA may fill in relation to an SME. The question refers to a
professional accountant in business (PAIB) who is ‘the accounting professional working in an
SME’. This reasonably can be interpreted to mean a full-time employed accountant who is
working as an accountant assisting managers and not working as another form of manager.
You might have mentioned any four of the following roles for a professional accountant working
as an employee of an SME:
• provide detailed management information reporting, budgeting and forecasting etc.;
• provide relevant ‘consultation’ advice to managers regarding value for customers and
shareholders;
• take responsibility for developing long-term and short-term budgets and ensure they are
effective in achieving motivation and value;
• provide formal accounting documentation including general purpose financial reports and
relevant board reports;
• undertake all formal reporting and compliance activity including in relation to company
regulation and tax regulation; and
• take charge of needs relating to tax planning and advisory work.
Question 1.5
From careful reading of Reading 1.1, it is apparent that:
• Roel van Veggel acts as CFO and has a clear understanding of the business and its key revenue
and cost activities, and the strong accounting team that he built is providing assistance.
• He takes control of risks, freeing Andre Rieu (the person) to concentrate on his music and
related skills to build the overall business.
• Roel has become a manager beyond his CFO role and helps Rieu ‘focus less on administrative
issues while providing greater support about strategic decision-making activities’.
• Roel has also taken steps to ensure that communication within the company is at a very
high standard.
68 | ACCOUNTING AND SOCIETY
Question 1.6
Some SMEs seek business advice extensively from external accountants; however it is apparent
that many SMEs are not yet taking this approach. The challenge for the profession is to engage
with SMEs so that the role of external accountants as business advisers (doing far more than
traditional bookkeepers, accountants and tax return agents) is better understood by all SMEs.
IFAC (2010) identifies that researchers have found ‘fortress mentality’ SME operators who simply
do not know how accountants may function as their valued business advisers. Other researchers
have identified that business advising is growing in range and quality. Obviously, SMEs operated
MODULE 1
by those with a fortress mentality need to be better informed about the range and quality
of external business advice from accountants. IFAC also identifies that as a matter of logic,
SMEs need external business advice and that change needs to occur. IFAC demonstrates that
change is occurring (in the article, they highlighted the business advising role of in-house
accountants) and that more change is needed. It is apparent that external accountants must learn
how to better communicate with clients and to ensure that SMEs with no in-house accountants
do not suffer by not having access to good business advice. External accountants must learn to
depict their role as being team players with those who manage SMEs and ensure that their role in
value creation is understood.
The following summary explains how IFAC (2010) discusses the issue.
• Researchers named by IFAC identified that some owner-managers want to ‘go it alone’ rather
than expose their problems to outsiders, depicting this as a ‘fortress enterprise’ mentality.
Owners displaying this attitude wanted to hide their weaknesses and typically they would
justify their approach by saying that outside advice was ‘irrelevant or poor.’ As they were not
using outside advice anyway—how would they know?
• Other researchers have pointed out that the ‘range and quality of advice available’ in relation
to business advising from external advisers is growing. This has been a derivative of the work
of external advisers helping SMEs to meet regulatory requirements and can be seen in the
increased number of advisers and the increasing advisory skills in relation to ‘regulatory and
day-to-day and strategic challenges’.
• ‘A priori’—or ‘based in logic’, it is apparent that SMEs do require external advice because
many smaller entities (much smaller than ‘Andre Rieu’ for example) will have no internal
accounting staff. Much advice has been in relation to meeting regulatory requirements but
demand is also evident in relation to business ‘monitoring and quality control’. Importantly,
IFAC states that ‘this is not merely confined to financial compliance’. While it is clear that
a compliance bias has continued, external advice and support have been sought from
accountants (as ‘general business advisers’) in relation to ‘employment, health and safety
and environmental regulations’.
Suggested answers | 69
Question 1.7
The four issues raised are:
• creative accounting;
• poor audit quality;
• lack of auditor independence; and
• financial accounting distortions.
One overarching reason that the profession may lose credibility from these problems is they can
all be linked to acting in a self-interested way that ignores serving the public interest.
MODULE 1
Another reason is linked to the interpretation that accountants are not as technically skilled and
capable as they claim. This is especially the case when issues of poor audit quality are raised.
Lack of auditor independence can lead many people to doubt the usefulness or worth of audits.
Instead of being perceived as a public service, audits may be seen as a waste of time and only
performed to generate extra fees for accountants.
Strategies for dealing with these issues may include more restrictive accounting standards and
rules to minimise creative accounting, and greater penalties for inaccurate financial reporting,
including fines and jail terms.
One proposed solution for addressing auditor independence is to have auditors appointed to a
particular company by an independent body, rather than by the company itself. This should help
avoid the inherent conflict of interest that exists with the current way auditors are appointed.
MODULE 1
References | 71
References
REFERENCES
MODULE 1
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MODULE 1
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References | 73
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MODULE 1
ETHICS AND GOVERNANCE
Module 2
ETHICS
* CPA Australia gratefully acknowledges the many authors who have contributed to this module.
76 | ETHICS
Contents
Preview 77
Introduction
Objectives
Teaching materials
Review 135
References 153
Ethics websites
Study guide | 77
Module 2:
Ethics
STUDY GUIDE
MODULE 2
Preview
Introduction
In Module 1, we discussed what it means to be a professional accountant. We now extend this
discussion to examine the practical implications of professional ethics, based on the notions of
the service ideal and the public interest. Professional ethics extends beyond compliance with
written codes and laws to also include the ethical commitment of the professional person to act
in the best interests of society.
Written codes and relevant rules provide the principles and expectations of professional conduct.
However, sometimes more detailed analyses are required in situations that involve ethical issues.
In this module, we introduce the notion of professional ethics and the analytical tools that guide
accountants and help them resolve ethical dilemmas. These tools include a code of ethics for
professional accountants, philosophical theories of ethics and ethical decision-making frameworks.
Objectives
After completing this module you should be able to:
• explain the concept of professional and business ethics;
• discuss the key philosophical approaches to ethics and how these impact on the
professional’s ethical decision-making;
• apply Compiled APES 110 Code of Ethics for Professional Accountants (APESB 2013);
• analyse and resolve ethical dilemmas in accounting;
• apply ethical decision-making models; and
• discuss the impact of decision-making and actions on society.
Teaching materials
• Compiled APES 110 Code of Ethics for Professional Accountants (APESB 2013)
Any professional ethics framework adopted must be understood by members of the profession
so that it forms the basis for sound and consistent ethical behaviour. The Accounting Professional
& Ethical Standards Board Compiled APES 110 Code of Ethics for Professional Accountants
(APESB 2013) is one such framework that we will explore in this module.
up and investigated.
A professional accountant is objective, takes full responsibility for the tasks they are entrusted to
do, adopts proper planning and control procedures, and possesses the integrity to maintain a
professional approach to work.
For example, ethical reporting of a poor financial position may lead to the failure of an
organisation. As its stakeholders lose faith, this may result in job losses and financial losses.
Despite this, ethical action is still desirable as it is likely to limit losses and lead to faster
resolution of issues. It also respects the rights of all stakeholders involved, despite the negative
outcomes for some.
The impact of unethical decisions can be considered in relation to the whole profession and at
the individual level as well. The two levels are connected because the ethical failings of individual
accountants (who may suffer personal consequences as a result) also affect the overall profession,
which suffers reduced credibility and increased restrictions on its ability to act autonomously and
to self-regulate.
Decisions that are not in line with accounting professional standards and legal obligations
can result in loss of membership, fines and even imprisonment. Therefore, it is important for
professional accountants to carefully assess decisions when faced with ethical choices to ensure
the decisions they make are satisfactory, both to other stakeholders and to themselves.
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A benefit of applying the frameworks that we will be describing in this module is that it helps us
focus not only on ourselves, but also on others who will be affected by our decisions. Using these
frameworks can guide the professional accountant to the most ethical decision, even when the
most suitable option is not readily apparent.
Ethics—an overview
So far in this subject we have looked at a variety of activities and attributes that are relevant
to professional accountants. We have identified that accounting has an impact on society and
that accountants are actively involved in creating social outcomes and social change. To be
professional, the activities of accountants need to be pursued appropriately and, where deliberate
social outcomes are intended, they must also be pursued in an appropriate manner.
Therefore, one person’s ethical code may judge an action to be ethical, but another’s may not.
To get a more definitive understanding of ethics, we need to delve further to contemplate
‘What exactly is ethics?’ and ‘How does ethics relate to professional ethics?’
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Sociologist Raymond Baumhart conducted a survey of business people in the early 1970s by
asking them ‘What does ethics mean to you?’ Some of the responses he obtained were:
• Ethics has to do with what my feelings tell me is right or wrong.
• Ethics has to do with my religious beliefs.
• Being ethical is doing what the law requires.
• Ethics consists of the standards of behaviour our society accepts (Baumhart, cited in
Mitchell 2003, p. 8).
However, simply equating ethics with feelings, religious beliefs, following laws and social
behaviour fails to identify an important aspect of ethics. Ethics needs to have some kind of
systematic process to create a coherent and consistent approach to resolving issues. Undertaking
actions based on one’s feelings of right or wrong is arguably a good approach—but, without any
systematic support or structured approach to making ethical decisions, relying on feelings is
neither convincing nor consistent. We suggest that a systematic approach is recommended to
resolving ethical issues, and in this module we introduce structured approaches to resolving
ethical issues that provide an alternative to a more instinctive approach. It is beyond the scope
of this module to discuss the differences and similarities of ‘ethics’ and ‘morals’. In many
circumstances, the two terms can be used interchangeably.
There is a difference between following laws and acting ethically. Just because you are complying
with the law does not mean you are acting ethically. An example of this situation can be seen
in Example 2.1, which examines the actions of the company James Hardie in dealing with its
asbestos liabilities.
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Prior to ASIC commencing its proceedings, the Special Commission of Inquiry into the MRCF released a
report in September 2004. Commissioner Jackson QC raised serious issues about corporate governance
and disclosure, and particular concerns about potential breaches of the Corporations Act. In the
Report of the Special Commission (Jackson 2004), Commissioner Jackson stated:
There was no legal obligation for JHIL [emphasis in original] to provide greater funding to the
Foundation, but it was aware – indeed, very aware because it had made extensive efforts to
identify and target those who might be “stakeholders”, or were regarded as having influence
with “stakeholders” – that if it were perceived as not having made adequate provision for
the future asbestos liabilities of its former subsidiaries there would be a wave of adverse
public opinion which might well result in action being taken by the Commonwealth or State
governments (on whom much of the cost of such asbestos victims would be thrown) to legislate
to make other companies in the Group liable … (para. 1.8).
The James Hardie Group has also indicated … (including that it is under no legal obligation
to do so), that it is prepared to fund the future asbestos liabilities. In my opinion it is right
that it should do so (para. 1.23).
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The current environment of continuous and rapid change, combined with the complexity of
accounting work, provides many challenges for accountants. This creates many types of pressures
that are compounded by the requirement to comply with deadlines. Such pressures may create
the risk that integrity or competence will be subordinated to expedience.
The following section draws from the various situations encountered by professional accountants
that highlight the complexity of conflicts and choices that accountants face in their day-to-day
professional lives.
Ethical dilemmas
A research project by Leung and Cooper (2005) explored the ethical dilemmas and experiences
of 1500 CPA Australia members. Accountants were asked to describe which ethical issues they
experienced and how important they perceived these issues to be. The items reviewed are
shown in Table 2.1.
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Source: Adapted from Leung, P. & Cooper, B. 2005, ‘Accountants, ethical issues and the corporate
governance context’, Australian Accounting Review, vol. 15, no. 1, p. 83.
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This list highlights the range of ethical issues an accountant may face. Some focus on technical
activity and others relate to behaviours. The item ranked sixth in importance indicates that ethics
goes beyond interacting with other stakeholders and includes having sufficient technical skill to
adequately perform an accountant’s professional role:
Such choices require not only competence in identifying the most appropriate accounting method
for measurement and disclosure of economic events and issues, but the courage and strength to
make the right professional decision under pressure and other constraints (Leung & Cooper 2005,
p. 80).
Having gained sufficient capital in these ventures, Jack began his own ‘bricks and mortar’ business,
a Texas BBQ restaurant that would be delivered solely via food trucks. He refitted the unzoned ‘303a’
address as a smokehouse kitchen and bought two ageing trucks. Running a comprehensive social
media promotion for the business, Jack soon attracted investment, and decided to grow the business
and seek partnerships. Gil White, a friend who had recently completed his CPA, bought one of three
20 per cent stakes in the business and took over finance and accounting for the business.
Over the next six months the business expanded; Jack and Gil bought and refitted three more trucks
and took on several employees. At the end of this period, Jack prepared a memorandum for the
partners, recommending that they sell the business, as interest was high and they could probably
net a considerable profit. Gil was a little surprised as the business seemed to be growing healthily.
He asked Jack if it was the best time to sell, and whether perhaps they should hang on to the business
for another year or so. Jack revealed that he’d heard rumours that there were plans to restrict the
movements of food trucks, heavily pushed by local restaurant owners who were feeling the pinch of
the competition. This would likely impact on the company’s viability in its expanded state. Gil realised
that Jack was probably right, and that exiting the business was the prudent move. Jack asked Gil to
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prepare the projected estimates in order to begin the process of courting buyers. Gil pointed out
that the estimates would depend heavily on whether the council restricted food truck operations.
Jack asked Gil to make no mention of the council plans, as nothing was yet official, and few people
were aware of the rumours. Jack had been closely monitoring local government planning since having
the garage redesignated. Furthermore, if they projected a downturn in revenue then they would likely
make a severe loss on the sale.
Your task
Which of the issues in Table 2.1 does this scenario relate to and why?
the business. While Sustainable Solutions maintained a constant client base, it was not clear that they
could expand this base proportionally to Joe’s proposed business expansion. Jane suspected that
the move was intended to embed Sustainable Solution’s current revenue in the new venture for the
foreseeable future. She suspected that Joe probably feared that a divorce may be imminent, and a
subsequent division of assets. By taking on this debt, Joe could probably delay any division of revenue
or company assets with Debbie. Jane felt she had a fiduciary duty to Debbie as much as Joe.
Your task
Which of the issues in Table 2.1 does this scenario relate to and why?
Note: A discussion of Examples 2.2 and 2.3 is provided in the Suggested answers section of this module.
Like most professionals, accountants work in an environment of high expectations and rewards.
However, rewards are often associated with responsibility and occasionally with extreme pressure.
The complexity of the work environment and the demands of a dynamic regulatory regime
sometimes create conditions that make it difficult for accountants to operate effectively.
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➤➤Question 2.1
Describe the likely implications for an accountant with insufficient time to perform their duties
properly. What advice would you give to an accountant faced with this situation?
Applying ethics
In this section we have defined and described ethics and highlighted that, as you pursue a career
in the accounting profession, you will be faced with many ethical issues.
In order for you to identify, understand, analyse and respond to ethical issues appropriately, it is
helpful to have a clear and coherent basis for your thoughts and actions.
To help with this, the next section provides a detailed overview of ethical theories, which is followed
by a practical examination of Compiled APES 110 Code of Ethics for Professional Accountants.
While some of this discussion is quite theoretical, it is important for you to develop a clear philosophy
and understand your own ethical thoughts and approaches. You should consider each theory carefully
and identify which most closely aligns with your own view of what is ethical.
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Normative theories of ethics propose principles that distinguish right from wrong by establishing
a norm or standard of correct behaviour that should be followed at all times. The awareness
and application of such theories provide two key functions. Firstly, they provide a framework
for judging the rightness of an act or decision after the event has occurred, and secondly,
they provide a framework for decision-making to resolve ethical problems. Applying different
ethical theories involves examining the situation or dilemma from multiple perspectives.
small minority of people whose needs are overlooked. This theory is explained in more detail later
in this module.
Normative theories of ethics can generally be divided into two broad categories: teleological
(or consequential) and deontological (or duty-based). The two categories and the types of
theories that are classified within these categories are discussed in the following sections.
From whose perspective should the consequences be evaluated? Do you think it should be based on
the consequences to the decision-maker or to those who are affected by the decision?
There is no correct answer to these questions. Rather, these different approaches are represented
by two traditional teleological theories: egoism and utilitarianism. In brief, egoism evaluates
the rightness of an action from the perspective of the decision-maker (self) whereas utilitarianism
evaluates the rightness of an action based on consequences to others. As each person is
a product of a number of factors, including education, culture and background, different
individuals may choose to apply these approaches differently. Remember that these theories are
conceptual approaches to how we ‘ought to’ behave, not how we do behave. When it comes
to making decisions, people are likely to make a decision based on a mix of different types of
ethical approaches, and their approach may also depend on the particular situation.
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Egoism
An ethical egoist approach describes the idea that it is right for a person to pursue an action in
their own self interest, assuming that everyone else is entitled to act in their own self-interest as
well. As stated previously, this is an ethical theory so, in reality, people are more likely to have a
mix of different ethical approaches. In this respect, ethical egoism is different from psychological
egoism, which describes how people tend to behave, without implying an ethical judgment
about how they should behave.
Ethical egoists evaluate the rightness of a proposed action by choosing a course of action
that maximises the net positive benefits to themselves. An example of egoism would be a
company that only releases information or clarifies issues when it is in the company’s self-interest
for the information to be released. Such companies display ethical egoism when they support
this behaviour as an appropriate general rule.
Based on the assumption that human beings tend to act in a way that brings them some form
of happiness or avoids some form of unhappiness, ethical egoism contends that this reality
should be accepted as a social norm.
The term ‘happiness’ has a number of connotations, but the characteristics of happiness
generally include a feeling of joy or delight, satisfaction or peace of mind, and the sense of
achieving one’s goals or desires. Correspondingly, unhappiness may be defined as a feeling of
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pain or sadness, frustration and the sense of failure in achieving one’s goals or desires. Although
this module refers to an egoist as a single person, the term ‘egoist’ can also refer to a group of
people or an organisation.
One difficulty with egoism is that acts of self-interest are commonly misunderstood as acts of
selfishness. According to this view, egoists are people who demonstrate a lack of concern for
the well-being of others and will justify questionable acts such as discrimination or dishonesty
if they promote self-interest. However, self-interest may well include concern for the well-being
of others, and can sometimes contradict selfishness. We use the term ‘enlightened self-interest’
precisely to highlight situations where acting selfishly may not be in our own self-interest.
According to ethical egoism, the accountant should provide full and accurate advice and allow the client
to employ the professional adviser of their choosing. It is not in the accountant’s long-term interest,
nor in the interests of those who rely on their advice, to offer less than frank or full advice. Overall,
the pursuit of self-interest will generally promote one’s well-being, but selfishness tends to ignore
the interests of others when they ought not be ignored. Therefore, ethical egoism contends that the
pursuit of self interest should not knowingly come at the expense of one’s well-being or that of others.
Ethical egoism also contends that the pursuit of self-interest should be constrained by the law
and the conventions of fair play. Rules and legal systems exist to resolve conflict. It is, therefore,
in the interests of all parties to obey and accept the decision of arbitration systems because,
without them, chaos will result. Thus, self-interest is not allowed to function unbridled by the law
or the dictates of what is considered fair competition. We can refer to this as restricted egoism.
Restricted egoism can be seen as an ethically more acceptable form of egoism. It sanctions
corporate self-interest and encourages competition to the extent that it leads to the
maximisation of utility and is in the interests of society as a whole.
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Utilitarianism
According to the utilitarian (or utility) principle, determining good from bad, or right from wrong,
is an act or decision that produces the greatest benefit or pleasure for the greatest number
of people. Similarly, if harm is inevitable, the right course of action is the one that minimises
harm or pain to the greatest number of people. Under utilitarianism, pleasure and pain may be
both mental and physical. As noted in the earlier example, one of the problems that may arise is
that an action that generates great benefit for many people may also come at the cost or harm
to smaller minority groups. This dilemma is often faced by governments, but is also faced by
organisations, which often need to make decisions that may benefit most employees but may
also have a negative impact on a few employees.
The utilitarian principle is attractive because it is easy to understand and provides a systematic
approach to problem resolution. Applying this principle to judgment, decision-making and
problem-solving is a process that relies on five basic steps:
1. Identify and articulate the ethical problem(s).
2. Identify all available courses of action that will resolve the situation.
3. Determine the foreseeable costs and benefits (short and long term) associated with
each option.
4. Compare and weigh the ratio of good and bad outcomes associated with each option.
5. Select the option that will produce the greatest benefit for the greatest number of people.
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While the process is conceptually simple, in certain circumstances it may lead to very complex
calculations.
A utilitarian analysis should be distinguished from a cost–benefit analysis that is normally applied
in business decisions. A cost–benefit analysis in business is generally weighed up in economic
terms and only as it relates to the decision-maker and the employing organisation.
Benefits
Savings 180 burn deaths, 180 serious burn injuries, 2100 burned vehicles
Unit $200 000 per death, $67 000 per injury, $700 per vehicle
Total benefit 180 × ($200 000) + 180 × ($67 000) + 2100 × ($700) = $49.5 million
Costs
Total cost 11 000 000 × ($11) + 1 500 000 × ($11) = $137 million
Source: Hoffman, W. M. 1982, ‘The Ford Pinto’ in Hoffman, W. M. & Moore, J. M. Business Ethics:
Readings and Cases in Corporate Morality, McGraw-Hill Book Company, New York, p. 415.
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The application of the utilitarian principle considers the costs and benefits for all who are affected
by the proposed decision or action (not just the decision-maker), and measures outcomes both
in economic and psychological terms. If executive management at the Ford Motor Company had
undertaken a utilitarian analysis, it may well have arrived at a different decision. Rather than a short-
term and narrow economic analysis of costs, management would have given due consideration
to the safety concerns of its customers as well as the long-term market reaction to a seemingly
callous decision.
Utilitarian theory has a much wider application than that of the impact on the immediate group,
or a group whose interests are immediately identifiable, which is arguably an ethical judgment
based on the theory of egoism. Most importantly, however, the application of the utilitarian
principle should not be reduced to a simple economic cost–benefit analysis measured in dollars
and cents.
Although it appears simple and widely applicable, utilitarianism is subject to four main limitations:
1. Measuring and assigning a numerical value to consequences is difficult and subjective,
particularly when dealing with non-economic outcomes. How should non-economic
outcomes such as pleasure, pain, health or improved personal rights be measured?
2. Identifying all stakeholders potentially affected by a decision or action and the ability to
reliably predict future outcomes is an uncertain and difficult process. Balancing risks against
benefits is a perpetual problem for which there is no easy solution. The risks include failing to
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identify the impact of any decisions on all stakeholders and whether all consequences have
been identified and examined.
3. Utilitarianism focuses on the results of proposed action and not the motivation, intention or
character of the action itself. Consequently, a questionable act may be justified on utilitarian
grounds because it brings greatest happiness to the majority, even if it disregards the
minority that may also be affected by the act. Therefore, it is concerned with total happiness
and may ignore the individual or the minority, and is indifferent to the distribution of benefits.
4. In business, utilitarian arguments are often relied on to justify a board’s decision to close
down a loss-making segment of the business so the entity can continue financially. That is,
the benefit of maintaining the entire business and its stakeholders outweighs ethical reasons
to maintain the loss-making segment. In this case, a utilitarian judgment may lead to
terminating the services of employees in this segment. Critics, however, contend that actions
such as this ignore other factors (e.g. community interests or the interests of the particular
employees whose employment was discontinued).
The key differences between ethical egoism and utilitarianism are highlighted in Table 2.2.
Ethical egoism
Theory (including restricted egoism) Utilitarianism
Proposes how one ought to behave. Proposes how one ought to behave.
Guiding principle Maximises net positive benefits to oneself. Maximises net positive benefits to the
greatest number of people.
Stakeholders Pursuit of self-interest should not come at Produces the best overall consequences
the expense of others. for everyone concerned.
➤➤Question 2.2
A candidate in the CPA program is explaining to a friend the concept of utilitarianism. In doing
so, the candidate defines utilitarianism as ‘an action that provides me with the greatest amount
of measurable monetary rewards over costs’.
Identify the problem(s) with this definition.
Take the example of telling a lie. Some look to the consequences that are likely to flow from
telling a lie (a consequential analysis), whereas a deontologist would argue that it is always wrong
to lie, whatever the outcome(s).
Motive
Deontology advocates that the motive is far more important than the action itself or its
consequences. Self-interest or emotion, rather than a sense of duty, are not appropriate motives
for an ethical act. The overriding value that guides duties, in Kant’s view, is respect for the
human dignity of all involved.
Although the good consequences that result from an act may be the same regardless of its
motive, it is the desire to do the right thing for its own sake that makes it an ethical act and
distinguishes it from an act of selfishness. Therefore, actions are right, not because of their
benefits but because of the nature of the actions or the rules from which they derive.
There are two major concepts in relation to which duties may be examined: rights and justice.
Rights
An ethical theory of rights contends that a good or correct decision is one that respects the
rights of others. Conversely, a decision is considered wrong if it violates the rights of a person or
organisation.
A right is an entitlement that a person may have in virtue of a particular characteristic, role or
condition that defines them. For example, it is generally recognised that each person has a right
to liberty, and therefore no one should be enslaved.
While rights are not to be confused with duties or obligations, there is a close correlation
between a person’s rights and the duty or obligation of another not to interfere with or abuse
these rights. In accounting, a client can expect to have their right to confidentiality protected
by their accountant, who has a duty not to breach this right unless the need to serve the public
interest supersedes it. A decision will be considered ethical if the resulting actions do not offend
the rights of anyone affected by that decision.
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Among the many types of rights that exist, legal rights are particularly important for the
accounting profession. Legal rights, namely those rights that are defined and enforced by
the legal system, prescribe both what people are entitled to and what duties others have to
protect those entitlements. Contractual rights (also called special rights) arise out of agreements
and relationships between individuals. An accountant has a contractual duty, for example,
to provide professional services that the client has a contractual right to receive. To do
otherwise may demonstrate a wrongful act on the part of the accountant.
Human rights, on the other hand, are more fundamental to society and relationships, and are the
key to maintaining social order. They are natural rights that apply to all people simply because
they are human beings. Some commonly recognised human rights are the right to life, freedom
of choice, right to the truth, right to privacy and freedom of speech.
One limitation of the rights principle is its inability to address conflicting rights and obligations.
What should one do when respecting one person’s rights contravenes the rights of another?
Which rights should be given preference? In Western societies, the right to free speech is often
considered a fundamental human right that should be respected. But what if allowing one person
to express their views brings harm to another? An important weakness of the rights principle
is that it provides little guidance on how to prioritise among different rights. A solution to this
problem may be examining the freedoms and interests at stake and deciding which one of all
those considered is more essential to human dignity.
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Justice
Under principles of justice, an ethical decision is one that produces: (1) the fairest process by
which any person in a particular situation should be treated by others (procedural justice); or
(2) the fairest distribution of benefits and burdens among members of a group or community
(distributive justice). Therefore, justice theory is concerned with issues of fairness and equality.
This example highlights a significant justice issue that exists in relation to the gender gap, where men
often receive higher wages than women for equivalent roles.
The principle of equality can be discussed in significantly different ways. Aristotle argued that
fairness does not mean treating everyone the same but acknowledging individual differences
and allocating resources to reflect these differences. In applying his account of fairness to
workers with disabilities, for example, treating equals equally and treating those who are
unequal differently or unequally requires that special provisions should be made for disabled
workers to access and enjoy the use of workplace facilities just as others do. Another qualified
approach to equality is the difference principle (Rawls 1971), which allows for unequal distribution
of resources only in circumstances where this distribution works to everyone’s advantage,
including those placed in an inferior position by the inequality that results.
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Irrespective of the nuances involved, according to the principle of distributive justice, an ethical
decision is one that results in a fair and equal distribution of benefits and burdens.
Virtue ethics
The previous discussion on normative theories of ethics described what a person should do
based on either consequences (teleology) or duty (deontology). Critics have challenged the
notion of what one should do according to principles of correct behaviour and argue that there
is a more important issue, namely, what people should be. If the guiding principle of right and
wrong is external to the self, as is the case with normative theories of ethics, then it lessens
individual responsibility because it shifts the burden of having to make decisions from oneself to
an external authority—be it a community, a principle or an abstract rule.
According to Melé (2005), determining what is right according to a set of duties or by systematically
analysing the consequences of an action may not motivate appropriate behaviour. Consistent
ethical behaviour is more likely to be the result of values such as integrity and good character.
According to this view, ethical character is seen to be more important than the right action.
This branch of ethics is known as ‘virtue ethics’. Its focus is to understand and develop virtues that
make us better people.
Virtues may be defined as attitudes, dispositions or traits of character that enable us to do what
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is ethically desirable, and which, through consistent practice, become habitual acts. Virtues
(e.g. courage, courtesy, compassion, generosity, fairness, fidelity, friendliness, honesty, integrity,
prudence and self-control) develop dispositions that favour ethical behaviour. Virtues are not
natural or inborn but rather they are developed through learning and practice.
Students acquire virtues or ethically ‘good’ habits by behaving ethically in context, much in the
same way as athletes or musicians gain the ability to perform. Through practice, students can
learn to be courageous and compassionate. Once they have been learned, these virtues are
internalised and become a character trait. Virtuous behaviour then becomes a natural reaction—
usually referred to as ‘second nature’. In other words, once acquired, virtues predispose us to
act ethically.
The concept of virtue ethics is arguably more applicable to the role of professional accountants
than are the traditional normative theories of ethics. The responsibilities and expectations of a
professional accountant and the principles of professional conduct are outlined in the Code of
Ethics for Professional Accountants.
Principles of professional conduct such as integrity, objectivity and competence (as outlined
in the Code of Ethics for Professional Accountants) are not unlike the virtues described
above. Doucet and Ruland (1994), for instance, identify three virtues of particular relevance for
accountants, which are necessary to enable them to fulfil their professional responsibilities.
These are expertise, courage and integrity:
In essence to have expertise means that the accountant knows what the rules and principles are …
Courage is necessary to resist client or competitive pressures … Integrity entails the disposition to
do the right and just action without regard to personal gain or advantage (Doucet & Ruland 1994).
A limitation of virtue ethics is that it does not always provide guidance when a person is faced
with a genuine ethical dilemma. Unlike traditional theories of ethics that emphasise a ‘right’
action, virtue ethics emphasises the personal attributes that an ethical person should possess.
However, it does not necessarily make clear what one should do in a specific conflict situation.
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Moral agency
Under the theory of moral agency, moral agents are rational persons who are capable of
understanding what it means to act ethically, and will therefore tend to act in that way. Accountants
are moral agents who are aware of the implications of their actions, as well as what their ethical
responsibilities are, and so they are accountable for their actions. Accountants cannot rely on
excuses such as lack of understanding to try to avoid their responsibility.
As moral agents, accountants can be relied upon to be a strong guiding force in ‘doing things
the right way’ if they have well-developed ethical standards and education. For example,
when financial statements are being prepared, the accountant can be relied upon to be
objective and impartial when it comes to the measurement and disclosure of an asset or liability.
This describes the common expectations placed by the profession on the person acting as
moral agent in an accountant role.
From this discussion you should be aware that two people may come to very different answers
about what is ‘ethical’ in a particular situation. You should also have a clearer understanding
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of your own ethical philosophy.
In the next section, we move away from the theoretical aspects of ethics to review the
Compiled APES 110 Code of Ethics for Professional Accountants, which outlines the ethical
principles guiding the behaviour of professional accountants.
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You are not expected to print out the entire Code, although it may be helpful to print sections that
are referenced and/or discussed in the study guide. Unless specifically noted, only the content in the
study guide is examinable.
In 2005, the International Federation of Accountants (IFAC) issued the Code of Ethics for
Professional Accountants (IFAC 2005) as a model that member bodies such as CPA Australia
could rely on to provide ethics guidance at a national level.
As a result of this initiative, the Accounting Professional and Ethical Standards Board (APESB)
released APES 110 Code of Ethics for Professional Accountants, which was based on the IFAC
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Code and was initially operative from 1 July 2006. The current version of the APESB Code of
Ethics was issued in November 2013. Paragraphs prefixed with the letters ‘AUST’ have been
inserted in the APESB Code of Ethics for Australian-specific ethical requirements.
Under s. 1.2 of the APESB Code of Ethics, ‘all members in Australia shall comply with APES 110
including when providing Professional Services in an honorary capacity’. Under s. 1.3 of the Code,
‘all Members practising outside of Australia shall comply with APES 110 to the extent to which
they are not prevented from so doing by specific requirements of local laws and/or regulations’.
CPA Australia members must comply with the APESB Code of Ethics.
The Code highlights the fundamental principles that apply to all aspects of a professional
accountant’s work, and also provides guidance for resolving conflicts of interest and other ethical
situations that may arise from time to time.
By joining a profession, members agree to uphold its high ethical standards. The proper fulfilment
of the role of an accountant involves discharging one’s professional work responsibilities while
ensuring compliance with all the obligations included in the Code.
IFAC (2010) defines the ‘public’ as including ‘the widest possible scope of society: individuals
and groups of all jurisdictions sharing an international marketplace for goods and services’
and ‘all users of financial information and decision-makers in the financial reporting supply
chain: citizens, financial preparers, corporate boards, stakeholders, auditors, governments and
financial industries’.
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IFAC defines ‘interest’ as the ‘responsibilities that professional accountants have to society’.
Examples of these responsibilities include the following:
• Providing sound financial and business reporting to stakeholders, investors, and all parties in
the marketplace directly or indirectly impacted by that reporting;
• Facilitating the comparability of financial reporting and auditing across different jurisdictions;
• Requiring that accounting professionals apply high standards of ethical behaviour and
professional judgment;
• Specifying appropriate educational requirements and qualifications for professional
accountants; and
• Providing professional accountants in business with the knowledge, judgment and means
to contribute to sound corporate governance and performance management for the
organizations they serve (IFAC 2010).
In the 2012–14 CPA Australia corporate plan, one of the key stated goals is:
protecting the public interest, through:
• ensuring that all of our members comply with a professional code of conduct;
• ensuring the highest standards for those members who provide accounting services
to the public;
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• requiring our members to keep their knowledge current; and
• advocating on behalf of our members’ (CPAA 2012).
Safeguarding the public interest is an overriding responsibility that underpins all professional
duties and obligations. To highlight the importance of the ‘public interest’ to the accounting
profession, the first sentence of the APESB Code of Ethics reads: ‘A distinguishing mark of
the accountancy profession is its acceptance of the responsibility to act in the public interest’
(s. 100.1).
In cases where the accountant has obligations to more than one stakeholder, the question arises
of to whom the accountant owes their primary loyalty. In public practice, it is tempting to assume
that the accountant–client relationship is central to the function of accounting. In this view,
no one else matters but the client. Similarly, in the accountant–employer relationship, it may be
presumed that accountants owe their primary loyalty to their employers. Both views are incorrect.
The accountant’s primary duty is not to the client or the employer, but to the public. Therefore,
emphasis on the public interest extends to interests beyond the needs of an individual client or
employer. In general, it is assumed that the accountant is obligated to advance the interests of
their client or employer, so long as this does not conflict with the obligation to safeguard the
public interest.
In addition to defining their obligations under the public interest, members of the accounting
profession must also understand what it means to serve the public interest. It encompasses the
pursuit of excellence for the benefit of others. This includes integrity, objectivity, independence,
confidentiality, adherence to technical and professional standards, competence and due care,
and ethical behaviour.
94 | ETHICS
Before continuing, read ss. 110 to 150 of the Code and familiarise yourself with the fundamental
principles of professional conduct.
As integrity is intrinsically linked with trust, the APESB Code of Ethics imposes an obligation on
accountants to be straightforward and honest in professional and business relationships (s. 110.1).
This means that accountants:
shall not knowingly be associated with reports, returns, communications or other information where
they believe that the information:
(a) Contains a materially false or misleading statement;
(b) Contains statements or information furnished recklessly; or
(c) Omits or obscures information required to be included where such omission or obscurity
would be misleading (s. 110.2).
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Objectivity (s. 120)
Objectivity refers to the state or quality of being true, outside of any individual feelings or
interpretations. Accountants may be exposed to numerous situations that may impair their
objectivity in the application of professional judgment. For example, a member in business may
feel pressure from a supervisor to overlook an accounting irregularity. Similarly, a member in
public practice may feel the need to support a client’s questionable assertions to secure ongoing
fees. In such circumstances, accountants may subordinate the interests of the public to those of
the client or themselves, or compromise one client’s interest over another’s.
Flowing from these examples are three obligations on accountants that are founded on the
principle of objectivity: they should be impartial, honest and free from conflicts of interest.
Consequently, accountants have a duty to avoid relationships or other situations that may
‘compromise their professional or business judgment because of bias, conflict of interest or
the undue influence of others’ (s. 120.1).
There are many circumstances that have the potential to compromise a member’s objectivity,
such as acquiring a financial interest in a client, formal or informal relationships with executive
management, or excessive fees from a single client. The issue of objectivity and public
accounting services is dealt with in detail in s. 280 of the APESB Code of Ethics.
The highest risk arising from related party transactions is that they may not be at arm’s length.
An arm’s length transaction is one in which both parties act in their own interests (e.g. to
maximise returns), without pressure or duress from the other party or a third party. To do this
effectively, it is important to keep the other party at a distance, or at arm’s length—and not
engage in relationships that may interfere with each party’s independent interests. As they
may not be at arm’s length, failure to disclose or report related party transactions may lead to
distorted representations of an organisation’s financial situation and may hide dealings that
benefit other parties to the detriment of the organisation.
Due care encompasses the responsibility to ‘act in accordance with the requirements of an
assignment, carefully, thoroughly and on a timely basis’ (s. 130.4). In addition to producing
credible and accurate reports, members should not accept jobs or tasks unless they possess
the requisite skill to perform the task properly. Supervisors have a corresponding duty to ensure
that those working under their authority have appropriate training and supervision (s. 130.5).
Due diligence and appropriate supervision are critical to the work of accountants, particularly
during busy and stressful times. Under the strain of a heavy workload, attention to detail may be
overlooked in favour of meeting deadlines and errors can occur.
Due care also imposes a condition of compliance with relevant technical and professional
requirements. Such requirements include accounting and auditing standards and other statutory
regulations such as taxation laws.
Clients and employers have a right to expect that accountants will not reveal anything about their
personal or business affairs. Accountants must also refrain from using confidential information
‘to their personal advantage or the advantage of third parties’ (s. 140.1).
The duty of confidentiality extends to all members, including those within employing firms
or organisations (s. 140.4), as well as prospective clients or employers (s. 140.3). Furthermore,
the duty of confidentiality does not end with the termination of the professional—client or
professional—employer relationship. The duty continues even after such relationships have
been terminated (s. 140.6).
Generally, the duty of confidentiality is relieved only when disclosure is required by law, or there
is a professional duty or right to disclose. The following are the circumstances listed in the
APESB Code of Ethics s. 140.7 when disclosure of confidential information may be appropriate:
(a) Disclosure is permitted by law and is authorised by the client or the employer;
(b) Disclosure is required by law, for example:
(i) Production of documents or other provision of evidence in the course of legal
proceedings; or
(ii) Disclosure to the appropriate public authorities of infringements of the law that come
to light; and
(c) There is a professional duty or right to disclose, when not prohibited by law:
(i) To comply with the quality review of a member body or professional body;
(ii) To respond to an inquiry or investigation by a member body or regulatory body;
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(iii) To protect the professional interests of a member in legal proceedings; or
(iv) To comply with technical standards and ethics requirements.
Therefore, in addition to their duty to clients, employers and the public, which comes with a
commitment to the public interest, accountants also have a responsibility to the accounting
profession and fellow members. They must act in a way that promotes the good reputation of the
profession and their colleagues. This includes avoiding exaggerated claims about the services
offered, qualifications or experience, and avoiding disparaging references or unsubstantiated
comparisons to the work of others (s. 150.2).
➤➤Question 2.3
As a newly qualified CPA, you are asked to perform an audit of a small electronic-parts
manufacturing firm. The manufacturer’s procedures are specialised and many of its contracts are
linked to the government, which requires the application of a specialised cost-accounting system.
You have no experience in the electronics industry or with the specialised cost-accounting system.
What should you do in these circumstances?
Case Study 2.1 is a comprehensive example requiring the application of the fundamental
principles of professional conduct.
98 | ETHICS
As a result of his position, London had access to highly sensitive and confidential information regarding
upcoming earnings announcements about KPMG clients before that information was disclosed to
the public. For over two years, London illegally provided this confidential information to his close
friend Bryan Shaw, who made over USD 1 million profit by using the information to trade securities.
In exchange, Shaw gave London thousands of dollars in cash, a Rolex watch and concert tickets
(FBI 2013).
On 1 July 2013, London pleaded guilty to insider trading and admitted to disclosing confidential
information to Shaw. On 27 September 2013, London was banned by the SEC from auditing public
companies and ‘denied the privilege of appearing or practicing before the Commission as an
accountant’ (SEC 2013b, p. 9).
On 24 April 2014, London was sentenced to 14 months in jail, commencing in July 2014, and ordered
to pay a $100,000 fine. After being sentenced, London said ‘I had to plead guilty. The impacts on the
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profession and on KPMG could have led to even further damage if there had been a long investigation
and court case. It doesn’t take long for bad public perception about accounting firms, like what
happened to Arthur Andersen in 2002. So I want to do as much as I can to set things right. What I did
was clearly wrong, and I take full responsibility. However, this is a subject matter that unfortunately
may be very prevalent with people who have access to confidential information, but it’s difficult to
catch people doing it. Even seemingly innocuous conversations with a good friend can lead a person
to be tempted and think they won’t get caught. I hope that my story can help prevent others from
crossing the line’ (O’Bannon 2014).
Your tasks
(a) Who were the stakeholders (individuals or groups who have a stake in what happens), and how
were they affected by the actions of Scott London?
(b) Did London breach any of the fundamental principles of professional conduct contained in the
Code of Ethics? If so, state those principles and explain why you think they have been breached.
Note: A discussion of all the case study tasks is provided at the end of the Suggested answers section
of this module.
You should now read ss. 100.6 to 100.11 of the Code and familiarise yourself with the conceptual
framework approach.
The conceptual framework approach requires members to identify, evaluate and respond to
any identified threat that may compromise compliance with the fundamental principles. If the
identified threats are not insignificant, members must apply safeguards to eliminate such
threats or reduce them to an acceptable level, so that compliance is no longer compromised.
If members are unable to implement appropriate safeguards, they should either decline or
discontinue the specific professional service involved, or consider resigning from the client or
employer. Figure 2.1 illustrates the conceptual framework approach.
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Threat identified
Yes
Implement safeguard(s)
Is threat
mitigated to an Yes
acceptable level?
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No
Decline or discontinue
service, client or employer
Source: Dellaportas, S., Alagiah, R., Gibson, K., Leung, P., Hutchinson, M. &
Van Homrigh, D. 2005, Ethics, Governance and Accountability: A Professional
Perspective, John Wiley & Sons, Milton, Queensland, p. 75.
The conceptual framework approach differs from rule-based codes, which merely require
adherence to a set of specific rules in terms of the specific actions that should or should not be
taken. The problem with a code that is entirely rules-based is that it becomes too prescriptive
and too voluminous to be of practical use. Excessive prescription causes ethical decision-making
to focus too much on whether the rule permits or prohibits a particular treatment or behaviour,
rather than using ethical judgment to determine whether a fundamental principle is protected.
Self-interest A financial or other interest will The member is in line for a bonus if profits
inappropriately influence the member’s hit a certain level in the current financial
judgment or behaviour. year. The member is thinking of deferring
a transaction that will significantly reduce
profit until the following financial year.
s. 200.4, s. 300.8
Self-review A member will not appropriately evaluate A member has been appointed to carry
the results of a previous judgment made out an audit on a process control that they
or service performed by the member, or by were originally engaged in implementing.
another individual within the member’s firm
or employing organisation, on which the Response: The member should remove
member will rely when forming a judgment themselves from the audit.
as part of providing a current service.
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s. 200.5, s. 300.9
s. 200.6, s. 300.10
Familiarity Due to a long or close relationship with A member has been appointed to audit
a client or employer, a member will be the financial statements of a company
too sympathetic to their interests or too where their brother/sister is the CFO.
accepting of their work.
Response: The member should remove
themselves from the audit.
s. 200.7, s. 300.11
Intimidation A member will be deterred from acting A member is being pressured by their line
objectively because of actual or perceived manager not to alert senior management
pressures, including attempts to exercise about a misstatement in the financial
undue influence over the member. report, and fears that they will be
demoted or lose their job if they report it.
s. 200.8, s. 300.12
Source: Accounting Professional and Ethical Standards Board 2013, Compiled APES 110
Code of Ethics for Professional Accountants, APESB, Melbourne, s. 100.12. Reproduced with
the permission of the copyright owner, Accounting Professional & Ethical Standards Board
Limited (APESB), Victoria, Australia.
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The following example illustrates the conceptual framework approach to compliance with the
fundamental principles of professional conduct.
The accountant must evaluate the significance of such a threat and, if the threat is other than clearly
insignificant, safeguards should be considered and applied as necessary to reduce the threat to an
acceptable level. One relevant safeguard includes consultation with superiors within the employing
organisation (such as the audit committee or other body responsible for governance), or with a relevant
professional body. If the threat cannot be mitigated to an acceptable level, the accountant should
consider discontinuing their service for the employer.
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Self-interest threat Self-review threat Advocacy threat Familiarity threat Intimidation threat
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• A financial interest in a • Reporting on the operation • Promoting shares in an • A member of the • Being threatened with
client. of financial systems after audit client. engagement team having dismissal from a client
• Undue dependence on being involved in their • Acting as an advocate on a close or immediate engagement.
total fees from a client. design or implementation. behalf of an audit client in family member who is a • An audit client indicating
• Having a significant close • Having prepared the litigation or disputes with director or officer of the that it will not award a
business relationship with original data used to third parties. client. planned non-assurance
an assurance client. generate records that are • A member of the contract to the firm if the
• Concern about the the subject matter of the engagement team having firm continues to disagree
possibility of losing a engagement. a close or immediate with the client’s accounting
client. • A member of the family relationship with treatment for a particular
• Entering into employment assurance team, being, an employee of the client transaction.
negotiations with an audit or having recently been, who is in a position to • Being threatened with
client. a director or officer of that exert direct and significant litigation.
• Contingent fees relating to client. influence over the subject • Being pressured to reduce
an assurance engagement. • A member of the matter of the engagement. inappropriately the extent
• Discovering a significant assurance team being, • A director or officer of the of work performed in order
error when evaluating or having recently been, client or an employee in a to reduce fees.
PUBLIC PRACTICE
the results of a previous employed by the client in a position to exert significant • Feeling pressured to agree
professional service position to exert direct and influence over the subject with the judgment of a
performed by a member of significant influence over matter of the engagement client employee because
the member’s firm. the subject matter of the having recently served as the employee has more
engagement. the engagement partner. expertise on the matter in
• Performing a service • Accepting gifts or question.
for a client that directly preferential treatment from • Being informed by a
affects the subject a client, unless the value is partner of the firm that
matter information of the trivial or inconsequential. planned promotion will
assurance engagement. • Long association of not occur unless the
senior personnel with the member agrees with an
assurance client. audit client’s inappropriate
accounting treatment.
Table 2.4: Examples of threats—accountants in public practice and business
Self-interest threat Self-review threat Advocacy threat Familiarity threat Intimidation threat
• Financial interests, loans or • Determining the • When choosing accounting • Being responsible for the • Threat of dismissal or
guarantees from the appropriate accounting policies or selecting employing organisation’s replacement of the
employing organisation. treatment for a business how to report financial financial reporting when an member in business or
• Incentive compensation combination after information. immediate or close family a close or immediate
arrangements offered performing the feasibility • Note that when furthering member employed by the family member over a
by the employing study that supported the the legitimate goals entity makes decisions that disagreement about
organisation. acquisition decision. and objectives of their affect the entity’s financial the application of an
• Inappropriate personal use employing organisations, reporting. accounting principle or
of corporate assets. members may promote • Long association with the way in which financial
• Concern over employment the organisation’s position, business contacts information is to be
BUSINESS
security. provided statements influencing business reported.
• Commercial pressure from made are neither false nor decisions. • A dominant personality
outside the employing misleading. • Acceptance of a gift or attempting to influence the
organisation. preferential treatment, decision-making process,
unless the value is trivial for example with regard to
and inconsequential. the awarding of contracts
or the application of an
accounting principle.
Source: Accounting Professional and Ethical Standards Board 2013, Compiled APES 110 Code of Ethics for Professional Accountants, APESB, Melbourne, ss. 200.4–8, ss. 300.8–12.
Reproduced with the permission of the copyright owner, Accounting Professional & Ethical Standards Board Limited (APESB), Victoria, Australia.
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104 | ETHICS
Some safeguards help to identify and deter unethical behaviour and apply across both of
the above categories. These include effective, well-publicised policies that outline required
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behaviours, as well as disciplinary and complaints systems that enable colleagues, employers and
members of the public to draw attention to unprofessional or unethical behaviour (s. 100.16).
Note that the safeguards listed above provide an overview of the different types of safeguards
available to organisations, whether they are public accounting firms or business entities. For
a more extensive list of safeguards applicable to accountants in public practice, see s. 200.12
(firm wide safeguards), s. 200.13 (engagement-specific safeguards) and s. 200.15 (safeguards
within client systems and procedures) of the Code. For safeguards applicable to members
in business, see ss. 300.13 to 300.15.
In practice, the type and nature of the safeguards that will mitigate specific threats to an
acceptable level will vary depending on the specific circumstances and the nature of the
dilemma. Ultimately, the member must select a safeguard, or implement a safeguard of their
own design, that best suits their circumstances.
Consideration should be given to what a reasonable and informed third party, having knowledge
of all relevant information, including the details of the threat(s) and the safeguard(s) applied,
would conclude.
Once these factors are considered, one should determine the appropriate course of action.
It may be wise to document the issue as well as relevant discussions and decisions made
(s. 100.22). If the matter is not resolved, it may be useful to consult with suitable people,
which may include the board of directors or audit committee (s. 100.21), CPA Australia or
legal advisers (s. 100.23). If it is not possible to resolve the issue, the accountant may consider
resigning from the specific engagement or employing organisation (s. 100.24).
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[AUST] Preface: Sections 290 and 291
Section 290 Independence—Audit and review engagements
Section 291 Independence—Other assurance engagements
Part B of the Code provides members in public practice with guidance on how to apply the
conceptual framework to the fundamental principles of professional conduct. We now consider
some of the specific issues covered by Part B of the Code.
For example, a member may be approached by a potential client to undertake tasks for which
the member has neither experience nor knowledge. In this circumstance, a self-interest threat
to professional competence and due care arises because the member does not possess the
competencies necessary to properly carry out the engagement (s. 210.6).
Appropriate safeguards outlined in the APESB Code of Ethics to address this issue may include:
• Acquiring an appropriate understanding of the nature of the client’s business, the complexity
of its operations, the specific requirements of the engagement and the purpose, nature and
scope of the work to be performed;
• Acquiring knowledge of relevant industries or subject matters;
• Possessing or obtaining experience with relevant regulatory or reporting requirements;
• Assigning sufficient staff with the necessary competencies;
• Using experts where necessary;
• Agreeing on a realistic time frame for the performance of the engagement; and
• Complying with quality control policies and procedures designed to provide reasonable
assurance that specific engagements are accepted only when they can be performed
competently (s. 210.7).
106 | ETHICS
It has long been considered a matter of etiquette for a proposed successor to communicate with
their predecessor before accepting a professional assignment. Communication provides the
proposed successor accountant with the opportunity to identify whether there are professional
reasons why the appointment should not be accepted. For example, this could include
intimidation threats where the predecessor had been placed under undue pressure to act in
a way that was illegal and/or unethical.
Additionally, the proposed successor accountant may discover client involvement in illegal
activities (such as money laundering), dishonesty or questionable financial reporting practices
that could threaten compliance with the principle of integrity.
A member ‘who is asked to replace an existing auditor shall request the client’s permission to
communicate with the existing auditor’ and, if this ‘is refused, the Member shall … decline the
audit engagement’ (AUST210.11.1).
Similarly, there may be a threat to professional competence and due care if an accountant
accepts the engagement before knowing all the facts regarding the client’s business (s. 210.9).
Thus, the matter becomes one of competence, integrity and objectivity.
One problem inhibiting effective communication is that existing accountants are bound by the
principle of confidentiality. The extent to which the existing accountant can and should discuss
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the affairs of a client with a proposed successor will ultimately depend on whether the client
has granted permission to do so (s. 210.13). In the absence of specific instructions by the client,
an existing accountant should not volunteer information about the client’s affairs. On receipt of
permission from the client, however, the existing accountant is to provide information ‘honestly
and unambiguously’ (s. 210.14).
Referrals
Referrals occur when a client requires specialist advice in an area that is beyond the competence
of their existing accountant. In this case, the member or the client should engage another
accountant with the required expertise. A referral should not be seen as an invitation for
the accountant who has received the referred special assignment to ‘take over’ the client.
The established relationship between the referring accountant and the client is maintained.
The underlying issue with referrals is one of professional competence. Knowing the extent of
one’s own skills and when the skills of a more qualified expert are required is closely linked to the
principle of professional competence.
It is difficult for an accountant to act in the best interests of two or more clients in a common
transaction. Where there is a conflict between two or more clients, serving the interest of one
client will occur at the expense of the second client.
Resigning from one or both clients is seen as an appropriate safeguard, but the loss of a client
might be to the client’s detriment as well as that of the member. However, the member must not
provide services to both clients unless consent to do so is received from both clients (s. 220.3).
In the absence of express consent from both clients, resignation from the conflicting engagement
may be the only appropriate safeguard (s. 220.5).
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tempted or swayed to protect their own financial interest ahead of their client’s interest.
In such circumstances, the member must apply appropriate safeguards to ensure their clients
are not disadvantaged. In this case, the member should obtain consent and notify all relevant
parties that they have relationships with competitor clients or third parties (s. 220.3).
➤➤Question 2.4
You have been asked to audit Toytown Pty Ltd’s half-year financial statements.
• The company was last audited by Smith, Jones & Associates, which resigned as the auditor
as a result of the retirement of the only registered company auditor within the practice.
• For the last three years, Toytown has engaged Ace Tax Services, a firm of local CPAs, to prepare
corporate income tax returns and wishes this arrangement to continue.
Are you required by the APESB Code of Ethics to contact or obtain professional clearance from
each of the above accounting firms before accepting the appointment as auditor of the half year
financial statements?
When a member is asked to provide a second opinion, the member should seek permission from
the client to contact the existing accountant and discuss the transaction in question to ensure that
the member provides a fully informed second opinion (s. 230.2). If the client refuses the member
permission to communicate with the existing accountant, the member should consider whether it
is appropriate to provide a second opinion (s. 230.3). In providing a second opinion, the member
should clearly describe, in communications with the client, the limitations surrounding any opinion
and also provide the existing accountant with a copy of the opinion (s. 230.2).
108 | ETHICS
A self-interest threat to professional competence and due care is created if the fee quoted is so
low that it may be difficult to perform the engagement in accordance with applicable technical
and professional standards for that price (s. 240.1). In these circumstances, safeguards outlined in
the APESB Code of Ethics that may be adopted include:
• Making the client aware of the terms of the engagement, in particular, the basis on which fees
are charged and which services are covered by the quoted fee; and
• Assigning appropriate time and qualified staff to the task (s. 240.2).
When the fees from a client or group of related clients represent a significant proportion of the
total gross fees for a firm, a self-interest threat arises because the dependence on that client
or group of clients will inevitably come under scrutiny and, accordingly, cast doubt on the
accountants’ ability to objectively apply professional judgment. Objective judgment on disputed
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accounting issues may be compromised by a fear of losing a client whose fees have significant
implications for the financial stability of the firm of accountants (s. 290.220).
The Code imposes a disclosure obligation where the fees generated by an audit client that is
a public interest entity (e.g. a listed entity) represent more than 15 per cent of the total fees
received by the firm for two consecutive years. Such circumstances must be disclosed to those
charged with governance of the audit client, along with specifying the appropriate safeguard that
will be applied (s. 290.219).
The safeguard in this circumstance is clear: one should not enter into a contingency fee
arrangement for professional services requiring independence and objectivity, such as an audit
engagement, as the threat created would be so significant that no safeguard could reduce
the threat to an acceptable level (s. 290.223).
In addition to fees for service, a member in public practice may also receive or pay a referral
fee (where the member does not provide the service) or commission from or to a third party
(in connection with the sale of goods or services) relating to a client.
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However, ‘accepting such a referral fee or commission creates a self-interest threat to objectivity
and professional competence and due care’ (s. 240.5). In this situation, informing the client in
writing of the following matters (APESB Code of Ethics, s. AUST240.7.1) is required to reduce the
threat to an acceptable level:
• the existence of such arrangement;
• the identity of the other party or parties; and
• the method of calculation of the referral fee, commission or other benefit accruing directly or
indirectly to the member.
Under s. AUST240.7.2, ‘the receipt of commissions or other similar benefits in connection with
an Assurance Engagement creates a threat to Independence that no safeguards could reduce
to an Acceptable Level. Accordingly, a member in public practice shall not accept such a fee
arrangement in respect of an Assurance Engagement.’
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Members in public practice who provide financial advice must be able to recognise potential
threats created by personal and business relationships. Those who provide financial advice
(which generally includes advice on financial products such as shares, managed funds,
master funds and life insurance) must follow the provisions of APS 12 Statement of Financial
Advisory Service Standards.
Receiving remuneration in the form of commissions and other financial benefits might threaten
a member’s objectivity (APS 12, para. 9.5). Commissions, as described above, create potential
self-interest threats to objectivity. Therefore, members should adopt a fee-for-service approach,
as this approach is seen as consistent with the principle of professional independence
(APS 12, para. 17.2).
At a minimum, where a member accepts commissions or other incentives, the member must
fully and clearly disclose to the client the nature and extent of such fees (APS 12, para. 20.1).
In addition to commissions, soft-dollar benefits received from third parties that create conflicts
can potentially undermine independent advice (APS 12, para. 21.1). Soft-dollar benefits include
all monetary and non-monetary benefits received from a third party, such as fund managers,
for the sale or recommendation of certain products. Remuneration in the form of soft-dollar
benefits has the potential to influence an adviser’s recommendations to clients, or at least give
the impression of such influence.
CPA Australia, through APS 12, has accordingly banned a wide range of benefits, gifts or other
incentives (soft-dollar benefits), including commissions based on sales volumes, preferential
commissions linked to in-house financial products, free or subsidised office equipment,
computers or software, and gifts over $300 in value (APS 12, para. 21.3).
110 | ETHICS
➤➤Question 2.5
‘You manage fundraising for a charity. You have been approached by a financial planner with
a client who is interested in contributing a $500 000 charitable gift for tax purposes. As the
transaction is being undertaken solely for tax purposes, the selection of the charitable recipient
is of little concern to the donor. The financial planner states that he will direct the gift to your
organisation upon signing an agreement to pay a 5 per cent ‘finder’s fee’ to the financial planner
upon receipt of the gift. You have never encountered such a proposal before and therefore you
need to seek guidance’ (Sexton 2009).
Evaluate whether this situation is possibly in violation of ethical fundraising principles.
While members in public practice may approach potential clients personally or through
direct mail to make known the range of services they offer, they must ensure that follow-up
communications are terminated when requested by the recipient. Otherwise, continued contact
could be regarded as harassment.
➤➤Question 2.6
James Chan is a sole practitioner in a large regional city specialising in audit services. James has
become interested in the new assurance services for the elderly provided by the profession.
He recently attended a presentation on care services for the elderly and believes that this new
assurance service will differentiate him from other practitioners in the area and, therefore, offers
a means to attract more clients.
James has placed a series of advertisements in the local press. The advertisements state that he can
provide expert reports to assure family members that proper care is provided by establishments
to elderly family members who are no longer totally independent.
Although James has no previous experience or training in this area, he believes that he can carry
out the work using traditional audit skills.
Do the advertisements of James Chan comply with the Code? Discuss.
There are no specific criteria for stating which gifts or hospitality are acceptable. Accountants
need to assess the size, style, type and value of the offering in order to determine whether it is
appropriate. Where a gift or other item is not appropriate it should not be accepted.
Study guide | 111
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after graduation, after a few weeks Tom found that there were some unfortunate consequences of
the company’s approach. The lower fees made them an attractive proposition for businesses trying to
cut costs, and many of their clients had switched from competitors. This had bred some resentment
within the industry towards the company, and promoted an isolationist culture in the company itself.
Having hostile relationships with several other auditing companies, contacting these companies was
generally discouraged in cases where these companies had previously audited their new clients,
or where Reliance employees were offering second opinions. The high client numbers taken on by the
company meant employees had heavy case-loads, making it difficult to allocate a sufficient amount of
time to each client. Their policy of accepting all new clients meant that the variety of clients was large,
and the high workload employees faced meant most were unwilling to take on referrals when their
colleagues felt unsure about aspects of their clients’ cases. Management encouraged self-reliance and
a competitive culture where the number of clients processed by each employee was tallied, and only
those with the highest tallies were eligible for promotion to supervisory positions. After a few months,
Tom also noticed a high staff turnover rate. Employees unable to process the required volume of client
engagement were given one warning and then dismissed. He realised it was this turnover rate that
had enabled him to find employment at the firm so quickly in the first place.
Your task
How do the environment and culture at Reliance impact on the ability of Tom and his colleagues
to act ethically? In particular, do they interfere with their ability to follow any of the principles of the
APESB Code?
Note: A discussion of this example is provided in the Suggested answers section of this module.
Sections 290 and 291 of the Code contain more than 200 paragraphs about identifying threats to
independence and related safeguards on various aspects of audit, review and assurance services.
You are NOT required to print and read ss. 290 and 291 of the Code. In relation to ss. 290 and 291,
only the content of this study guide is examinable.
112 | ETHICS
The concept of independence is so important and ingrained that it is often regarded as the
cornerstone on which much of the ethics particular to the audit profession is built. The entire
rationale for the profession of public accounting rests on the foundation of integrity, of which
independence is an important part. Cottell and Perlin (1990) remind us that independence should
be considered of utmost importance if the profession is to maintain the confidence of the public.
Debate about [independence] … will continue if the profession is to be viable, for such a debate
is an indicator of ethical health … Perhaps the greatest danger to the profession lies in potential
apathy toward independence. If the public and its representatives were ever to perceive that
independence was a sham, the profession would likely be swept away like a sand castle before the
tides (Cottell & Perlin 1990, p. 40).
Objectivity, closely associated with independence of mind, may be defined as a state of mind
that imposes upon an individual the obligation to be impartial and free from conflicts of interest.
There are practical difficulties in determining whether a member is truly independent since it is
impossible to observe and measure a member’s mental attitude and personal integrity. This is
one reason why independence in appearance takes on increasing significance.
Being independent means that one is not only unbiased, impartial and objective but is also
perceived to be that way by third parties. Independence in appearance is the avoidance of facts
and circumstances where a reasonable and informed third party, having knowledge of all relevant
information, including any safeguards applied, would reasonably conclude that the accountant’s
integrity or objectivity has been compromised. While independence is applicable to all
accounting professionals, independence is especially important for members in public practice.
The rules pertaining to independence for members in public practice who perform audits
are detailed and technical. CPA Australia has produced a checklist (Figure 2.2) to assist in
determining whether the firm in which they are employed complies with the independence
rules, regulation and interpretations of CPA Australia and relevant statutory bodies.
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Completion of this form provides data for determining that the practice is complying with the
independence rules, regulations and interpretations of CPA Australia and relevant statutory bodies.
Yes† No
Do you have a direct or indirect material financial interest in a client or its subsidiaries/
affiliates?
Do you have a financial interest in any major competitors, investees or affiliates of a client?
Do you have any outside business relationship with a client or an officer, director or principal
shareholder having the objective of financial gain?
Do you owe any client any amount, except as a normal customer, or in respect of a home
loan under normal lending conditions?
Do you have the authority to sign cheques for a client, or make electronic payments on
their behalf?
Are you connected with a client as a promoter, underwriter or voting trustee, director,
officer or in any capacity equivalent to a member of management or an employee?
Do you serve as a director, trustee, officer or employee of a client?
Has your spouse or minor child been employed by a client?
Has anyone in your family been employed in any managerial position by a client?
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Are any billings delinquent for clients that are your responsibility?
Have you received any benefits such as gifts or hospitality from a client, that are not
commensurate with normal courtesies of social life?
Are there any other independence issues that you believe are relevant to disclose?
I have read the Independence Policy of the practice, and professional standards related to independence,
and I believe I understand them. I am in compliance except for the matters listed below.
†
Note: If you answered ‘YES’ to any of the answers above, please also complete the Professional
Independence Resolution Memorandum.
The support for accounting as a profession rests on the public’s acceptance of independence
in appearance. Thus, what a reasonable person perceives is critical to the appearance of
independence. During the recent era of fraudulent practices and large-scale business failures
that came without warning to the public, the perceived independence of the profession was
challenged, with new regulatory requirements codifying practices associated with independence.
The Code provides extensive guidelines on potential threats to independence in the provision
of public accounting services. For illustrative purposes some common situations that give rise to
threats to independence in audit and review engagements and relevant safeguards are outlined
in Table 2.5.
114 | ETHICS
Table 2.5: C
ommon threats to independence and relevant safeguards—
audit and review engagements
➤➤Question 2.7
Your firm executes investment transactions for a client. You are now asked to audit this client.
Is there a threat to your independence? Apply the Code’s conceptual framework approach in
answering this question.
However, the provision of non-assurance services to an audit client may also create real or
perceived threats to independence (s. 290.154). They can also create self-review, self-interest and
advocacy threats. For example, when a client asks its audit firm to prepare the original books of
entry, a conflict is created because the audit team is placed in a position where it will audit its
own work. In this situation, the auditor theoretically can alleviate this self-review threat by making
arrangements so that the personnel providing accounting services do not participate in the
assurance engagement.
Arthur Andersen
Throughout the 1990s, accounting firms, including Arthur Andersen, offered consulting services along
with traditional auditing services, and discovered that consulting work was often more profitable.
Critics argue that the two services are incompatible as auditors verify and communicate to users the
accuracy of company reports, but, as the auditors were providing consulting services, they would be
checking their own work. Auditors must be independent of their clients, and consulting enmeshes
them in their clients’ business in ways that compromise independence (Aronson 2002).
During the 1990s the firm separated into two units, Arthur Andersen and Andersen Consulting (known
as Andersen Worldwide). In 1996, Steve Samek ‘became the firm’s worldwide head of auditing,
with indirect responsibility for 40 000 people. In the spring of 1998, he headed Arthur Andersen’s US
operations, which accounted for about half of the firm’s revenue. Mr Samek gave rousing speeches
designed to inspire the auditors to sell to their clients everything from tax services to consulting work
(Brown & Dugan 2002).
Meanwhile, Andersen Consulting more than doubled its revenue to USD 3.1 billion, ‘bringing in
58 per cent of the overall firm’s revenues, and subsidizing the accountants to the tune of about
$150 million a year’. In 1997, Andersen Consulting partners ‘voted unanimously to split off entirely’
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(Brown & Dugan 2002) and changed its name to Accenture.
Embroiled in the multi-billion-dollar bankruptcy of Enron, Arthur Andersen shared with its client the
accusation of not fully disclosing Enron’s financial position to investors. In the lead-up to pending
enquiries, Arthur Andersen destroyed (by shredding) a significant number of documents relating to
the Enron audit.
On 15 June 2002, Arthur Andersen was convicted of obstruction of justice for shredding documents
related to its audit of Enron. The firm ultimately lost its right to practice.
Arthur Andersen’s greatest foe was not the courts, but market forces and public perceptions (Simpson
2002). This included the termination of merger talks between Arthur Andersen and another major
accounting firm. Clients terminated their relationship with Arthur Andersen and many employees
resigned. The market and public imposed the ultimate penalty on Arthur Andersen, hastening its
implosion in 2001 (Simpson 2002). On 31 May 2005, the Supreme Court of the United States unanimously
overturned Arthur Andersen’s conviction, due to flaws in the jury instructions. By this time it was too
late for Arthur Andersen.
Your tasks
(a) Describe Arthur Andersen’s organisational culture and explain how the firm’s culture may have
contributed to its downfall.
(b) Explain why the provision of non-auditing services to an audit client may compromise the auditor’s
independence. In your answer, list two threats that jeopardise compliance with the principle of
independence, and explain why they are threats.
(c) List the safeguards that Arthur Andersen might have employed to reduce the threat to an
acceptable level.
(d) Explain how Arthur Andersen failed to act according to the public interest principle.
116 | ETHICS
Part C of the Code provides members in business with guidance on how to apply the conceptual
framework to the fundamental principles of professional conduct. Section 300.3 provides a
detailed definition of a Member in Business:
A Member in Business may be a salaried employee, a partner, Director (whether executive or
non-executive), an owner manager, a volunteer, or someone working for one or more employing
organisations. The legal form of the relationship with the employing organisation, if any, has no
bearing on the ethical responsibilities incumbent on the Member in Business (s. 300.3).
We will now consider some of the specific issues covered by Part C of the code.
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The perceived lack of independence of members in business, due to the contractual nature
of their relationship with their employer, often reflects a mistaken belief that their status as
employees imposes a duty of loyalty to the employing entity that takes a higher priority than any
obligations to third parties or to complying with the fundamental principles in the APESB Code
of Ethics. This is incorrect. Members in business have a duty to conduct their work honestly and in
accordance with professional standards.
Members in business who are involved in preparing and reporting information must ‘prepare or
present such information fairly, honestly and in accordance with relevant professional standards
so that the information will be understood in its context’ (s. 320.1).
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The APESB Code of Ethics continues: ‘Threats to compliance with the fundamental principles,
for example self-interest or intimidation, threats to integrity, objectivity or professional competence
and due care, are created where a member in business is pressured (either externally or by the
possibility of personal gain) to prepare or report information in a misleading way or to become
associated with misleading information through the actions of others’ (s. 320.4).
Safeguards to mitigate such threats ‘include consultation with superiors within the employing
organisation, the audit committee or those charged with governance of the organisation,
or with a relevant professional body’ (s. 320.6). ‘Where it is not possible to reduce the threat
to an acceptable level, a member in business shall refuse to be or remain associated with
information the member determines is misleading’ (s. 320.6).
The Institute of Chartered Accountants in England and Wales (ICAEW 2007) developed a
framework for reporting with integrity. While integrity is often associated with the ethics of the
individual, according to this framework, reporting with integrity is a joint endeavour of individuals,
organisations and the profession.
A person with integrity will then demonstrate desirable behavioural attributes that are associated
with integrity, such as being honest and compliant with the relevant laws and regulations.
Overall integrity in reporting is underpinned by ethical values such as honesty, motives such
as fairness, a commitment to users, and qualities such as scepticism and diligence. Reporting
with integrity relies on all entities (e.g. audit firms) to take steps to promote integrity through
leadership, strategy, policies, information and culture.
118 | ETHICS
➤➤Question 2.8
Explain why integrity is an essential attribute of the profession.
Potential threats include having insufficient time to properly perform or complete relevant duties,
and having insufficient experience, training and/or education (s. 330.2). Safeguards to any threats
include obtaining additional advice or training, ensuring that there is adequate time available
for performing the relevant duties, and obtaining assistance from someone with the necessary
expertise (s. 330.3).
Examples of financial interests that may create self-interest threats include those in which a
member holds a financial interest (such as shares), has share options, or has the opportunity to
receive bonuses from the employer that may affect the decisions to be made by the member
(s. 340.1). Safeguards that may help reduce or eliminate these threats include having salaries
and remuneration developed by an independent committee, formal disclosure of any relevant
interests (such as shareholdings), and appropriate audit procedures (s. 340.4).
Whether a threat exists depends the size, type and intention of the offer. If an independent
observer considers the inducement insignificant and not intended to encourage unethical
behaviour, then it is likely no significant threat exists (s. 350.3). If an inducement is made,
the member should consider informing higher levels of management with the employing
organisation or third parties (professional body or the employer of the individual who made the
offer). If the threat cannot be reduced to an acceptable level in this way, the member shall not
accept the offer (s. 350.4).
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In some situations, it may be that members in business consider making the offer of inducement
rather than receiving one. Members, under pressure from within the employing organisation,
such as from a superior, may be expected to offer inducements to influence the judgment of
another individual or organisation, influence a decision-making process or obtain confidential
information (s. 350.5). There are no safeguards that can mitigate such threats to an acceptable
level, so the member should not offer an inducement to improperly influence the professional
judgment of a third party (s. 350.7).
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principles contained within Part A and Part C of the APESB Code of Ethics. APES GN 40 includes
21 case studies incorporating examples from commercial, public and not-for-profit sectors where
professional accountants in business encounter ethical conflicts in their workplace that require
application of the fundamental principles of the APESB Code of Ethics.
On 14 September 2011 the CPA Australia Disciplinary Tribunal imposed the following penalties
and costs against Causer:
• forfeiture of Membership:
• non-eligibility for readmission for 30 years;
• a fine of $100,000; and
• costs of $464 (CPA 2011).
Sources: Adapted from R v. Causer [2010] VSC 341 2010, Supreme Court of Victoria, 19 August;
Butler, B. 2010, ‘ITL revises hire policy after fake CV’, The Age, 14 August 2010, CPA Australia Member
Discipline outcome “Sonya Causer” 14 September 2011, accessed October 2015, cpaaustralia.com.au/~/
media/Corporate/AllFiles/Document/about/about-member-conduct/mdh-sonya-causer-2011.pdf.
The Executive Director of the Australian Crime Commission, Michael Outram, said, ‘Through the
use of false documents, Mr Thomson deliberately attempted to hide profits generated by his
clients’ businesses and knowingly misled the Australian Government, to ensure his clients did not
pay their required tax’.
Sources: Adapted from Sentencing remarks of McKechnie, J. 2010, R v. Thomson, Supreme Court
of Western Australia, 13 May (WASC INS 172 of 2009); Australian Crime Commission and Australian
Taxation Office 2010, ‘Operation Wickenby—Tax fraud jails Perth accountant for 13 months’, Joint Media
Release, 13 May, accessed October 2015, https://www.crimecommission.gov.au/media-centre/release/
australian-crime-commission-joint-media-release/operation-wickenby%E2%80%94tax-fraud.
Banksia was based in regional Victoria and was involved in raising money from the public by
issuing debentures and lending the funds raised to third-party borrowers for property investment
and development purposes. Banksia was able to raise approximately $663 million from 15 000
investors by 25 October 2012. On that date Banksia was placed into receivership following
concerns that it was insolvent or likely to become insolvent.
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ASIC found that Sinnott did not conduct the audits in accordance with the Australian Auditing
Standards. In relation to each audit ASIC formed the view that Sinnott failed, among other
things, to:
• perform sufficient audit procedures in relation to loan receivables and obtain sufficient
appropriate audit evidence to reduce the risk of material misstatement of loan receivables
to an acceptably low level;
• display an appropriate level of professional scepticism when auditing the valuation of,
and provision for, impairment of loans receivable, and adequately document his conclusion
about the reasonableness of the provision for impairment;
• remain alert through the audits that the risk of the potential impairment of loan receivables
may cast doubt over Banksia’s ability to continue as a going concern;
• take responsibility for the overall quality of the audit and provide an appropriate level of
supervision and review; and
• appropriately conclude that he had obtained reasonable assurance to form an appropriate
opinion on the financial report.
Sources: Adapted from ASIC 2014, ‘14-127MR ASIC suspends former Banksia auditor for five years’,
13 June, accessed June 2014, http://www.asic.gov.au/asic/asic.nsf/byHeadline/14-27MR%20ASIC%20
suspends%20former%20Banksia%20auditor%20for%20five%20years?opendocument.
ASIC Enforceable Undertaking—Section 93AA ASIC Act—Warren John Sinnott, accessed June 2014,
http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/028290022.pdf/$file/028290022.pdf.
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© Australian Securities & Investments Commission. Reproduced with permission.
On 11 June 2014, the Australian Securities & Investments Commission (ASIC) accepted an
undertaking from Warren Sinnott, a registered company auditor, that he would not practise as
an auditor for five years.
122 | ETHICS
We can see from Figure 2.3 that although we attempt to take a disciplined and rational approach
to decision-making, it is strongly affected by many things. The more we are aware of these
influences, the more we consider them as part of the decision-making process, to make sure they
do not have a negative effect. In the centre we have our individual influences, which will include
our character and past experience, and these will then be strongly influenced by the organisation
we are working within.
In general, the intensity with which these variables affect decision-making is directly related to
their proximity to the individual, as appears in the diagram below. For example, organisational
values have a more significant effect on decision-making than professional values. Understanding
these influences will help professional accountants identify factors that may impact on their
ethical decision-making. Of course, each decision should be judged on its merits.
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Societal
Professional
Organisational DECISION
PROBLEM
Corporate
Individual
Culture
culture
Stress
Cognitive
Law
development
Codes and
significant others
Code of ethics
Decision-making is the thought process necessary to select a course of action to achieve a desired
result from among two or more options. Put more simply, it involves making a purposeful choice
from a set of alternatives. Decision-making with ethical implications is simply another form of
problem-solving. The chief difference between decision-making and ethical decision-making is the
consideration of ethical values and implications in the selection of an appropriate alternative.
Therefore, ethical decision-making is defined as reaching a responsible decision after taking into
consideration the general ethical beliefs of the individual, the ethical implications of a course of
action, and the norms and rules pertaining to the circumstances of the situation.
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The following example highlights the issues involved in making an ethical decision.
For accountants, whistleblowing, which may be in the public interest, may be in conflict with the
professional requirement to maintain confidentiality. This highlights the difficulty of making ethical
decisions.
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of organisational, psychological and environmental factors.
The factors that influence ethical decision-making can be classified into four broad categories
that are introduced in order of their likely influence on decision-making. Despite some
interrelated dependencies between the categories, these factors may be characterised as
individual, organisational, professional and societal.
Individual factors
Arguably, the factor having most influence on a person’s decision-making is their cognitive ability
to judge the ethical rightness of a situation. People have different levels of moral development.
Some people are selfish and may only act in the right way out of fear of punishment, rather than
because it is the right thing to do. Others (who are self-interested) may act appropriately in
order to gain additional benefits from others. Others may act in a particular way to gain approval
from other people they see as significant to them.
Obeying the law and the rules also motivates many people, without much thought as to
whether those laws and rules are appropriate. Meanwhile, others may focus on acting based on
intentions to do the right thing—regardless of external factors such as peer approval or legal
rules (Kohlberg 1981).
From this, we can summarise that people at different levels of moral development have
varying capacities to judge what is ethically right and so may react differently to a similar
situation. Therefore, the higher a person’s moral development, the less dependent that person
is on outside influences and, hence, the more that person is likely to behave autonomously
and ethically.
124 | ETHICS
A junior or recently qualified accountant may not be in a position to act with courage when faced
with an ethical situation due to a fear of superiors or the possible loss of employment. However,
a more experienced accountant may not hold such fears and will not be intimidated by demands
from other people. The ability to act with courage can be developed over time.
Organisational factors
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Corporate culture is defined as patterns and rules that govern the behaviour of an organisation
and its employees. Corporate culture defines acceptable behaviour within an organisation.
The culture of an organisation may be formally expressed in the form of written policies
and codes of ethics or may be informally expressed through the words and actions of
significant others.
A culture that lacks written policies and codes of ethics and accepts dishonesty and unethical
conduct may have a strong influence on a person’s ethical decision-making. They may feel
compelled to go along with what is being done for fear of being excluded from the group.
In the 1960s the social psychology experiments of Solomon Ash, Stanley Milgram and
Philip Zimbardo, which investigated the effects of conformity, obedience to authority,
assigned roles and situational environments on our behaviour, showed how much our actions
are influenced by the people, the authority structures and the environment surrounding us.
Similarly, organisational research finds that even honest employees will behave in deviant ways if
their environment, or management, encourages it. Pressure to conform, excessive performance
demands and unfair treatment have all been found to contribute to organisational misconduct
(Litsky & Eddlestone et al. 2006). Unsupportive management styles and organisational cultures
as well as hierarchical structures that are not open to upwards communication can also lead
to employee silence on issues such as supervisor and colleague competence, dysfunctional
organisational processes and working conditions. Fear of poor treatment, negative labelling and
distrust by colleagues as well as feelings of futility can prevent employees notifying management
of these problems, resulting in inefficiency, employee apathy and high turnover, at considerable
costs to the organisation (Milliken & Morrison et al. 2003). This can be offset by ensuring rules
and procedures are perceived as fair and by managers establishing trusting relationships with
employees, including them in decision-making processes, setting measurable and attainable
goals, offering consistent performance evaluation, leading by example and creating ethical
climates (Litsky & Eddlestone et al. 2006).
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Top-tier management is considered the most influential factor in setting organisational values,
which in turn determines the culture that influences members’ behaviour. The actions and
decisions of management have a significant contribution to the culture and ethical approach
of an organisation. Schein (2004) identifies six areas in which such actions and decisions are
most relevant:
• What leaders pay attention to, measure, and control on a regular basis.
• How leaders react to critical incidents and organizational crises.
• How leaders allocate resources.
• Deliberate role modelling, teaching, and coaching.
• How leaders allocate rewards and status.
• How leaders recruit, select, promote, and excommunicate (Schein 2004, p. 246).
There is a direct and positive relationship between the strength of the organisation’s culture and
the extent of that culture’s influence on ethical behaviour. A strong culture is likely to have more
influence on people’s daily decisions than a weak one. If the culture is strong and supports high
ethical standards, it should have a powerful and positive influence on employees’ behaviour.
Conversely, a weak ethical culture tends to have a negative influence on employees’ behaviour.
Ethical climates, or cultures, have been found to affect various organisational outcomes
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(Simha & Cullen 2012). More ‘instrumental’ climates, where egoistic, opportunistic behaviour
predominates, have been associated with low job satisfaction for employees and managers,
low employee commitment and high turnover, low moral reasoning, unethical behaviour,
organisational misconduct and bullying. More principal-based climates, where rules and
regulations are faithfully adhered to, and more benevolent climates, where decisions are made
mindful of the interests and needs of all affected organisational members, perform considerably
better on these measures, with benevolent climates generally performing the best.
Generally, the more ethical the culture of an organisation, the more ethical employee behaviour
is likely to be. While the ethical culture of an organisation might be formally expressed in
the form of written policies and a code of ethics, its effectiveness is subject to the actions
of management.
If it is the aim of top management to develop an ethical culture based on the principles of the
organisation’s code of ethics, there must be consistency between the words and behaviour of top
management and the behavioural expectations of the code. In this way, the code of ethics and
the ethical culture are congruent.
The major limitation in achieving acceptance of the code by employees is the belief that the
code is merely rhetoric and serves as a public relations document. To this end, codes are only as
good as the commitment made by management.
In addition to the benefits that are derived from ethical behaviour, an ethical culture may also
enhance a company’s productivity. In a survey on business ethics administered to over 15 000
professionals, 80 per cent of respondents said they would work harder for an ethically run
company and 75 per cent said that they would leave the company if it was violating their core
ethical principles (Dent 2009).
126 | ETHICS
Sims and Brinkmann (2002) examined the case of Salomon Brothers and the role played by John
Gutfreund, the CEO of the investment banking division at Salomon Inc., at the time of its bond trading
scandal in 1991. The authors link Gutfreund’s irresponsible leadership style to a win-at-all-costs culture
at the bank, which led to the unethical and illegal behaviour of its members. Sims (2000) describes
how Warren Buffett, after displacing John Gutfreund as the CEO, successfully changed the culture
at Salomon Brothers following the bond fiasco. However, Gutfreund’s style was so ingrained in the
culture of Salomon that simply removing Gutfreund was not enough.
Further steps were necessary to turn the culture away from a short-term win-at-all-costs attitude to
that of responsible corporate citizenship. Changes to the firm’s compensation system proved to be
the most difficult for Buffett to manipulate. Salomon lost many of its best performing members and
the remaining employees had to be assured that their positions were safe.
Sims and Brinkmann (2003) conducted a similar analysis on the Enron failure and the results were
comparable to those of the Salomon Brothers case. The authors had no reservations in blaming the top
executives for the unethical behaviour that took place within the company, which eventually brought
down one of the world’s largest and seemingly most successful organisations. The authors conclude that
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‘in retrospect, the leadership of Enron almost certainly dictated the company’s outcome through their
own actions by providing perfect conditions for unethical behaviour’ (Sims & Brinkmann 2003, p. 250).
Dellaportas and Alagiah et al. (2007) considered the case of the National Australia Bank, in which four
rogue traders incurred and concealed losses of AUD 360 million (one of Australia’s largest banking
losses due to deception). The bank recruited traders who had a reputation for creating outstanding
profits and encouraged risk-taking beyond prescribed limits, suggesting a profit-driven culture.
However, it was management’s abrogation of responsibilities that contributed to the problem. Issues,
when they arose, were ignored or deferred by management and, in so doing, management neglected
its responsibility for rectifying the identified problems. It was this leadership style that reduced the
likelihood of detecting and dealing with rogue behaviour.
Make a list of rules and regulations that exist in your place of employment and classify each item as
explicit or implicit. Explicit rules are formal rules, such as those found in company policy or codes of
ethics, and implicit rules are those recognised and accepted by a large majority of your colleagues but
not formally expressed in company documents. Then consider how each item affects your behaviour.
with these companies, and that it streamlined the process both for Omega and for their clients.
Omega was transparent about the referral commissions, or fees, received from the specialists to whom
it referred these cases, and it was a standardised rate, yet the sheer volume of referrals must have
made the total commissions or fees received from these companies sizeable. Jerry noticed also that
following his query his caseload increased, explained by management as due to an overall growth in
client numbers, but Jerry had heard similar stories from other employees. It was suspected that this
was an informal punitive measure to discourage employees from questioning managerial decisions
and to restrict both their discretion and autonomy. One consequence of this increase was a further
reduction in the ability to examine alternative specialist options, and the necessity to increase referrals
to those companies already receiving considerable business from Omega.
Your task
What is the effect of the culture at Omega Finance on the individual ethical decisions of the employees
such as Jerry? Can you think of any possible violations of the APESB Code of Ethics these decisions
may present?
Note: A discussion of this example is provided in the Suggested answers section of this module.
➤➤Question 2.9
What reasons or factors can you think of that may cause an employee to compromise their
personal ethics in a corporate environment?
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Professional factors
In addition to individual and organisational factors influencing ethical decision-making,
accountants are also influenced by their membership of a profession. We have already described
the APESB Code of Ethics in detail and how members must follow the Code, which unites
members by having a common set of values and standards of behaviour.
The extent of the influence on decision-making is dependent on the effectiveness of the Code.
According to the Code, members in business ‘may hold a senior position within an organisation.
The more senior the position, the greater will be the ability and opportunity to influence
events, practices and attitudes. A Member in Business is expected, therefore, to encourage
an ethics‑based culture in an employing organisation that emphasises the importance that senior
management places on ethical behaviour’ (s. 300.5).
➤➤Question 2.10
Why should accountants in business be accountable to a higher authority such as the professional
accounting bodies?
Societal factors
Societal factors that influence decision-making generally relate to the world we live in.
These include the laws that govern our behaviour and culture, which reflect the attitudes and
values of the community.
➤➤Question 2.11
Discuss whether decisions that are compliant with the law will always result in ethical decisions.
Culture
Understanding the culture of the community in which an organisation is operating is an essential
first step in identifying the effects that the attitudes and values of the community may have on
how decisions are made. Cultural values play an important role in the way business is conducted
and in determining people’s perceptions about what is important and what is not.
In ethics, cultural values have a major influence in determining what is considered proper and
ethical in a particular society. Ethical relativism holds that ethical behaviour is relative to the
norms of one’s culture. That is, whether an action is right or wrong depends on the ethical norms
of the society in which it is practised. If ethical relativism is accepted, the rightness or wrongness
of an act depends on a society’s norms and any act inconsistent with those norms is ethically
wrong. Alternatively, an ethical act is one that is consistent with the norms of society. Therefore,
a person with good ethical intentions will be influenced to act in accordance with society’s norms.
A common saying describing the practice of relativism is ‘When in Rome, do as the Romans do’.
Relativism is premised on the belief that there is no single ethical standard. While this is the
major premise of relativism, it is also the cause of its major criticism: there is no universal standard
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of right and wrong that can be applied to all people at all times. In this sense, no guidance
on accepted behaviour is provided when there are divergent opinions within society or across
societies. The same action may be ethical in one society but unethical in another.
This is particularly important in multicultural societies and multinational companies where cultural
practices can directly or indirectly influence respective business behaviour, giving rise to possible
conflicts of opinion and ethical values. For the ethical relativist, there is no universal standard of
right or wrong but only the standard of a particular society. Therefore, unlike normative theories
of ethics, there is no common framework for resolving ethical dilemmas across different societies.
➤➤Question 2.12
You are an employee of a company operating in a culture where bribery is commonplace. You have
been offered a gift, but no favours have been sought. Returning the gift will offend the donor.
What should you do?
However, we can recognise that different people, and different cultures, hold different values,
and that many of these are valid, without accepting that any value is equally valid to other
values. Related to the notion of cultural relativism is cultural diversity—observations of the
different values embraced by different cultures. One of the most widely cited studies of cultural
differences was by Geert Hofstede (1980), who measured differences in values held by employees
in IBM offices around the world to study the way organisational culture varied from country to
country. Sorting these differences along five dimensions—masculinity/ femininity, individualism/
collectivism, high/low uncertainty avoidance, high/low power distance and short/ long term
perspective—this research has been a significant resource for organisational studies, as many
items have clear relevance for organisational decision-making. A company culture that is high
in power distance, for instance, will likely employ a hierarchical structure and top-down decision
process, and the questioning or feedback of subordinates is less likely to be encouraged than
in a company culture that is low in power distance. An organisational culture that has low
uncertainty avoidance is likely to tolerate higher levels of risk and seek fewer assurances than one
that is high in uncertainty avoidance. Since Hofstede, other studies, such as the World Values
Survey and the Global Leadership and Organizational Behavior Effectiveness (GLOBE) study,
have measured differences in values between countries both among their general populations
and within business organisations.
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This can lead to simplistic approaches to decision-making that are often called heuristic
approaches. The term ‘heuristics’ is used to describe a set of decision-making rules or
approaches based on past experience, intuition or mental short-cuts. Decision rules are a
convenient way of reducing the number of alternatives that must be evaluated. However,
the problem with this approach is that it is limited to the individual’s background, previous
experience, memory, knowledge and perceptions.
Often, the decision-maker may not have a sufficient knowledge base to make proper decisions,
particularly when faced with new and difficult situations. Although decision-making that relies on
the application of decision rules may be justified on practical grounds, it might not be adequate
from an ethical point of view. Some situations may require a more systematic approach to
problem resolution.
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A more systematic approach is to use structured methods of decision-making that help reduce
the potential for inappropriate and inconsistent decision-making processes and outcomes.
These models are often based on normative ethical theories and ask probing questions to help
identify the underlying ethical issues, as well as the outcomes that various choices will have on
different stakeholders. This helps avoid the problem of forgetting to consider the ramifications of
a particular course of action or ignoring a minority interest group.
We have already outlined the conceptual framework approach to applying the APESB Code
of Ethics. In this section we outline two additional models (the philosophical model and the
American Accounting Association model) that will help people make well-reasoned ethical
decisions. A detailed discussion of all ethical decision-making models is beyond the scope of
this module.
The following decision-making models will not guarantee the correct or ethical decision, but they
should reduce the possibility of an incorrect or inappropriate decision being made. It is likely
to lead to a more systematic analysis and comprehensible judgment, clearer reasons and a
justifiable and more defensible decision than would have otherwise been the case.
Decision-making models also assist accountants in exercising proper judgment when faced with
difficult or complex situations. This will strengthen the ability of accountants to act in the public
interest, since our decision-making process is carried out with integrity and objectivity.
There is no perfect or correct model to use. It is not unusual to use one or more ethical decision-
making model when assessing ethical situations so as to gain different perspectives on the same
situation. Ultimately, it is up to the accountant to assess the suitability of the various frameworks.
We recommend referring to a range of models and selecting one or more that are most useful to
the circumstances.
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For example, consider a situation where a private business has a small number of significant
external investors and a large level of debt funding. The business has experienced some
difficulty and the accountant in the business has been asked to ‘produce’ the right figures
(in effect, manipulate them, to create the appearance of better results). These results are to be
distributed to the external lenders and investors. The accountant is advised that a bonus is on
offer for achieving strong results, but that ‘there will be significant trouble if we fail to satisfy
these stakeholders’.
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The accountant can evaluate the situation by considering potential courses of action,
which include complying with the request or refusing to comply. For Question 1 we see that
the immediate financial benefits of complying with the unethical request will be greater than
refusing. Harm to oneself may come from doing the right thing, although there would also be
long-term harm in terms of loss of integrity by complying with the request.
Considering Question 2, we see that the benefits of honest reporting would be linked to the
external investors and lenders who receive accurate information and may be able to protect their
investments, whereas harm will probably come to the owners of the company as the financial
results may lead to action being taken against them.
In relation to Questions 3 and 4, deceiving the external funding providers is disrespectful of their
rights, and leads to an unfair distribution of benefits and burdens. All of these factors can then be
weighed as the accountant makes the decision.
The overall objective of the philosophical approach is to provide a framework within which
ethical issues can be identified, analysed and resolved. The strength of this approach lies in the
application of multiple theories to an ethical dilemma, rather than a single theory. Each normative
theory of ethics is subject to inherent limitations. Therefore, adopting multiple ethical theories
will overcome the limitations of individual theories. In this model, the ideal course of action is one
that satisfies all four principles: one that is just, respects the rights of others and maximises the
net benefit to stakeholders. Striving to satisfy all four principles will be difficult, but attempting to
do so is more likely to result in the best decision overall.
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➤➤Question 2.13
Alpha Ltd, a clothing manufacturer in Australia, has decided to outsource its clothing production
to a supplier in Bangladesh to take advantage of the relative strength of the Australian dollar
and lower operating costs.
The company identified a supplier, called Delta Ltd, which was capable of providing this work.
Delta Ltd had offered to do the work at a lower price than other competitors, and a review of
the work quality indicated that it was at a comparable and suitable level.
During a visit to the production factory, the Australian management team observed the working
arrangements, how the factory was set up, and discussed working conditions with local employees.
They noticed and were advised of potential problems in terms of work safety, in relation to noise,
fire and ventilation. However, the managers of Delta Ltd explained that the factory was a typical
example in Bangladesh and that it was compliant with all relevant laws.
Using the philosophical model of ethical decision-making, recommend whether Alpha Ltd should
decide to work with Delta Ltd.
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financial reporting. Jaqueline Chan found herself in her first full-time employment as DIGFX’s in-house
accountant, overviewing and finalising its accounts for the financial year and its projected estimated for
the coming financial year. This was part of a company-wide report to be disseminated to shareholders
at the AGM. While checking the projected estimates, however, Jaqueline noticed that DIGFX had
included a prospective deal with NovaTech, a biomedical supplies company researching new ways
to manufacture cardiac valves. Jacqueline was sure that she had overheard conversations regarding
the deal, and that it had been successfully made some weeks earlier. The deal guaranteed DIGFX a
new revenue stream from orders above those generated by their current clients. She brought this up
with the company’s CFO, Paul O’Brien, who passed it off lightly, saying that the deal was still being
finalised, and that passing the expected revenue into the next year’s expected revenue would release
the pressure on the accounts section to process the paperwork before the end of financial year,
in which was in a week. Jacqueline returned to preparing the report, but was concerned that shifting
the expected revenue from NovaTech to the coming financial year may violate tax law. Researching
the matter further, she found her suspicions confirmed: that even if the revenue from the deal had
not as yet found its way into DIGFX’s accounts, the deal’s confirmation required that the revenue
generated be noted in the current report. She emailed Paul to that effect, to ensure that she had
covered all bases. Paul again thanked her for her thoroughness and expressed interest in her findings,
suggesting a meeting to discuss it further. Feeling gratified that her efforts had been appreciated,
Jacqueline was keen to meet soon enough to finalise the accounts for the AGM report. Given time
pressures, Paul suggested a working lunch. Over lunch, Paul explained that they were in a bit of a bind.
The 3D printing scene was one that quickly evolved, and the deal with NovaTech guaranteed DIGFX
the resources to properly update their inventory to deal with the project they were taking on, so long
as it was largely untaxed. The problem was that if the revenue was counted in the current financial year,
it would be heavily taxed. In the coming financial year, however, the revenue could be offset against
the cost of the upgraded printers, reducing the taxable return on investment. Shifting the profits a
year ahead would strongly affect DIGFX’s viability, and hence the tenure of Jacqueline’s position.
Furthermore, the contract had been kept word of mouth, so there was (as yet) no written document
to demonstrate that it had already been confirmed, and the revenue guaranteed.
Your task
Apply the philosophical model of ethical decision-making to the scenario. What would you do if you
were Jacqueline?
Note: A discussion of this example is provided in the Suggested answers section of this module.
132 | ETHICS
The purpose of the seven-step model is to develop a systematic approach to making decisions
that can be used in any situation with ethical implications. The advantage of the Langenderfer
and Rockness (1990) model is the ethical awareness it creates by giving particular attention to
stakeholders and ethical issues.
resolution process.
3. What are the norms, principles and values related to the case?
The norms, principles and values relating to all stakeholders at all levels, including
corporations, individuals and members of society, should be identified. Generally, norms,
principles and values are standards, rules and beliefs that guide acceptable and ethically
‘good’ conduct. Examples of principles include integrity and respect for individuals.
5. What is the best course of action that is consistent with the norms, principles and values
identified in Step 3?
At this point, all alternatives are considered in light of the norms, principles and values
identified in Step 3. One purpose of this process is to determine whether any norm, principle
or value (or a combination of them) is so persuasive that resolution is obvious. For example,
protecting the environment is important to avoid permanent damage and to respect the
rights of the communities who rely on the environment for survival.
A comparison of the AAA model with the APESB Code of Ethics framework or model shows
that they are consistent with each other. However, the Code attributes greater emphasis to the
fundamental principles, threats and safeguards. The AAA model is a model of ethical decision-
making applicable to all settings and not specific to accounting.
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Until recently, Booker Manufacturing Company had been a family business. Booker manufactured
small machines and household equipment as its primary product line. Recently, the company was
bought by a large equipment firm that wished to expand its product line into household equipment.
The financial director of Booker, Paul Davis, CPA, had been asked to stay on in his position. In the
future, however, Paul Davis would report to both the CEO of the Booker subsidiary and the CEO of
the parent company. Paul had a close relationship with the Booker CEO, but he realised that he would
have to prove himself to the CEO of the parent company.
In preparation for the acquisition, Davis was asked to supply the parent company with a list of Booker’s
fixed assets, their date of acquisition, the original cost and the accumulated depreciation, all on an
individual asset basis. In general, the fixed assets were relatively old and, therefore, the book values
were substantially lower than the original costs. Davis assumed that the parent company needed
this information to determine the fair market values of these assets in order to arrive at an estimated
purchase price for Booker. Eventually, the fair market values assigned to the fixed (i.e. non-current) assets
would be used in the consolidated financial statements. These values would be used to determine
the portion of the purchase price that should be allocated to goodwill.
When Davis was shown the consolidated balance sheet, as at the date of acquisition on 13 April 2014,
he noted that Booker’s tangible fixed assets were assigned a fair market value. Davis agreed with that
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value. The excess purchase price above the fair market value of the assets was included as goodwill.
This amounted to $450 000. During late May and early June of 2014, the parent company’s auditors
spent time at Booker. Their purpose was to become familiar with the operations and to conduct a full
scale audit. They would publish their opinion on the consolidated financial statement for the financial
year ending 30 June 2014.
Shortly after the audit was completed, Davis received a copy of the consolidated financial statements
and was surprised to note that the goodwill amount of $450 000 was not shown as such but had been
used to raise the asset value. Most of these assets were quite old and not as efficient as the new
machines because current technology had improved considerably since the assets had been acquired.
To add to his concern, Davis noted that the auditors had given an unqualified opinion on the financial
year-end statements.
Davis is aware that the company policy was to amortise goodwill over 20 years. However, assets are
depreciated over five to 10 years. He was aware that the company’s contract with its labour unions was
soon to be renegotiated and he wondered if the higher asset values, with a much faster write-off than
over 20 years, were a relevant factor in preparing the figures for the negotiation. He learned that the
company might sell some of its assets owing to an expansion of product lines. A higher book value
would most likely result in a recognised loss at the time of sale.
The more Davis thought about the treatment of the Booker company assets, the more upset he
became. He felt that the parent company deliberately ‘cooked the books’ (misrepresented the
accounts) and that the auditors were either a party to it or did not do a sufficiently careful audit of
the Booker company assets.
Your task
What are the ethical issues in this context? What should Davis do? Use the American Accounting
Association (AAA) ethical decision-making framework in analysing this case.
Source: CPA Australia gratefully acknowledges this material as adapted from Langenderfer, H. Q.
‘An asset by any other name’, Case 1 in Ethics in the Accounting Curriculum: Cases and Readings,
May, W. (ed.), American Accounting Association, Sarasota, Florida, 1990, pp. C1.1–C1.2.
Note: A discussion of the tasks for this example is provided at the end of the Suggested answers
section of this module.
134 | ETHICS
Jenna revised the projected estimate in line with a more conservative ongoing value of coal. When she
submitted her revisions, the document was returned to her by her manager, pointing out what they
considered to be an error—her revised estimate of the mine’s projected revenues. She forwarded
her workings on the topic, but was sent a curt reply to use the value initially supplied by Deep Vein.
The superannuation market was competitive and Millennial couldn’t afford to lose members to their
rivals. Furthermore, Jenna’s performance review would be coming at the end of the year, and it would
not help that process if she’d been found to be unhelpful in these essential matters.
Your task
Apply the American Accounting Association model to the scenario. What action would you recommend
in this situation?
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Note: A discussion of this example is provided in the Suggested answers section of this module.
Study guide | 135
Review
Ethics is the study of right and wrong, and of the choices of action and behaviour—with the best
or most appropriate options not always being immediately evident. Accountants should be aware
of the complexity of their professional relationships, and of situations where different choices of
actions and judgments govern their behaviour.
There are many guidelines that provide certain basic ethical expectations and standards for
accountants. They include, for example, the Compiled APES 110 Code of Ethics for Professional
Accountants and the policies and codes of conduct within accounting firms and organisations.
Nevertheless, accountants often face difficult decisions over choices in accounting policies
(such as in measurement and disclosures), relationships with clients, employers and peers,
corporate policies and societal expectations that are often not clear in law, and other
professional guidelines.
While elaborating on the regulatory and professional conduct professed by accounting bodies,
accountants should develop an ethical framework based on their own judgment and experience,
in order to be able to manage ethical problems and dilemmas.
This module has introduced the theoretical approaches to ethics, such as the different
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orientations of teleology, deontology and virtue ethics. This background provides a broad
understanding of how ethics can be viewed and understood.
In this module, we have introduced a broad framework for all such factors that may affect
the circumstances in which accountants have to make choices and decisions. In order to help
accountants handle practical problems, this module also introduced ethical decision-making
models.
The various ethical and decision-making frameworks can be viewed as examples to demonstrate
a variety of methods in dealing with ethical dilemmas. All frameworks have similar features,
such as considering one’s duties, examining the consequences of alternatives, and identifying
stakeholders.
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Suggested answers | 137
Suggested answers
SUGGESTED ANSWERS
Question 2.1
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In these situations, there is insufficient time to adequately examine all the issues, undertake
careful analysis and reflect on one’s work. Professional and ethical concepts such as due
professional care, competence and adequate supervision are well established. High-quality
personal and professional management requires that activities be planned, organised, directed
and controlled. Lack of time can lead to errors, mistakes and a rushed, unprofessional approach.
As difficult as it may be, you should remind your supervisor that trying to do too much in a short
span of time is damaging. The quality of one’s work is likely to be compromised, which has
important implications for those who rely on your services. Doing less with adequate resources
means that you are likely to do things better and, in the long term, at a lesser cost. Try suggesting
to your supervisor an alternative plan with adequate time allocations, indicating the benefits of
this plan while pointing out the cost of rushing such tasks and how that cost can be avoided.
Constructive suggestions should be appreciated in the workplace.
Question 2.2
The candidate is confusing the concept of egoism with utilitarianism:
• an ethical egoist is one who evaluates the rightness of a proposed action by choosing a
course of action that maximises the net positive benefits to oneself; and
• a utilitarian act or decision is one that produces the greatest benefit to the greatest number
of people.
While both theories are based on consequential analysis, the major distinction between egoism
and utilitarianism is the perspective from which consequences are analysed. Egoism considers
consequences as they apply to advancing one’s own interest, whereas utilitarianism considers
consequences to all parties affected.
138 | ETHICS
A second problem with this definition relates to the cost–benefit or outcome analysis. The phrase
‘measurable monetary rewards over costs’ implies that relevant outcomes should include only
those that can be measured in monetary or dollar terms. This is inconsistent with the utilitarian
principle’s inclusion of both economic and non-tangible or psychological outcomes (e.g. pleasure
and pain).
Question 2.3
You have been approached by a potential client to undertake a task in which you have
little knowledge or experience. You should talk to a manager or partner to discuss the task.
The following options may be identified:
• accept the audit with the hope that you will learn on the job;
• accept the audit and employ a professional with the requisite skills;
• inform the client that you do not possess such expertise and suggest a referral; or
• decline the job.
Accepting the job means that you will gain a major client which, in turn, may bring in future
revenue and job opportunities. This is a major benefit. However, in accepting the job, you would
be misrepresenting yourself (breach of integrity) to the client if you purported to possess the
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skills necessary to undertake the job with competence and due care.
Furthermore, if you attempt to deal with problems unprofessionally due to lack of expertise and
knowledge (violating professional competence and due care), the practice will be liable for any
negligence arising from your performance of the tasks. Also, there would be a violation of trust
on the client’s part that you have the required skills (violating professional behaviour). The client
is relying on you to perform the job.
If you inform the client of your lack of experience, you might lose the client and, of course,
may experience embarrassment or feel humbled. Alternatively, you could inform the client that
you may need to solicit the assistance of another expert or professional accountant. The crucial
point is that there will be a breach of professional care if you undertake the job without making
sure that you have the skills to do so.
A further possibility is that you could decline the job and commence further professional
education to broaden your skills.
Question 2.4
Smith, Jones & Associates
Section AUST210.11.1 of the Code of Ethics for Professional Accountants requires the auditor
to obtain professional clearance from the previous auditor. Specifically, the auditor must request
the client’s permission to communicate with the previous auditor and, on receipt of permission,
should ask the previous auditor to provide all relevant information in order to decide whether
to accept the audit. This information should be treated in the strictest confidence.
Question 2.5
Recognising that financial planners have access to wealth and are in a position to refer donors,
charities may well wish to establish productive relationships with these professionals and the
companies with which they are affiliated. However, in so doing, it is necessary to establish clear
guidelines in relation to any compensation issues.
Charities rely on donors to support their work and the level of trust a prospective donor has in a
charity will influence whether the individual chooses to support the charity as well as the amount of
that support. Although in this case the donor does not care which charitable organisation receives
the funds, other prospective donors may prefer organisations that maintain the highest principles.
Many charities believe that paying commissions and/or finders’ fees adversely affect their image
and therefore include ‘ethical fundraising principles’ in their fundraising policies, which state that
commissions paid ‘as a condition for delivery of a gift’ are inappropriate. It is important to refer
to your organisation’s fundraising policy and, if such a policy does not exist, the matter should be
referred to the board or a governing body.
Not-for-profit organisations exist to fulfil their charitable mission and serve the public. Where a
charity has engaged a financial planner in advance to meet with a prospective donor and assist with
the donation of a gift, it may be appropriate to pay the planner an hourly consulting fee based on a
reasonable hourly rate.
In addition, if the financial planner is a member of the accounting profession, there is an obligation
to comply with the fundamental principles outlined in the APES 110 Code of Ethics for Professional
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Accountants as well as APS 12 Statement of Financial Advisory Service Standards.
Accepting a referral fee or commission in this situation does not give rise to self-interest threats
to objectivity, professional competence and due care, as the choice of charity does not affect the
taxation advice provided and the member is not adversely influenced by third party remuneration in
the preparation of advice to their client.
There are, however, other ethical considerations.
The principle of integrity imposes an obligation on all members to be straightforward and honest
in professional and business relationships and also implies fair dealing and truthfulness. It would
therefore be expected that any fees and/or commissions are disclosed to the client.
A 5 per cent finder’s fee may be viewed as excessive or even totally unreasonable by the client,
who is almost certainly already paying for the financial adviser’s services.
Further, the principle of professional behaviour imposes an obligation on members to comply
with relevant laws and regulations and avoid any action or omission that may bring discredit to the
profession. This includes actions or omissions that a reasonable and informed third party, having
knowledge of all relevant information, would conclude negatively affect the good reputation of
the profession. Demanding a finder’s fee or commission for facilitating a charitable donation may
contravene this principle because self-interest may be seen to outweigh the public benefit of the
whole donation being paid to the charitable organisation.
Source: Sexton, T. 2009, ‘Ethical dilemma’, INTHEBLACK, vol. 79, no. 3, April, p. 58.
Question 2.6
Section 250.2 of the Code of Ethics for Professional Accountants states that, in connection with
marketing of professional service, a member in public practice ‘shall be honest and truthful’.
James Chan is not an expert in elder care services and advertising himself as such is false,
misleading and deceptive. His traditional audit skills will not enable him to provide high-quality
elder care assurance services without proper training in this area.
140 | ETHICS
Question 2.7
The conceptual framework approach to the APESB Code of Ethics is a three-step process
(see Figure 2.1):
1. Identify threats.
2. Apply safeguards.
3. Continue with service only if threats have been reduced to an acceptable level.
Please note that other threats may also be applicable, but in this instance these two are most
relevant.
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Question 2.8
The motto of the profession is ‘integrity’ and as such accountants have long been trusted to
assure the community of reliable and accurate financial information. According to this view,
integrity underpins and supports high-quality information for the efficient functioning of capital
markets. Consequently, people who rely on the services provided by accountants expect those
accountants to be highly competent and objective. Therefore, those who work in the field of
accounting must not only be well qualified but must also possess a high degree of integrity.
Promoting integrity within the profession through leadership, policies, information and culture
will in turn produce desirable behavioural attributes in members, such as honesty, fairness,
a commitment to others and compliance with relevant laws and regulations. Only then will the
profession reduce the incidence of accounting failures. To this end, integrity is intrinsically linked
to trust, which is vitally important to the reputation of individuals, reporting entities and the
profession. Without trust, the work of accountants would be ignored. Integrity and trust are also
linked to the public interest ideal, which obliges accountants to advance the interests of the
public before the interests of others. This duty is mandatory and applies without exception.
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Question 2.9
There are many factors that may cause an employee to compromise their personal ethical
standards. Although the ethical culture of the firm is a primary influence, there are many
other factors listed (supporting or countering the existing culture) that could influence such
behaviour. The list is not exhaustive. You will find that a careful examination of your own
corporate environment and discussion with colleagues in business will highlight numerous other
factors. The intention here is to highlight some of the major and more obvious influences on
personal behaviour:
• tight or unrealistic targets cause pressure to cut corners and therefore quality;
• remuneration or reward systems often overemphasise profit-oriented bonuses, causing
actions that focus on profit maximisation—possibly at an ethical cost;
• the ethical culture of an organisation creates an environment that condones questionable acts;
• top management—through its management style—sets the tone for inappropriate
behaviour; and
• a lack of explicit rules defining acceptable behaviour (such as a code of conduct) or,
alternatively, codes that are not enforced may result in instances of inappropriate behaviour.
Question 2.10
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The notion of trust in the professional–client relationship is fundamental to the concept of
professionalism. Without public trust, the status of the accounting profession would be reduced
considerably. Unfortunately, the actions of a questionable few can affect the reputation of the
entire profession. For this reason, it is the aim of the profession to maintain a proper ethical
image. This is possible by informing and reminding members that their primary responsibility
is to serve the public (rather than self) interest. This is normally achieved by implementing and
enforcing the APES 110 Code of Ethics for Professional Accountants.
Question 2.11
Law generally codifies society’s customs and values, and undoubtedly any changes to law are
reflections of changes in society’s attitudes. But it is wrong to suggest that legal compliance will
amount to satisfactory ethical conduct. Generally, it will be more accurate to claim that legal
compliance sets the minimum standard for ethical conduct, implying that the standard of ethical
conduct is higher than that expected from the law. The real dilemma, for which there is no easy
solution, is: to what extent is moral conduct higher than legal conduct? Similarly, breaking the
law does not necessarily mean conduct is immoral. The law in question could be outdated or
simply wrong.
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Question 2.12
Gifts are a common practice for companies operating internationally. The problem for many
companies and their members is that gifts can influence business behaviour, giving rise to
possible conflicts. In some cultures, gift giving and receiving are simply expected. For an ethical
relativist, there is no universal standard of right or wrong but only the standard of a particular
society. The problem for many people is that they may feel constrained to accept such practices
while knowing or feeling that they are unacceptable.
The decision to accept or reject the gift is a difficult issue. Refer to the guidelines provided in
the Code to help you make a decision. You have a number of options available to you, such as
informing your superiors or referring to company policy for guidance. In general, it is normally the
size of the gift and the intention of the giver that determines whether it is unethical. In this case,
the intention appears honourable; therefore, it is the size of the gift that will determine whether
you should reject the gift. Company policy will normally provide guidance in this area.
If the gift is deemed to be of considerable value, then it must be returned. A thank you note
with an explanation will ease any potential ill feelings. Nowadays, with the extent of trade
internationalisation, business people worldwide are well informed on the courtesies of gift giving
and receiving.
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Question 2.13
To apply this model we ask four questions:
Recommendation
There is no single correct answer to this issue. The purpose of this model is to ensure all relevant
factors are considered from a variety of perspectives. Your final recommendation will depend
on the specific answers provided, based on the specific details of the case.
Suggested answers | 143
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–– traders in securities of KPMG audit clients—lack of awareness that London and Shaw
were trading in securities using inside information, thus placing other securities traders at
a disadvantage.
(b) Integrity. London had an obligation to be honest in his professional relationships with clients.
London’s involvement in insider trading was dishonest conduct.
Professional competence and due care. London may have been technically competent
in the work he performed, but he did not show due care to his clients and KPMG, as he did
not provide his services in accordance with relevant laws and regulations. Being involved in
insider trading showed a lack of due care to his clients.
Professional behaviour. London should have complied with the relevant laws and
regulations so as to avoid any discredit to the accounting profession. His failure to comply
with the securities laws and KPMG’s internal procedures has indeed brought discredit to it.
It can be concluded that London placed his own self-interest ahead of his duties to the audit
clients, KPMG, the securities market and the accounting profession.
144 | ETHICS
The firm had undergone significant change during the 1980s and 1990s. Arthur Andersen
became a business that focused on financial gains at the expense of its third-party obligations.
This focus on self-interest was also evidenced by the firm’s behaviour in relation to the
document shredding.
(b) Audit firms such as Arthur Andersen traditionally provided to their audit clients a range of
non-audit services that were consistent with their skills and expertise. The provision of non
audit services (which include all fees that do not constitute audit services) to assurance clients
is an activity that often provides additional value for an audit client. Consequently, audit
clients benefit from the non-audit services provided by their audit firms, who have a good
understanding of the client’s business.
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However, the provision of non-audit services may create real or perceived self-interest (profit
over quality of service) and self-review threats to independence because the audit team may
be reluctant to criticise the non-audit services provided by their colleagues within the same
firm. Critics argue that, in such situations, audit firms are influenced to serve client satisfaction
ahead of their professional responsibilities.
(c) Under the Code of Ethics for Professional Accountants, the following safeguards may be
applicable in reducing, to an acceptable level, threats created by the provision of non
assurance services to audit clients:
–– To avoid the risk of assuming a management responsibility when providing non-assurance
services to an audit client, the firm shall be satisfied that a member of management
is responsible for making the significant judgments and decisions that are the proper
responsibility of management, evaluating the results of the service and accepting
responsibility for the actions to be taken arising from the results of the service.
–– ‘Providing an audit client with accounting and bookkeeping services, such as preparing
accounting records or financial statements, creates a self-review threat when the firm
subsequently audits the financial statements’ (s. 290.168). However, activities considered
to be a normal part of the audit process (such as the application of accounting standards,
making judgments about the appropriateness of financial and accounting control and the
methods used in determining the stated amounts of assets and liabilities, or proposing
adjusting journal entries) do not, generally, create threats to independence. Similarly,
responses to requests for technical advice on accounting issues ‘do not, generally,
create threats to independence provided the firm does not assume a management
responsibility for the client’ (s. 290.170). Hence, safeguards will be provided by ensuring
compliance with such Code provisions pertaining to preparing accounting records and
financial statements.
Suggested answers | 145
In doing the above, Arthur Anderson put the interests of Enron (its client) before the interests
of the public. As such, it failed to give precedence to the interest of the public and so failed
to act according to the public interest principle.
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Example 2.2: Keep on trucking
This relates to the issue of presentation of information to avoid deception. This conflicts with
numerous requirements of the APESB Code of Ethics, and further information about these
conflicts can be found in part C of the module. They include the fundamental principle of
integrity (s. 110), and in particular s. 110.2, in relation to being knowingly associated with a report
that ‘omits or obscures information required to be included where such omission or obscurity
would be misleading’. This also conflicts with the principle of professional competence and
due care (s. 130), and in particular s. 130.1: the requirement ‘to act diligently in accordance
with applicable and professional standards when providing Professional Activities’. Similarly,
the proposal conflicts with the principle of professional behaviour (s. 150), and in particular the
requirement to ‘comply with relevant laws and regulations and avoid any action or omission that
the member knows or should know may bring discredit to the profession’ (s. 150.1).
Section 210 of the Code (Professional Appointment) specifies that clients should not be granted
automatically (s. 210.1) which Reliance’s employees are forced to do. In particular, many of the
employees do not have the appropriate competencies to carry out some of their engagements,
conflicting with s. 210.6. The working conditions prevent the employees from employing some
safeguards (such as acquiring sufficient competencies) while company culture prevents others
(such as using experts or agreeing on a realistic timeframe) (s. 210.7), and the discouragement
of employees contacting a client’s previous firm prevents them from maintaining the etiquette
of doing so (s. 210.11), raising the risk that they are unable to know all relevant facts about the
client’s business (s. 210.9).
The culture discouraging seeking referrals also threatens the ability of employees to ensure that
engagements are carried out in accordance with the Code’s recommendations for etiquette
regarding second opinions (s. 230). The Code specifies that a member should seek contact with
a client’s other existing accountant (s. 230.2) and consider whether an opinion should be offered
if they are unable to do so (s. 230.3). The discouragement of contact with other firms inhibits
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In addition, s. 240.1 of the Code specifies that a threat to professional competence and due care
may be created if the fee quoted to a client is so low that a member may be unable to perform
the engagement ‘in accordance with applicable technical and professional standards at that
price’. The company culture discourages the appropriate safeguard of ‘assigning appropriate
time and qualified staff to the task’ (s. 240.2).
Finally, s. 250.2 of the Code specifies that members should not make exaggerated claims about
qualifications gathered or experience possessed. While Reliance’s employees are not doing this
personally, Reliance is doing so on their behalf in advertising a range of expertise not possessed
by many of the employees they engage.
The lack of choice afforded to Jerry in making these referrals, by the workload and punitive
culture, implicates him in the potential violation. Furthermore, in referring clients to the specialist
firms in this complete and wholesale fashion, Jerry is unable to maintain an ongoing relationship
with the client (as per s. 210 of the Code). The pressure placed on employees such as Jerry
through the high workload means insufficient time and knowledge are applied either to the
client or to the referral.
Suggested answers | 147
The chief cost is a loss of tax revenue, affecting government finances and those that draw
benefit from them (the general public).
It could be argued that the direct and considerable benefits to the stakeholders of DIGFX
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and NovaTech outweigh the indirect and minimal costs to the general public.
The rights of employees have not been clearly violated unless it can be established that they
have a right to know the details of all relevant financial deals made by the company, which it
generally cannot unless the employees have some representation on the board.
The rights of suppliers, clients and competitors can all be said to have been respected,
for similar reasons to those of employees, in the absence of any case to suggest that they
had a right to consultation in the managerial decisions of DIGFX.
The rights of the government, and via them the elective community, have not been
respected, as they have been deceived out of the benefit of the appropriate amount
of taxation.
At the time of the takeover, Davis considered that the fixed assets were assigned their fair
market value and that the purchase price included $450 000 for goodwill. The figures seemed
reasonable. Later, the end of financial year consolidated financial statements for 2014 did not
show the $450 000 as goodwill; instead the entry had been used to raise the overall value of
fixed assets. The auditors had rendered an opinion lacking requisite detail.
The parent company stood to gain from ‘cooking the books’ in its negotiations with the
unions. Union claims were based on company profits, which were reduced because the
depreciation charges for the assets exceeded the amortisation charge for the goodwill.
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(b) What are the ethical issues? Most of these concern Davis’s integrity, namely:
|| his integrity versus his job security;
|| his integrity versus his loyalty to the firm;
|| his integrity versus the reputation of the external auditors;
|| his integrity versus the reputation of the parent company’s CEO; and
|| the company’s financial health versus the unions’ right to information.
An ethical issue or dilemma arises when there are two or more equally compelling courses
of action without clear resolution. The conflict could involve two or more obligations, duties,
principles, rules or loyalties. But irrespective of the nature of the conflict, the two principles,
duties and so on, contradict each other. Similarly, each alternative has negative and positive
outcomes, and choosing one alternative will come at the expense of the other.
Suggested answers | 149
In this case, Davis’s integrity is at odds with his self-interest and the interests of the
company as well as with external parties such as the shareholders and the union. In brief,
if Davis remains silent, he protects his self-interest, but this comes at a cost to the unions
and shareholders (who act according to diminished information) and to his own integrity.
If Davis acts on this information, he protects his integrity but it may disadvantage his career.
Each alternative Davis faces produces negative and positive outcomes and supports
different principles.
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especially those that are closer to win–win solutions. The options, for discussion purposes,
include the following:
–– do nothing—accept the judgment of the external auditors;
–– raise the matter with the internal auditors, the external auditors or both;
–– report the matter to the CEO of the parent company;
–– report the matter to the unions; or
–– some combination of the last three.
The primary function of this step is to determine whether there is one principle or value,
or a combination of principles or values, so compelling that a particular option is clear
(e.g. correcting a major defect that is almost certain to cause loss of life).
(b) Raise the matter with the auditors (or the CEO, with possibly the same result):
|| they may stand fast;
|| they may change their reports on the statements;
|| unions will benefit from the change;
|| Davis’s conscience is clear;
|| the company may pay more wages; and
|| Davis’s job may be in jeopardy.
(c) Raise the matter with the unions:
|| auditors will be challenged;
|| labour negotiations may be tougher;
|| Davis is likely to be in trouble; and
|| the company may pay higher wages.
Our preferred solution is that Davis should raise the matter with the CEO. By sending a
memorandum to the CEO, Davis is clearly making a stand and preserving his integrity.
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He is acting in the public interest and is attempting to comply with Section 130 Professional
Competence and Due Care by having the $450 000 recorded as goodwill. Of course,
Davis is in a potentially dangerous situation if the CEO refuses to comply. If he refuses,
Davis could either:
(i) resign and maintain his professional reputation and integrity, or
(ii) back down and keep his job but with a loss of reputation and integrity.
In light of the justification provided above in support of our preferred option, we do not
recommend the ‘do nothing’ approach as it is not consistent with the professional duties
required of an accountant.
3. What are the norms, principles and values related to the case?
This case relates to several of the fundamental principles of the APESB Code of Ethics, and to
the normative values expressed in several of the ethical theories discussed in part B.
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–– Section 150 of the Code—Professional behaviour—in particular the requirement to
‘comply with relevant laws and regulations and avoid any action or omission that the
member knows or should know may bring discredit to the profession’ (s. 150.1).
5. What is the best course of action that is consistent with the norms, principles and
values identified in Question 3?
Disclosing the probable value of the investment and approaching a senior manager would
both satisfy requirements of s. 110, s. 130 and s. 150 (Professional behaviour). They would
also accord with the company’s duty to provide accurate information and the right of
investors and potential investors to accurate reporting. Both courses of action also accord
with the interests of the majority of people affected (utilitarianism) if we assume that a poor
investment choice will affect more stakeholders (e.g. investors, employees) negatively than
positively. Disclosing the probable value of the investment is unlikely to accord with Jenna’s
own self-interest (egoism), as it is likely to threaten her job security. Approaching a senior
manager, such as the CFO, may or may not accord with her self-interest, depending on
whether management takes a sympathetic attitude to her disagreement, or sides with her
manager, though it may offer her a safeguard.
152 | ETHICS
Preparing the report as recommended incorporating Deep Vein’s estimates would accord
more with Jenna’s self-interest (egoism) but would violate the conditions specified by s. 110,
s. 130 and s. 150 of the Code. It would probably harm the interests of more stakeholders
than it would benefit (failing the utilitarian test) and violate the contractual duties and rights
specified between Millennial, its investors and potential investors.
The primary norms, values and principles suggest either to include the revised estimate in
the report, or to consult with a senior manager, perhaps the CFO. However the consequences
of these two options are the most uncertain, and pose the highest risk for Jenna.
There is no guarantee that the inaccuracy will ever come to light, and so going against
her supervisor may simply jeopardise her job security with no other effect. However, if the
inaccuracy is disclosed in some other way, the company may well assign all responsibility to
Jenna, as she signed off on the accounts, making her legally liable for the misrepresentation,
and her integrity may be brought into question.
The action you consider preferable is your own decision, but should be supported with
good reasons.
Our recommendation would be that Jenna consults with a senior manager, perhaps the CFO,
as it will enable her to maintain her obligations under s. 110, s. 130 and s. 150 of the Code
and maintain Millennial’s fiduciary obligations, as well as offering Jenna a possible safeguard,
though it may cause a backlash from her manager.
References | 153
References
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in the Workplace—Considerations for Members in Business, APESB, Melbourne, March, accessed
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miscues’, The Wall Street Journal, 7 June.
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Dellaportas, S., Alagiah, R., Gibson, K., Leung, P., Hutchinson, M. & Van Homrigh, D. 2005,
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Dellaportas, S., Cooper, B. & Braica, P. 2007, ‘Leadership, culture and employee deceit: The case
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154 | ETHICS
Dent, G. 2009, ‘Ethics offer an edge’, Business Review Weekly, April 30 –June 3.
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Morality, McGraw-Hill Book Company, New York, pp. 412–20.
ICAEW (The Institute of Chartered Accountants in England and Wales) 2007, Information for
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IFAC (International Federation of Accountants) 2005, Code of Ethics for Professional Accountants,
IFAC, New York.
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http://www.ifac.org/sites/default/files/meetings/files/5892_0.pdf.
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Essays in Moral Development, vol. 1, Harper & Row, New York.
Langenderfer, H. Q. & Rockness, J. W. 1990, Ethics in the Accounting Curriculum: Cases and
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Ethics websites
Useful websites on professional and business ethics
• Accounting Professional & Ethical Standards Board
accessed September 2015, http://www.apesb.org.au
Module 3
GOVERNANCE CONCEPTS
* CPA Australia gratefully acknowledges the many authors who have contributed to this module.
158 | GOVERNANCE CONCEPTS
Contents
Preview 161
Introduction
Objectives
Review 250
Appendix 251
Appendix 3.1 251
References 267
MODULE 3
MODULE 3
Study guide | 161
Module 3:
Governance concepts
STUDY GUIDE
Preview
Introduction
Governance describes the overall guidance of organisations and focuses on achieving strong
performance while ensuring compliance with obligations. In this module, we provide a detailed
explanation of the concept of governance and how it has evolved.
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Effective governance is very important and poor governance has often led to financial disasters
for individual companies, and even whole economies, in the past.
In Part A, we outline the agency theory interpretation of corporate governance. This highlights
the issues that arise because of the separation of ownership and control of companies.
It also demonstrates the importance of governance mechanisms to protect the interests
of the shareholders. In addition to shareholders, we consider a wide range of stakeholders
involved with governance, both inside and outside of companies. These include the directors,
auditors and regulators.
Part B explores the development of corporate governance over the past 30 years. Change has
often arisen in response to particular crises, leading to calls for reform to avoid repeating the same
problems. In Part C, we move onto some very specific principles, recommendations and guidance,
to become familiar with best practice in corporate governance. A detailed review of several
codes is provided and you are expected to be able to analyse case situations and apply specific
elements of these codes to highlight areas where governance may be improved. This section
concludes with a comparison of governance systems used in different parts of the world, exploring
differences—especially between the market-based systems of the United States, United Kingdom
and Australia and the relationship-based systems found in Europe and Asia. The module then
goes on in Part D to examine some of the main governance issues encountered in public sector
enterprises and in the not-for-profit sector.
In Part E, we consider several causes of governance failures and some opportunities for
improvement. This provides a link with Module 4, which considers several of these issues in
greater detail.
162 | GOVERNANCE CONCEPTS
Objectives
After completing this module, you should be able to:
• describe corporate governance and explain why it is important;
• evaluate the importance of the key elements of the corporate governance framework;
• describe the nature of corporations and the division of corporate powers;
• discuss agency theory and how it is used to understand corporate behaviour;
• discuss the key features of corporate structure;
• examine the characteristics and duties of directors and other officers;
• explain the various international approaches to corporate governance;
• analyse how robust governance is relevant to public sector and non-corporate entities; and
• interpret and apply codes and principles of corporate governance.
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Study guide | 163
The governance of enterprises is broadly structured by the law, not just corporate law (or trust
or other relevant law) but also employment law, environmental law and so forth. It is the first
duty of directors to ensure that the enterprise operates within the law. However, beyond
requiring a board of directors exercise certain duties such as the duty of care and diligence,
corporation law gives considerable scope for directors to exercise decision-making in the best
interests of the company. It is here where the skills of governance become critical: the capacity
to understand and interpret the strengths and weaknesses of the enterprise, and how to direct
the enterprise towards business success while maintaining accountability and good relationships
with all stakeholders. Good governance is a hallmark of enterprises that achieve improving and
sustainable performance even in changing and unpredictable environments.
The need for governance arises when an individual, group or entity assumes responsibility to
look after the rights or interests of other individuals, groups or entities. Those assuming such
responsibilities are called agents. Those whose rights or interests are being looked after are the
principals. Agents can exist in a variety of situations. Consider Table 3.1, which shows where a
principal allows an agent (individual or group) to act on their behalf.
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Table 3.1: Examples of agents and principals
The key feature of each case is that principals are represented by agents, and the principals
give or delegate to their agents the freedom or authority to make decisions on their behalf.
Shareholders entrust company directors to pursue the success of the company, citizens elect
representatives to pursue their democratic interests in government, and in voluntary associations
the members similarly elect a board to represent their interests. To ensure this role is performed
in a systematic way, we use a framework of corporate governance, defined as follows:
Corporate governance is the system by which business corporations are directed and controlled
(CFACG 1992, para. 2.5).
164 | GOVERNANCE CONCEPTS
There are many legal forms for business associations; however, the public corporation is the
legal form we are most familiar with as it is the one adopted by many of the largest business
organisations. Corporate law as in the Australian Corporations Act 2001 (Cwlth) provides
a framework of regulations within which companies must operate. Corporate law defines
company directors’ duties and reporting obligations at the annual meeting of shareholders.
The law sets out the rights of shareholders relative to creditors and other stakeholders.
Essential characteristics of corporate law include the consideration of the corporation as a
separate legal person for the purposes of the law, which enables the corporation to act as an
autonomous entity. Limited liability means the shareholders’ liability is limited to the value of
their shares in the corporation, and direction of the company is delegated to a board of directors.
Within the different types of corporate structure permitted by corporate law, there is the freedom
of directors to govern by pursuing the best interests of the corporation.
‘Direction’ refers to steering the organisation towards its performance goals. ‘Control’ relates
at least in part to ensuring compliance with rules. We use the word ‘corporate’ to indicate
that we are focusing on the governance of corporate or business organisations. This may be
a formal corporate structure (e.g. company) or a non-corporate entity such as a not-for-profit
organisation (e.g. charity or government entity) or an incorporated association (e.g. sporting
club). Note that the term ‘corporate governance’ is, in practice, also used by non-corporate
entities. The important thing to grasp is that all entities acting on behalf of the rights or interests
of others need to respect basic principles of governance if they are to act with integrity, authority
and accountability.
It is important not to focus solely on the compliance and regulatory aspects of governance,
which must always be balanced with a focus on pursuing an effective strategy and successfully
achieving organisational goals and objectives. As such, corporate governance extends to both
conformance with all the necessary rules for the proper conduct of the organisation, including
compliance with external regulations and internal organisational policies, and performance,
with a focus on economic success. If an organisation is a not-for-profit entity, then its performance
will relate to the economy, efficiency and effectiveness of its activities.
A large amount of discussion and effort in the governance area has focused on compliance
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rather than performance. As a result, some people have argued that the term ‘corporate
governance’ is limited and solely focused on compliance, and that a different name, ‘enterprise
governance’, is needed to describe the broader focus on both conformance and performance.
In this subject we take the perspective that this is not necessary, and corporate governance
is a broad enough term to capture both approaches. Organisations need to demonstrate
compliance and accountability to offer assurance to investors and other stakeholders, and they
need strategies to achieve higher performance if they are to offer the returns and benefits
that investors and stakeholders expect. Indeed, it is when accountability and strategy are well
integrated that organisations perform most effectively. In the public and not-for-profit sectors,
similar standards of accountability and performance are required even though the mission is
to provide high‑quality public and social services, and while there may not be shareholders to
satisfy, there are many stakeholders who must be considered.
The Ethics and Governance subject emphasises the conformance aspect of governance.
Both performance and conformance are equally important, and performance aspects are
covered in other subjects of the CPA Program. However, it is important to appreciate the close
relationship between strategy and accountability: strategy without accountability may lead to
recklessness, and accountability without strategy may lead to paralysis (Clarke 2016).
Importance of governance
Good governance aims to ensure that organisations are properly run in the best interests of their
stakeholders, including the optimal performance of national and international economies.
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In extreme cases, public organisations may be run more as personal fiefdoms where personal
greed is put ahead of the interests of shareholders and other stakeholders. To reduce undesirable
consequences for shareholders and other stakeholders and to ensure personal accountability,
organisations need an appropriate system of checks and balances in the form of a corporate
governance framework. This framework emphasises both conformance and performance as vital
elements of the way that companies are run.
An organisation with good governance can instil confidence in its shareholders and other
stakeholders. For example, transparent disclosure policies are crucial for ensuring shareholders
and lenders continue to supply the finance required by organisations. The performance of
individual organisations also contributes to the enhanced performance of national economies,
not just through their individual contributions, but also through their role in fostering positive
relationships with other organisations in the economy. Corporate governance is also one of the
criteria that foreign investors increasingly rely on when deciding in which companies to invest.
It should be noted that while good governance can bring benefits to companies, it can also
temper growth. For example, strict governance policies and practices can lengthen the time to
undertake mergers and acquisitions due to the requirement to follow extensive due-diligence
procedures. (However, growth is more valuable when it is durable through being built on solid
foundations, rather than hastily pursued as opportunities arise.) The ability of management to
make quick decisions may be constrained by the need to observe proper governance policies
and practices. These risk-mitigation requirements contained within compliance-oriented rules
need to be understood. As was seen in the global financial crisis (GFC), excessive risk-taking
and ‘management enthusiasm’ (often based on personal motivations) can result in devastating
166 | GOVERNANCE CONCEPTS
consequences for shareholders and other stakeholders. In many ways, good governance is a
balancing act between the two extremes of unfettered excessive risk taking and overly restrictive
decision-making.
As Robert Tricker (1984) highlights, the management role is to run the business efficiently and
effectively, while the governance role is to give strategic direction to the enterprise, as well as
ensuring accountability. ‘If management is about running the business; governance is about
seeing that it is run properly’ (Tricker 1984, p. 7). This is a very critical distinction in governance.
If the board is performing its role effectively, it will ensure that management is held to account.
However, this does not mean that the board intervenes in the management of the enterprise.
The board must work with and through the chief executive officer (CEO) and other executive
directors and senior executives of the company. It is the senior executives’ role to run the
company, but within the policy and strategic parameters that have been set by the board.
The multi-faceted elements of governance are clearly revealed in Tricker’s (2012) framework for
analysing board activities (Figure 3.3). The framework illustrates the accountability activities of the
board: monitoring and supervising management by reviewing business results and budgetary
controls. Externally the board provides accountability through reporting to shareholders and
ensuring regulatory compliance. The board also has a role in performance through policy-
making and approving budgets. By creating a corporate culture, a framework for performance
improvement is put in place, which is focused through strategic analysis and reviewing
competitiveness.
MODULE 3
Two contrasting theories that have been proposed to explain behaviour are agency theory and
stewardship theory. Stewardship theory suggests people in power (the agents or stewards)
will act for the benefit of those who have engaged them. Agency theory takes the alternative
view and assumes people have a self-interested egoist approach. These theories are discussed
in more detail below.
Stewardship theory
Stewardship theory sees appointed directors as ‘stewards’ who carefully look after the resources
they have been trusted with. Rather than directors and managers as agents who act in their own
self-interest, these stewards are expected to naturally act favourably on behalf of the owners
(Donaldson & Davis 1991). Executive self-interest is not expected to interrupt corporate goals
and genuine stakeholder outcomes. In this situation, financial reports provide a formal means for
the directors to declare their stewardship obligations to the owners.
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While stewardship theory accepts that directors must also consider the interests of groups other
than shareholders (i.e. ‘stakeholders’ such as employees, suppliers, customers), the primary duty
of directors is for the interests of shareholders. The boundaries of corporate governance under
stewardship theory are therefore defined by the relationship between directors and shareholders.
The interests of other stakeholders are assumed to be addressed by relevant laws outside
the boundaries of corporate governance, such as consumer protection or competition laws.
A strength of stewardship theory is that it perceives directors as professionals able to demonstrate
their commitment to the company and its shareholders in a virtuous and capable way without
constant oversight. One criticism of this theory is the assumptions that ‘good stewards’ do exist
and that these stewards will maintain their virtues over extended periods of time.
Agency theory
Agency theory views corporate governance through the relationship between agents and
principals. As we saw at the start of this module, at its broadest level, agency consists of giving
power to individuals or groups to act on behalf of others. Agents are permitted to act in place
of, and to make decisions for and on behalf of, the principals and to comply with the terms of
the agency and the rules applying to them. While agents are expected to act on behalf of the
principal, agency theory differs from stewardship theory because it suggests the agent may not
naturally act in the best interests of the principal. The underlying assumption of agency theory
is that all parties are rational utility maximisers, which means agents may pursue different goals
from those of the principals. Therefore, potential for conflict arises and mechanisms such as
corporate governance must be in place to ensure the agent acts appropriately.
Agents must therefore be aware of the concepts and principles of good governance, and to
comply with the terms of the agency and the rules applying to them. Jensen and Meckling define
agency and comment on its central problem:
We define an agency relationship as a contract under which one or more persons (the principal(s))
engage another person (the agent) to perform some service on their behalf, which involves
delegating some decision making authority to the agent. If both parties to the relationship are
utility maximizers, there is good reason to believe that the agent will not always act in the best
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interests of the principal (Jensen & Meckling 1976, p. 308).
The key question to be resolved in any agency is: How do you align the interests of the principals
and agents, thereby modifying any self-serving and ill-informed behaviour of the agents in
order to minimise agency costs? Such alignment, which can be called ‘goal congruence’, is a
critically important aspect of good governance. The costs of not achieving interest alignment can
sometimes be catastrophic.
Specific examples of governance that address this issue and are discussed in this module include
a remuneration committee that sets management performance targets and rewards, and an audit
committee that focuses on ensuring financial information and internal controls are in order.
Most of the discussion in this module is directed at large corporations whose shares are sold
on public stock exchanges. The shareholders or owners are the principals and the managers
of the corporation are the agents. The concept of agency is particularly pertinent here due
to the usually wide separation between the owners and the board and other management.
Nevertheless, the concept of agency is common in all entities—small or large, public or private.
168 | GOVERNANCE CONCEPTS
Within corporations, shareholders are the principals and boards are their agents. Similarly,
when the board engages the chief executive officer (CEO) and other senior managers and
delegates with specific management powers, another principal or agent relationship arises.
In this case, the board is the principal, and the CEO and managers are the agents.
It is common practice for boards to delegate day-to-day operational powers to the CEO, but not
extensive, strategic decision-making powers. Boards need to carefully consider all delegations.
Sir Adrian Cadbury (CFACG 1992) has stated that there must be a ‘series of checks and balances’,
and the freedom to delegate broadly is implicitly limited by the system of checks and balances.
A director cannot delegate and then deny all responsibility. In Module 1, we observed the
importance of ‘professional judgment’. It is clear that boards must understand good judgment,
exercise sound judgment and act accordingly.
➤➤Question 3.1
What is one major issue that arises from an agency relationship, where powers of control
are delegated?
Agency theory identifies three types of agency costs: monitoring costs; bonding costs; and costs
relating to residual loss. These costs can arise as a result of:
• information asymmetry (where the agent has more information than the principal);
• poor communication;
• poor understanding;
• innocent and unintended self-interested behaviour by agents;
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Monitoring costs
Monitoring costs are incurred by principals because an agency relationship exists. Some monitoring
costs are compulsory, such as costs relating to annual reporting and external auditing. Other
monitoring costs are discretionary, such as the work required to construct and analyse activities
according to a strategic or balanced scorecard.
Bonding costs
Bonding costs are costs incurred by the agent to demonstrate to the principal that they are
goal congruent. This may include voluntary restrictions on the agent’s behaviour or benefits to
demonstrate goal congruence, and are part of the explanation for the development of executive
stock options and other benefits that have significantly increased executive rewards in recent
decades. A detailed example of bonding costs is provided later in Example 3.1.
Residual loss
Residual loss is a cost incurred by the principal. Residual loss arises because, no matter how
good the monitoring and bonding efforts, the agent will inevitably make decisions that are
not consistent with the principal’s interests. Any loss or cost or underperformance arising from
these decisions or actions by the agent represents a residual loss of value to the principals.
Some examples of residual loss are described next.
Study guide | 169
Empire building
Empire building refers to acts by management to increase their power and influence in a
company for reasons associated with personal satisfaction. Such personal aggrandisement or
excess may have little or no congruence with company profitability or success.
An example would be the recommendation to the board by a CEO that it should purchase a
subsidiary. Having a desire for growth, as is common in many corporations, the board may agree
to the acquisition without sufficient consideration. In fact, the board may not know that the real
motivation driving the CEO was the opportunity to enhance their own power and authority,
and the prospect of additional financial rewards in relation to additional responsibilities.
Importantly, increased shareholder value was not a key goal.
Risk avoidance
Depending on how managers are remunerated, there may be little incentive for them to engage
in risky investments. The higher returns associated with risk might be actively sought by some
shareholders who have the ability to diversify their own risk through their portfolio of investments.
If managers are remunerated with fixed salary packages and do not participate in the higher
returns, the only rational approach for them is to minimise the downside risk (losses) that may
affect their continued employment. The organisation may therefore underachieve, with higher
returns forgone, representing a loss of value to the shareholders.
While risk avoidance can be a result of a lazy, self-seeking agent (the board or manager
MODULE 3
depending on the agency under consideration), it is a requirement that principals must properly
instruct agents so that the risk appetite of the corporation is structured according to the wishes
of the owners. Agency is highly dependent on communication, and failed communication
may damage agency as much as, or more than, self-seeking agents.
The time frame is an important consideration when designing remuneration schemes. A well
designed scheme will provide management performance rewards that correlate the timing of
management performance with the timing of shareholder performance expectations.
Example 3.1 provides an example of all three types of agency cost. Many costs may be
conceptual rather than dollar costs, and this is especially so for bonding costs.
170 | GOVERNANCE CONCEPTS
Robert later retired and his position was advertised. Susan was interviewed by the board for the
position. Susan had sought extensive information about the corporation and had learned about
Robert’s regular travel and holidays. At the interview, without inappropriately referring to Robert,
Susan advised the board that:
• she would only travel with permission from the corporation chair;
• if urgent travel were required without permission from the chair, she would provide a written report
to the board following the travel;
• if the report were not accepted immediately, she would pay the travel costs personally without
further request to the corporation; and
• she would undertake a review of the efficiency of all overseas branches with a view to closing
those that were not profitable.
In this example, Robert’s expenses are an example of residual loss. Susan’s behaviour demonstrates
voluntary restrictions accepted by Susan in order to show that she is bonded to the corporation.
Restrictions on freedoms are bonding costs borne by agents. In this example, Susan will also bear
a dollar cost if the board does not approve the travel. Her willingness to undertake the overseas
branch review is possibly another bonding cost. Also, note that Susan has suggested extra duties
to the chair. If performed, these extra duties are a monitoring activity, the cost of which is borne by
the principal.
Aside from self-interest, ineffective communication between principal and agent will result in
residual loss, as agents will not know or understand the principal’s goals—meaning that good
goal congruence will be highly unlikely.
When we consider remuneration issues, we might find that an agent who is highly bonded should
be remunerated more abundantly. The diminished residual loss and the reduced need to monitor
a highly bonded agent would seem to imply that the extra value available to the principal might,
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➤➤Question 3.2
Describe key aspects of the principal and agent problems that exist within corporations and that
can result in loss of value for the shareholders.
Obviously, there will be differing governance approaches across organisations, with the actual
components also varying from one organisation to another. Appreciating the following most
basic component parts of governance is a first step on the path to full understanding. In looking
at these components, we will see that there is a strong international commonality regarding their
design—even so, variations between jurisdictions and cultures are just one of the complicating
factors to be seen and understood.
Study guide | 171
Figure 3.1 offers a process view of the components of governance, with the external framework of
governance established through the legal and regulatory activity of governments, the requirements
of investors and the standards set by industry and professional bodies. The internal governance of
the company is established by the board, who are appointed by the shareholders, and who in turn
appoint the chief executive officer. Finally, the external auditor reviews the financial reporting of the
company (Kiel & Nicholson et al. 2012).
Recommend External
Stakeholders—may set Set the
appointment Auditor
specific requirements, frame- BOARDS
Reporting and
e.g. owners works accountability
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Reporting and Appointment
accountability and review Review and
Industry/professional recommend
bodies
Accounting standards, MANAGEMENT,
industry standards etc. LED BY A CEO
Source: Kiel, G. & Nicholson, G. et al. 2012, Directors at Work, Thomson Reuters, Sydney.
Reproduced with permission.
Corporations
Corporations are frequently at the heart of debate and discussion about corporate governance.
As ‘fictional entities’ brought into existence through legal means (e.g. being registered
under the Corporations Act 2001 (Cwlth) (Corporations Act)), they give rise to a number of
distinct advantages over other forms of business organisation (such as sole traders or
partnerships), including:
• Separate legal entity distinct from its owners. This results in the ability to hold and own
property in the name of the corporation, to sue and be sued, and to enter into contracts.
• Limited liability. This provides that the liability of the owners of a corporation is limited to
the original capital invested by owners. Other rules may be defined, such as ‘no liability’,
where unpaid capital is not at risk, and ‘unlimited liability’, where some corporations leave
owners exposed beyond the amount of invested capital.
172 | GOVERNANCE CONCEPTS
• Perpetual succession. As an artifice of law, corporations do not have a finite life. Individuals
(as a biological fact) and trusts (as a legal requirement) have finite lives and a partnership
legally terminates and re-forms whenever a partner leaves or enters a partnership.
Ownership by, and operations of, corporations can theoretically last forever. A corporation
ceases existence only through formal legal procedures that result in the corporation
‘winding up’.
In the 1960s, noted economist Milton Friedman argued that the primary responsibility of a
corporation is to maximise the wealth of its shareholders. However, increasingly this view has
been challenged by people who believe that an organisation should also consider the interests
of a wider group of stakeholders such as employees, customers and suppliers. This point of view
is discussed further in Module 5.
Corporations vary enormously in size, capitalisation, structure, the nature of their activities,
number of employees and other factors. They may be for-profit or not-for-profit, private or public,
with no liability, limited liability or unlimited liability, and listed or unlisted. Table 3.2 provides
examples of different types of corporations.
Figure 3.2 demonstrates how the level of regulation, reporting and disclosure vary depending on
the type of corporate structure.
Study guide | 173
Listed
company
Public
company
Large private
company
Small private
company
Low High
Regulation
Shareholders
Shareholders are the persons or entities who own a company and have an important part to play
in corporate governance. Shareholders elect directors to operate the business on their behalf
and, therefore, should hold them accountable for its success or failure. One needs to recognise
that shareholders have delegated much authority to the directors. This is the classic principal/
agent relationship.
All shareholders do not have the same need or opportunity to participate in the governance of the
company in which they hold shares. In fact, as the company is a separate legal entity, the powers
MODULE 3
of shareholders are often clearly defined in law and limited to certain decisions, such as:
• changes in a company’s constitution;
• the appointment and removal of directors and auditors; and
• the approval of directors’ remuneration.
The issues that concern each group of shareholders will vary and depend, for example, on the
number of shares they hold, the length of time their shares will be held, and the level of interest
demonstrated by the shareholders. Despite varying levels of need and opportunity, shareholders
in general do have similar rights and obligations. These are discussed in detail in the section on
OECD Principles later in this module.
Shareholders who hold a significant stake in a company are often able to use their voting
power to gain places for themselves or their nominees on the board. In principle, these
nominee directors are supposed to act in the interests of the company, not the interests of
the major shareholders. However, in practice, there is a risk of decisions being made that
favour major shareholders at the expense of the minority shareholders. If any shareholder
has a controlling shareholding, then it may be possible for them to use their voting power to
create a board that is unbalanced. Boards should be balanced and demonstrate substantial
independence in their composition.
174 | GOVERNANCE CONCEPTS
Individual shareholders
The increase in the number of individuals holding shares is having far-reaching effects on
companies. A substantial number of these shareholders may be retired and have time to devote
to the task of keeping themselves informed. This has been facilitated by investors’ greater
access to technology such as the internet. In addition, organisations exist that represent the
collective interests of smaller shareholders, such as the Australian Shareholders’ Association
(ASA), which has been active in striving for improvements in the corporate governance of
Australian companies.
Individual shareholders want companies to be run efficiently and profitably, and for the
companies in which they invest to be adequately supervised by the board. They also want
honesty from directors and managers. To achieve these objectives, shareholders are prepared
to be more vocal. The media and the internet have provided vehicles for shareholders to more
publicly express their concerns regarding poor corporate governance practices.
Institutional shareholders
The terms ‘institutional shareholders’ or ‘institutional investors’ include insurance companies,
pension funds, investment trusts and professional investment fund managers. This class of
shareholder is becoming more important in corporate governance, due to the substantial
retirement savings managed by them, of which a significant proportion is invested in shares.
Institutional investors can possess great power to control corporations through the voting power
they exercise in respect of these shares. For example, the Norwegian pension fund is estimated
to have assets worth more than USD 750 billion, and it is estimated to be the largest owner of
shares in Europe (Norwegian Finance Department 2013). Other global investment funds are
achieving vast scale, for example by June 2015, BlackRock’s assets under management totalled
USD 4.721 trillion across equity, fixed income and other assets. These investment institutions
now own the majority of shares in most equity markets around the world. Generally, institutional
shareholders want the opportunity to have input into the board’s decision-making processes to
the extent that it suits them to do so. On the other hand, there are limitations on the degree
to which some institutional shareholders can affect a company’s conduct with their voting power.
MODULE 3
There has been criticism of the institutional shareholders’ failure to publicly use their voting
power to encourage companies to adopt sound corporate governance policies. For example,
these institutions often prefer not to vote or give their proxies to the board without instructions
to vote for or against resolutions.
An institution that has the capacity to vote at general meetings and wants to achieve short-term
performance targets would not necessarily wish to stay invested in a company that requires an
overhaul of its corporate governance practices.
Because of the rise in share ownership, there is correspondingly more interest in the media over
such issues. The California Public Employees’ Retirement System (CalPERS) is an extremely large
institutional investor that invests the pension funds for more than 1.6 million people in California.
This quote describes its philosophy on corporate governance:
We believe good corporate governance leads to better performance. We seek corporate reform
to protect our investments. The corporate governance team challenges companies and the status
quo—we vote our proxies, we work closely with regulatory agencies to strengthen our financial
markets, and we invest with partners that use corporate governance strategies to earn value for our
fund by turning around ailing companies (CalPERS 2011).
The UK Stewardship Code is a starting point for much stronger international attention to the
considerable and rapidly growing power of large institutions with global relevance. The core
principles underlying this code are described below. Institutional investors should:
1. publicly disclose their policy on how they will discharge their stewardship responsibilities;
2. have a robust policy on managing conflicts of interest in relation to stewardship and this policy
should be publicly disclosed;
3. monitor their investee companies;
4. establish clear guidelines on when and how they will escalate their stewardship activities;
5. be willing to act collectively with other investors where appropriate;
6. have a clear policy on voting and disclosure of voting activity; and
7. report periodically on their stewardship and voting activities
Source: The UK Stewardship Code. Financial Reporting Council 2012, p. 5. Reproduced with permission.
Contains public sector information licensed under the Open Government Licence v3.0.
MODULE 3
Provided below is the additional guidance on the principle that states that ‘institutional investors
should have a clear policy on voting and disclosure of voting activity’.
Institutional investors should seek to vote all shares held. They should not automatically support
the board.
If they have been unable to reach a satisfactory outcome through active dialogue, then they should
register an abstention or vote against the resolution. In both instances, it is good practice to inform
the company in advance of their intention and the reasons why.
Institutional investors should disclose publicly voting records
Source: The UK Stewardship Code. Financial Reporting Council 2012, p. 9. Reproduced with permission.
Contains public sector information licensed under the Open Government Licence v3.0.
The board
Boards and directors are the most significant components of corporate governance. It is
essential to develop a clear understanding of what a director is and what a board of directors is.
The following description of a company and the directors is useful in considering the role that
directors play in an organisation:
176 | GOVERNANCE CONCEPTS
A company may in many ways be likened to a human being. It has a brain and a nerve centre which
controls what it does. It also has hands which hold the tools and acts in accordance with directions
from the centre. Some of the people in the company are mere servants … who are nothing more
than hands to do the work and cannot be said to represent the mind or will. Others are directors
and managers who represent the directing mind and will of the company, and control what it does.
The state of mind of these people is the state of mind of the company and is treated by the law as
such (L J HL Bolton Engineering Co. Ltd v. TJ Graham & Sons Ltd [1957] 1 QB 159 at 179).
In this section we provide a considerable discussion about various aspects of this area,
including the main functions of the board of directors (see summary in Figure 3.3) and different
types of director, as well as exploring the legal duties with which directors must comply.
Providing Strategy
accountability formulation
Inward
looking
MODULE 3
Source: Tricker, R. I. 2015, Corporate Governance: Principles, Policies and Practices, 3rd edn,
Oxford University Press, Oxford.
Board of directors
The board of directors (the board) is the body that oversees the activities of an organisation.
The board has a wide range of roles and functions that address both performance and
conformance.
It is preferable that the roles and responsibilities of the board be explicitly set out in a written
charter or constitution. A significant court case in Australia regarding what boards should do has
received international recognition in the Anglo-American corporate world. In AWA Ltd v. Daniels
(1992) 10 ACLC 933, Rogers C J concluded that the role of the board in modern companies is
to set policy and organisational objectives (performance) and then ensure adequate controls
and review procedures are in place (conformance) to ensure effective implementation by
management (performance).
However, Rogers C J observed that the board is not in place to actually run the business itself.
That part of the governance process is delegated to the CEO, although the board must remain
informed and is responsible for taking timely action where fundamental CEO failures arise.
Rogers C J stated:
Study guide | 177
The board of a large public corporation cannot manage the corporation’s day-to-day business.
That function must by business necessity be left to the corporation’s executives. If the director of a
large public corporation were to be immersed in the details of day-to-day operations, the director
would be incapable of taking more abstract, important decisions at board level (AWA Ltd v. Daniels
(1992) 10 ACLC 933, p. 1013).
Therefore, directors are entitled to rely on management to manage the daily operational
activities of the corporation. The board need not be informed of these details and will expect
the paid managers to run the corporation according to strategies and policies set by the board.
However, the board cannot leave everything to the managers, as the board also has an ongoing
oversight responsibility.
The board must ensure appropriate procedures are in place for risk management and internal
controls, and it must also ensure that it is informed of anything untoward or inappropriate in the
operation of those procedures. Any major operational issues will also be brought to the attention
of the board for appropriate consideration and decision.
The role of the board of directors has become more onerous, making support mechanisms
more important. These include induction for new directors and relevant education and training
for all directors. Furthermore, to enable directors to properly carry out their legal and ethical
duties, it is necessary for them to be provided with expert advice (including legal and financial).
Such advice should be objective and as independent as possible. Professional accountants,
along with other professional groups and other experts, are important contributors to meeting
these needs of boards.
MODULE 3
As previously noted, the board is elected by shareholders and functions as their agent. Boards
are expected to act for, on behalf of or in the best interests of shareholders. Under Anglo–
American law (which has been developed in many Western countries), companies developed with
the concept that shareholders are part of the company, being the owners. Therefore, the primary
duty of boards is to shareholders, with the duty to all other stakeholders deriving from the
directors’ duty to ‘act in good faith in the best interests of the company’ (Corporations Act 2001
(Cwlth), s. 181). Obviously, it is not possible to make all shareholders happy at all times, but if the
directors genuinely make decisions intended to be good for the general body of shareholders,
then this is satisfactory.
Directors
Boards of directors are composed of a chair, executive directors (usually including the CEO),
and non-executive directors.
Board chair
Each board must have a chair. The role of the chair is to lead the board of directors, including
determining the board’s agenda, obtaining contributions from other board members as part
of the board’s deliberations, and monitoring and assessing the performance of the directors.
This role is crucial in ensuring that the board works effectively.
In some countries, it is important that the chair be independent (i.e. without any direct link to
the company, for example, by being a former CEO of the company, or a principal consultant
to the company), while in others this is not seen as critical. For example, in the United Kingdom
the largest listed companies are expected to have a chair who is independent at the time of
appointment. In contrast to this, many companies in the United States allow a person to fulfil
both the role of CEO and chair of the board at the same time. However, an increasing number
of US companies are separating the roles of CEO and chair, and where the roles are combined
it is the usual practice to have a senior independent director who can, if required, express an
independent view of the board from the CEO/chair.
The CEO effectively has two roles, board member and CEO, and potentially two identifiable
agency relationships arise—one with shareholders and another with the board. This duality
results in a series of governance rules and laws designed to control problems that can arise.
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The CEO, in conjunction with the management team, is responsible for constructing the
strategies and the significant policies of the company. However, this will be the result of
boardroom deliberations in which the CEO, as a director, will participate. When the process
is completed to the satisfaction of the board, the board will formally approve these corporate
strategies and policies. The task of implementing corporate strategies and policies rests with
the CEO and the management team.
The CEO must keep the board informed on key issues relating to the management of the
company—for example, through monthly management reports to the board. These reports
should include information on performance and key risks, and also exceptional/significant
events (such as the loss of a key customer). The CEO also works with the board (primarily the
chair) and the company secretary to prepare the agenda for board meetings and to ensure that
appropriate background information accompanies the agenda to enable the board to make the
right decisions.
➤➤Question 3.3
Describe the role of the CEO, and give examples of the types of activities the CEO and the board
should perform.
Study guide | 179
Independence of directors
There are two main types of director—executive directors, who also work as employees within
the organisation; and non-executive directors, who do not.
It is crucial to appreciate the importance of independence in the role of directors. All independent
directors must be non-executive directors, but not all non-executive directors are independent.
Sometimes people confuse these two terms or use them interchangeably, but they are different.
Therefore, there are three main categories of director:
1. executive directors who are never independent;
2. non-executive directors who do not work in the organisation, but are not independent
because of a particular relationship; and
3. independent non-executive directors, who are free from influences that cause bias, and
exhibit the characteristics of independence.
While there are checklists that help identify those who have lost their independence, it is always
difficult to discern if someone is independent or not, and it has been said that independence
is a state of mind. However, to assist in the determination of independence, the Australian
Securities Exchange (ASX) and other regulators have delineated criteria of independence in the
ASX Corporate Governance Principles in Recommendation 2.3. Each person must be assessed
based on the following principles.
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The UK Corporate Governance Code (produced by the UK Financial Reporting Council and
known as the FRC Code) provides the following items to help guide consideration of whether a
director is independent, by asking if the director:
• has been an employee of the company or group within the last five years;
• has, or has had within the last three years, a material business relationship with the company
either directly, or as a partner, shareholder, director or senior employee of a body that has such
a relationship with the company;
• has received or receives additional remuneration from the company apart from a director’s
fee, participates in the company’s share option or a performance-related pay scheme, or is a
member of the company’s pension scheme;
• has close family ties with any of the company’s advisers, directors or senior employees;
• holds cross-directorships or has significant links with other directors through involvement in
other companies or bodies;
• represents a significant shareholder; or
• has served on the board for more than nine years from the date of their first election
Even if a director is not independent, it is important to appreciate the concept and to ensure
decisions are made as impartially (i.e. as independently) as possible. This obligation is actually
required by law in most jurisdictions.
Figure 3.4 expands on the classification of executive and non-executive directors to include the
independence of directors.
Directors
These directors satisfy the concept of These directors lack independence. This could
independence (as fully discussed above). be because they are executives or, if they are
Sometimes these are referred to as not executives, because they satisfy the
‘independent non-executive’ directors but conceptual approaches that deny
this is unnecessary and potentially independence (as discussed previously).
confusing—being an executive of the
corporation automatically means a director Sometimes the term ‘non-executive directors’
is not independent. is used. In practice this term used alone is not
useful. A non-executive director may, or may
Independent directors are important as they not, be independent. Merely referring to a
are able to make reliable judgments on both person as a non-executive does not inform
performance and compliance based only on us about independence.
their capabilities and without appearing to be
or acting other than on an independent basis.
These directors, as well as occupying the These directors are not executives and are not
‘office’ of director, also hold an ‘office’ as an independent. For convenience we use the
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In addition to this, certain committees should only have independent or at least non-executive
members on it, as shown by the following requirements provided by the ASX for listed companies.
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management. Over time, the legal duties and responsibilities of directors have evolved to
protect the interests of the owners, who are not able to observe closely the daily occurrences
within a corporation.
In most jurisdictions, there is a core group of directors’ duties and responsibilities that have arisen
from either statute or case law. The key duties, which are considered in further detail next, are to:
• avoid conflicts of interest and where these exist, ensure they are appropriately declared and,
as required by law, otherwise managed correctly;
• act in the best interests of the corporation;
• exercise powers for proper purposes;
• retain discretionary powers and avoid delegating the director’s responsibility;
• act with care, skill and diligence;
• be informed about the corporation’s operations; and
• prevent insolvent trading.
182 | GOVERNANCE CONCEPTS
Conflict of interest
Conflict of interest is an issue that often arises with respect to all types of agency. The ever-
present opportunities that would benefit the agent due to their position provide significant
temptation. Potential conflicts may be at the expense of the corporation, or may even be
beneficial to the corporation. That is, it is not necessary that there be fraud, dishonesty or loss
to the corporation, as the corporation does not have to suffer a detriment for the director to be
in breach of their duty. An example of this would be when a contract is awarded to a supplier
that is owned by one of the directors. It may still provide a benefit to the organisation in terms
of the best price and appropriate quality, but this does not remove the conflict of interest for the
particular director involved.
All agents, including directors, need to be aware of conflicts and must manage them correctly. As a
fundamental of good corporate governance compliance, directors need to fully understand that
the law requires that directors of larger corporations (including all public and listed corporations)
must not be involved in decisions where any actual or potential conflicts of interest are identified.
They can bypass this rule if they clearly advise the board of the conflict and also gain approval
from the remaining directors or from the shareholders or from corporate regulators. Failure to
disclose to the board or seek necessary shareholder approvals can result in civil liabilities,
full obligations to compensate persons (natural and corporate) who are harmed and even
criminal prosecutions, including possible jail and fines.
There are a number of examples of possible conflicts of interest to be aware of, including:
• relationships or circumstances that create conflicts of interest where no relevant gains to a
director may ever arise, but where the ability of the director to be regarded as independent
is compromised by relationships such as competing shareholdings, the interests of relatives
or friends etc.;
• bribes, secret commissions and undisclosed benefits (e.g. in the awarding of a tender);
• misuse of corporation funds (e.g. for personal expenses);
• taking up corporate opportunities (e.g. purchasing land to on-sell to the corporation at
a profit);
• using confidential information (e.g. to trade in the corporation’s shares);
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• competing with the corporation (e.g. tendering for the same project); and
• using a position in the corporation improperly (e.g. to secure a personal discount to the
detriment of the corporation).
It should be noted that accepting or being involved in secret commissions (which are often in
the form of bribes) is an offence in Australia under relevant criminal codes such as the Crimes Act
1958 (Cwlth). This legal concept has legislative equivalents in most countries. Legislation for such
actions often has a wide reach, with citizens of a country being liable for prosecution for actions
committed outside their home country.
In many jurisdictions, the test for this is whether directors themselves believed their actions to be
in the best interests of the corporation. Directors who use good business judgment and behave
honestly in a way that a reasonable person in their position would act will satisfy the duty.
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It is important to note that action that is perceived to be in the best interests of the corporation is
still unacceptable if it goes beyond the authority given to a director. This duty to exercise powers
for proper purposes is usually linked to legislation and the constitution of the corporation or its
equivalent, which outlines the authority of directors.
Possible breaches of this duty include making anti-competitive agreements that benefit the
corporation but are illegal (e.g. price-fixing). There are a number of situations where the issue
of improper purpose may arise, including defensive actions during hostile takeovers (that are
focused on protecting the current management team rather than getting the best deal for
shareholders) and actions to destroy majority voting power (where a small minority gains
control of a corporation at the expense of the majority).
Nominee directors
A difficult situation arises when powerful interest groups appoint nominee directors to a board.
These directors are appointed to represent third-party interests, such as a major shareholder,
a class of shareholders or a holding corporation. However, this may put the nominee in a position
where their loyalties are divided between the conflicting interests of the nominator and the
corporation. The nominee director must always act in the best interests of the corporation and
use their powers only for proper purposes when making a decision as a director of a board.
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in using the corporation’s funds in an election campaign to stop the nominees of FAI Insurances Ltd
from gaining a place on the board, and to return the current directors to the board.
The allegation was that the material sent to the shareholders included misleading and prejudicial
material that should not have been paid for by the corporation. The court decided that, although the
directors acted honestly and in good faith, they exceeded their power and used their power for an
improper purpose. The case highlights the position of directors who act beyond their power, however
innocently (Advance Bank Australia Ltd v. FAI Insurances Ltd (1987) 5 ACLC 725).
The board must not, without express authority from the corporation’s constitution or from statute,
delegate their discretion to act as directors to others. While the directors can engage employees
and agents to perform the ordinary business of the corporation, the directors must not let
someone who is not a director carry out their duties. In addition, as directors owe a fiduciary
duty to the corporation to give proper consideration when exercising their right to vote or act—
they cannot simply accept the direction of others as to how they will vote at board meetings.
184 | GOVERNANCE CONCEPTS
Where a director has delegated powers to anybody (usually managers), the director (or the whole
board jointly and severally) remains responsible for the exercise of the power by the delegate,
as if the director had exercised the power themselves.
However, corporate legislation in various jurisdictions usually allows directors to escape this total
liability for every action by a manager to whom power is delegated. Delegates (i.e. managers)
need to be properly appointed by boards (of directors) using professionally acceptable
procedures (as to competence, qualifications, etc. of the manager).
Additionally, the board must carry out correct and ongoing oversight. Note, however, that the
board does not undertake day-to-day operational management, so a balanced approach is
required. If these two obligations are met, then boards can be comfortable that they will not be
exposed to a vast array of management-induced personal liabilities.
A word of caution is required however. From both the Centro case and the James Hardie
case—to be discussed shortly—a residual matter arising in discussion relates to the fact that
some director’s duties and tasks are simply ‘non-delegable’. This means that any attempt
to delegate these ‘non-delegable’ functions (to managers or to other fellow directors) will
comprise inappropriate action by a director and will not deem the director immune from liability.
The obligation to report correctly to shareholders on major matters affecting the finances of the
corporation, which directors should do or be aware of, appear from the Centro and James Hardie
decisions to be ‘non-delegable’.
There are two interesting situations where the standard of care may differ even between directors
of the same corporation:
• A director who also has professional qualifications (e.g. a CPA) and uses them in an executive
capacity (e.g. as a CFO) may be subject to a higher level of responsibility. In this sense,
such directors may have a higher standard of care than unqualified directors because
of their higher level of skills and the specific role they fulfil and for which they receive
executive remuneration.
• Non-executive directors who are not involved in the business on a day-to-day basis are
still required to demonstrate a duty of care. However, the care, skill and diligence that a
non executive director may be expected to exercise may not equate to that of an executive
director who also holds professional qualifications.
A director will be called to account for breach of the duty to use care, skill and diligence in their
dealings with and on behalf of the corporation where they have failed to act with reasonable care
in the performance of their duties. This will usually include keeping themselves abreast of any
developments and the financial affairs of the corporation.
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In Australia, an important protection for directors acting properly is the business judgment rule,
also known as the safe harbour rule. The criteria to gain the protection of this rule involve each
director, when making any decision, and in respect of that decision, ensuring that they are:
• acting in good faith in the best interests of the corporation and also acting in such a way
that they are using their powers as a director for a proper purpose;
• not affected by a conflict of interest;
• appropriately informed regarding the subject matter of the decision; and
• making the decision in such a way that another reasonable person in the same position
would consider the decision to be appropriate and not irrational.
Most of the corporate governance regimes around the world including the OECD Principles
(2015), Sarbanes–Oxley Act (2002), and EU Transparency Directive (2013) commit companies
to disclosure as a vital basis for the effective operation of all of the other mechanisms of
governance and investment.
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UNCTAD has summarised these collected guidelines into requirements on financial
disclosures stating:
The quality of financial disclosure depends significantly on the robustness of the financial reporting
standards on the basis of which the financial information is prepared and reported. In most
circumstances, the financial reporting standards required for corporate reporting are contained
in the generally accepted accounting principles recognized in the country where the entity is
domiciled … the board of directors could enrich the usefulness of the disclosures on the financial
and operating results of a company by providing further explanation (UNCTAD 2006, pp. 3–4).
However the requirement for continuous disclosure is not confined to financial information,
and includes any information that is expected to have a material effect on the price of securities.
Further explanation of the board becomes necessary in continuous disclosure regimes when a
critical accounting or material matter occurs that might ‘have material impact on the financial
and operating results of the company’.
The test of whether disclosure is required is outlined within the Australian Corporations Act:
The test for determining whether information is market sensitive and therefore needs to be
disclosed under Listing Rule 3.1 is set out in section 677 of the Corporations Act. Under that
section, a reasonable person is taken to expect information to have a material effect on the price or
value of an entity’s securities if the information ‘would, or would be likely to, influence persons who
commonly invest in securities in deciding whether to acquire or dispose of’ those securities.
The ASX Continuous Disclosure guide (ASX 2014) gives the following examples of information
that could be market sensitive:
• a transaction that will lead to a significant change in the nature or scale of the entity’s activities;
• a material mineral or hydrocarbon discovery;
• a material acquisition or disposal;
• the granting or withdrawal of a material licence;
• the entry into, variation or termination of a material agreement;
• becoming a plaintiff or defendant in a material law suit;
• the fact that the entity’s earnings will be materially different from market expectations;
• the appointment of a liquidator, administrator or receiver;
• the commission of an event of default under, or other event entitling a financier to terminate,
a material financing facility;
• under-subscriptions or over-subscriptions to an issue of securities (a proposed issue of
securities is separately notifiable to ASX under Listing Rule 3.10.3);
• giving or receiving a notice of intention to make a takeover; and
• any rating applied by a rating agency to an entity or its securities and any change to such
a rating.
While understanding the broad principles and necessity of continuous disclosure, boards and
directors are often challenged on exactly when disclosure is required. The ASX advises:
Under Listing Rule 3.1, market sensitive information must be disclosed to ASX immediately upon
the entity becoming aware of the information, unless it falls within the carve-outs from disclosure in
Listing Rule 3.1A (see below). The word ‘immediately’ does not mean ‘instantaneously’, but rather
‘promptly and without delay’. Doing something ‘promptly and without delay’ means doing it as
quickly as it can be done in the circumstances (acting promptly) and not deferring, postponing or
putting it off to a later time (acting without delay)
Further advice offered by the ASX regarding the immediacy of the need for disclosure includes
when and where the information originated (rumours abound and need to be countered
carefully); the forewarning the entity had of the information and the need to verify the bona
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fides of the information; and the need for an announcement to be drawn up that is accurate,
complete and not misleading.
ASIC alleged that the defendants had contravened their statutory duties of care and diligence under
the Corporations Act in relation to their approval of the consolidated financial statements of the Centro
group for the year ended 30 June 2007. In particular, it was alleged that the consolidated financial
statements were incorrect as they incorrectly classified $1.5 billion of debt as non-current liabilities
when in fact they should have been classified as current liabilities.
Furthermore, it was alleged that the defendants had failed to disclose USD 1.75 billion of guarantees
as a material post balance date event in the financial statements of Centro. Centro’s auditor,
PricewaterhouseCoopers, did not identify any such errors in the financial statements of Centro.
In June 2011, Justice Middleton of the Federal Court of Australia (FCA) held that each of the directors
had breached their duty of care and diligence in relation to the Centro group of entities and had
failed to take all reasonable steps to ensure compliance with the financial reporting obligations of
the Corporations Act.
The directors were also found to have approved the financial statements of Centro without receiving
a CEO/CFO declaration that complied with section 295A of the Corporations Act. The court held
that each director knew or should have known of the extent of the relevant entities’ borrowings and
maturity profiles as well as the post balance date guarantees.
Key lessons for directors arising out of the Centro case include the following matters.
Duty of care
The Centro case emphasises the duty of care expected of public company directors when they approve
financial statements. The directors should apply their minds to the proposed financial statements,
including a careful review of how the financial analysis is presented and the clarity of the accompanying
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directors’ report.
The directors should determine whether the information contained in these documents is consistent
with their knowledge of the company’s affairs and that they do not omit material matters known, or that
should have been known, to the directors.
The directors should know enough about basic accounting concepts to enable them to carry out their
responsibilities adequately. Furthermore, they should make appropriate inquiries if they are uncertain.
Reliance on others
The Centro directors argued that the Corporations Act permits reasonable reliance on others in the
discharge of their duties, and that they reasonably relied on Centro’s management and the external
auditor to ensure that the financial statements complied with relevant accounting standards.
The court found that the directors may rely on others, including management and external advisors,
who prepare financial statements and advise on accounting standards. Such reliance can exclude
independently verifying the information on which the advice is based, provided that there is no cause
for suspicion or circumstances demanding critical attention.
However, directors cannot substitute reliance on advice for their own attention and examination of
important matters within the board’s responsibilities (i.e. the directors must approach their tasks with
an enquiring mind). Therefore, the directors’ failure is not excused even if others on whom they relied
fell into error.
188 | GOVERNANCE CONCEPTS
Delegation
The obligation of directors to approve the financial statements, and to express an opinion as to their
compliance with accounting standards and that they give a true and fair view, rests with the directors
and is not able to be delegated to others. The court referred to the ‘core, irreducible requirement of
directors to be involved in the management of the Company’.
Information flow
Directors have a duty to take into account information they receive from all sources when reviewing
the financial statements, including information about loan maturities provided in board papers.
Having to deal with complex and voluminous material is no excuse for failure to take sufficient care
and responsibility.
The board can control the information it receives, so it can take steps to prevent information overload.
Over time, it is expected that directors will or should accumulate sufficient knowledge of what is
contained in regular board reports. Information provided to directors by management is assumed to
be given to them for a reason.
Financial competence
Directors are required to have the financial literacy to understand basic accounting conventions and
to exercise proper diligence in reading the financial statements. Note that this does not mean that
the director should have a working knowledge of all the accounting standards.
While there are many matters a director must focus on, the financial statements are regarded as one
of the most important matters. For instance, directors should understand that financial statements
classify assets and liabilities as current and non-current and directors should understand what these
concepts mean.
➤➤Reflective question
Do you agree with the idea that different directors within the same organisation may be held to
have a different standard of care based on their qualifications?
Example 3.4 further illustrates the importance of directors not relying on others to avoid their
duty to use care, skill and diligence in their dealings with and on behalf of the corporation.
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The group restructured itself to separate those subsidiaries from the group and a foundation was
established by the group to compensate the victims of asbestos-related diseases who had claims
against the two subsidiaries.
February 2001
The board of James Hardie Industries Limited (the parent in the James Hardie Group) announced to
the ASX that the foundation had sufficient funds to meet all anticipated compensation claims. In fact,
the announcement was misleading because the foundation was underfunded by $1.5 billion.
2007
ASIC brought proceedings against the directors of James Hardie Industries Limited and certain officers
for failing to exercise due care and diligence in approving and releasing the ASX announcement.
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May 2012
The High Court of Australia (ASIC v. Hellicar (2012) HCA 17) found that the directors of James Hardie
Industries Limited had breached their duties to act with due care and skill by approving the release of a
misleading announcement to the ASX concerning the funding arrangements for the asbestos liabilities.
It was held that none of the directors were entitled to abdicate responsibility (in relation to the
misleading ASX announcement) by delegating their duty to a fellow director or by pleading reliance
on management or expert advisers for the task of approving a draft of the ASX announcement.
Following the Centro and James Hardie cases, there are some non-delegable duties and these
apply to ‘business judgment’ decisions. While the area is unclear, it can be stated with reasonable
certainty that if matters are considered carefully by a director and on an informed basis, it would
seem that directors can delegate to others.
This would include the concept that non-executive directors delegate to appropriately qualified
executive directors with the expectation that personal liability is also ‘delegated’. If the matter is
of major importance, delegation may not be effective—just as it would not be if the delegate is,
on an ongoing basis, objectively considered not to be reliable and appropriate as a delegate.
From a regulatory perspective, several types of officers or agents deserve special mention.
Other than directors, a number of agents in a corporation play important roles in its governance.
(Note that many of these may also have the office of director, meaning that they hold two
‘offices’—one as a director and another as a skilled executive.) These ‘other offices’ include
positions that are simply defined as offices and other positions where responsibilities may have
a significant impact on the corporation. Offices under either approach include:
• chief executive officer (CEO);
• chief financial officer (CFO);
• company secretary;
• legal counsel; and
• internal auditor.
Without a highly competent CEO who is committed to good governance, it would be difficult
for good governance practices to be effectively implemented. To enhance governance,
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some corporations are also appointing chief operating officers, compliance officers,
ethics officers and risk managers. The titles are often somewhat meaningless on their own—
the crucial issue on every occasion is for the board (and each director) to establish the
responsibilities and capabilities of these officers and to ensure that all delegations to the
officers are understood and properly documented.
The board needs to understand and take appropriate responsibility for the formal approval
of all significant delegations and their documentation. Correct board policies and knowledge
relating to systems and procedures involving significant delegations is an important foundation
of good corporate governance.
190 | GOVERNANCE CONCEPTS
While the laws relating to corporate insolvency and liquidations can be complex and contain
important technical differences across countries, the following summary covers the key issues
under the Corporations Act, from the point of view of directors.
A basic duty of directors under the Corporations Act is to ensure that a company can pay its
debts. This means that the directors must, at the time a debt is incurred, have reasonable
grounds to believe that the company will be able to pay its debts when they are due for payment.
An insolvent company is one that is unable to pay all its debts when they fall due. If a company
becomes insolvent, the directors must not allow it to incur further debts.
Serious penalties can be imposed on directors if they allow a company to trade while insolvent.
It is therefore very important that the directors are constantly aware of the company’s financial
position—not just at the end of the financial year when they sign off the company’s financial
statements. Directors need to pay careful attention to the declaration where they confirm
whether or not, at the date of the declaration, there are reasonable grounds to consider that
the company will be able pay its debts as and when they fall due and payable. In situations
where the company is experiencing financial difficulty, it may be prudent for directors to seek
independent advice on their responsibilities.
Unless the company can obtain sufficient finance or trade its way out of financial difficulty,
the options available to directors are to appoint a voluntary administrator or a liquidator. In a
voluntary administration, an independent and suitably qualified person will assume full control
of the company to try to work out a way to save either the company or the company’s business.
If it isn’t possible to save the company or its business, the aim is to administer the affairs of the
company in a way that results in a better return to creditors than they would have received if the
company had instead been placed straight into liquidation.
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After reading this set of duties and responsibilities, please complete Question 3.4.
The board’s responsibilities and functions, according to the Tricker model considered earlier
(refer to Figure 3.3) and as detailed by Henry Bosch, one of the foremost Australian authorities on
corporate governance, include:
Providing accountability
• determining that the company has instituted adequate reporting systems and internal controls
(both operational and financial) together with appropriate monitoring of compliance activities;
• determining that the company accounts conform with Australian Accounting Standards and
are true and fair;
• determining that satisfactory arrangements are in place for auditing the company’s financial
affairs and that the scope of the external audit is adequate;
• selecting and recommending auditors to shareholders at general meetings; and
• ensuring that the company has in place a policy that enables it to communicate effectively
with shareholders, other stakeholders and the public generally
Strategy formulation
• determining the company’s vision and mission*;
• reviewing opportunities and threats to the company in the external environment,
and strengths and weaknesses within the company*;
• considering and assessing strategic options for the company*; and
• adopting a strategic plan for the company, including general and specific goals,
and comparing actual results with the plan.
* Note: Bullet points identified by asterisk (*) are not from the Bosch Report, but are added by the author.
Policy making
• establishing and monitoring policies directed at ensuring that the company complies with the
law and conforms to the highest standards of financial and ethical behaviour;
• selecting and, if necessary, replacing the CEO, setting an appropriate remuneration package
for the CEO, ensuring adequate succession plans are in place for the CEO, and giving
guidance on the appointment and remuneration of other senior management positions;
• adopting formal processes for the selection of new directors and recommending them for
the consideration of shareholders at general meetings, with adequate information to allow
shareholders to make informed decisions; and
• reviewing the board’s own processes and effectiveness, and the balance of competence on
the board.
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• Approving and working with and through the CEO
• adopting clearly defined delegations of authority from the board to the chief executive officer
(CEO) or a statement of matters reserved for decision by the board; and
• agreeing on performance indicators with management.
Source: Bosch, H. 1995, Corporate Practices and Conduct, 3rd edn, Pitman, Melbourne,
p. 9. Reproduced with permission.
➤➤Question 3.4
Classify each of the board responsibilities and functions above as having either a performance
focus or a conformance focus.
192 | GOVERNANCE CONCEPTS
Furthermore, in relation to issues that involve conflicts of interest (e.g. related party transactions,
financial reporting and setting executive remuneration), subcommittees are important for
creating environments where independent directors’ views can take priority in order to achieve
independent decisions.
The chairs of committees are singled out for attention in some corporate governance
requirements or guidance. In particular, the importance of independent directors as chairs can
be observed. This role is discussed later in Part C with regard to specific codes and guidance on
corporate governance.
However, these committees do not reduce the responsibility of the board as a whole, and care
needs to be taken to ensure that all those concerned understand their functions. It is important
to note that the board of directors is still responsible for decisions made by the committees.
The delegation of duties from the board to the committees enables examination of issues in
greater detail and discussion of issues in the absence of executive directors—and in some cases,
with only independent directors present.
Carefully written terms of reference for each committee are required along with defined
procedures for reporting to the full board. Modern corporate governance principles allow
that some matters may be delegated fully (e.g. executive remuneration delegated to a
remuneration committee). The recommendations of such a committee will be accepted by the
board without further consideration by the whole board. Where this occurs, very careful attention
to procedures and protocols is required so that board delegations are fully understood and
properly carried out.
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Important committees that may exist are discussed below. The three committees that are
normally required by various corporate governance codes/recommendations are the nomination
committee, remuneration committee and audit committee. Risk management committee are also
common. Boards are also free to choose to have any additional committees that may assist in
creating a better governance structure for running the corporation.
Nomination committee
This committee is primarily responsible for recommending the succession procedures within
an organisation. Succession is the concept of identifying and selecting people who will replace
senior staff when they leave.
This committee, because of the skills each member acquires in this role, is valuable in assessing
the overall performance of the board itself—and sometimes key executives. A key aspect of
succession responsibilities comprises making candidature recommendations for directorships
whereby they will be presented as candidates for shareholders to vote on to the board
as directors. Given that boards comprise a balance of directors, including executives, it is
appropriate for the nomination committee to include executive directors.
Remuneration committee
This committee deals with remuneration—especially for senior executives. Aspects of
remuneration that are important include what and how directors and executives are paid.
It is apparent that this area is particularly complex. One of the main causes of the GFC was
the setting of inappropriate remuneration policies that focused almost entirely on short-term
revenue generation and marginalised the concern for risk management. The sensitivity of setting
a remuneration policy can be reduced if executives are not involved in the committees that
decide their remuneration. Furthermore, in order to ensure independence, it is necessary that
executives do not set the remuneration of independent directors.
Audit committee
The audit committee is, in many ways, the most important in relation to the conformance aspects
of corporate governance. It is often considered the appropriate conduit between the company
and the external auditor, ensuring that the work of the external auditor maintains the utmost
integrity and independence.
While this committee is recommended for all listed companies (and will be valuable in
many others), it can also be mandatory to have an audit committee. For example, the top
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500 corporations on the ASX, which in 2015 accounted for 77 per cent of the Australian
equity market (known as the All Ordinaries index), must have an audit committee. In addition,
the top 300 corporations’ audit committees must conform to the recommendations regarding
membership as stated in the ASX Principles.
To ensure the independence of the audit committee, it is recommended that the audit committee
comprise only non-executive members, with a majority being independent. An audit committee
with no executives means that communications with the external auditor at a formal level will
take place without the CFO.. This is an important aspect of good governance at the auditing/
reporting phase.
Under the US Sarbanes–Oxley Act (US Congress 2002), all US-listed companies must have an
audit committee. The committee must comprise only independent directors and must be the
principal communication conduit between the company and the external auditor. The Sarbanes–
Oxley Act also provides that the audit committee has the responsibility to ‘hire and fire’ auditors.
The audit committee has many responsibilities and its role should include reviewing the
adequacy of operational and internal controls (including the internal audit function) and
reviewing half-year and full-year financial statements prior to board approval (Percy 1995).
Percy identifies that the audit committee’s review should place particular focus on changes in
accounting policies, areas requiring the use of judgment and estimates, audit adjustments,
and compliance with accounting, legal and stock exchange requirements. A detailed list of audit
committee responsibilities is provided in Appendix 3.1, which reviews relevant extracts from the
FRC Code (FRC 201 4) and will be discussed later in this module.
194 | GOVERNANCE CONCEPTS
It is also preferable that the role and responsibilities of the audit committee be explicitly set out
in a written charter, in order to avoid misunderstandings.
Audit committees may also be formed as a means of giving the appearance of good corporate
governance without achieving any useful purpose for the organisation and with little commitment
to attempting to improve the monitoring of the organisation. However, with the major corporate
failures including Enron linked to audit failure, and the increasing emphasis of regulation
including Sarbanes Oxley in the United States, and the Corporate Law Economic Reform
Program (CLERP) in Australia, companies are invariably taking the work of their audit committees
more seriously.
One situation in which audit committees are formed without regard for quality or effectiveness of
their work, is fear of litigation. Although it could be argued that the mere fact that a firm has an
audit committee is evidence that the directors take due care in performing their duties, if this is
the only reason for the audit committee being formed, then potentially the whole board is
derelict in its duty. An effective board will always ensure the audit committee is performing its
role with diligence and competence.
One member of this committee, John Wakeham, had in place a USD 72 000 per year consulting contract
with Enron. Two other committee members had been employees of universities that had received
significant charitable contributions from Enron or its chairman, Kenneth Lay (Lavelle 2002, p. 28).
Specifically, one of these members, Jon Mendelsohn, was also president of the M. D. Andersen
Cancer Centre at the University of Texas. Lavelle (2002, p. 29), reported that this centre had received
USD 332 150 from Enron and Lay since 1999. Under disclosure rules at the time, it was not necessary
to disclose this relationship to Enron’s shareholders and there was no voluntary public disclosure of
these arrangements.
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Another committee member, Wendy Gramm, was an employee at the Mercatus Centre at George
Mason University. According to the university’s records, USD 50 000 was collectively paid by Enron and
Lay to this centre from 1997. Moreover, Wendy Gramm’s spouse, Senator Phil Gramm (Republican,
Texas), received USD 80 000 in political campaign donations from Enron and its employees from 1993,
when she became a director of Enron (Lavelle 2002).
It should also be noted that the chair of Enron’s audit committee, Robert Jaedicke, was aged 72 years at
the time of Enron’s collapse. While he was eminently qualified for the role—he had worked at Stanford
University as an accounting professor until his retirement some 10 years earlier—his advanced age
and the complexity of Enron’s finances and operations called into question his competence for this
high-level role (Lavelle 2002).
There were also concerns about the lack of action taken by the audit committee against questionable
accounting practices by management. The minutes of an audit committee meeting held in February
1999 indicated that the senior audit partner had told the committee that accounting work relating to
several areas, including ‘highly structured transactions’, was considered ‘high risk’.
The accounting firm’s (Arthur Andersen) legal counsel later testified that this risk rating was designed
to convey to the audit committee that the company was ‘using accounting practices that, due to their
novel design, application in areas without established precedent or significant reliance on subjective
judgements by management personnel, invited scrutiny and presented a high degree of risk of
non-compliance with generally accepted accounting principles’ (COGA 2002, pp. 15–16). The audit
committee seemingly chose to ignore these warnings.
196 | GOVERNANCE CONCEPTS
The Enron case demonstrates that good governance is about far more than establishing
board committees. The members of each committee need to demonstrate independence and
be prepared to stand up to management in the event of questionable practices. Moreover,
they need to adopt a sceptical view of management submissions and be prepared to delve
deeper when they do not receive the answers they want or they suspect something is not quite
right. Clearly, the individual members of an audit committee are required to be competent,
experienced and even courageous in adequately performing such a key role.
➤➤Question 3.5
Examine the Enron audit committee role and independence in light of the earlier discussion on
the benefits and limitations of audit committees. Evaluate the effectiveness of the committee
and what steps you would recommend to improve the Enron audit committee in this situation.
The external audit is also a vital part of the corporate governance process. Investors rely heavily
on information provided in financial reports. It is therefore essential that these reports are
accurate and free from material misstatement. Accordingly, the capacity of external auditors to
conduct a thorough and independent review of the financial statements is the cornerstone of
the corporate governance process. ‘Audit failure’ is the term used when an audit is deficient due
to negligence, incompetence or lack of independence by the auditor. While the vast majority of
audits are conducted in a satisfactory manner, regrettably, there are exceptions.
The external auditor, as an independent party with a detailed knowledge of the entity’s financial
affairs, is able to provide substantial advice to the audit committee. The external auditor may also
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assist the audit committee by informing it of any developments such as legislative changes or
new accounting standards.
It is also important that the external auditor should attend the full board meeting when the
financial statements are approved, to enable all directors to ask any questions they may have
regarding the financial statements or the audit process.
Regulators
Objective of regulation
The business environment is increasingly competitive, with companies constantly trying to
improve performance. There are often strong incentives to achieve these objectives and,
sometimes, questionable methods may be used.
Effective regulation and enforcement is essential to ensure that companies can compete against
each other in a fair and reasonable manner. Failure to create such an environment can lead
to poorer outcomes for all stakeholders. ASIC states that the following are traits of a sound
regulatory system, which are also relevant internationally.
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• Companies can get on with doing business confident that the same rules are applied to
everybody. They can seek capital in Australian markets at rates that are broadly competitive
with leading world markets and without paying a significant market risk premium.
• Financial products and services businesses can operate profitably and efficiently, while treating
customers honestly and fairly. Being in a well-regulated market helps them do business
across borders.
• Financial markets are well respected and attractive internationally, and clean, fair and reliable.
• Everybody can find and understand their obligations.
• Investors and consumers participate confidently in our financial system, using reliable and
trustworthy information to make decisions, with ready access to suitable remedies if things
go wrong.
• The community is confident that markets, corporations and businesses involved in them
operate efficiently and honestly and contribute to improving Australia’s economic performance.
Firm action is taken against fraud, dishonesty or misconduct. The regulatory system is respected
(ASIC 2006, p. 4).
From this regulatory perspective, the purpose of regulation is to support free and open markets.
Yet many businesses and some economists argue that imposing restrictions on corporations’
activities, and the way they are governed, stifles incentive, creativity and entrepreneurship.
They believe that wealth creation is maximised by allowing markets to be free of restrictions.
Nobel prize–winning economist Milton Friedman is of the view that ‘there is one and only one
social responsibility of business—to use its resources and engage in activities designed to
increase its profits so long as it engages in open and free competition without deception or
fraud’ (Friedman 1970). However, critics ask: at the expense of whom?
Others argue that corporations do not exist in a vacuum. Instead, they are an integral part
of society and the focus should be much broader than just increasing profits and returns
to shareholders.
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Self-interest often appears to be the guiding philosophy of certain groups, even if they do
appear to be ideologically based. Business groups and trade associations that promote free
markets and limited regulation often are led by the vested interests, which can sometimes
be inconsistent with the advocacy of free markets. They may strongly favour government
intervention, such as subsidies or tariffs, when it assists that particular industry, while opposing
government intervention elsewhere in the economy. Governments may also advocate free trade
while continuing to protect certain domestic industries for political purposes.
This approach provides more flexibility in implementing specific corporate governance practices
in view of the potential diversity of corporations. Under the United Kingdom and Australian
approach (also seen in Singapore and Hong Kong, for example), the board of a corporation
may decide not to follow the local principles or recommendations, which may be allowed, but it
must then disclose that it is not following them and explain why. Sometimes, some principles or
recommendations must be followed fully and the board is not allowed a choice.
To help appreciate the difference between these two approaches, we consider the example of
forming an audit committee.
Principles approach. The regulations may state that it is important to have an audit committee,
and it should have members who are suitable to the role. If there is no audit committee,
an explanation must be provided.
Rules-based approach. The regulation may state that there must be an audit committee. It must
have at least four members. These members must all be independent directors. These members
must all have financial qualifications.
From these examples, it is clear that the principles approach creates a broad guideline, which it
is then up to the company to apply in the most appropriate way. The rules-based approach gives
very specific instructions and must be complied with.
Stakeholders
Stakeholder concept
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The Anglo-American corporation law approach is that directors must act in the best interests of
the corporation as a whole. This means corporations are run according to corporate law duties
in relation to shareholders. However, this approach does not mean that a corporation should be
run for the exclusive benefit of its shareholders. Any director or senior manager who believes
that acting according to this approach will lead to long-term success and satisfactory corporate
governance is mistaken.
The success of an organisation depends on the successful management of all the relationships
an organisation has with its stakeholders. The term ‘stakeholder’ is used in a very broad sense,
meaning anyone who is affected by the operations of an entity. These stakeholders include not
just shareholders (for corporate entities) but other parties, such as employees, competitors,
customers and suppliers, lenders, society generally and, indeed, even the environment.
Milton Friedman, a noted economist, argued that the primary responsibility of the managers of a
corporation is to maximise shareholder wealth. It is often forgotten that Friedman also said that
this pursuit of shareholder wealth should be ‘within the rules’. He did not say ‘within the law’.
The ‘rules’ today arguably include expectations about proper treatment of all stakeholders.
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Edward Freeman (1984), writing about the importance of stakeholders, created the ‘stakeholder
theory’ to emphasise the importance of a broad analysis of the needs of all stakeholders. He was
critical about the way those managing businesses too often failed to take into consideration
the wide range of groups that can affect, or are affected by, corporations. Stakeholder theorists
argue that attention to a broader range of stakeholders is important, not just from a moral or
ethical perspective, but also because survival of a firm depends on the management of a range
of relationships.
Duties to these other stakeholders can be indirect (sometimes called derivative) duties, as we see
under the Anglo-American approach, or they can be direct duties where corporation laws specify
that directors must give attention to stakeholders.
Whichever view is considered, the fact is that ignoring stakeholders will result in poor performance
and even failure. Hence, even if shareholder attention is the primary concern, any director or
manager who fails to take care of the essential derivative duties to stakeholders will be derelict in
their direct duty to shareholders.
The principal focus of our discussion in this module is on the Anglo-American derivative duties
approach to stakeholders. Stakeholder theory is considered further in Module 5 as part of the
discussion of sustainability and social responsibility concerns.
Stakeholder map
Stakeholders will differ across organisations. Figure 3.5 provides a list of potential stakeholders
that may be of concern to an organisation. In any situation, some stakeholders will be
more important than others to a particular corporation at a particular time and, inevitably,
this stakeholder map may omit relevant stakeholders. You should observe that stakeholders
are not only people or corporate entities—even the environment is a stakeholder. Notice also
that competitors are treated as stakeholders (because there must be a commitment to open
and fair competition in the market place, and if a competitor undermines this, both producers
and consumers suffer). Those affected by a particular corporation are stakeholders of that
corporation. Where a stakeholder’s interest is significant, corporations must manage the
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relationship carefully.
Environment
Community Agents
Government Owners
Corporation
Suppliers/
Regulators
Lenders
Employees Consumers
Auditors Competitors
Customers Purchase goods/services Satisfaction with value from Poor value from failure
purchase to deliver goods
or services and/or
warranty and repairs
In addition to the problem of identifying significant stakeholders, other issues arise from
stakeholder theory, including the following:
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• How should managers allocate (prioritise) limited time, energy and other resources among
stakeholders—and according to what time frame? Balancing the interests of stakeholders
is obviously an important aspect of corporate success, and the best boards and managers
do this well and will enjoy success accordingly.
• Some argue that stakeholder theory places too much discretion with management.
They contend that stakeholder theory is too vague. For example, management could claim
to be balancing the interests of various stakeholders while in fact acting to further their own
interests. Generally, self-interest is not a bad motivator, but it must not be at the expense of
stakeholders. In Module 5, the concept of enlightened self-interest is discussed further. In this
module, we have discussed remuneration approaches under agency theory and have seen
that self-interest is a key factor in seeking to ensure that agents perform their duties to a
high standard.
• Critics of stakeholder theory decry the infringement of property rights of the owners
of the corporation. For example, free market supporters have taken the approach of
Milton Friedman and argued that stakeholders other than shareholders should not form
part of management thinking.
• Some consider that under ‘stakeholder management’, there is the potential for stakeholders
to be co-opted, captured and controlled. Stakeholder management approaches are
considered in Module 5.
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Employees
These are important stakeholders in any corporate environment. In increasingly knowledge-
based businesses, it is the knowledge and skill of the employees (including managers) that will
be critical to the success of the company. In this sense, the employees become the greatest
asset (as in professional service firms) and without this asset the company cannot compete.
In some jurisdictions, where ‘dual board’ structures exist (e.g. Germany, China), employees may
have a more formal role on boards—especially on the lower-tier board. It is not uncommon for
very senior managers also to be on boards. For example, the CFO may well join the CEO on
the board and will therefore also possess the joint characteristic of being an executive and a
director—and have the complex mix of two sets of duties.
Importantly, in all jurisdictions, managers and employees alike are owed duties by corporations
and, in turn, owe duties to the corporation. For example, employees are entitled to safe working
conditions and holiday periods, while employers are entitled to expect diligent service and
protections such as confidentiality about commercially sensitive information.
Developing and maintaining good relationships with suppliers and lenders will improve
performance (e.g. ensuring legal compliance and correct ethical relationships). On the
performance side, good relationships add value by avoiding disruptions, and reducing
transaction costs and the cost of borrowing (through lower interest rates if lenders better
understand a borrower). In fact, often businesses are more immediately dependent on the
goodwill of their suppliers and lenders for their continuing success on a day-to-day basis than
on their shareholders with whom they may have a more distant relationship which only becomes
focused more sharply at the time of reporting the annual results.
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It is important to appreciate that, just as a business will wish to have dealings with ethical
lenders and suppliers based on well-understood relationships, lenders and suppliers will have
the same expectations in return. Good ethical relationships will make it easier to conduct
business and will reduce overall costs. Table 3.4 provides a (non-exhaustive) list of important
matters to consider in regard to suppliers and lenders as stakeholders of a corporation.
Consumers (customers)
Consumers or customers are very important stakeholders. Corporations recognise that the long
term support from consumers for their outputs will be important for long-term value generation
and corporate performance. However, many managers and corporations succumb to the
temptation to seek quick profits without proper care for consumers and their long-term needs.
Sometimes, there are even deliberate attempts to target vulnerable consumers by deception and
dishonesty. Consumer law is discussed in Module 4.
For many businesses, the relationship with customers is changing: rather than the customer
being the passive purchaser of a good or service, the customer’s views and ideas are actively
canvassed as a means of product and performance improvement. This can serve to deepen the
relationship with customers, and in some instances customers become more active collaborators
in the design of products and services. This form of active customer intelligence and involvement
is what is required in rapidly changing markets with constant innovation.
Management
As has been emphasised in this module, in formal corporate governance principles, managers are
the agents of the board, responsible for pursuing the vision of the company as developed by the
board, and fulfilling the strategic direction determined by the board. The CEO in most companies
is also a director and a member of the board (and there are often other executive directors such
as the CFO of the company). These executive directors have a full role working with the board to
advance strategic direction and establish the policy and values of the company. Once these are
decided, it is the manager’s duty to actively pursue these, and the board’s role is to monitor the
results for the business.
Of course, in reality the interface of governance and management is more complex. Often boards
and managers respect and understand the different roles and have a commitment to make the
relationship work. However, sometimes tensions do emerge, for example, in the choice of strategy.
Because of rapidly changing markets and technology, boards often have to be continuously
engaged in strategic decisions, unlike in the past. At times, managers may feel that the board is
becoming too involved in the implementation of strategy when it is the management team who
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have the operational experience required to guide strategies to success. On other occasions,
the board may feel that managers are making significant strategic decisions without properly
securing the approval of the board.
Skeet (2015) examines this issue from the perspective of both the board of directors and the
management team. When CEOs are asked what issues contribute to the board and management
being at cross purposes, they point to two main factors: directors acting ‘out of position’
and attempting to play a management role; or a conflict of interest where, even if disclosed,
directors are not able to place the interests of the organisation above their own or those of the
group they are representing.
Often what boards interpret as arrogance of the CEO and the management team can be,
in reality, a lack of experience, strategic direction differences or deceit. These can all lead to the
management team withholding information from the board. Board members should consider
what information they do not currently have and request this additional information if they feel
the CEO or management team may be concealing something. This is a legal right of the board,
and the management team is not permitted to suppress this information, once requested.
The board is able to draw on multiple points of view when making decisions, which is a strength
of shared governance (Skeet 2015).
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This tension occurred some years ago at BHP Billiton when a newly appointed CEO began
negotiating for major acquisitions without fully consulting the board. The board became
concerned about the serious risk implications of the CEO’s actions, and the contract of the CEO
was terminated. With the appointment of another new CEO, the BHP board was careful to agree
on a series of protocols regarding the scope for independent decision-making by the CEO on
financial and other matters, and the issues that always needed to be brought to the board for
consideration. These protocols appear to have worked well, and in other large corporations,
similar, clear understandings exist between board and executive management on their respective
roles and powers.
Operational management
It is certainly the case that it is management at the sharp end of delivering the aspirations of the
board for the company. Boards of directors are often highly skilled at financial analysis, strategic
thinking and policy development, but it is the managers who have to implement all of these,
which requires considerable intellectual, operational and technical skills. It is the management
who must inspire employees with the goals of the enterprise, delight customers with the quality
of the product or service, convince suppliers and distributors that the company deserves their full
support, and keep stakeholders onside.
Ensuring that there is the energetic commitment of managers to their task of realising the
vision of the board and making a success of the company is ultimately the role of the CEO,
who is the essential link between the governance mechanisms and the operational mechanisms
of the company.
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204 | GOVERNANCE CONCEPTS
Globalisation has caused major changes in the way corporations are run. Inevitable changes
in the size and structure of companies, including their ownership structures, have had a
substantial effect on the way corporations are controlled. For example, many traditional
Australian companies, some listed on the ASX, are now effectively controlled by owners in
diverse locations such as the United States, China, Singapore, India, the United Kingdom and
Germany. These owners are subject to governance standards that differ from those in Australia.
Even so, listing in Australia means that they must comply with Australian governance standards in
addition to those of their own country.
The modern corporate governance world has become very complex and accountants must be
aware of this. As an internationally mobile profession, working with and within international
corporations, accountants must be equipped to deal with this complexity and be prepared to
provide leadership on corporate governance.
Key factors driving the need for better corporate governance internationally include the following:
• Corporations are being exposed to more competition as a direct result of globalisation.
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This has placed additional pressure on corporations as they strive to improve on their historic
levels of performance.
• Capital markets have been ‘freed up’ as a result of advances in technology and globalisation
allowing rapid flows of debt and equity capital, each requiring optimal returns. This long
process of deregulation in international capital markets was interrupted by the GFC.
However, as we have seen in the post-GFC world, only the best organisations will attract
low‑cost capital. Therefore, corporations exhibiting high levels of good governance will
receive the lowest cost debt and equity finance.
• Company performance and other related measures are more readily available to the public
as a result of technological advances and the consequential rapid growth of timely and easily
accessible information. Investors have also become more sophisticated due to an improved
understanding of economic systems. This has further heightened the demand for information
and performance.
• Shareholder activism, which is growing for two key reasons:
1. The global aging population is demanding adequate financing of retirement. This has led
to significant growth in superannuation funds and pension plans and, with that growth,
the need for superior financial performance of those plans. CalPERS, which manages
pension and health benefits for more than 1.6 million Californian public employees,
retirees and their families, is one example of an active (institutional investor) pension
fund. The investment power of pension funds is becoming a globally significant factor.
2. The significant growth in small shareholder ownership of major corporations internationally
has meant there are more interested stakeholders demanding accountability. The growth
in Australia of self-managed superannuation funds has also contributed to a high level of
small shareholder ownership.
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It is valuable to look back over the past 30 years, an era of rapid economic and technological
change. Major economic reforms, led by the early 1980s United States tax reductions under
President Reagan, and similar extensive economic reforms by the Thatcher government in the
United Kingdom, resulted in a more liberal international marketplace. This marketplace also
became inclusive of the rapidly growing Asian economies. The dominance of the United States
and United Kingdom, along with Japan, at that time resulted in many countries freeing up
their economies.
The Australian dollar was floated and bank restrictions were dramatically reduced, as were tax
rates. All of this resulted in an economic boom that came to an end with the economic crash
of 1987.
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By the late 1990s, there was another economic boom. However, the Asian financial crisis of the
late 1990s created difficulties for some Asian companies, and the ‘dotcom’ boom and bust
around 2000 demonstrated great corporate instability. This instability was further demonstrated
in 2001–02 with the collapse of Enron, WorldCom, HIH Insurance and many other companies.
The most recent severe economic downturn was the GFC of 2007–08 (the reverberations of which
persist with events such as the 2010 ‘Irish bailout’ and sovereign debt issues being experienced
in several southern European countries, culminating in the protracted economic crisis in Greece
that began in 2010 and erupted in 2015.
United Kingdom
In 1991, following a series of high-profile corporate collapses, the London Stock Exchange,
together with industry and accounting and finance professionals, established the Cadbury
Committee. The Cadbury report, Financial Aspects of Corporate Governance (CFACG 1992),
gave recommendations to companies that have been adopted in varying degrees by the
European Union, the United States, the World Bank and many other countries and regions.
The recommendations on governance had an important feature that is still used today—
the concept of ‘comply or explain’. This approach meant that if a company chose not to
comply with a governance recommendation, the company had to identify the non-compliance
and then explain it to shareholders. This may also be described as ‘if not, why not’ reporting.
What this provision allows is for principles to be established, while retaining the possibility of
companies deciding that they wish to adopt a different policy and explaining the reasons for
this to the market. This allows investors to determine whether the policy is acceptable or not
(by selling their shares, or voting at the next AGM against the directors).
206 | GOVERNANCE CONCEPTS
In the 1990s, the remuneration of directors became a prominent issue in the UK. The Greenbury
Committee was formed, and in 1995 it made recommendations designed to enhance
transparency in relation to directors’ remuneration.
The Cadbury and Greenbury Committees’ work was reviewed by the Hampel Committee in
1995. The Hampel Report (CCG 1998) became known as the ‘supercode’ and was adopted
into the listing rules on the London Stock Exchange. Over time, the supercode was refined and
improved to become a Combined Code (FRC 2003) consisting of 18 principles and 48 code
provisions. Revised versions were released in 2006, 2008, 2010, 2012 and 2014. The 2014 version
is considered in detail later in the module.
United States
Committee of Sponsoring Organizations of the Treadway Commission
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) was formed
in 1985 to sponsor the National Commission on Fraudulent Financial Reporting. Its 1994 report,
Internal Control—Integrated Framework (COSO 1994), provided a detailed definition and
discussion of internal control. In 1999, it reported on fraudulent financial reporting (COSO 1999).
Important findings included the frequent involvement of the CEO and CFO in frauds, captured
boards that were dominated by insiders, and unqualified opinions made by auditors despite
the fraud.
Sarbanes–Oxley Act
In response to a loss of investor confidence following corporate scandals in the United States,
the US Congress passed the Sarbanes–Oxley Act in 2002. The purpose of the act was to protect
investors and provide guidelines for financial reporting. Some of the measures introduced by the
Sarbanes–Oxley Act are described below.
Audit reform
• Auditors are prohibited from performing certain non-audit services for their audit client.
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Corporate accountability
• Each company must establish an audit committee drawn from members of the board of
directors. The members of the audit committee must be independent.
• CEOs and CFOs must certify that the financial reports filed with the SEC do not contain
untrue statements or material omissions.
• Annual reports filed with the SEC must state that management is responsible for the
internal control structure and procedures for financial reporting, and include management’s
assessment of the effectiveness of those internal control structures and procedures.
The OECD Principles of Corporate Governance are discussed in the next section.
Australia
Ramsay Report
Ian Ramsay chaired a committee that produced the Ramsay Report (Ramsay 2001). That report
examined the adequacy of Australian legislative and professional requirements regarding the
independence of external auditors and made recommendations for changes. Some parts of the
report were concerned directly with audit independence (employment relationships, financial
relationships and the provision of non-audit services) and others were designed generally to
enhance audit independence (e.g. establishing audit committees and a board to oversee audit
independence issues).
One of the key recommendations was that auditors would not be seen to be independent if
their employment relationships with the audit client created a conflict of interest, for example,
holding financial investments in the client, owing debts to the client, or if members of the team
had a business relationship with the client. Ramsay (2001) did not recommend a ban on the
provision of non-audit services to audit clients. Instead, he recommended that the disclosure
requirements be enhanced.
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of the principles will be examined later in the module.
The CLERP discussion paper (CLERP 2004, referred to as CLERP 9, as it resulted from the ninth set
of deliberations in this scheme of legislative amendments) took into consideration the initiatives
introduced by the Sarbanes–Oxley Act, as well as the recommendations of the Ramsay Report.
After a period of consultation, the Corporate Law Economic Reform Program (Audit Reform and
Corporate Disclosure) Act 2004 (Cwlth) was passed by the Australian Government, coming into
effect on 1 July 2004. Some of the key changes are described below.
208 | GOVERNANCE CONCEPTS
Audit reform
• Oversight of auditors was strengthened.
• The Auditing and Assurance Standards Board (AUASB) became a Commonwealth statutory
body (rather than remaining controlled by the major accounting bodies in Australia).
• The auditing standards made by the AUASB were given legal authority (under the
Corporations Act).
• Independence requirements for auditors were introduced.
Financial reporting
• Requirements for the CEO and CFO to make a written declaration stating whether the
financial records have been properly maintained, and whether the financial statements and
notes comply with accounting standards and give a true and fair view.
• Expansion of the requirements for the disclosure of the remuneration of directors and
executives of listed companies.
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The OECD Principles are general or principles based. The OECD Principles are ‘good practice
guidelines’ and are not written for companies or directors. They are written so that governments
writing detailed laws relevant to individual nations will have a framework that provides sound
guidance. They are also valuable for ensuring that corporate governance guidelines developed
by various agencies are consistent with the OECD Principles. The OECD Principles can also be
used as a guidance framework for profit-seeking businesses and not-for-profit organisations.
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3. Institutional investors, stock markets, and other intermediaries;
4. The role of stakeholders in corporate governance;
5. Disclosure and transparency; and
6. The responsibilities of the board.
In the discussion that follows we introduce each principle with its sub-principles (OECD 2015).
E. Supervisory, regulatory and enforcement authorities should have the authority, integrity and
resources to fulfil their duties in a professional and objective manner. Moreover, their rulings
should be timely, transparent and fully explained.
F. Cross-border co-operation should be enhanced, including through bilateral and multilateral
arrangements for exchange of information. (OECD 2015, pp. 14–17)
Source: OECD 2015, G20/OECD Principles of Corporate Governance, OECD Publishing, Paris,
accessed October 2015, http://www.oecd.org/daf/ca/Corporate-Governance-Principles-ENG.pdf.
As the OECD advises governments on corporate governance, its focus here is on macro
performance at the market level. This acknowledges that the appropriate mix of legislation,
regulation, self-regulation and voluntary standards will vary across jurisdictions.
This principle emphasises that all shareholders, including minority and foreign shareholders,
should be treated equitably by controlling shareholders, boards and management. Transparency
is required with respect to distribution of voting rights and the way that voting rights are
exercised. Insider trading and abusive self-dealing are prohibited. There should be appropriate
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disclosure of all material interests that managers and directors have in transactions or matters
affecting the corporation.
A. Basic shareholder rights should include the right to: 1) secure methods of ownership
registration; 2) convey or transfer shares; 3) obtain relevant and material information on the
corporation on a timely and regular basis; 4) participate and vote in general shareholder
meetings; 5) elect and remove members of the board; and 6) share in the profits of
the corporation.
B. Shareholders should be sufficiently informed about, and have the right to approve or
participate in, decisions concerning fundamental corporate changes such as: 1) amendments
to the statutes, or articles of incorporation or similar governing documents of the company; 2)
the authorisation of additional shares; and 3) extraordinary transactions, including the transfer
of all or substantially all assets, that in effect result in the sale of the company.
C. Shareholders should have the opportunity to participate effectively and vote in general
shareholder meetings and should be informed of the rules, including voting procedures,
that govern general shareholder meetings:
1. Shareholders should be furnished with sufficient and timely information concerning the
date, location and agenda of general meetings, as well as full and timely information
regarding the issues to be decided at the meeting.
2. Processes and procedures for general shareholder meetings should allow for equitable
treatment of all shareholders. Company procedures should not make it unduly difficult or
expensive to cast votes.
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3. Shareholders should have the opportunity to ask questions to the board, including
questions relating to the annual external audit, to place items on the agenda of general
meetings, and to propose resolutions, subject to reasonable limitations.
4. Effective shareholder participation in key corporate governance decisions, such as the
nomination and election of board members, should be facilitated. Shareholders should
be able to make their views known, including through votes at shareholder meetings, on
the remuneration of board members and/or key executives, as applicable. The equity
component of compensation schemes for board members and employees should be
subject to shareholder approval.
5. Shareholders should be able to vote in person or in absentia, and equal effect should be
given to votes whether cast in person or in absentia.
6. Impediments to cross border voting should be eliminated.
D. Shareholders, including institutional shareholders, should be allowed to consult with each
other on issues concerning their basic shareholder rights as defined in the Principles, subject to
exceptions to prevent abuse.
E. All shareholders of the same series of a class should be treated equally. Capital structures
and arrangements that enable certain shareholders to obtain a degree of influence or control
disproportionate to their equity ownership should be disclosed.
1. Within any series of a class, all shares should carry the same rights. All investors should
be able to obtain information about the rights attached to all series and classes of shares
before they purchase. Any changes in economic or voting rights should be subject to
approval by those classes of shares which are negatively affected.
2. The disclosure of capital structures and control arrangements should be required.
F. Related-party transactions should be approved and conducted in a manner that ensures
proper management of conflict of interest and protects the interest of the company and
its shareholders.
1. Conflicts of interest inherent in related-party transactions should be addressed.
2. Members of the board and key executives should be required to disclose to the board
whether they, directly, indirectly or on behalf of third parties, have a material interest in any
transaction or matter directly affecting the corporation.
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G. Minority shareholders should be protected from abusive actions by, or in the interest of,
controlling shareholders acting either directly or indirectly, and should have effective means
of redress. Abusive self-dealing should be prohibited. (OECD 2015, pp. 21–28)
Source: OECD 2015, G20/OECD Principles of Corporate Governance, OECD Publishing, Paris,
accessed October 2015, http://www.oecd.org/daf/ca/Corporate-Governance-Principles-ENG.pdf.
In many jurisdictions, the reality of corporate governance and ownership is no longer characterised
by a straight relationship between the performance of the company and the income of the ultimate
beneficiaries. In reality, the investment chain is often complex, with numerous intermediaries
between the company and the ultimate beneficiary. The principles recommend that institutional
investors disclose their corporate governance policies. Shareholder engagement is also noted to
take various forms from voting at shareholder meetings to direct contact and dialogue with the
board and management (OECD 2015, pp. 31–32). The following principles are recommended.
212 | GOVERNANCE CONCEPTS
A. Institutional investors acting in a fiduciary capacity should disclose their corporate governance
and voting policies with respect to their investments, including the procedures that they have
in place for deciding on the use of their voting rights.
B. Votes should be cast by custodians or nominees in line with the directions of the beneficial
owner of the shares.
C. Institutional investors acting in a fiduciary capacity should disclose how they manage
material conflicts of interest that may affect the exercise of key ownership rights regarding
their investments.
D. The corporate governance framework should require that proxy advisors, analysts, brokers,
rating agencies and others that provide analysis or advice relevant to decisions by investors,
disclose and minimise conflicts of interest that might compromise the integrity of their analysis
or advice.
E. Insider trading and market manipulation should be prohibited and the applicable rules enforced.
F. For companies who are listed in a jurisdiction other than their jurisdiction of incorporation,
the applicable corporate governance laws and regulations should be clearly disclosed. In the
case of cross listings, the criteria and procedure for recognising the listing requirements of
the primary listing should be transparent and documented.
G. Stock markets should provide fair and efficient price discovery as a means to help promote
effective corporate governance. (OECD 2015, pp. 32–35)
Source: OECD 2015, G20/OECD Principles of Corporate Governance, OECD Publishing, Paris,
accessed October 2015, http://www.oecd.org/daf/ca/Corporate-Governance-Principles-ENG.pdf.
The OECD sees duties to stakeholders as an important and integral part of corporate governance.
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In some countries, stakeholders who are not shareholders have significant influence (e.g. banks are
involved in Japanese companies and employees in German companies).
Under Anglo-American legal approaches, companies are run for shareholders, being the owners
of the companies, with the duty to stakeholders being a derivative of this primary duty. Under the
stakeholder model, there are arguably ‘direct duties’ to stakeholders, but the OECD recognises
that duties to stakeholders are only valid if also balanced against the duties and rights of
shareholders (see Principle 2).
The differences between ‘shareholder models’ and ‘stakeholder models’ are largely theoretical in
the global corporate world. We will consider this further when we explore the FRC Code and the
ASX Principles.
A. The rights of stakeholders that are established by law or through mutual agreements are to
be respected.
B. Where stakeholder interests are protected by law, stakeholders should have the opportunity
to obtain effective redress for violation of their rights.
C. Mechanisms for employee participation should be permitted to develop.
D. Where stakeholders participate in the corporate governance process, they should have access
to relevant, sufficient and reliable information on a timely and regular basis.
E. Stakeholders, including individual employees and their representative bodies, should be able
to freely communicate their concerns about illegal or unethical practices to the board and to
the competent public authorities and their rights should not be compromised for doing this.
F. The corporate governance framework should be complemented by an effective, efficient
insolvency framework and by effective enforcement of creditor rights. (OECD 2015, pp. 37–37.)
Source: OECD 2015, G20/OECD Principles of Corporate Governance, OECD Publishing, Paris,
accessed October 2015, http://www.oecd.org/daf/ca/Corporate-Governance-Principles-ENG.pdf.
In economies where freedom of accurate information and disclosure have not traditionally been
practised, the impact of Principle 5 will be immediately obvious.
A. Disclosure should include, but not be limited to, material information on:
1. The financial and operating results of the company.
2. Company objectives and non-financial information.
3. Major share ownership, including beneficial owners, and voting rights.
4. Remuneration of members of the board and key executives.
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5. Information about board members, including their qualifications, the selection process,
other company directorships and whether they are regarded as independent by the board.
6. Related party transactions.
7. Foreseeable risk factors.
8. Issues regarding employees and other stakeholders.
9. Governance structures and policies, including the content of any corporate governance
code or policy and the process by which it is implemented.
B. Information should be prepared and disclosed in accordance with high quality standards of
accounting and financial and non-financial reporting.
C. An annual audit should be conducted by an independent, competent and qualified, auditor in
accordance with high-quality auditing standards in order to provide an external and objective
assurance to the board and shareholders that the financial statements fairly represent the
financial position and performance of the company in all material respects.
D. External auditors should be accountable to the shareholders and owe a duty to the company to
exercise due professional care in the conduct of the audit.
E. Channels for disseminating information should provide for equal, timely and cost-efficient
access to relevant information by users (OECD 2015, pp. 42–49).
Source: OECD 2015, G20/OECD Principles of Corporate Governance, OECD Publishing, Paris,
accessed October 2015, http://www.oecd.org/daf/ca/Corporate-Governance-Principles-ENG.pdf.
214 | GOVERNANCE CONCEPTS
This principle states the OECD’s basic view on the board and its responsibilities. As a document
for global consumption, it states a series of general requirements but does not provide a detailed
analysis of the type we will see when we look at the UK FRC Corporate Governance Code or at
the ASX corporate governance guidelines.
A. Board members should act on a fully informed basis, in good faith, with due diligence and care,
and in the best interest of the company and the shareholders.
B. Where board decisions may affect different shareholder groups differently, the board should
treat all shareholders fairly.
C. The board should apply high ethical standards. It should take into account the interests
of stakeholders.
D. The board should fulfil certain key functions, including:
1. Reviewing and guiding corporate strategy, major plans of action, risk management policies
and procedures, annual budgets and business plans; setting performance objectives;
monitoring implementation and corporate performance; and overseeing major capital
expenditures, acquisitions and divestitures.
2. Monitoring the effectiveness of the company’s governance practices and making changes
as needed.
3. Selecting, compensating, monitoring and, when necessary, replacing key executives and
overseeing succession planning.
4. Aligning key executive and board remuneration with the longer term interests of the
company and its shareholders.
5. Ensuring a formal and transparent board nomination and election process.
6. Monitoring and managing potential conflicts of interest of management, board members
and shareholders, including misuse of corporate assets and abuse in related party
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transactions.
7. Ensuring the integrity of the corporation’s accounting and financial reporting systems,
including the independent audit, and that appropriate systems of control are in
place, in particular, systems for risk management, financial and operational control,
and compliance with the law and relevant standards.
8. Overseeing the process of disclosure and communications.
E. The board should be able to exercise objective independent judgement on corporate affairs.
1. Boards should consider assigning a sufficient number of nonexecutive board members
capable of exercising independent judgement to tasks where there is a potential for
conflict of interest. Examples of such key responsibilities are ensuring the integrity of
financial and non-financial reporting, the review of related party transactions, nomination
of board members and key executives, and board remuneration.
2. Boards should consider setting up specialised committees to support the full board
in performing its functions, particularly in respect to audit, and, depending upon the
company’s size and risk profile, also in respect to risk management and remuneration.
When committees of the board are established, their mandate, composition and working
procedures should be well defined and disclosed by the board.
3. Board members should be able to commit themselves effectively to their responsibilities.
4. Boards should regularly carry out evaluations to appraise their performance and assess
whether they possess the right mix of background and competences.
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F. In order to fulfil their responsibilities, board members should have access to accurate, relevant
and timely information.
G. When employee representation on the board is mandated, mechanisms should be developed
to facilitate access to information and training for employee representatives, so that this
representation is exercised effectively and best contributes to the enhancement of board skills,
information and independence (OECD 2015, pp. 52–61).
Source: OECD 2015, G20/OECD Principles of Corporate Governance, OECD Publishing, Paris,
accessed October 2015, http://www.oecd.org/daf/ca/Corporate-Governance-Principles-ENG.pdf.
➤➤Question 3.6
Discuss whether there is potential for conflict between Principle 2, Item A4 and Principle 2, Item G.
➤➤Question 3.7
Evaluate the following case study using the OECD Principles.
Sweet Dreams Ltd is a technology company that is developing natural organic sleeping pills for
people who have trouble sleeping. The company has been listed for one year and has:
• established a board of directors made up of executive and non-executive directors. The two
non-executive directors include a major potential customer who works closely with the
company, and a major shareholder who has asked for a board position to monitor their
investment closely;
• required shareholders who purchased shares in the initial public offering to purchase and
hold shares for at least two years—the explanation for this requirement is that the company
wants to ensure a stable position on the stock market while it establishes itself in the
marketplace; and
• announced that to prevent a takeover by one of its competitors (resulting in it either being
shut down or its intellectual property being taken) it has created contracts with senior
management that will see them paid $20 million each if such a takeover occurs.
Outline three actions in the case study above that create issues in relation to the OECD Principles.
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UK Financial Reporting Council Corporate
Governance Code
We now consider the 2014 version of the UK FRC Code. Appendix 3.1 also provides a guide that
reproduces key points within this code. It is very important to read Appendix 3.1 carefully, as it
deals with important core knowledge relating to corporate governance approaches that are used
in the United Kingdom and which are followed substantially internationally.
While this version is very similar to the previous editions, there are several new inclusions.
These include the requirement that FTSE 350 companies (the largest companies listed on the
London Stock Exchange) put external audit contracts out to tender at least once every 10 years
(FRC 2014, para. C.3.7).
➤➤Question 3.8
Under the UK FRC Corporate Governance Code:
(a) Who is responsible for reviewing a company’s internal controls?
(b) How often should a board undertake a formal evaluation of its own performance?
(c) Outline whether a chief executive may also be the chair. Suggest reasons why the FRC Code
has taken this view.
➤➤Question 3.9
Review the following case scenario.
A large listed company has a board of directors with seven members:
• The chair is a non-executive director who holds a 25 per cent shareholding in the company.
• Four of the members are executive directors including the CEO and the CFO.
• The board has one subcommittee—an audit committee with three members. This includes
the chair, an independent director and the CFO, who is able to provide specific information
about the company.
Outline areas where this structure does not comply with components of the FRC Code that are
outlined in Appendix 3.1.
This code is valuable in that it demonstrates the way that governance has developed in most
jurisdictions using the Anglo-American model. Under this model, company law developed in
conjunction with common law principles. The first modern joint stock companies (i.e. with shares)
were formed in the 1860s under the very simple Companies Acts. Inevitable gaps in the law were
filled by the courts as litigation on particular issues arose.
Over time, the courts decided more and more rules about how companies should operate.
Successive parliaments around the world, with the United Kingdom and the United States as
leaders, created additional responses and also wrote the decisions of the courts into various
company statutes. The underlying rule in the Anglo-American approach to company law is that
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the key duty of directors is to act for proper purposes and to act in good faith in the interests
of the company as a whole.
The ‘company as a whole’ refers to the shareholders as a body—meaning that directors must
act for all shareholders. Be aware that a decision that hurts some people is permitted as long as
that outcome is a reasonable harm given the genuine attempt to act for the good of the general
body of shareholders. However, there must not be a deliberate attempt to harm a minority
shareholder group.
At the time when detailed company law rules were growing in Anglo-American legal systems,
there was the concurrent growth of laws designed to create strong social outcomes. These laws
related to:
• contracts;
• employment and employment conditions;
• products and product safety (for consumers);
• anti-trust laws;
• trade practices laws;
• consumer protection laws; and
• more recently, the environment.
These are in addition to the numerous other laws that protect people, property and wellbeing in
modern economies. Importantly, these laws apply to all entities—including companies. We might
describe these laws another way, from a corporation’s perspective. They are, in a very real sense,
‘stakeholder protection’.
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The FRC Code is relevant to the Anglo-American approach. It is written in the context that
directors have direct duties (under corporations laws) to shareholders and a variety of other
‘derivative duties’ to many other stakeholders. Where directors fail to have due regard for
stakeholders and therefore damage shareholders, they in effect breach their direct duty to
shareholders by allowing or causing other stakeholders to harm the company.
For example, if a corporation sells cheap and poor-quality products to customers, then short-
term gains that may arise will be overwhelmed as customers abandon the corporation’s products.
This will hurt shareholders in the long run. We can see that the failure to meet the derivative
duty to a stakeholder results in failure regarding the direct duty to shareholders. Interestingly,
the FRC Code does not once mention stakeholders—by implication it seems simply to assume
their existence and the need to meet their needs—otherwise the duty to shareholders is
effectively meaningless.
As noted previously, Anglo-American approaches have been proven effective, not just in the
United Kingdom and the United States but in countries as diverse as Singapore, Hong Kong,
South Africa, Nigeria, India, Canada, Australia, New Zealand and many others. The evident
economic successes in many of these countries, although some of them occasionally
demonstrated poor governance, were probably a key factor leading to the OECD Principles,
which were considered a way of building resilience into companies through more robust
governance. The modern approach to ‘corporate governance’ whereby boards and directors
are the focus of attention was arguably led by Sir Adrian Cadbury, the author of the original
corporate governance code adopted by the London Stock Exchange in 1992.
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The third edition of the ASX Principles took effect from 1 July 2014 (ASX CGC 2014). One
important change in the more recent versions of these recommendations relates to gender
balance on the board of directors. Another change in later versions compared to the earlier
versions relates to membership recommendations for the remuneration committee—and
these are linked to mandatory requirements of new ASX Listing Rules, which apply to certain
larger companies.
There are eight broad principles, which are supported by 29 detailed recommendations.
1. Lay solid foundations for management and oversight: A listed entity should establish
and disclose the respective roles and responsibilities of its board and management and how
their performance is monitored and evaluated.
2. Structure the board to add value: A listed entity should have a board of an appropriate
size, composition, skills and commitment to enable it to discharge its duties effectively.
3. Act ethically and responsibly: A listed entity should act ethically and responsibly.
4. Safeguard integrity in corporate reporting: A listed entity should have formal and rigorous
processes that independently verify and safeguard the integrity of its corporate reporting.
5. Make timely and balanced disclosure: A listed entity should make timely and balanced
disclosure of all matters concerning it that a reasonable person would expect to have a
material effect on the price or value of its securities.
218 | GOVERNANCE CONCEPTS
6. Respect the rights of security holders: A listed entity should respect the rights of its
security holders by providing them with appropriate information and facilities to allow them
to exercise those rights effectively.
7. Recognise and manage risk: A listed entity should establish a sound risk management
framework and periodically review the effectiveness of that framework.
8. Remunerate fairly and responsibly: A listed entity should pay director remuneration
sufficient to attract and retain high quality directors and design its executive remuneration
to attract, retain and motivate high quality senior executives and to align their interests with
the creation of value for security holders
These specific principles often need to be applied to particular sets of case facts, so a thorough
understanding of them is required. These principles are recommended for implementation in
specific ways—just as was the case in the United Kingdom—although the Australian principles
are a little different as are the Australian implementation recommendations. Further discussion of
each of the core principles and recommendations of the ASX Principles follows.
In fact, all ASX corporate governance principles and recommendations for listed companies
potentially apply on the ‘if not, why not’ approach. This concept is similar to the ‘comply or
explain’ approach in the UK FRC Code. It operates so that non-compliance is generally permitted
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1
All material from the ASX Principles is used with permission and is © Copyright 2014 ASX Corporate
Governance Council.
Study guide | 219
Recommendation 1.2
A listed entity should:
(a) undertake appropriate checks before appointing a person, or putting forward to security
holders a candidate for election, as a director; and
(b) provide security holders with all material information in its possession relevant to a decision on
whether or not to elect or re-elect a director.
…
Recommendation 1.3
A listed entity should have a written agreement with each director and senior executive setting out
the terms of their appointment.
…
Recommendation 1.4
The company secretary of a listed entity should be accountable directly to the board, through the
chair, on all matters to do with the proper functioning of the board.
…
Recommendation 1.5
A listed entity should:
(a) have a diversity policy which includes requirements for the board or a relevant committee of
the board to set measurable objectives for achieving gender diversity and to assess annually
both the objectives and the entity’s progress in achieving them;
(b) disclose that policy or a summary of it; and
(c) disclose as at the end of each reporting period the measurable objectives for achieving gender
diversity set by the board or a relevant committee of the board in accordance with the entity’s
diversity policy and its progress towards achieving them, and either:
(1) the respective proportions of men and women on the board, in senior executive positions
and across the whole organisation (including how the entity has defined “senior executive”
for these purposes); or
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(2) if the entity is a “relevant employer” under the Workplace Gender Equality Act, the entity’s
most recent “Gender Equality Indicators”, as defined in and published under that Act.
…
Recommendation 1.6
A listed entity should:
(a) have and disclose a process for periodically evaluating the performance of the board,
its committees and individual directors; and
(b) disclose, in relation to each reporting period, whether a performance evaluation was
undertaken in the reporting period in accordance with that process.
…
Recommendation 1.7
A listed entity should:
(a) have and disclose a process for periodically evaluating the performance of its senior
executives; and
(b) disclose, in relation to each reporting period, whether a performance evaluation was
undertaken in the reporting period in accordance with that process.
220 | GOVERNANCE CONCEPTS
(b) if a director has an interest, position, association or relationship of the type described in Box 2.3
but the board is of the opinion that it does not compromise the independence of the director,
the nature of the interest, position, association or relationship in question and an explanation
of why the board is of that opinion; and
(c) the length of service of each director.
…
Recommendation 2.4
A majority of the board of a listed entity should be independent directors.
…
Recommendation 2.5
The chair of the board of a listed entity should be an independent director and, in particular,
should not be the same person as the CEO of the entity.
…
Recommendation 2.6
A listed entity should have a program for inducting new directors and provide appropriate
professional development opportunities for directors to develop and maintain the skills and
knowledge needed to perform their role as directors effectively.
Source: ASX CGC 2014, Corporate Governance Principles and Recommendations, 3rd edn, pp. 8–18.
© Copyright 2014 ASX Corporate Governance Council.
Study guide | 221
Boxes highlighting specific issues are also provided among the recommendations and principles.
Box 2.3 is linked to Recommendation 2.3 and provides a detailed list of factors to consider when
identifying whether a director is independent.
Examples of interests, positions, associations and relationships that might cause doubts about the
independence of a director include if the director:
• is, or has been, employed in an executive capacity by the entity or any of its child entities and there
has not been a period of at least three years between ceasing such employment and serving on
the board;
• is, or has within the last three years been, a partner, director or senior employee of a provider of
material professional services to the entity or any of its child entities;
• is, or has been within the last three years, in a material business relationship (e.g. as a supplier or
customer) with the entity or any of its child entities, or an officer of, or otherwise associated with,
someone with such a relationship;
• is a substantial security holder of the entity or an officer of, or otherwise associated with, a substantial
security holder of the entity;
• has a material contractual relationship with the entity or its child entities other than as a director;
• has close family ties with any person who falls within any of the categories described above; or
• has been a director of the entity for such a period that his or her independence may have
been compromised.
In each case, the materiality of the interest, position, association or relationship needs to be assessed to
determine whether it might interfere, or might reasonably be seen to interfere, with the director’s capacity
to bring an independent judgement to bear on issues before the board and to act in the best interests of
the entity and its security holders generally.
Source: ASX CGC 2014, Corporate Governance Principles and Recommendations, 3rd edn, p. 16.
© Copyright 2014 ASX Corporate Governance Council.
A review of these recommendations indicates strong similarities to the UK FRC Code that is
outlined in Appendix 3.1. For example, similarities exist for the recommended tests for evaluating
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whether a director is independent, as well as the requirement to have an independent chair,
a majority of independent directors and separation of the role of CEO and chair.
One way to enhance companies’ behaviour is to create formal codes of conduct. If these
are carefully considered and well constructed, they will provide a far stronger basis for the
implementation of good business ethics. From that point of view, it will be necessary to
ensure all staff are trained appropriately in the ethical code of business conduct and then to
ensure that the code is maintained and developed as necessary according to business and
environment changes.
Recommendation 3.1
A listed entity should:
(a) have a code of conduct for its directors, senior executives and employees; and
(b) disclose that code or a summary of it.
222 | GOVERNANCE CONCEPTS
Recommendation 4.1
The board of a listed entity should:
(a) have an audit committee which:
(1) has at least three members, all of whom are non-executive directors and a majority
of whom are independent directors; and
(2) is chaired by an independent director, who is not the chair of the board,
and disclose:
(3) the charter of the committee;
(4) the relevant qualifications and experience of the members of the committee; and
(5) in relation to each reporting period, the number of times the committee met throughout
the period and the individual attendances of the members at those meetings; or
(b) if it does not have an audit committee, disclose that fact and the processes it employs that
independently verify and safeguard the integrity of its corporate reporting, including the
processes for the appointment and removal of the external auditor and the rotation of the
audit engagement partner.
…
Recommendation 4.2
The board of a listed entity should, before it approves the entity’s financial statements for a
financial period, receive from its CEO and CFO a declaration that, in their opinion, the financial
records of the entity have been properly maintained and that the financial statements comply with
the appropriate accounting standards and give a true and fair view of the financial position and
performance of the entity and that the opinion has been formed on the basis of a sound system of
risk management and internal control which is operating effectively.
…
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Recommendation 4.3
A listed entity that has an AGM should ensure that its external auditor attends its AGM and is
available to answer questions from security holders relevant to the audit.
Source: ASX CGC 2014, Corporate Governance Principles and Recommendations, 3rd edn, pp. 19–23.
© Copyright 2014 ASX Corporate Governance Council.
Under the ASX Listing Rules, audit committees are compulsory for all companies listed in the
top 500 (Standard & Poor’s listing of the ASX) according to market capitalisation (i.e. total market
value of the shares).
Unlike the Sarbanes–Oxley Act and the FRC Code, which both require at least one financial
person on the board, the ASX does not include this requirement. Nonetheless, arguably, it would
be a poor board structure that did not select people with appropriate skills. One of the greatest
failures a true professional can make is to accept duties that are not within their capabilities.
It is strongly arguable that a director who, without appropriate skills, takes a place on an audit
committee would be making a negligent ‘business judgment’. Negligent business judgments can
result in significant legal difficulties for a director (and perhaps for the entire board) who act in
this way.
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Another feature of the Sarbanes–Oxley requirements that contrasts with the ASX Principles is
that all members of the audit committee must be independent at all times according to strict
criteria. Furthermore, Sarbanes–Oxley mandates that the primary external auditor relationship
must be with the audit committee. Note that these specific legislative requirements are not part
of the framework in Australia or the United Kingdom, nor in other places such as Hong Kong,
Singapore or India.
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Recommendation 6.3
A listed entity should disclose the policies and processes it has in place to facilitate and encourage
participation at meetings of security holders.
…
Recommendation 6.4
A listed entity should give security holders the option to receive communications from, and send
communications to, the entity and its security registry electronically.
Recommendation 7.1
The board of a listed entity should:
(a) have a committee or committees to oversee risk, each of which:
(1) has at least three members, a majority of whom are independent directors; and
(2) is chaired by an independent director,
and disclose:
(3) the charter of the committee;
(4) the members of the committee; and
(5) as at the end of each reporting period, the number of times the committee met throughout
the period and the individual attendances of the members at those meetings; or
(b) if it does not have a risk committee or committees that satisfy (a) above, disclose that fact and
the processes it employs for overseeing the entity’s risk management framework.
…
Recommendation 7.2
The board or a committee of the board should:
(a) review the entity’s risk management framework at least annually to satisfy itself that it continues
to be sound; and
(b) disclose, in relation to each reporting period, whether such a review has taken place.
…
Recommendation 7.3
A listed entity should disclose:
(a) if it has an internal audit function, how the function is structured and what role it performs; or
(b) if it does not have an internal audit function, that fact and the processes it employs for
evaluating and continually improving the effectiveness of its risk management and internal
control processes.
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…
Recommendation 7.4
A listed entity should disclose whether it has any material exposure to economic, environmental
and social sustainability risks and, if it does, how it manages or intends to manage those risks.
Source: ASX CGC 2014, Corporate Governance Principles and Recommendations, 3rd edn, pp. 24–34.
© Copyright 2014 ASX Corporate Governance Council.
It should be noted that the financial markets supervision has been transferred from the ASX to
ASIC, as the Australian Government was concerned that greater independence was required of the
regulator of the financial markets sector, and that greater powers of investigation and legal action
were necessary.
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Alternative international approaches
to governance
While corporate governance rules and guidelines largely originated from developed markets
such as the US and UK, the importance of good governance is now recognised in both
developed markets and emerging markets in South-East Asia, Eastern Europe and Latin America.
This global awareness is due to:
• a general trend in society towards openness, transparency and disclosure;
• a gradual realisation of the growing significance of the scale and activity of corporations in
determining the prosperity and wellbeing of economies;
• the growth of international capital markets resulting in companies globally needing to
comply with acceptable corporate governance practices in order to tap the funding available
in these markets;
• the increasing amounts of individual wealth held in equities through the huge growth of
investment institutions, including pension funds and insurance companies; and
• the growing acceptance by many people, including senior business and government officials,
that good corporate governance can be a matter of national interest.
The different systems of corporate governance found globally are classified as either market-
based or relationship-based systems. Each of these systems has inherent strengths and
weaknesses that have been demonstrated in recent times. Note that there are several terms
that are used interchangeably to describe each type of governance system.
226 | GOVERNANCE CONCEPTS
Terms used to describe the market-based systems include the outsider system, the Anglo-Saxon
system and the shareholder system. Terms used to describe the relationship-based systems
include the insider system and the stakeholder system. Examples of each type of system are
shown in Table 3.5.
Market-based systems
The market-based systems of corporate governance of the United States and the United Kingdom
are the most established and have had the greatest influence on the rest of the world. This is
because of the historical strength of the US and UK capital markets, and the growth of their
investment institutions that have become increasingly active internationally. This is the model that
has been adopted in many other countries, including Australia and New Zealand. The central
characteristics of the market-based system are as follows:
• widespread equity ownership among individuals and institutional investors, with institutions
often having large shareholdings;
• shareholder interests as the primary focus of company law;
• an emphasis on minority shareholder protection in securities law and regulation; and
• stringent disclosure requirements.
In these countries, a growing amount of the national wealth is held by institutions, including:
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• insurance companies;
• pension funds; and
• mutual funds.
There has been considerable growth in the financial assets of institutional shareholders relative to
GDP over the last decade. Institutional shareholders have been the dominant owners of equity in
the United Kingdom for some time now, and they are achieving this position in the United States
as well. They are charged with the responsibility of securing the maximum return on their
investments for their beneficiaries, balancing risk and return over time, and in accordance with
their investment mandates.
In the past, institutional shareholders demonstrated little interest in influencing the companies
they invested in, employing strategies of portfolio diversification and indexation. However, more
recently, there has been evidence of institutional shareholders becoming more actively engaged.
The market-based system of corporate governance has been characterised as disclosure based,
as the numerous investors depend on access to a reliable and adequate flow of information
to make informed investment decisions. Regulation is intended to ensure all investors remain
fully informed, and to prevent privileged groups of shareholders sharing information only
among themselves.
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The role of the banks is less central in a market-based system of corporate governance.
Normally, bank finance is short term, and usually banks operate at arm’s length in their dealings
with corporations. Equity finance is seen as more important as a means of developing companies
(Nestor & Thompson 2000, p. 7).
Under a market-based system, shareholders have the right to use their voting power to select the
board and decide on certain issues facing the company, such as the appointment of an external
auditor. However, in practice, fragmented investors rarely exercise this control when faced with an
informed and determined management.
In the past, investors who were dissatisfied with how a company was being managed and directed
tended to sell their shares in the company. When this happens in sufficient numbers, it can depress
the share price to the point where a company becomes a target for hostile takeover.
Moreover, many institutional shareholders have become so large that they need to invest in
a large number of companies to spread their risk. Some investors, such as pension funds and
insurance companies, being typical institutional investors, also need to take a longer-term view of
their investments.
These factors, together with pressure from regulators and beneficiaries, are forcing more
institutional shareholders to practise ‘responsible investing’ and to become more engaged
with companies they are investing in. This means that, rather than just selling their shares when
they are unhappy with the management or board, they are using a range of strategies—such as
private meetings, voting against resolutions, and applying public pressure using the media.
➤➤Question 3.10
Why is disclosure important for the integrity of equity markets? In your answer, you should address
what occurs when information is monopolised by privileged groups.
The United States is the world’s major capital market. It operates a market-based system that
has some distinct characteristics. In the United States, the board of directors is entrusted with
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an important responsibility—to monitor the company on behalf of shareholders. However, in the
United States, boards of directors are often dominated by the company management.
As a consequence, there have been efforts to achieve greater accountability by requiring that
boards have a majority of independent non-executive directors. This is now required under the
listing rules of the two major stock markets in that country: the New York Stock Exchange (NYSE)
and the NASDAQ. (When NASDAQ was originally conceived in the 1970s, the acronym stood
for the National Association of Securities Dealers Automated Quotations. Since then it has been
known for its listing of growth companies.) Moreover, in the United States, it is common for the
chair of the board and the CEO to be the same person. This practice differs from many other
countries where these roles are expected to be separate.
To enhance the oversight function of boards and limit the powers of CEOs, committees were
established in the 1980s in US corporations to undertake critical tasks. These tasks included the
remuneration of executive directors, nomination of new board members and key decisions in
respect of auditing. As a result, most CEOs of large companies in the United States could no
longer decide their own pay, select their own board and audit their own financial performance.
However, in many companies, CEOs continued to wield considerable power in the boardroom,
partly because they also retained the role of chair.
228 | GOVERNANCE CONCEPTS
Other checks on management include the more active role being played by institutional
shareholders and rules such as Sarbanes–Oxley. As previously noted, many of these large investors,
such as CalPERS, closely monitor the corporate governance practices of companies in which they
invest. However, in practice, shareholders in the United States possess limited power to appoint
or remove directors. This is because in a public company with widely dispersed share ownership,
it is difficult and expensive for shareholders to take all of the actions and achieve the necessary
coordination to remove directors. There are also other administrative hurdles.
➤➤Question 3.11
Is interest in corporate governance regulation and legislation inevitably associated with recession,
market failure and corporate collapse, or is it possible to maintain attention on improving standards
of corporate governance at times of market expansion and business growth?
➤➤Question 3.12
Identify the strengths and weaknesses of the market-based system of corporate governance as
practised in countries such as the United States, the United Kingdom and Australia.
systems. The main difference between corporate governance systems in the United States and the
United Kingdom and those of European countries is that the Europeans emphasise cooperative
relationships and consensus, whereas the Anglo-Saxon tradition emphasises competition and
market processes (Nestor & Thompson 2000).
With the move towards equity financing and broader share ownership in Europe in the 1990s,
it seemed at times that the market-based system was gaining favour. However, important
elements of the European tradition have proved resilient and enduring.
Stable investment and cross-shareholdings mean that the discipline of management by the
securities market is not strong, and similarly, the market for corporate control is weak, with hostile
takeovers rarely occurring. In other words, long-term large shareholders give the company a
degree of protection from both the stock market and the threat of takeover. The continental
European system is characterised by a supervisory board for the oversight of management,
where banks play an active role, inter-corporate shareholdings are widespread and, often,
companies have close ties to political elites.
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In most European countries (and indeed most countries in the world), ownership and control are
held by cohesive groups of insiders who have long-term stable relationships with the company
(La Porta & Lopez-de-Silanes et al. 1999). Groups of insiders tend to know each other well and
have some connection with the company in addition to their investment (e.g. through family
interests, allied industrial concerns, banks and holding companies). Insider groups monitor
management that often acts under their control. The agency problem of the market-based system
is much less of a problem in the relationship-based system (Nestor & Thompson 2000, p. 9).
Corporate finance in such countries is highly dependent upon banks, with companies having
high debt-to-equity ratios. Banks often have complex and longstanding relationships with
corporations, rather than the arm’s length relations of equity markets. As a result, rather than the
emphasis on public disclosure as in the market-based system, the insider system is based on a
deeper but more selective exchange of information among insiders.
• Company law
Many European countries have a distinctive tradition of company law influenced by prescriptive
Roman law. In France, regulations on incorporation were inspired by the Napoleonic code.
In Germany, regulation insisted upon a board of supervision separate from the company’s
board of directors to represent and protect shareholders’ interests. Company law is embedded
in different and often unique political, cultural and social traditions.
• Employee representation
Employee representation is embedded in law in Austria, Denmark, Germany, Luxembourg
and Sweden. Employees of companies of a certain size have the right to elect some
members of the supervisory board. In Finland and France, company articles may provide
this right. In other European countries, it is the shareholders who elect the members of the
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supervisory board.
• Stakeholder issues
Different European countries articulate the purpose of corporate governance in different
ways. Some place emphasis on a broader range of stakeholder interests, while others strongly
emphasise the ownership rights of shareholders.
• Disclosure
Variations in disclosure requirements and the resulting differences in information provided
to investors are a potential impediment to a single European equity market. Nevertheless,
the amount of disclosure is increasing, and there is more agreement about the type of
information that needs to be disclosed. In part, this is due to the promotion of International
Financial Reporting Standards.
Germany
The German business sector is typified by the following characteristics:
• a relatively strong concentration of ownership of individual enterprises;
• the importance of small and medium-sized unincorporated companies;
• a close correspondence between owners and managers; and
• the limited role played by the stock market.
The central characteristic of the corporate governance of German enterprises is their relationship-
based nature in which all interested stakeholders (managers, employees, creditors, suppliers
and customers) are able to monitor corporate performance. The German Corporate Governance
Code was first published in 2002 and has since been amended several times, including in 2015.
It stresses the need for transparency and clarifies shareholder rights in order to promote the trust
of investors and capital market development. It also seeks to enhance investors’ understanding of
the complex civil law–based corporate governance framework by setting out key principles in the
one document (Government Commission 2015). Moreover, the code’s ‘comply or explain principle’
seeks to foster transparency by requiring an explanation from those corporations not complying
with the provisions of the code (Enriques & Volpin 2007).
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France
France and Italy are the European countries with the smallest ownership of company shares
by financial institutions. The majority of shares have traditionally been owned by non-financial
enterprises, which reflects an elaborate structure of cross and circular ownership. That is,
companies own one another’s shares in a circular relationship. No external party can readily
gain entry to the network, or seize control of any entity in the network, and all of the member
companies support one another against outsiders.
Another distinguishing feature of France is the concentration of ownership, which is higher than
in any other Group of Seven (G7) industrialised country, with the exception of Italy. In France,
half the firms are controlled by one single investor who owns the absolute majority of capital.
On boards, the role of non-executive directors is muted, as business tends to be dominated
by the president directeur général (PDG) who combines the functions of chair and CEO.
The independence of the PDG is reinforced by the legal notion that enterprises should pursue
the intérêt social de l’entreprise. This law is interpreted in two ways:
• that management has to act in the interests of shareholders; but also
• that management has to act in the interest of the enterprise (e.g. to ensure its survival)
(OECD 1997, p. 113).
➤➤Question 3.13
Identify the advantages and disadvantages of the European relationship-based insider system
of corporate governance.
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In certain Asian countries (such as China), there are still many government-controlled
organisations carrying out roles that are typically performed by the private sector in Western
countries. This situation reflects the history of that country where, after 1949, all significant
business entities in China were created and owned by the government. From the late 1980s
onwards, the Chinese government began to reform state-owned enterprises, with many small
and medium-sized ones being privatised.
Nevertheless, there are still many government-controlled entities in existence today. They are
typically controlled by local governments and the central government. Given their public
charter, they are expected to perform roles that are consistent with the broad social aims
of the government. Consequently, their governance structure and processes reflect heavy
government influence and control.
In Singapore, many of the largest listed companies have the state as the largest shareholder,
although in terms of number, there are more listed companies that have either families or
founder-managers as the largest shareholders.
The relationship-based form of conducting business contrasts with the rules-based systems
that predominate in Western industrial countries, where a combination of internal and external
controls is exerted on companies. Internally, company directors are responsible for exercising
a duty of care and diligence that includes ensuring financial controls are effective. This financial
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discipline is reinforced by the requirement to audit the annual company accounts. Externally,
the company operates within a framework of company law that is enforced by regulatory
authorities. Finally, there is the enveloping discipline of the capital market, the effect of which
is to exercise a commercial discipline on companies.
The most prevalent company form in East Asia is the diversified conglomerate that is controlled
and managed by a single extended family. Companies with widely dispersed ownership are rare
in Asia. In this context, it is difficult to protect the rights of minority shareholders. Though there
are usually laws and penalties against insider-trading and related party transactions, as well as
on the conduct of substantial transactions and takeovers, it is open to question how often and
how rigorously these are enforced (Prowse 1998). An example of change can be seen in Japan,
which in very recent years has taken a number of steps to improve corporate governance,
including new rules designed to improve independence in the boardroom.
232 | GOVERNANCE CONCEPTS
In the past, the boards of directors of companies in Asia have often served little more than a
nominal role. The role of non-executive directors has frequently been relatively unimportant
and consequently boards have not always exercised strong control over executives (including
executive directors) and the relationships that exist between the corporation and third parties.
Boards have been (and often still are) effectively dominated by majority shareholders. A result
is that disclosure and transparency are often minimal, making it more difficult for investors and
regulatory authorities to have adequate knowledge about corporate activities. Furthermore,
in the past, institutional shareholders and fund managers have not been significant in Asian
markets, so the extent of external monitoring by powerful institutions is only now becoming an
influential force for better corporate governance. This influence is now beginning to grow, with a
significant proportion of foreign institutional ownership of shares in Japan.
In a decade of rapid growth, the economies of East Asia rebounded from the 1997 Asian financial
crisis. The GFC has, however, affected some of these countries in the last few years, although
generally the impact has been far less than in Europe and the United States. All of the countries
concerned are committed to a reform of corporate governance. A range of external agencies
including the International Monetary Fund, World Bank and Asian Development Bank have
an interest in sustaining the reform process and they have all engaged in major initiatives to
facilitate and support the reform process.
The reform process will take different paths in different countries, but the main principles and
objectives can be outlined as:
• ensuring clear and effective financial control structures within firms;
• developing external monitoring and control, with improvements in the legal framework,
regulatory agencies and disclosure environment; and
• advancing training and development programs to encourage the understanding of
corporate governance procedures and issues.
The following overviews of corporate governance in Japan, China and India illustrate how
their different cultures and histories have shaped the development of their corporate
governance models.
Japan
The formal legal features of the Japanese corporate governance system resemble those in most
other advanced industrial countries. Corporate law in Japan was modelled, starting in 1899,
on the German system, with the establishment of limited liability corporations, typically with a
two-tier board structure. As in most OECD countries, the majority of enterprises are organised
as public limited companies, though in Japan, a significant number of medium-sized firms are
private limited corporations.
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The functioning of all of the major institutions and mechanisms of corporate governance,
including shareholders, banks and boards of directors, is different in Japan. For example, in the
West, the board of directors is largely appointed from outside the company and serves to
monitor management. However, in Japan, the main board of directors plays a more strategic and
decision-making role, and is more fully drawn from the ranks of management who are employed
by the company. Putting it simply, in the West, the board members are outsiders representing the
shareholders; in Japan, the board members are insiders leading management (Yasui 1999, p. 4).
A problem with this approach is that, over time, there is a tendency for boards to grow in size as
more managers need to be rewarded. The average board size in Japan is much larger than in
the West, often with around 20 directors, with some boards reaching as many as 40 members.
As a result, most companies form a board committee whereby some senior board members
make all of the essential management decisions, which are later ratified by the main board as
a formality. Thus, the role of Japanese boards may be considered superficial in supervising the
executive management. In terms of responsibility for the company, the Japanese main board’s
role is limited. However, there is no doubt regarding the executive management’s commitment
to and responsibility for the company, which is often more intense than anything experienced in
the West.
The ownership structure of Japanese companies is also different from those in Western countries.
Many large companies are formed into what are termed keiretsus, which are essentially sets of
companies with interlocking business relationships and shareholdings. The major keiretsus are
centred on one bank, which lends money to the keiretsus member companies and holds equity
positions in the companies.
Each bank has significant control over the companies in the keiretsus and acts as a monitoring
entity and as an emergency bail-out entity. Prominent keiretsus are Mitsubishi and Toyota.
One effect of this structure is to minimise the incidence of hostile takeovers. This concentrated
pattern of shareholding has created considerable stability, but at the potential expense of the
market, due to corporate control being restricted. Traditionally, keiretsus have put more emphasis
on expanding their business rather than on seeking short-term returns.
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Though Japanese companies may be moving in the direction of the Anglo-Saxon model,
this movement is one of degree. The distinctive interrelated elements of the Japanese economic
and social systems, together with legal, regulatory, financial market and employment systems,
will continue to have a powerful effect. Though reforms are under way in the Japanese system
of corporate governance, the progress has at times been at only a gradual pace. The Japanese
highly value their culture and institutions, and are not eager to change them without fully
understanding or accepting the reasons for change (Seki & Clarke 2014).
China
Extraordinary economic progress has occurred in China. Much of this progress was in the
early days of ‘opening up’, before China had created laws that reflect international corporate
law systems. By the end of the 1990s, there was widespread recognition by leading Chinese
economists, government and corporate advisers that China’s sustained economic growth of more
than 10 per cent and its increasing prominence in international business required it to develop
more robust approaches to corporate law and better corporate governance.
In the early 2000s, when it entered the World Trade Organization and was awarded the 2008
Olympics, China was developing enhanced corporate laws and governance understandings,
which are continuously being developed. However, these developments take time before they
become fundamental to the way that corporations operate within an economy.
234 | GOVERNANCE CONCEPTS
There are a number of forms in which enterprises may operate within China including:
• state-owned enterprises (SOEs);
• collective-owned enterprises;
• sole proprietorship companies;
• Sino–foreign cooperative enterprises (jointly owned by Chinese and overseas interests);
• wholly foreign-owned enterprises; and
• Chinese listed public companies—joint stock companies including foreign-funded
shareholder companies.
The state-owned enterprise model dominated from the 1950s through to the 1980s in a
negotiated system of central planning. The SOE Law of 1988 (PRC 1988) called on the SOEs to
separate themselves from government, and exercise their responsibilities as businesses. From
1992, Deng Xiaoping supported the call for the introduction of a market economy, and growing
entrepreneurship has followed, involving many thousands of small and medium-sized companies.
There are also many large corporations—many still demonstrating substantial state involvement.
This factor is thought by many to be a limiting factor in regard to China’s growing international
corporate significance.
Joint ventures with Chinese partner companies have been the traditional means by which
overseas companies entered China. These ventures have brought the benefit of foreign technical
expertise combined with local market knowledge.
Many large and small enterprises in China have diversified their ownership through public listing.
Strategically significant industries, such as energy and steel, have traditionally been in public
ownership, but with the split-share reform over the last 10 years, many government-controlled
enterprises are also listed with significant numbers of private shareholders. As mentioned
previously, a legal framework of company law along with more robust contract law, accounting
and accountability rules, securities laws and controlled securities markets (such as the Shanghai
Stock Exchange) have also been established.
The financial system has become more independent of political influence, and regulators’
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capacity has strengthened. A corporate governance code has been introduced for listed and
non-listed companies by the China Securities Regulatory Commission and the State Economic
Trade Commission. This code contains a number of mandatory requirements relating to
accountability that reflect the Germany/Japan approach to listed corporations—that is, a two
tier board structure is required.
In China, many different government entities have roles to play in business and corporation
activities, so the institutional framework is complicated. Some difficulties were raised by
He (2011):
• A great majority of listed companies are owned by the state, and most management teams
include government officials.
• Due to the fast transition in the Chinese economy, many corporations lack personnel
experienced in corporate governance.
• Banks and financial market are carefully controlled in China.
However, in most East Asian economies, families are in a position to exercise ownership and
control over many listed entities. This dominance of companies by families casts doubt on the
relevance of the theory of the separation of ownership and control, and of the principal/agent
model that informs much of Western thinking regarding corporate governance.
In Asia, there is a tendency to establish interlocking networks of subsidiaries and sister companies
that include partially owned listed companies. This allows investors to support the management
team of their choice, and invest in industries in which particular subsidiary companies specialise:
A particular feature of the Asian corporate landscape is a relatively high concentration of family-run
or state-owned firms. Quite frequently, ownership control is effected through extensive, interlocking
networks of subsidiaries and related companies that include partially-owned, publicly-listed firms.
On the one hand, the use of such subsidiaries and affiliated companies permits investors not only
to place their money with the management team of their choice, but to direct their money to the
markets and industries in which particular subsidiaries specialise and which investors believe hold
the greatest potential for profits. On the other hand, by spreading operations across companies
that have different pools of non-controlling shareholders, controlling insiders invariably create
tensions and conflicts when deciding how to allocate capital and business opportunities among
these companies
Source: OECD 2011, Reform Priorities in Asia: Taking Corporate Governance to a Higher Level,
p. 44. OECD Publishing, Paris, accessed October 2015, http://www.oecd.org/corporate/ca/49801431.pdf.
➤➤Question 3.14
Outline the benefits and costs of the family-based insider system of corporate governance
practised in Asia.
India
Despite a legal system substantially similar to that of Britain and therefore a corporate
governance approach that follows the Anglo-American model, India has still found it difficult
to develop a fully functional corporate governance system. It requires a system that balances
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international approaches with its unique culture, including extensive family control of even the
largest corporations and, in recent years, the phenomenal rate of growth achieved, locally and
internationally, by Indian corporations.
An example of corporate governance failings involved one of India’s largest corporate frauds—
resulting in substantial international damage. In 2009, the internationally significant listed
Indian computer corporation Satyam Computer Services was the subject of a major fraud
involving, among other things, extensive overstatement of profits. Its founder, R. Ramalinga Raju,
resigned after admitting that the company had fraudulently misrepresented its profits.
In addition to criminal prosecutions in India, there have been international ramifications—
including regulatory legal action in the United States. In April 2011, Satyam Computer Services
and its former auditor, PW India (an affiliate of PricewaterhouseCoopers), accepted fines totalling
USD 17.5 million in the US in relation to the fraud and the negative impact it had on trading on
Satyam shares on the New York Stock Exchange (The Hindu 2011).
It seems that at least some of the corporate governance problems in India arise from the fact
that British corporate governance approaches, which have formed the basis of Indian corporate
governance, do not easily fit into the Indian environment.
236 | GOVERNANCE CONCEPTS
India’s most significant governance issue is likely to be ensuring that a dominant shareholder
does not abuse their power, and protecting minority shareholders. This is different from the
Western focus on the separation of owners (principals) and control (agents) and the need to
align the two. This may limit the ability to transfer external models of corporate governance
directly into the Indian commercial environment. In addition to this, India has trouble with weak
enforcement of corporate governance regulations (Pande & Kaushik 2011, p. 2).
We can deduce from these observations that corporate governance in India is still in development,
but that India is prepared to take major steps to achieve successful corporate governance.
The fact that rapid changes in direction in the past have not solved problems shows that achieving
better corporate governance is a slow and painstaking process that requires constant effort and
an acceptance that perceptions and approaches matter more than rules.
If we accept that Australia and the United Kingdom, for example, have more effective corporate
governance, it must be remembered that, in each of those locations, the development of better
corporate governance has been constant in direction and effort for decades. Even so, we still find
examples of failure in both—so it is hardly surprising if things are difficult in a society as socially
complex as India. Progress may be slower than wished in India, but long-term improvements are
taking place and will continue to do so.
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Study guide | 237
SMEs are often family-owned. Corporate governance for family-owned firms has been the focus
of the paper by Sir Adrian Cadbury, author of the Cadbury Report, which was the forerunner for
the Combined Code on Corporate Governance. The paper, ‘Family firms and their governance:
Creating tomorrow’s company from today’s’ (Cadbury 2000), states that family-owned firms
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comprise 75 per cent of registered companies in the United Kingdom and 95 per cent of
companies in some economies.
Distinctive features of family firms were identified by Cadbury (2000). These included a longer-
term perspective with a focus on building the firm to be passed onto future generations,
often combined with a culture based on the unique values of a founder. Conflict between family
members poses significant risk, as does the problem of successful growth. While this might seem
unusual, a major issue occurs when the business grows successfully, beyond the ability of family
members to manage it effectively. This often leads to the need for external professional support
and this transition can be very difficult. Moving to more formal methods of decision-making and
control can be troublesome and many companies do not make the transition successfully.
To combat these issues, Cadbury recommended that a family council be used to structure
family engagement and that a board of directors should be established. The inclusion of outside
directors would benefit the company through the introduction of new ideas and a broad range
of experience. The establishment of a board would reorient the firm from being based on
family relationships to being based on business relationships.
238 | GOVERNANCE CONCEPTS
There are several concerns for small companies, and a key issue is the level and cost of compliance.
The need to conform to the recommended audit committee, which requires a minimum number
of three directors, one of whom is to have financial expertise, may be impractical for a small,
closely held company. However, the involvement of the company’s external accountants can
overcome some of the resource limitations in ensuring good corporate governance, particularly
with regard to risk management, the introduction and management of internal controls, and the
adequacy of financial reporting.
➤➤Question 3.15
What do you consider to be the main corporate governance issues affecting small family
businesses?
Not-for-profit organisations
Good corporate governance is equally essential for entities that do not have a profit motive as
their main objective. From a performance perspective, effectiveness in achieving goals will be
crucial for a not-for-profit organisation. The ideals and broad objectives of not-for-profit can be
very compelling. However, there is sometimes difficulty in translating these broad objectives into
specific goals. This can be difficult as the goals of such organisations may not be clearly stated
and will often have no discernible financial component of a type that most business people can
readily understand. Efficiency in the conversion of resources into outputs will also be important
for such organisations.
Furthermore, the price at which resources are acquired and converted (economy) will be
important. It is not only the three Es (economy, efficiency and effectiveness) of performance
that are important. Not-for-profits often aim to achieve a great deal with very few resources,
and therefore these must be utilised even more carefully than in a commercial organisation.
Conformance is also important in terms of adherence to basic rules of governance standards,
risk management, and financial and operating procedures. For example, not-for-profit
organisations such as charities may be susceptible to scandal or fraud, which may have an
adverse impact on the public’s perception of the particular organisation or indeed the entire
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sector of which the organisation forms a part. The non-conformance can also have a major
performance impact.
Despite the different corporate governance goals between profit-oriented and not-for-profit
organisations, there are many similarities in their objectives and principles. For example:
• Similar responsibilities exist to maintain solvency within their available funding.
• A similar focus is required on strategy, performance, accountability and stewardship.
• Larger not-for-profits will have committee structures similar to their for-profit counterparts.
• Although the directors may act in an honorary (unpaid) capacity or receive minimal director
compensation, the same director’s liability may exist as that expected in a for-profit company.
➤➤Question 3.16
What are the key issues of governance affecting not-for-profit organisations, and how might
these issues be addressed?
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As with commercial organisations, not-for-profits face governance dilemmas. The first is securing
people with the appropriate skills and experience to contribute to making the board an effective
body for governing the organisation. In this sector, board members are invariably volunteers,
and few may possess professional experience. Resources are usually in extremely short supply
and the funds of the not-for-profit have to be carefully managed. The loss or misallocation of
the funds of not-for-profits is a serious issue that can damage the work and reputation of the
organisation. However, many not-for-profits are exceptionally cost conscious and do a remarkable
job of conserving resources and applying them to best effect.
They called for elections to the board and at the first meeting of the board, a chair was elected.
Then they discovered they had no-one on the board with financial skills and had to nominate someone
to the board to become the treasurer. They realised it would be advantageous to form a company
limited by guarantee for their dealings with the bank, other suppliers and their employees. After seeking
legal advice, they succeeded in registering their company, and as the popularity of the childcare centre
grew, they realised there was a future for the centre.
However, in the second year of operation some members of the board wanted to extend the hours of
the centre, and to introduce new facilities. The full-time manager of the centre was cautious about this
initiative, and was concerned the centre might not be able to meet its obligations. Relations became
strained and the manager moved on to a larger childcare centre. After recruiting a replacement,
the board realised they would have to work more cooperatively with the manager of the centre, and that
they could not simply impose their will. Over time, the increasing experience and professionalisation
of the board membership and procedures meant it was easier for the manager to bring concerns to
the board, confident that the board would listen and contribute to resolving issues in a productive
way. The maturing of the governance of the childcare centre was allowing the provision of a more
efficient and effective service.
Whereas companies focus mainly on shareholder returns, the public sector’s role is to implement
programs cost-effectively in accordance with government legislation and policies. There are also
review processes normally imposed by governments and their committees. The international
association of auditors-general (i.e. government auditors) is the International Organisation of
Supreme Audit Institutions (IntOSAI). IntOSAI identifies the three E’s—economy, efficiency and
effectiveness—as the heart of public sector governance.
Government agencies must satisfy a complex range of political, economic and social objectives,
and operate according to a different set of external constraints and influences compared to
private or public businesses. In addition, they are subject to the expectations of, and forms
of accountability to, their various stakeholders, who are more diverse and likely to be more
contradictory in their demands than those of a private sector company. Nevertheless,
private sector approaches can be adapted to reflect the different nature of public sector
agencies, in particular their different statutory and managerial frameworks and their wider
and more complex accountabilities.
Study guide | 241
The fact that the public sector collects and redirects public monies for the greater social good
is in itself a reason to require good corporate governance. It could be said that failure to ensure
that objectives and accountabilities are met will be reflected in the electoral process, but with
election time frames of three or four years in most cases, that process is not timely in ensuring
ongoing good governance.
According to Harris (1997), a former auditor-general of New South Wales in Australia, there are
important guiding principles that achieve more effective governance by boards in the public
sector. In addition to having clear and separate roles of ministers and boards, Harris also strongly
recommends the use of legislation to set out the roles, powers and responsibilities of the board
and provide the board with enough authority to perform its role.
Uhrig (2003) noted a lack of effective governance for several statutory authorities due to a
range of factors, including unclear boundaries in their delegation, a lack of clarity in their
relationships with ministers and portfolio departments, and a lack of accountability in the
exercise of their power (Uhrig 2003, p. 5). To address these issues, he recommended several
best practice approaches that are very similar to recommended best practice for publicly listed
companies. These included the use of committees to enhance effectiveness, annual board
reviews, appropriate experienced directors, and set terms to ensure a rotation of directors.
In addition to these items, he also suggested that representational appointments (e.g. specific
appointments to a board by a government minister) be limited.
➤➤Question 3.17
How can the broad public service mission of publicly owned companies be focused and delivered
through better governance?
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management of public organisations often simply looked to their political masters for guidance,
and sometimes ignored the interests of their clients—the general public—who were rendered
relatively powerless compared to market-based business systems.
However, a process of reform has taken place in the public sector just as dramatic and far
reaching as in the private sector, and often inspired by the transformation of private sector
governance. For example the Uhrig Report on public sector governance argued:
There are benefits in looking to developments and lessons learnt in the private sector when
considering appropriate governance frameworks for the public sector. The environment in which
the private sector operates creates significant challenges for companies. The consequences
of failure and threat of takeover provide incentives for the private sector to constantly strive to
improve governance practices. In dealing with the challenges of the market, the private sector has
gained considerable experience in applying the core elements of governance (Uhrig 2003, p. 26).
As a result of the widespread reform movement in the public sector in Australia and in other
countries, public organisations now have much more responsive governance, including
autonomous boards with independent directors responsible for strategies to meet clients’
needs, and with authority to distribute resources appropriately (within agreed parameters).
242 | GOVERNANCE CONCEPTS
Yet the public sector remains different in values, objectives and methods compared to the
private sector:
• The public sector produces ‘public values’, promotes equity, and protects the collective
interests (e.g. about the environment and international relations) as well as market ones;
• The public sector operates in a complex decision-making environment, usually manages many
and diverse stakeholder interests and often considers short, medium, and long range effects
of decisions (inter-generational equity is one example);
• The public sector’s effectiveness often relies on the co-operative, as opposed to the
competitive, participation of others. Competition has a dysfunctional effect if applied
inappropriately in the public sector: examples include service duplication, loss of scale
economies, the dismantling of collaborative institutional arrangements, and the focusing on
marketing at the expense of service delivery;
• The public sector uses diverse resources to achieve its policy ends, involving not only public
money but, significantly, public power as well (Halligan & Horrigan 2005, p. 16).
In the previous analysis, whatever delegated powers the board of a public organisation are given,
there is an obligation to work broadly within the framework of government policy, and to engage
with other public agencies in the achievement of policy goals, rather than pursuing separate
institutional policies. Yet ‘the conventional spectrum of bureaucratisation, commercialisation,
corporatisation and privatisation of government entities still leaves much room for a multiplicity
of governance arrangements at both sectoral and organisational levels’ (Edwards & Halligan et al.
2012, p. 175).
Clearly these are more substantive and demanding objectives than commercial banks face. The RBA
has two boards: the RBA board, which is responsible for monetary and banking responsibility, and the
Payment Systems Board, which is responsible for payment systems. Successive Australian governments
have emphasised the RBAs independence, yet the bank is connected to the government in a number
of ways. The board must keep the government informed of its monetary and banking policy, and if
the RBA and the federal Treasurer disagree on how well the policy is serving the Australian people,
they must strive to reach agreement. If they cannot reach agreement, the government has formal
mechanisms at its disposal to ensure its view prevails, but governments are very reluctant to ever
exercise this power as not only would it undermine the independence of the RBA, it would damage
the government, and possibly the Australian economy (Edwards & Halligan et al. 2012, p. 187).
This critical example illustrates the governance dilemmas frequently encountered in the public sector:
pursuing a much wider and more vital public purpose; enjoying a degree of autonomy, which must be
exercised with extreme care; and being subject to the ultimate sanction of the government, even if
this is rarely, if ever, exercised.
Study guide | 243
The SME sector is of great significance in every economy and community, providing substantial
economic activity and employment. The SME sector represents the corner shop and the local
business without which communities could not function properly, and they are vital to the
provision of many goods and services. While the governance of small enterprises is necessarily
simple, it is nonetheless important that these enterprises are accountable to assure those that
they do business with that they will not encounter unexpected losses.
In addition, there is the public sector, which continues to have a substantial impact even after
the episodes of privatisation in recent decades. For example, there were more than 500 major
government business enterprises in 2013, including the ABC television company, power and
water utilities, and other public agencies, which function more or less autonomously from
government and have their own form of governance. Finally there are government business
enterprises, which remain part of federal and state governments, and maintain governance
accountability to the elected government, such as the Australian Postal Corporation and the
NBN Co Limited.
A further dimension of economic activity (which begins to merge with social, cultural and sporting
activity) is the work of not-for-profit organisations (NFPs). NFPs are organisations that cannot
distribute their earnings to those who exercise control in the organisation, but are dedicated to
a wider purpose (Hansmann 1980). Though composed largely of small and local organisations,
the NFP sector is vast, with 600 000 organisations employing more than one million people
(ABS 2014). In addition, the sector has more than five million volunteers and reaches an annual
turnover in excess of $100 billion. (Pro Bono Australia 2014).
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244 | GOVERNANCE CONCEPTS
Lamers (2009) also highlights the importance of cash flow in ensuring the ongoing viability of a
business. Dunn & Bradstreet CEO Christine Christian notes that businesses are more likely to fail
because of poor cash flow than poor sales, with this being more prevalent in times of economic
recession or downturn (Heaney 2011). National Credit Insurance (Brokers) Pty Ltd, which offers
insurance to protect companies in the event of bad debts in their debtors’ lists, reported a
significant rise in the number of claims against bad debtors following the GFC, indicating
businesses were not prepared for the slowdown in the economy, resulting in a strain on cash
flows (Lamers 2009).
Corporate culture has also been identified as a significant factor in corporate failure. The following
extract from Cruver (2002) about the collapse of Enron demonstrates the culture in that company
during the 1990s:
Fear among competitors, suppliers, customers, and even Enron’s own employees … Greed among
those who dreamed of colossal bonuses, millions in stock options, and generous campaign
contributions. Fear and greed … were radically and permanently entrenched—throughout the
culture, the people, and the industries Enron touched (Cruver 2002, p. xv).
This highlights the importance of understanding agency theory and the related issues and costs.
According to Monks and Minow (2008), there has been significant abuse, not just by the directors,
but by all involved in the corporate governance process. This includes incompetence and
negligence as well as corruption by managers and directors as well as other peripheral players
including securities analysts and lawyers, accountants and financiers, and even shareholders.
Study guide | 245
The GFC provided a number of lessons for governance. The OECD identified that corporate
governance weaknesses in remuneration, risk management, board practices and the exercise of
shareholder rights had played an important role in the development of the financial crisis and
that such weaknesses extended to companies more generally (OECD 2010, p. 3). These issues are
explored further in the following extract from an article that considers the corporate governance
lessons from the GFC:
The financial crisis can be to an important extent attributed to failures and weaknesses in corporate
governance arrangements. When they were put to a test, corporate governance routines did
not serve their purpose to safeguard against excessive risk taking in a number of financial
services companies.
A number of weaknesses have been apparent. The risk management systems have failed in many
cases due to corporate governance procedures rather than the inadequacy of computer models
alone: information about exposures in a number of cases did not reach the board and even senior
levels of management, while risk management was often activity rather than enterprise based.
These are board responsibilities. In other cases, boards had approved strategy but then did not
establish suitable metrics to monitor its implementation. Company disclosures about foreseeable
risk factors and about the systems in place for monitoring and managing risk have also left a lot to
be desired even though this is a key element of the Principles.
Accounting standards and regulatory requirements have also proved insufficient in some areas
leading the relevant standard setters to undertake a review.
Last but not least, remuneration systems have in a number of cases not been closely related to the
strategy and risk appetite of the company and its longer-term interests.
The Article also suggests that the importance of qualified board oversight, and robust risk
management including reference to widely accepted standards is not limited to financial
institutions. It is also an essential, but often neglected, governance aspect in large, complex non
financial companies.
Potential weaknesses in board composition and competence have been apparent for some time
and widely debated. The remuneration of boards and senior management also remains a highly
controversial issue in many OECD countries..
Source: Kirkpatrick, G. 2009, ‘The corporate governance lessons from the financial crisis’,
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OECD Journal: Financial Market Trends, vol. 2009/1, accessed October 2015,
http://www.oecd.org/daf/corporateaffairs/corporategovernanceprinciples/42229620.pdf.
Other issues that have been linked to governance failures include remuneration, wilful blindness
and poor risk management—especially in relation to managing complex financial products.
These are discussed below.
Remuneration
Two major issues arise in relation to the remuneration that senior executives receive.
First, there are concerns about the extent to which high executive earnings are linked to
performance. Remuneration methods may fail to achieve alignment or congruency between the
agent and principal. They may actually encourage the agent to behave in ways that the principal
does not desire at all. This may be the result of linking too much remuneration to excessive
risk‑taking, or to focusing remuneration too closely on short-term performance while ignoring
long-term sustainable and reliable growth and profits.
Second, there is frequently shareholder concern regarding the total amount that executives
receive, which is often regarded as excessive and involves a residual loss agency cost. This cost
is borne by the shareholders whose returns are reduced by the payments received by senior
executives. Despite constant attempts by organisations and corporate governance advisory
bodies, most attempts to manage and control remuneration levels have not been successful.
This issue is discussed in detail in Module 4.
246 | GOVERNANCE CONCEPTS
Wilful blindness
‘Wilful blindness’ (or ‘wilful ignorance’) is a term that is sometimes used to refer to types of cases
involving serious corporate governance failure. Although it is not a formal legal term under,
for example, Australian or UK law, it is a term referred to in US legislation such as the US Foreign
and Corrupt Practices Act (1977) and the US Bankruptcy Code. In essence, wilful blindness refers
to situations where individuals seek to avoid their legal liability for a wrongful act by deliberately
putting themselves in a position where they are unaware of facts that will make them liable.
In US cases where defendants have sought to escape legal liability on this basis, the courts have
frequently rendered defendants liable on the basis that they could and should have known of
facts that, had they been acted upon, would have prevented the wrongful act.
The concept of wilful blindness was referred to in the case involving Enron CEOs Kenneth Lay
and Jeffrey Skilling. The Sarbanes–Oxley regulations aim to prevent this type of approach by
requiring the CEO and CFO to sign off on the financial accounts and certify the appropriateness
of internal controls.
From a corporate governance perspective, allegations of wilful blindness can have serious
reputational consequences for the individuals and organisations concerned, and potentially
serious legal consequences. This highlights that it is important for directors and others to uphold
ethics and follow good corporate governance practices in order to prevent such incidents in the
first place.
without the board being aware of them until it was too late. More recently, a much larger scandal
erupted concerning the fixing of the rates with the LIBOR (London Interbank Offered Rate),
which is the primary benchmark for short-term interest rates around the world. It was discovered
that traders at a large number of international banks were manipulating these rates, leading to
excessive interest payments by customers. The banks involved were heavily fined, though the
boards of the banks and senior executives insisted they were not aware of the systemic
manipulation of rates that was taking place.
Risk management
Risk management should enable a company to maximise opportunities and minimise
losses (of all types) by assessing the different types of risk and improving safety, quality and
business performance.
Often, the result of risk assessment can enable the board to determine appropriate insurance
cover, but there will be occasions when no amount of insurance will protect the company.
The successful management of risk and the laying down of guidelines on how risk is to be
assessed can have additional positive benefits.
The analysis of the data collected to enable the risks to be calculated and planned for can lead
to regular monitoring by the board and management, thus raising their awareness of the issues
involved for the company.
Risk management has been defined as ‘the culture, processes and structures which come
together to optimise the management of potential opportunities and adverse effects’
(Standards Australia 2004).
Within each organisation, the board must determine the framework it considers appropriate
for the company’s needs. Risk management is a process designed to serve a number of goals,
including to identify, analyse, evaluate, treat, monitor and communicate the information gathered
for the benefit of the company.
The nature of the data collected will depend very much on the activities undertaken by the
company. Risks may be associated with any activity, function or process of the company.
For example, one type of risk might stem from legal liability arising from the company’s conduct
(e.g. the liability for environmental damage in the 1984 Union Carbide gas disaster at Bhopal,
India or the BP oil spill in the Gulf of Mexico in 2010).
Identifying, evaluating and addressing risk are essential features of modern management
techniques. The role of the board in understanding and dealing with enterprise risks has
been well articulated in many of the recommendations made by various committees over the
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years. The IFAC PAIB (IFAC 2004) identified risk as being important for both performance and
conformance aspects of governance.
The OECD (2010) specifically identified the failure to properly identify and manage risk as being
central to the GFC. The need for improvement is apparent from the large number of corporate
and government failures seen in the GFC period. Good risk control should give superior
performance, but bad risk understanding and practices have resulted in financial disasters.
In Australia, the prudential authority APRA has instituted a rigorous policy of risk management
in major financial institutions which comprises:
systems for identifying, measuring, evaluating, monitoring, reporting, and controlling or mitigating
material risks that may affect its ability, or the ability of the group it heads, to meet its obligations
to depositors and/or policyholders. These systems, together with the structures, policies,
processes and people supporting them, comprise an institution’s risk management framework
(APRA 2015, p. 1).
248 | GOVERNANCE CONCEPTS
Note that effectiveness and efficiency are both performance-related matters. Auditors must
obtain an understanding of the internal control structure and gather related evidence to support
that assessment. Weaknesses in internal control can result in material losses (under-performance)
and misstatements (i.e. compliance).
External auditors are required to report material weaknesses to the board on a timely basis and
internal auditors are expected to assist in this process using as much independent judgment
as possible.
Over the past two decades, organisations have invested heavily in improving the quality of their
internal control systems because:
1. good internal control is good business—it helps organisations ensure that operating,
financial and compliance objectives are met;
2. more organisations are required to report on the quality of internal control over financial
reporting, compelling them to develop specific support for their certifications and
assertions; and
3. internal control assists in providing reasonable assurance that the entity is complying with
applicable laws and regulations.
The Sarbanes–Oxley Act in the United States has received much attention about the necessity
of documenting the internal controls that affect the financial information communicated to
the investing public. In particular, s. 404 of this Act specifies that annual reports lodged with
the SEC must state management’s responsibility for establishing and maintaining an adequate
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internal control structure and procedures for financial reporting. Furthermore, the annual report
must contain an assessment of the effectiveness of the company’s internal control structure and
procedures for financial reporting, as at the end of the most recent financial year.
Another example of this link between corporate governance and risk management is found in
ASX Principle 7. It requires organisations to: ‘Recognise and manage risk: A listed entity should
establish a sound risk management framework and periodically review the effectiveness of that
framework’ (ASX CGC 2014, p. 28).
Source: OECD 2010, Corporate Governance and the Financial Crisis: Conclusions and Emerging Good
Practices to Enhance Implementation of the Principles, accessed October 2015,
http://www.oecd.org/daf/ca/corporategovernanceprinciples/44679170.pdf.
There is no imperative statement by the OECD that the chair should not also be the CEO.
The fact that, in many US corporations, ‘presidents’ are the chair and the CEO at the same time
is perhaps an influencing factor in the OECD conclusions. However, it seems that this policy is
slowly achieving traction even in the United States. As noted earlier, there is a gradual trend
in S&P 500 companies in the United States towards separating the roles of chair and CEO.
Nonetheless, the importance of independence, or independence protocols, is clearly identified
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in the United States in Sarbanes–Oxley and in other governance systems principles.
Review
This module explored the importance of having clear principles in place for guiding organisations
to achieve their objectives while conforming to expected business behaviour and rules.
It included explanations of how governance is the way in which organisations are directed
and controlled, and how the various stakeholders actually perform their governance roles.
Directors, with their relevant duties and obligations, have the greatest role in governance,
and also the power to have the most impact, both positively and negatively, on the organisation.
Shareholders, auditors and regulators all have roles to play to ensure that problems are quickly
identified and rectified, and to help organisations pursue their goals and objectives appropriately
and successfully.
After considering the development of corporate governance best practice over the past 30 years,
the module focused specifically on best practice principles as outlined in the OECD Principles,
the FRC Code and the ASX Principles. This included a detailed review of specific items that have
been recommended as helpful or essential for ensuring good governance in both corporate and
non-corporate sectors.
We then looked in more detail at the non-corporate sector (including family-owned businesses
and SMEs, not-for-profit organisations and the public sector), discussing some of their
characteristics and their significance to the economy.
The module concluded by focusing on causes of governance failure that have been identified and
may well arise again in the future, as well as recommendations for improvement. This demonstrates
that governance best practice is not finalised and constantly evolves as the business, economic
and global environments changes. Without vigilance, good governance is often forgotten in strong
economic times, only to be remembered when financial troubles arise.
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Appendix 3.1 | 251
Appendix
APPENDIX
Appendix 3.1
Understanding the UK FRC Corporate Governance Code
The 2014 version of the UK Financial Reporting Council Corporate Governance Code (FRC Code)
is an important mechanism designed to improve corporate governance in the United Kingdom—
from the conformance and performance perspectives. Although it only formally applies in the
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United Kingdom, it has international importance. You will find it valuable to download and
review this document. Only the parts of the FRC Code that are reproduced in the Study Guide
(including this Appendix) are examinable.
In this Appendix, we will review relevant extracts from the FRC Code.
Governance and the FRC Code
…
4. The Code is a guide to a number of key components of effective board practice. It is based
on the underlying principles of all good governance: accountability, transparency, probity and
focus on the sustainable success of an entity over the longer term.
…
6. The new Code applies to accounting periods beginning on or after 1 October 2014 and
applies to all companies with a Premium listing of equity shares regardless of whether they are
incorporated in the UK or elsewhere.
Comply or explain
The ‘comply or explain’ approach is outlined on page 4 of the FRC Code and relevant sections
are reproduced below. This is a similar concept to that used in Australia—where we refer to
‘if not, why not’ (i.e. if not complying, explain why not) compulsory ‘listing rules’ applicable to all
listed entities.
2. The Code is not a rigid set of rules. It consists of principles (main and supporting) and
provisions. The Listing Rules require companies to apply the Main Principles and report to
shareholders on how they have done so. The principles are the core of the Code and the way in
which they are applied should be the central question for a board as it determines how it is to
operate according to the Code.
3. It is recognised that an alternative to following a provision may be justified in particular
circumstances if good governance can be achieved by other means. A condition of doing so
is that the reasons for it should be explained clearly and carefully to shareholders, who may
wish to discuss the position with the company and whose voting intentions may be influenced
as a result. In providing an explanation, the company should aim to illustrate how its actual
practices are consistent with the principle to which the particular provision relates, contribute
to good governance and promote delivery of business objectives. It should set out the
background, provide a clear rationale for the action it is taking, and describe any mitigating
actions taken to address any additional risk and maintain conformity with the relevant principle.
Where deviation from a particular provision is intended to be limited in time, the explanation
should indicate when the company expects to conform with the provision.
Every company should be headed by an effective board which is collectively responsible for the
long-term success of the company.
There should be a clear division of responsibilities at the head of the company between the running
of the board and the executive responsibility for the running of the company’s business. No one
individual should have unfettered powers of decision.
The chairman is responsible for leadership of the board and ensuring its effectiveness on all aspects
of its role.
As part of their role as members of a unitary board, non-executive directors should constructively
challenge and help develop proposals on strategy.
Section B: Effectiveness
The board and its committees should have the appropriate balance of skills, experience,
independence and knowledge of the company to enable them to discharge their respective
duties and responsibilities effectively.
There should be a formal, rigorous and transparent procedure for the appointment of new
directors to the board.
All directors should be able to allocate sufficient time to the company to discharge their
responsibilities effectively.
Appendix 3.1 | 253
All directors should receive induction on joining the board and should regularly update and refresh
their skills and knowledge.
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.
The board should undertake a formal and rigorous annual evaluation of its own performance and
that of its committees and individual directors.
All directors should be submitted for re-election at regular intervals, subject to continued
satisfactory performance.
Section C: Accountability
The board should present a balanced and understandable assessment of the company’s position
and prospects.
The board is responsible for determining the nature and extent of the significant risks it is willing to
take in achieving its strategic objectives. The board should maintain sound risk management and
internal control systems.
The board should establish formal and transparent arrangements for considering how they
should apply the corporate reporting and risk management and internal control principles and for
maintaining an appropriate relationship with the company’s auditor.
Section D: Remuneration
Executive directors’ remuneration should be designed to promote the long-term success of the
company. Performance-related elements should be transparent, stretching and rigorously applied.
There should be a formal and transparent procedure for developing policy on executive remuneration
and for fixing the remuneration packages of individual directors. No director should be involved in
deciding his or her own remuneration.
Section E: Relations with Shareholders
There should be a dialogue with shareholders based on the mutual understanding of objectives.
The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders
takes place.
The board should use the AGM to communicate with investors and to encourage their participation.
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Source: FRC Code 2014, pp. 5–6. The UK Corporate Governance Code,
Financial Reporting Council. Reproduced with permission.
Please review these carefully and consider how these items all have an impact in terms of
creating best practice approaches to corporate governance.
254 | GOVERNANCE CONCEPTS
Section A: Leadership
A.1: The Role of the Board
Main Principle
Every company should be headed by an effective board which is collectively responsible for
the long-term success of the company.
Supporting Principles
The board’s role is to provide entrepreneurial leadership of the company within a framework of
prudent and effective controls which enables risk to be assessed and managed. The board should
set the company’s strategic aims, ensure that the necessary financial and human resources are in
place for the company to meet its objectives and review management performance. The board
should set the company’s values and standards and ensure that its obligations to its shareholders
and others are understood and met.
All directors must act in what they consider to be the best interests of the company, consistent with
their statutory duties.
Code Provisions
A.1.1. The board should meet sufficiently regularly to discharge its duties effectively. There should
be a formal schedule of matters specifically reserved for its decision. The annual report should
include a statement of how the board operates, including a high level statement of which types of
decisions are to be taken by the board and which are to be delegated to management.
A.1.2. The annual report should identify the chairman, the deputy chairman (where there is one),
the chief executive, the senior independent director and the chairmen and members of the board
committees. It should also set out the number of meetings of the board and those committees and
individual attendance by directors.
A.1.3. The company should arrange appropriate insurance cover in respect of legal action against
its directors.
A.2: Division of responsibilities
Main Principle
There should be a clear division of responsibilities at the head of the company between
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the running of the board and the executive responsibility for the running of the company’s
business. No one individual should have unfettered powers of decision.
Code Provision
A.2.1 The roles of chairman and chief executive should not be exercised by the same individual.
The division of responsibilities between the chairman and chief executive should be clearly
established, set out in writing and agreed by the board.
A.3: The chairman
Code Provision
A.3.1. The chairman should on appointment meet the independence criteria set out in B.1.1. A chief
executive should not go on to be chairman of the same company. If exceptionally a board decides
that a chief executive should become chairman, the board should consult major shareholders in
advance and should set out its reasons to shareholders at the time of the appointment and in the
next annual report.
Source: FRC Code 2014, pp. 7–8. The UK Corporate Governance Code,
Financial Reporting Council. Reproduced with permission.
Appendix 3.1 | 255
Section B: Effectiveness
B.1: The Composition of the Board
Code Provision
B.1.1. The board should identify in the annual report each non-executive director it considers to be
independent. The board should determine whether the director is independent in character and
judgement and whether there are relationships or circumstances which are likely to affect, or could
appear to affect, the director’s judgement. The board should state its reasons if it determines that a
director is independent notwithstanding the existence of relationships or circumstances which may
appear relevant to its determination, including if the director:
• has been an employee of the company or group within the last five years;
• has, or has had within the last three years, a material business relationship with the company
either directly, or as a partner, shareholder, director or senior employee of a body that has such
a relationship with the company;
• has received or receives additional remuneration from the company apart from a director’s
fee, participates in the company’s share option or a performance-related pay scheme, or is a
member of the company’s pension scheme;
• has close family ties with any of the company’s advisers, directors or senior employees;
• holds cross-directorships or has significant links with other directors through involvement in
other companies or bodies;
• represents a significant shareholder; or
• has served on the board for more than nine years from the date of their first election.
B.1.2. Except for smaller companies, at least half the board, excluding the chairman, should
comprise non-executive directors determined by the board to be independent. A smaller company
should have at least two independent non-executive directors.
Source: FRC Code 2014, pp. 10–11. The UK Corporate Governance Code,
Financial Reporting Council. Reproduced with permission.
B.7: Re-election
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Code Provisions
B.7.1. All directors of FTSE 350 companies should be subject to annual election by shareholders.
All other directors should be subject to election by shareholders at the first annual general meeting
after their appointment, and to re-election thereafter at intervals of no more than three years.
Non executive directors who have served longer than nine years should be subject to annual re
election. The names of directors submitted for election or re-election should be accompanied by
sufficient biographical details and any other relevant information to enable shareholders to take an
informed decision on their election.
B.7.2. The board should set out to shareholders in the papers accompanying a resolution to elect
a non-executive director why they believe an individual should be elected. The chairman should
confirm to shareholders when proposing re-election that, following formal performance evaluation,
the individual’s performance continues to be effective and to demonstrate commitment to the role.
Section C: Accountability
C.2: Risk Management and Internal Control
Main Principle
The board is responsible for determining the nature and extent of the significant risks it is
willing to take in achieving its strategic objectives. The board should maintain sound risk
management and internal control systems.
Code Provision
C.2.1. The directors should confirm in the annual report that they have carried out a robust
assessment of the principal risks facing the company, including those that would threaten its
business model, future performance, solvency or liquidity. The directors should describe those risks
and explain how they are being managed or mitigated.
C.2.2. Taking account of the company’s current position and principal risks, the directors should
explain in the annual report how they have assessed the prospects of the company, over what
period they have done so and why they consider that period to be appropriate. The directors
should state whether they have a reasonable expectation that the company will be able to
continue in operation and meet its liabilities as they fall due over the period of their assessment,
drawing attention to any qualifications or assumptions as necessary.
C.2.3. The board should monitor the company’s risk management and internal control systems
and, at least annually, carry out a review of their effectiveness, and report on that review in the
annual report. The monitoring and review should cover all material controls, including financial,
operational and compliance controls.
C.3: Audit committee and auditors
Code Provisions
C.3.1. The board should establish an audit committee of at least three, or in the case of smaller
companies two, independent non-executive directors. In smaller companies the company chairman
may be a member of, but not chair, the committee in addition to the independent non-executive
directors, provided he or she was considered independent on appointment as chairman. The board
should satisfy itself that at least one member of the audit committee has recent and relevant
financial experience.
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C.3.2. The main role and responsibilities of the audit committee should be set out in written terms
of reference and should include:
• to monitor the integrity of the financial statements of the company and any formal
announcements relating to the company’s financial performance, reviewing significant
financial reporting judgements contained in them;
• to review the company’s internal financial controls and, unless expressly addressed by a
separate board risk committee composed of independent directors, or by the board itself,
to review the company’s internal control and risk management systems;
• to monitor and review the effectiveness of the company’s internal audit function;
• to make recommendations to the board, for it to put to the shareholders for their approval in
general meeting, in relation to the appointment, re-appointment and removal of the external
auditor and to approve the remuneration and terms of engagement of the external auditor;
• to review and monitor the external auditor’s independence and objectivity and the
effectiveness of the audit process, taking into consideration relevant UK professional and
regulatory requirements;
• to develop and implement policy on the engagement of the external auditor to supply
non-audit services, taking into account relevant ethical guidance regarding the provision
of non-audit services by the external audit firm, and to report to the board, identifying any
matters in respect of which it considers that action or improvement is needed and making
recommendations as to the steps to be taken; and
• to report to the board on how it has discharged its responsibilities.
Appendix 3.1 | 257
C.3.7. The audit committee should have primary responsibility for making a recommendation on the
appointment, re-appointment and removal of the external auditors. FTSE 350 companies should
put the external audit contract out to tender at least every ten years. If the board does not accept
the audit committee’s recommendation, it should include in the annual report, and in any papers
recommending appointment or re-appointment, a statement from the audit committee explaining
the recommendation and should set out reasons why the board has taken a different position.
Source: FRC Code 2014, pp. 17–19. The UK Corporate Governance Code,
Financial Reporting Council. Reproduced with permission.
Section D: Remuneration
D.2: Procedure
Code Provisions
D.2.1. The board should establish a remuneration committee of at least three, or in the case of
smaller companies two, independent non-executive directors. In addition the company chairman
may also be a member of, but not chair, the committee if he or she was considered independent
on appointment as chairman. The remuneration committee should make available its terms of
reference, explaining its role and the authority delegated to it by the board. Where remuneration
consultants are appointed, they should be identified in the annual report and a statement made as
to whether they have any other connection with the company.
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shareholders with the option to direct their proxy to vote either for or against the resolution or
to withhold their vote. The proxy form and any announcement of the results of a vote should make
it clear that a ’vote withheld’ is not a vote in law and will not be counted in the calculation of the
proportion of the votes for and against the resolution.
Source: FRC Code 2014, pp. 22–3. The UK Corporate Governance Code,
Financial Reporting Council. Reproduced with permission.
Conclusion
The United Kingdom is one of the world’s most important investment locations. The rules relating
to investment in and through the London Stock Exchange have provided leading-edge practical
approaches that have been followed successfully in many jurisdictions. Understanding these
approaches is a great advantage to becoming a professional accountant with knowledge and
skills that will add value to societies and corporations globally.
MODULE 3
Suggested answers | 259
Suggested answers
SUGGESTED ANSWERS
Question 3.1
Conflict of interest is a major issue that arises when an agent receives delegated powers.
The agent is required to act in the best interests of the principal. However, the temptation to
act for the agent’s own interest is strong, as agents have significant power and often control the
flow of information, and there may be little chance of getting caught.
Question 3.2
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Agency theory recognises that agents may do all they can to show loyalty (and, therefore,
agents accept the costs of bonding). No matter how well bonded an agent may be, it is a
fact that the agent is not the principal and will not act in the same way and will not reach the
same outcomes as the principal. Insofar as the agent does not achieve what would have been
achieved by the principal, this is termed ‘residual loss’. It will possibly arise because of deliberate
(self seeking) actions by the agent or unintentionally, by mistake or by simply not understanding
the principal’s goals. Whatever the final cost, we can describe the non-congruence of goals
between agent and principal as the key to understanding residual loss.
The existence of agency relationships means that there is a need to monitor activity so that
residual loss is identified and then can be further explored to rectify problems arising from
lack of goal congruence between the agent and principal. This means that there will always be
monitoring costs. The law, for example, demands financial audits and full public reporting as part
of monitoring. Aside from legally required monitoring, there are many ways in which monitoring
can be carried out and, therefore, a vast array of ways in which monitoring costs will be incurred.
Residual loss and monitoring costs are both borne by the principal and, as they are paid out of
the company’s resources, will clearly result in a diminution of the company’s value.
260 | GOVERNANCE CONCEPTS
Question 3.3
The role of the CEO is to take charge of the management of the company’s business and,
in consultation with the board, recommend strategies and policies and identify issues that are
important to the company.
The board finalises and formalises strategic planning and high-level policy-making of the
company and has a supervisory role in relation to the CEO and management. It is also in charge
of the appointment of senior executives, including the CEO, and monitoring the performance
of the company. It should also ensure adequate planning is in place for board succession and
risk management. Boards must also ensure correct communication to shareholders, including
ensuring shareholders are aware of the nature of the board’s responsibilities.
Question 3.4
Note that there is not always a clear distinction for each category. For example, budgeting is a
useful tool in achieving improved performance, but it also provides a useful conformance and
control mechanism to ensure resources are effectively managed and monitored.
Conformance Performance
• Taking steps designed to protect the company’s • Determining the company’s vision and mission
financial position and its ability to meet its debts
and other obligations as they fall due
• Ensuring systems are in place that facilitate the • Considering and assessing strategic options
effective monitoring and management of the for the company
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• Determining that the company has instituted • Adopting a strategic plan for the company,
adequate reporting systems and internal including general and specific goals,
controls (both operational and financial) and comparing actual results with the plan
together with appropriate monitoring of
compliance activities
• Establishing and monitoring policies directed • Adopting an annual budget for the financial
at ensuring that the company complies with the performance of the company and monitoring
law and conforms to the highest standards of results on a regular basis
financial and ethical behaviour
• Determining that satisfactory arrangements are • Selecting and, if necessary, replacing the
in place for auditing the company’s financial CEO, setting an appropriate remuneration
affairs and that the scope of the external audit package for the CEO, ensuring adequate
is adequate succession plans are in place for the CEO,
and giving guidance on the appointment
and remuneration of other senior
management positions
Suggested answers | 261
Conformance Performance
• Selecting and recommending auditors to • Adopting formal processes for the selection
shareholders at general meetings of new directors and recommending them for
the consideration of shareholders at general
meetings, with adequate information to allow
shareholders to make informed decisions
• Ensuring that the company has in place a policy • Reviewing the board’s own processes and
that enables it to communicate effectively effectiveness, and the balance of competence
with shareholders, other stakeholders and the on the board
public generally
Source: Adapted from Bosch, H. 1995, Corporate Practices and Conduct, 3rd edn,
Pitman, Melbourne, p. 9. Reproduced with permission.
Question 3.5
Usually, the expected benefits of audit committees include:
• improving the quality of financial disclosures;
• acting as a forum for the resolution of disagreements between management, the internal
auditor and the external auditor; and
• ensuring that an effective whistleblower system is in place.
The Enron audit committee failed to achieve these desired outcomes. Possible reasons why they
were not obtained can be linked to the limitations of audit committees, which include:
• committee members may be selected because of their association with the CEO or chair,
thus reducing their real independence; and
• audit committees may be formed as a means of giving the appearance of good corporate
governance without achieving any useful purpose for the organisation.
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The main positive points include:
• all members of the Enron audit committee were non-executive directors; and
• all members were highly qualified.
In addition to the issues about how the committee was structured, there were issues about
how the committee behaved. Although questionable practices were raised, there was a lack of
remedial action. There appeared to be a lack of rigour in pursuing the committee’s role.
Improvements should have focused on both the structure and the committee’s activities.
Having non-executive directors is not enough. There need to be independent non-executive
directors who actively perform their roles in a diligent manner.
262 | GOVERNANCE CONCEPTS
Question 3.6
Principle 2 Item G states that minority shareholders should be protected from abusive actions
by controlling shareholders. However, Principle 2, Item A4, states that basic shareholder rights
include participating and voting in general shareholder meetings.
There may be times when the majority of the organisation’s shareholders want a particular
event to occur, but this may be perceived to go against a small minority who do not want this to
happen. The minority may view this as an abusive action, while the majority may regard it as a
legitimate business transaction.
An example where this may arise is when a company votes on a significant issue, such as
an equity raising that dilutes current shareholdings, or a sale of a major component of the
business, or a significant change in strategy. In this situation, the intention of the action becomes
important—it will generally be permissible if it was done for the benefit of the company as a
whole, with no intention to deliberately hurt the minority. The law in this case becomes complex.
Question 3.7
These three actions all create issues in relation to the OECD Principles (OECD 2015).
1. There are no independent board members, therefore the composition of the board of
directors does not appear to satisfy Principle 6, Item E1, which states that ‘boards should
consider assigning a sufficient number of non-executive board members capable of
exercising independent judgment to tasks where there is a potential for conflict of interest’.
2. The restriction on selling shares does not satisfy Principle 2, Item A2, which suggests that
basic shareholder rights include the right to convey or transfer shares.
3. Contracts that are triggered because of a takeover event are often regarded as anti takeover
devices. They are designed to protect the current management rather than maximise
shareholder returns. This fails to satisfy Principle 2, Item H2, which indicates that anti takeover
devices should not be used to shield management and the board from accountability.
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Question 3.8
All references below are to the FRC Code (FRC 2014).
(a) The audit committee is responsible for reviewing the company’s internal controls (C.3.2).
(b) A formal evaluation of its own performance should be conducted by the board on an annual
basis (B.6).
(c) The same individual should not have the roles of chairman and chief executive at the
same time (A.2.1). One important reason for this is that the chair should be independent,
which cannot be the case if the position is held by the CEO. In addition to this there needs to
be clear separation of duties and the avoidance of giving a single person too much power.
Suggested answers | 263
Question 3.9
The areas in this case scenario that do not comply with the FRC Code:
• The chair is not independent as required, as this director holds a significant shareholding
(A.3.1 and B1.1).
• At least half the board excluding the chairman should be independent (B.1.2). The board
currently has at least five members who are not independent (the four executives and
the chair).
• There should be three independent members of the audit committee. The chair and the
CFO are not independent (C.3.1).
• The company does not have a remuneration committee (D.2.1).
Question 3.10
Full disclosure is the foundation upon which the integrity of equity markets is built. Without an
equal sharing of available information, investors who are informed will have an advantage over
those who are not. This can lead to exploitation of uninformed shareholders, and the growth of
equity markets would be inhibited by the resulting lack of confidence. As equity markets mature,
there is an increasing emphasis on full and continuous disclosure (which modern communication
technologies facilitate).
Essentially, markets are built upon trust. Once this trust is damaged, such as when it is revealed
that privileged groups have monopolised information for their own benefit, it is very difficult to
rebuild trust. Therefore, full disclosure and transparency are not only the practical mechanisms by
which markets operate efficiently; they are the central ethical principles of markets.
Question 3.11
MODULE 3
Internationally, there is a clear correlation between market failure and corporate collapse,
and renewed interest in review commentary and extension to regulations. It is only natural
when investors have lost considerable amounts of money that attention is given to the viability
of regulatory systems. However, as corporate governance is about wealth generation and
risk management, these duties require continuous and simultaneous performance. Avoiding
mandatory restrictive over regulation requires active market regulation, particularly at times of
expansion. The drive to make corporations improve corporate performance and governance and
enhance corporate accountability needs to continue as an essential part of building sustainable
economies and enduring companies.
264 | GOVERNANCE CONCEPTS
Question 3.12
The market-based system of corporate governance has the following strengths:
• dispersed ownership and strong institutional investors;
• primacy of shareholder interests in company law;
• emphasis on protection of minority shareholder interests in law and regulation;
• stringent requirements for disclosure;
• fluid capital investment in dynamic economy; and
• competitive performance.
Question 3.13
The advantages of the European relationship-based system are as follows:
• Diverse interests are represented on the board of directors.
• Insider groups monitor management and there are fewer agency problems.
• A wider group of stakeholders is actively recognised (including employees, customers,
banks, suppliers and local communities).
• Close relationships with banks provide stable finance.
• Inter-corporate shareholdings provide stability of ownership.
• Strong established governance procedures are established.
• Longer-term business strategies are possible.
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Question 3.14
The benefits of the family-based insider system of corporate governance practised in Asia
are as follows:
• Flexibility and dynamism contribute to rapid economic growth.
• Unity of ownership and control eliminates principal/agent problems.
• Investors can support successful management teams and companies.
• Interlocking networks of subsidiaries and sister companies create commercial strength
and capability.
• Understanding of customary practices generates a sense of purpose and cohesion.
• It has strength and stability of tradition.
Suggested answers | 265
The costs of the family-based insider system of corporate governance are as follows:
• Minority shareholders can be persistently neglected.
• Dominant shareholders, through pyramidal structures, acquire control of operations and/or
cash flow disproportionate to their equity stake in the company.
• The independence and diligence of boards of directors can be called into question.
• Standards of disclosure and transparency are minimal
• Regulators are unable to act because of poor information and access.
• Weak courts make the enforcement of contracts problematic.
Question 3.15
One issue is that many small businesses lack resources and skills, particularly in long-term
strategic planning and marketing. Cadbury (2000) found that in family businesses, some of the
governance issues revolved around dissension between family members. Where independent
managers or directors are appointed, there can be conflict with family managers or directors
who have historical and emotional involvement with the company. There are often no formalised
processes to deal with this conflict.
Question 3.16
The key governance focus in not-for-profit organisations is on stakeholders, as ownership is in
many ways problematic and almost exclusively not reliant on shareholders. There is a high level of
emotional involvement from many of the stakeholders. Boards are generally, but not necessarily,
larger and consist primarily of unpaid directors. There is often no formal nomination process,
no equity injection from owners, and no profit distribution. The board is often more ‘hands-on’
to compensate for the low-cost administration. The focus is on both financial and non-financial
objectives, with the key reason for its existence being to provide the service for which the
organisation was formed.
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Question 3.17
The challenge of public sector enterprise governance is that it is informed by a broad public
service mission, while private enterprise may focus more on the bottom line profit. That is,
while the public sector enterprise will be required to work within a budget, the definition of its
mission is often broad enough to demand careful assessment of the priorities the enterprise
must pursue. Often for public sector enterprises, there is unlimited demand for services from the
public, and therefore the analysis of priorities and the assessment of performance in meeting
those priorities needs to be finally tuned.
In this context, good governance is required to deliver on the three Es—economy, efficiency
and effectiveness. With such wide and competing economic and social objectives, the boards of
public enterprises need to build good relationships with wider stakeholders to fully understand
their needs, while engaging with government to remain fully accountable. There must be a
clear delineation of the roles and powers of government ministers and boards, and capable
directors, while boards need to be given the opportunity to do their work with responsibility
and accountability, and without undue intervention from government ministers.
MODULE 3
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the European Union and its Member States, European Commission, Internal Market Directorate,
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Yasui, T. 1999, Corporate governance in Japan’, paper delivered at the conference ‘Corporate
governance in Asia: A comparative perspective’, 3–5 March, OECD/Korean Development
Institute, Seoul.
MODULE 3
ETHICS AND GOVERNANCE
Module 4
GOVERNANCE IN PRACTICE
* CPA Australia gratefully acknowledges the many authors who have contributed to this module.
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Contents
Preview 275
Introduction
Objectives
Corporate governance success factors 277
Board appointment and cessation
Diversity—fairness and performance
Remuneration and performance
International debates about remuneration levels and fairness
Operational issues 293
Employees generally
Occupational health and safety
Fair pay and working conditions
Family and leave entitlements
Ethical obligations—employee governance
Trade and labour unions
Audit and related regulation
Impact of the legal system on the corporation 300
The legal system
The economy and the legal system
Proof, penalties and redress—criminal and civil 301
Laws leading to criminal penalties
Laws with civil outcomes and civil penalties
Redress compared with penalties
Competition and protecting markets for goods and services 304
Competition policy
Competition and stakeholders
Regulating anti-competitive conduct
Abuse of market power
Mergers and acquisitions
Agreements between competitors—cartel conduct
Unilateral restrictions on supply (exclusive dealing)
Resale price maintenance
Approvals procedures
Legal compliance and governance 316
Whistleblower protection
Consumers and customers 322
Caveat emptor to consumer protection
Misleading conduct and representations
Unconscionable conduct 327
Governance issues in the non-corporate sector 329
Government bodies
Charities and not-for-profits sector
The corporation and financial markets 334
Role of markets
Information and the media
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Review 357
References 367
Study guide | 275
Module 4:
Governance in practice
STUDY GUIDE
Preview
Introduction
This module addresses the ‘balancing act’ that confronts modern corporations internationally
as they seek to conform with societies’ rules and expectations and at the same time perform for
the overall benefit of these same diverse international societies.
The process of constructing the board of directors and the relationships between effective
boards, shareholders and society at large is the focus of the first part of this module. Important
issues include who may be a director and how directors are appointed. Internationally, the issue
of diversity within the boardroom, including gender diversity (which should mean the end
of boardrooms as ‘old boys’ clubs) is becoming increasingly important. Greater diversity is
more than just about fairness; it is also arguably an important part of increasing the focus on
performance as the partner of compliance in achieving good corporate governance. Including
diverse decision-making capabilities in the boardroom helps ensure that innovation and new
thinking are part of the process for better performance in many more corporations. An important
feature of diversity is that it must occur not only at board level but at all levels of the corporation,
so that all employees are encouraged and assisted towards being potential senior managers and
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directors—to the benefit of the corporation and its shareholders, the relevant individuals and
society generally.
The international focus on remuneration policies, and their relationship with performance,
is another important area. We see increasing power being given to shareholders, to the partial
exclusion of directors and executives, in relation to board and management remuneration
decisions. This is a direct response to the large numbers of executives who, in recent years,
have been rewarded by boards with enormous remuneration benefits at the same time that their
corporations have under-performed or even failed.
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Within the module, we also look at a range of operational matters that are important within
organisations and in respect of which boards must understand the role of appropriate policies
and managers must understand the details of day-to-day rules. These include some rights and
relationships for employees of corporations, such as health and safety, working conditions,
holiday entitlements and trade union operations. We also look at an area of protection relating
to employees and others that is referred to as ‘whistleblower protection’.
The module looks at an array of interactions that the corporation has with the legal system
and explains some fundamentals of legal proof and also the type of penalties that can apply
to those who breach the law. It then looks at the nature of markets for goods and services
and the protections that boards and executives must understand in relation to these markets.
As part of this, international approaches to competition law are explored. We then address,
albeit briefly, the very large field of modern international legal protection for consumers. We will
find that strong, and quite similar, consumer protection laws have developed in a number
of jurisdictions—including laws that protect ‘businesses as consumers’. Specific consumer
protections addressed include ‘deceptive conduct’ and ‘unconscionability’.
Finally, in the last section of this module, we explore the rules that directly affect the financial
markets (specifically share markets). This is a vital aspect of corporate governance as these
markets are important in creating the financing opportunities that corporations require. They are
also the locus of a vast proportion of the wealth of societies generally.
Indeed, a large number of detailed rules and requirements exist—and are all important for
good corporate governance. As we saw in Module 3, some rules are directed specifically
at corporations and their directors and officers. Other rules apply generally across society,
and therefore to all legal persons. Both these types of rules must be understood by and within
corporations (and by CPAs as active participants within corporations of all types). Together they
provide the legal framework and the ethical and social underpinning necessary for the effective
operation of corporations and for the success of society in virtually all countries.
It is important to note that evidence suggests that following these rules contributes to good
corporate governance. For example, a working paper prepared for the Australian Treasury
(Brown & Gørgens 2009) identifies, through research into performance measures, that compliance
with corporate governance principles does link to improved performance.
Successful corporations must appreciate the complex environment and must ‘get the balance
right’. CPAs, as moral agents who understand these many complexities, are a crucial component
in the development and operation of better corporate governance internationally.
Objectives
After completing this module, you should be able to:
• evaluate the implications of board diversity and executive remuneration in relation to
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This module builds on the discussion of corporate governance in Module 3 through the
consideration of additional issues and international trends (including new legal rules) in relation
to boards and management. Important factors relate to how directors are appointed and the
diversity of board candidates and managers. We also look at the role of shareholders in voting
for the appointment of directors, and how directors cease to be on the board. This voting power
is gaining new significance because of the vexed issue of executive remuneration and corporate
performance as a key part of good corporate governance.
The appointment of directors is traditionally strongly influenced by the board, even though
the shareholders legally appoint them. In most jurisdictions, the annual general meeting of
shareholders will vote in favour of candidates recommended by the board (or recommended
by the nomination committee). Indeed, endorsed directors of ASX 200 companies have
averaged about 95 per cent of the vote in favour since 2000. Where a ‘casual vacancy’ arises,
it is common for the board to use its powers to appoint a director immediately (for later
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ratification by shareholders’ vote at the next AGM). Rarely are shareholders presented with
a range of options from which to choose.
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De-staggering
As we observed in Module 3, the Financial Reporting Council (FRC) in the United Kingdom,
in its Corporate Governance Code (FRC Code), recommends (subject to the ‘comply or explain’
approach) that all directors of the FTSE 350 (i.e. larger listed corporations) should be subject to
a shareholder vote every year (FRC 2014). This enhances the importance of shareholder votes
and is gaining international acceptance. Australian investors have been exposed to this direction
change (e.g. at the 2012 AGMs of Rio Tinto, BHP Billiton and News Corp). In the United States,
annual voting for all directors is now very common, which is a major step forward from past
practices where US shareholders could not actually vote ‘against’ a director, but instead simply
‘withheld’ a vote in favour.
The standard period of director appointment has tended to be around the three-year mark
in most countries—with just a few directors being re-elected by shareholders each year
under ‘staggered’ voting. A three-year ‘staggered vote’ cycle for directors means that every
year, one‑third of the directors are required to resign and then typically all, or most, of these
individuals will stand again for re-election.
A staggered process would look like this for a board with nine directors:
2015: Board members 1, 2 and 3 are required to retire from their position and if they want to
re‑join the board they must be subject to a shareholder vote of approval.
2016: Board members 4, 5 and 6 are required to retire, and these directors also require a
shareholder vote of approval to re-join the board.
2017: Board members 7, 8 and 9 are required to retire and also require a shareholder vote of
approval to re-join the board.
So every year you only get to vote on three directors, and the vote for these directors is
‘staggered’ over a three-year period.
‘De-staggering’ means to stop engaging in the staggering sequence over time and do it all at
once. A de-staggered process would look like this:
2015: All board member appointments expire and reappointment is subject to shareholder vote
and approval.
2016: All board member appointments expire again and reappointment is once again required.
In Australia, an election exemption exists for the managing director (ASX Listing Rule 14.4).
The managing director is usually the CEO of the organisation. Many managing directors will
employ this exemption and may never face a shareholder election.
An annual cycle still leaves the possibility of excessive ‘continuing appointment’ of directors.
Boards need renewal, as weary or tired directors are unlikely to bring any new ideas to the
boardroom and may often be resistant to change. Further, the relationships that arise within
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boards mean that independent directors will gradually lose their independence as board
and corporate familiarity grow over time. Both the UK and Australia have specified maximum
periods for directors to be considered ‘independent’, although boards often conclude that
independence persists despite the fact that directors have moved beyond the recommended
time limits (e.g. 10 years). This is less than satisfactory, because deciding that independence is
likely to cease after a designated period can encourage board renewal and help create a clear
majority of independent directors.
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While the trend towards annual elections of the whole board is regarded by some as a way of
improving corporate governance, an appropriate degree of board continuity (i.e. all directors
not being replaced at the same time) is also important to ensure the orderly oversight of
corporations by directors with ‘corporate knowledge’. As in all matters of good corporate
governance, a balance of skills and judgment is vital in ensuring sound board composition.
On this, Kiel and colleagues offer the following advice:
Since it takes a year for a director to experience the full board cycle, anything less than two
(and possibly three) years is likely to underutilise the skills of the individuals involved. Similarly,
by presenting an upper limit of around five years before a director has to stand for re-election,
the board guards against directors becoming entrenched (Kiel & Nicholson et al. 2012, p. 215).
Departures
Directors may resign from their position during the current term, or, alternatively, choose not
to stand for re-election as a director at the end of their current board term. The resignation or
death of a director will result in a board vacancy that allows the board, if it chooses, to make
a temporary appointment, subject to later shareholder vote (usually at the next annual
general meeting).
While a director’s resignation does not have the same negative connotations as a formal
‘removal’ or a legal ‘disqualification’, it is important for shareholders to be informed of the
reasons behind any particular resignation. In Australia, shareholders and other stakeholders
will normally be informed through Australian Securities Exchange (ASX) processes or possibly,
in the case of financial institutions, by the Australian Prudential Regulation Authority (APRA).
Similar agencies exist in many jurisdictions.
The problem is that the real reasons for resignation are not usually known. Even if there is
good reason to believe that something is seriously wrong, resignation statements generally
indicate such reasons as ‘health’ or to ‘pursue other interests’. Corporate governance can be
greatly enhanced if directors who resign on a point of principle follow the Bosch Committee
recommendation and make their concerns known either to shareholders or to the relevant
regulator (Bosch 1995).
Removal
As with appointments of directors, in most jurisdictions a vote by shareholders at a general
meeting can also remove a director from office. Furthermore, in some countries, it may be
possible for the remaining directors to pass a resolution to remove a director, although there
usually needs to be just cause to do so.
Removal of a director of a public company in Australia before their term has expired can only be
by a shareholders’ vote at a general meeting. Under Australian law, any individual or group of
shareholders holding 5 per cent of the issued capital—or at least 100 small shareholders acting
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together—can call an extraordinary general meeting and seek to remove individual directors by
way of an ordinary resolution requiring support of 50 per cent of the votes cast. However, this can
be a difficult and costly exercise and should not be undertaken lightly. It is also significant in a
legal sense and local corporate regulators will usually require an explanation of such changes.
Such a vote commonly will require the support of larger institutional shareholders if it is to
be successful.
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The two-strikes rule provides that the entire board can be removed after a shareholder vote
‘to spill the board’. However, this spill vote can only occur after the eligible shareholders have
voted twice against the remuneration report. When voting on remuneration policies, not all
shareholders are permitted or eligible to vote. Those shareholders who hold key management
positions or are conflicted in some other way are not eligible to vote. When there is a large
number of ineligible shareholders (e.g. when the managers own a large proportion of the
shares), this gives the other shareholders significant power to reject the remuneration report
and potentially cause a spill of the whole board.
The first strike occurs where 25 per cent or more of the eligible shareholders vote ‘No’ on the
mandatory resolution by the board that shareholders accept the corporation’s remuneration
report (i.e. the remuneration report in the annual report).
Following the first strike, the company’s subsequent remuneration report (i.e. in the next annual
report) must explain the board’s action in response to the negative vote or, if no action was
taken, the board’s reason for inaction. The subsequent remuneration report must also disclose
all relevant information for the (second) year, just ended. The second strike occurs where once
again 25 per cent or more of eligible votes are ‘No’ in respect of the second year’s board
resolution to shareholders that the remuneration report be accepted.
Following the second strike, and at the same annual general meeting at which it occurs,
a resolution to ‘spill’ (i.e. remove the whole board) must be put to shareholders. Other than
the managing director, all directors who were on the board when it resolved for the second time
to put the remuneration report to shareholders must be subject to the spill vote.
The spill resolution is successful if a simple majority (i.e. 50% or more) of ‘eligible votes’ is in
favour of the spill at that time. This concept is extremely important, as no ‘key management
personnel’ (KMP) (or any of their related parties) are eligible to vote on either the remuneration
reports or the spill motion. Importantly, this generally gives independent shareholders larger
voting power proportions than usual, because the large numbers of shares often held by
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directors and executives (and their related parties) are not permitted to vote. Note that the
Corporations Act specifically uses the ‘KMP’ definition from AASB 124 Related Party Disclosures:
Key management personnel are those persons having authority and responsibility for planning,
directing and controlling the activities of the entity, directly or indirectly, including any director
(whether executive or otherwise) of that entity (AASB 2010, para. 9).
The shareholders’ meeting to elect a new board must take place within 90 days. At this meeting,
all shareholders are permitted to vote, as the board represents all shareholders including
KMP. The 90-day period allows for new persons to nominate for appointment to the board by
shareholders’ vote. Notably, the law provides that at least two of the old directors (other than the
managing director) are required to continue in order to ensure continuity of the board.
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This is an important new direction, but with this new power being given to shareholders in the
search for improved corporate governance, we must understand fully how its measures operate
and how it may be received. The newspaper report (Wen 2013) in Example 4.1 gives valuable
insight into how it has the potential to be misused.
Chairman David Trebeck and deputy Andrew Fletcher were both re-elected after receiving 78 per cent
of the vote at an extraordinary general meeting in Adelaide on Friday.
Both men had already created a bit of unwanted Australian corporate history, with the small Adelaide-
based chemicals manufacturer that has a market capitalisation of $10 million thrust into the spotlight
for being the first board to be spilled and forced to fight for re-election.
Shareholders rejected the company’s remuneration report for the second year in a row in October.
The ‘two-strikes’ rule was designed to deliver shareholders a greater say in the executive remuneration
policies of large corporates, particularly as pay packets bulged, often at odds with diminishing
shareholder returns.
But after the meeting on Friday, Mr Trebeck said the negative vote against the remuneration report
‘had more to do with general shareholder disaffection’—the company’s poor performance, a declining
share price and the absence of dividends—than it did with excessive executive pay.
‘Ideally, the two-strikes policy should be terminated,’ he said, adding that before the two-strikes rule,
shareholders who were disgruntled with the performance of the board could still muster enough
support to request an extraordinary general meeting and move against some or all directors.
Shareholder advocacy groups and large institutional funds have largely delivered positive feedback
on the ‘two-strikes’ regime, and the fact that company directors were now more open to shareholder
feedback.
Influential fund manager AMP Capital said earlier this month that it had experienced a ‘dramatic
increase’ in companies engaging with it, when previously concerns ‘fell on deaf ears’.
Source: Wen, P. 2013, ‘Penrice duo pass two-strike spill’, The Age, 26 January, accessed October 2015,
http://www.theage.com.au/business/penrice-duo-pass-twostrike-spill-20130125-2dca3.html.
➤➤Question 4.1
Explain the significance of the shareholder vote in the ‘two-strikes’ rule and the fact that at different
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points it includes 25 per cent and 50 per cent of ‘eligible votes’ and finally the participation of
all shareholders as a simple majority.
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Disqualification
Disqualification from managing corporations in any circumstances, either as a director
or as an officer, looks for the existence of some element of legally defined commercially
unacceptable behaviour or relevant defined legal wrongdoing. Specific ‘wrongs’ that may
lead to disqualification include:
• responsibility for defined civil wrongs as directors or other officers;
• financial market misconduct;
• responsibility for multiple insolvencies;
• significant dishonest actions and corporate crimes; and
• civil and criminal wrongs in relation to anti-competitive conduct in markets for goods
and services.
Disqualification may also occur because of an order of the court, where the misbehaviour of a
director or other senior officer is of a type that the courts are empowered to punish through
disqualification—with periods of disqualification often being as long as 20 years. The types
of misbehaviour leading to court-ordered disqualification involve various legislatively defined
‘civil wrongs’ including legislatively defined breaches that lead to civil penalties.
Ethics of disqualification
Offences relating to dishonesty will usually automatically disqualify a person from serving as
a director of a corporation. Automatic disqualification aims to act as a deterrent to would-be
offenders and helps protect the public from exposure to persons who may reoffend. It also
gives reassurance to markets and individual investors. It is useful to note that the rules regarding
disqualification relate to managing a corporation as a director and also managing a corporation
as a senior executive (or other ‘officer’), whether a director or not. Simply being a poorly
performing director, who is not in breach of a relevant law, will not result in disqualification—
so the importance of appointing capable people who can do the job is very important, as the
removal of poor appointees may simply not occur.
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When looking at the reasons for disqualification, it is possible that a person who has exercised
poor judgment on a number of occasions, leading to the insolvent failure of the corporation of
which they are a director, may be disqualified because of that poor judgment. In doing so, it is
arguable that the disqualification of the person from managing the corporation is not to act as a
deterrent to others or to punish unethical behaviour—rather it is to remove that person from the
commercial arena and, therefore, prevent further harm. Inherent in the word ‘failure’ (i.e. of the
corporation of which the person was a director or officer) is the financial harm caused to creditors
of the corporation. To some extent, there does appear to be measurable overlap between the
law and underlying ethical precepts. Arguably, a person who allows multiple insolvencies to occur
really is not behaving ‘properly’ in a corporate context.
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➤➤Question 4.2
From the perspective of the disqualified person, what is the effect of being disqualified and
what is the key difference between disqualification that is ordered by the courts (or by ASIC in
Australia) and a disqualification that is automatic?
In recognition of a lack of gender diversity in Australian boardrooms and at the request of the
Australian Government, the Corporations and Markets Advisory Committee (CAMAC 2009)
reported on Diversity on Boards of Directors. Following the CAMAC report, the ASX Principles
were amended in 2010 to promote greater diversity, particularly gender diversity, among the
employees and boards of ASX-listed companies (ASX CGC 2010). The recommendations on
diversity in the ASX Principles aim to address the major challenge of balancing gender on boards,
since there are currently far fewer women than men who can progress to board level in the upper
levels or echelons of organisations. The Australian Census of Women in Leadership (WGEA 2012)
indicated that the number of women on ASX 200 boards was only 12.3 per cent, with even fewer
women in executive ranks. Since then, a considerable effort has been made to increase the
participation of women in leadership by the ASX, the Australian Institute of Company Directors
(AICD) and other bodies, with a marked improvement to 20 per cent. However, though targets
have been set in major Australian corporations, in European countries that have adopted
mandatory quotas, 40 per cent of board members of large corporations are now women.
The approach in Australia is similar to that of the United Kingdom, where the FRC Code,
most recently amended in September 2012 (FRC 2014), includes, among other things,
a recommendation that companies apply a formal, rigorous and transparent procedure
when appointing new directors to the board, with due regard to the benefits of diversity,
including gender. Indeed, many countries are now including recommendations that boards
establish policies on the board’s approach to achieving diversity. For example, the Malaysian
Code on Corporate Governance (Securities Commission Malaysia 2012) suggests that boards
should disclose their gender diversity policies and targets in their annual reports.
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It is important to note that many criticise mandatory percentages or quotas because they may
create token directors. Furthermore, critics argue that mandatory approaches result in board
appointment regardless of capability. They argue that the ‘too early’ placement of women
onto boards instead of into important senior executive positions may possibly create a group
of women who are directors to the exclusion of other women (i.e. a parallel of the much-
criticised ‘old boys clubs’ of male directors). These are defensive responses to the challenge
of introducing greater diversity, and a more positive approach is to be proactive. In Australia,
leading corporations are voluntarily committing to achieving significantly greater participation
of women on boards, and backing this up with commitments to also increase the participation
of women in senior executive ranks. Creating greater gender balance in management is
a sign of the preparedness on the part of companies to utilise all of their potential talent
(Klettner & Clarke et al. 2015).
The importance of improving the gender balance of boards is backed by research. For example,
research by Credit Suisse found that over a six-year period, ‘companies with at least some female
board representation outperformed those with no women on the board in terms of share price
performance’ (Credit Suisse 2012).
While the number of women with experience at board level in large corporations in Australia
and elsewhere is still relatively limited, non-executive directors can be drawn from a much wider
pool, including the public sector and not-for-profit organisations. In this regard, recruitment
agencies have a role to play, by widening the pool of potential candidates they look at and
thereby increasing the number of women candidates put forward. Boards themselves can have a
fundamental impact by advocating and supporting appropriate mentoring schemes for women
in their organisations.
Further, the diversity debate should not be confined to women. A case can also be made to
include more people from different backgrounds and of varying ages on boards. Aside from
the inequities involved in excluding women from boards, whether done consciously or not,
the UK’s FRC, in guidance published to accompany its corporate governance code, stresses the
importance of diversity at the board level:
It is important to consider a diversity of personal attributes among board candidates, including:
intellect, critical assessment and judgement, courage, openness, honesty and tact; and the ability
to listen, forge relationships and develop trust. Diversity of psychological type, background and
gender is important to ensure that a board is not composed solely of like-minded individuals.
A board requires directors who have the intellectual capability to suggest change to a proposed
strategy, and to promulgate alternatives (FRC 2011, p. 10).
Adopting diversity
Adopting diversity is not just a matter of rules and targets. It is necessary to create an environment
where diversity becomes part of the culture of good corporate governance generally. This can
result in long-term high performance of the organisation and a contribution to the capabilities of
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The National Australia Bank (NAB) is an example of an ‘early adopter’ of diversity in the
boardroom and at management levels (consistent with the ASX Principles). As stated on its
website, ‘NAB believes that investing in its employees is crucial to building a sustainable
business’ (NAB 2013). Diversity improvements take time to effect actual changes. As at August
2015, NAB’s board of 10 directors included two female members and the bank’s senior executive
group also included three female executives of the total of 10. The impact of adopted diversity
policies may be slow, but progress is being made in many organisations. NAB’s formal adoption
and implementation of relevant policies will no doubt see greater female involvement at
board and senior executive levels in future years. One of the more vital campaigns is that
of the 30percentclub.org, which is an industry-led body looking for a rapid increase in the
United Kingdom, Australia and other countries to 30 per cent female participation on boards.
Study guide | 285
An AICD report (2010) quotes the set of detailed diversity approaches being implemented at
NAB. These approaches provide a valuable platform for considering at least some of the issues
of making diversity an effective part of good corporate governance within the organisation.
They also will equip a more diverse array of people to contribute as part of society generally,
as a large corporation such as NAB would expect many employees to move to other corporations
in their working lives.
The key points of NAB’s diversity approach identified by the AICD (2010) are:
• career development and mentoring programs specifically designed to support women
progress their careers;
• an initiative to prevent parental leave disconnection, which keeps employees in touch while
on parental leave;
• recruitment practices that ensures a mix of males and females are short-listed for each role,
and that both males and females make hiring decisions together;
• positive recruitment targeting women looking to join the financial services industry;
• remuneration fairness; and
• age, disability and other diversity initiatives such as addressing employment opportunities
for Indigenous Australians, job sharing, telecommuting and supporting mature age workers
(AICD 2010).
Subsequently, in a path-breaking report, the Business Council of Australia (the lead body for
large Australian corporations) committed to a policy to increase the number of women in senior
executive positions to 50 per cent within 10 years (BCA 2013). To assist member companies
in achieving this goal, the BCA commissioned a report on best practices for recruitment,
selection and retention.
In considering diversity and its implementation, it is important to reiterate that policies are
actually ‘set’ by boards working in conjunction with managers. Good policies are always
crucial for good corporate governance. Ensuring the right people are contributing within an
organisation and that the right people are chosen as managers and directors is crucial for good
corporate governance.
executives to take risks to create profits, leading to the appearance of solid financial performance
by their organisations. Some boards and executives took higher risks when their remuneration
was based upon short-term financial performance, effectively acting for personal gain.
Debate has now turned to whether payments effectively achieve future performance, and how
they relate to incentive and motivation. The pressure to link performance and pay has seen some
jurisdictions mandate the disclosure of executive remuneration to shareholders and the wider
community, described as ‘having a say on pay’ in countries such as Australia, the United Kingdom
and the United States. More recently, recommendations for boards to institute ‘clawback’ policies
to recoup excessive performance-based remuneration have featured in best-practice guidance.
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As this discussion shows, the debate on executive remuneration is complex; this is further
demonstrated by the subject occupying almost 500 pages in the Productivity Commission’s
2009 report on executive remuneration in Australia, which has influenced legislative changes
in Australia. A speech delivered in 2012 by Jan du Plessis, chairman of Rio Tinto, revealed that
corporations are beginning to recognise the need to curb remuneration excess. He stated that
the ‘spiral’ in executive pay in the past two decades ‘simply cannot continue … Many businesses
sometimes appear to have lost all touch with reality’ (du Plessis 2012, quoted in Maiden 2012).
Example 4.2 further illustrates that the perceptions of shareholders, employees and the
community with respect to excessive executive remuneration are having an effect.
CBA, which reported a $7.8 billion profit last week, had the freeze on salary increases in place throughout
the 2013 financial year, but will not continue it into 2014.
Despite ending the salary pause, CBA chief Ian Narev has sought to play down expectations of big
pay increases.
‘The specific freeze, we haven’t said that we are going to roll that over, but we have said to everybody
starting with me that we are going to be very, very moderate in the way that we think about any
remuneration. And those decisions for this year are just starting to be made now,’ Mr Narev said.
‘We are keeping a very strong look on year-on-year remuneration increases, that has always got to
start with me and my executive team.
‘We are not saying anything publicly about exactly what the numbers on remuneration increases are
but we are keeping them very much in tune with the environment.’
CBA’s pay freeze applied to the bank’s top 400 managers, including Mr Narev and his senior executive
team.
However, it only covered fixed salaries and not performance-based incentive bonuses, which are
linked to meeting targets for profits, share price performance, customer satisfaction and other factors.
CBA’s shares are trading at near-record highs following its bumper profit result last week, while it is
ranked number one for customer satisfaction among the big four banks for both retail and business
customers.
The bank will disclose the pay of senior executives for 2013—including bonuses—in its annual report
this week.
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‘In an environment where customer satisfaction is good, shareholders are happy, people engagement
is good and we have managed risk well, the executives tend to do pretty well, that’s what short-term
incentives are all about. But again, overall in terms of remuneration, we have to make sure we cut our
cloth to suit the times,’ Mr Narev said.
Source: Liondis, G. 2013, ‘Narev signals end to CBA’s pay freeze’, The Australian Financial Review,
19 August, accessed October 2015, http://www.afr.com.
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For example, a report on this issue in the Economic Times (Goyal 2012) comments on the
need for Indian corporations to remunerate top executives on a global scale so that Indian
corporations can succeed (perform) at international levels. We assume that new Indian graduates
earn relatively low levels of pay consistent with national pay levels in India. Perhaps this results in
the very high multiple seen in India (Table 4.1), which indicates that a CEO’s compensation is on
average 675 times that of the minimum wage earned by entry-level graduates. Whatever the
reason, it emphasises that executive salaries are indeed the subject of strong social and
political commentary.
Table 4.1: Wage gap between CEOs and entry level graduates (multiples)
EU Zone 142
Australia 197
China 268
UK 270
Canada 295
US 423
India 675
Source: Adapted from Goyal, M. 2012, ‘Why India Inc’s CEOs are overpaid and will it change’,
The Economic Times, 1 July, accessed October 2015, http://articles.economictimes.indiatimes.com/
2012-07-01/news/32484860_1_global-executives-global-talent-inequality.
It is interesting to note that this set of data shows that in the eurozone, the CEO remuneration
package is 142 times that of a new graduate, and for Australia it is 197 times—which seem
relatively moderate when compared to the US figures. However, even in Europe, remuneration
is a topic of debate. For example, on 14 June 2013, the Swiss Federal Council (the executive
branch of the Swiss federal government) submitted for public consultation a draft ordinance
on ‘say‑on‑pay’ and excessive executive remuneration. The new rules aim to limit excessive
remuneration practices and boost shareholders’ roles and responsibilities regarding
remuneration matters. Bypassing this legislative approach, French corporations agreed to a
new code that includes a vote on executive remuneration for shareholders at annual general
meetings, similar to current practice in the United Kingdom and United States (Carnegy 2013).
While not legally binding, in the case of a negative vote, the board would have to consult its
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remuneration committee and make public the action it intends to take in response. As discussed
earlier, the two-strike rule is exerting pressure on boards to ensure executive remuneration is
linked to performance and supported by shareholders. A further brake on executive reward
introduced recently in the United States is an SEC requirement for companies to disclose the
ratio of CEO pay to ordinary workers in their company (SEC 2015). This pay ratio disclosure
highlights the frequent disparity between rapidly inflating CEO pay and average wages,
which have remained fairly static in most US corporations for many years.
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The question, only very slowly being answered, is how far corporations can increase salaries
without creating community reactions that hurt themselves and shareholder wealth. The surge
in procedures designed to empower shareholders to control executive salaries and specific
responses by governments indicate that there is a limit—albeit a limit hard to state with
any precision.
Non-executive directors
Good practice guidance, such as the ASX Principles, recommend that non-executive directors
should not be remunerated according to performance achieved or to be achieved, except
to the extent that they hold shares in the company and benefit from a rising share price.
Their remuneration should be based primarily on a reasonable return for time dedicated to the
corporation’s business. They should not receive incentive-based payments and should receive
only basic additional payments (such as superannuation at reasonable levels and out-of-pocket
expenses). The payment of non-executive directors is best undertaken by deliberation of the
entire board. Their overall remuneration packages should be fully known and understood by
shareholders so that they understand how non-executive directors are remunerated and also so
that any shareholder approvals are fully informed. While current Australian law gives shareholders
limited influence over the amount of cash paid to executives or employees, the overall pool of
cash paid to the non-executive directors as a whole requires specific shareholder approval.
The reason for the different pay arrangements for non-executive directors and executives is
simple—performance-based remuneration is not consistent with an independent approach to
decision-making and it is necessary that all non-executive directors (even those otherwise not
independent) are not subject to remuneration types that lessen or deny independence.
should be on the remuneration committee. In Australia, the ASX Principles permit executives to
be on the remuneration committee, but the Principle 8 commentary states that ‘no individual
director or senior executive should be involved in deciding his or her own remuneration’
(ASX CGC 2014, p. 31).
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Performance-based remuneration
Payments to economic agents (in this case, executive directors and other managers—sometimes
also including other ‘incentivised’ employees) typically consist of ‘fixed’ and ‘at-risk’ remuneration
components. The fixed portion represents a base payment that is constant regardless of
individual and/or corporation performance, such as flat annual salaries and superannuation
(i.e. retirement fund contributions). The at-risk portion (i.e. failure to perform means that the
recipient will suffer reduced or non-payment) is based on the agent and/or entity reaching certain
goals and performance benchmarks (both short- and long-term). These benchmarks are often
called key performance indicators (KPIs). In Australia, short-term incentive payments tend to be
paid annually and they are more likely to be cash based, whereas long-term incentives are based
over three to four years of performance and have a greater focus on shares or options.
Performance payments should not just be a reward for past superior performance but should
be designed to motivate senior managers’ future performance. This motivation needs careful
consideration because, recognising the nature of agency theory, it is vital that the remuneration
structure appropriately build on the self-interest of the manager(s). A good remuneration system
will promote goal congruence between the managers, the board and the shareholders, and will
help avoid the worst aspects of agency costs. Therefore, ideally KPIs should not refer only to past
performance but also to motivate and enhance future performance. For example, share-based
awards may be granted to certain executives for good past performance, but may also include
future performance conditions (including service conditions) that must be satisfied before the
executive becomes unconditionally entitled to the share-based award.
An area of recent strong attention relates to payments made upon early resignation from
executive responsibilities. Boards and their remuneration committees need to take great care
to ensure that payments made when executive directors and other senior executives retire or
resign are in fact relevant to performance and that the concerns of shareholders and society
generally are understood and addressed.
This concept is consistent with a rule in the US Sarbanes–Oxley Act 2002. It is also seen in the
current ASX Principles, in the discourse statement regarding remunerations, that the report
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should ‘include a summary of the entity’s policies and practices regarding the deferral of
performance-based remuneration and the reduction, cancellation or clawback of performance-
based remuneration in the event of serious misconduct or a material misstatement in the entity’s
financial statements’ (ASX CGC 2014, p. 33).
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Best practice corporate governance requires that there should be transparency in setting
directors’ remuneration. A key governance principle is that no individual should be involved in
setting or determining their own remuneration levels. This can become difficult when setting
the chairman’s fee, although at least Australian shareholders must approve the overall fee cap
available to the non-executive directors. To enhance the transparency of the remuneration-
setting process, as we have already discussed, internationally, laws now require a remuneration
report to be included within the annual directors’ report to shareholders.
In the United States, the Securities and Exchange Commission (SEC) amended its rules in
December 2006. It required that executive remuneration be accompanied by a detailed
explanation of the rationale for that remuneration, to strengthen the communication with
shareholders on remuneration issues. The Dodd–Frank Act (US), effective from January 2011,
has given shareholders a non-binding vote on top executive compensation.
In the United Kingdom too, investors are better informed about how much directors have been
and will be paid, along with how pay relates to corporate performance. As a result, shareholders of
the approximately 900 Main Market companies (i.e. larger, more established corporations listed on
the London Stock Exchange) will be better prepared to hold companies to account, using clearer
information on pay to exercise their new legally binding vote on executive pay (BIS 2013).
Not everyone agrees with the strong emphasis on disclosure and reporting, as wide disclosure
may not always lead to the expected benefits. Some commentators argue that an increase in
remuneration disclosure has led to higher and, indeed, excessive levels of remuneration being
paid to executives and some directors. The argument is based on the premise that remuneration
committees do not wish to be seen to be paying less-than-average market remuneration.
Therefore, as corporations seek to set their remuneration levels slightly above the average,
this leads to higher payments across the market incrementally over time. If we accept these
concerns as real, then it becomes apparent that the growing strength of direct shareholder voting
(as in the Australian two-strikes rule) is an important factor in controlling possible ‘reporting-
induced’ salary growth.
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One legislative response to excessive remuneration that has proved successful is the noticeably
reduced size of so-called ‘golden handshakes’. In 2009, the law was changed so that any
termination payment exceeding more than 100 per cent of the executive’s 12-month fixed pay
would need shareholder approval. Previously, the limit was seven times the average total pay of
an executive over their final three years of employment. This earlier ‘seven times’ rule allowed
Oz Minerals to correctly pay its departing CEO AUD 8.35 million in 2008. It is interesting to note
that an earlier proposal to pay the CEO AUD 10.7 million at his departure had been voted down
by shareholders (Leyden 2008). Note that this larger amount was subject to a shareholder vote as
it exceeded the payment that could, at that time, be made without shareholder approval.
A broad-ranging report into executive remuneration in Australia was completed by the Australian
Government Corporations and Markets Advisory Committee (CAMAC 2011). This inquired into
aligning executive remuneration with company performance, and examined how the incentive
components of executive pay arrangements could be simplified in order to improve transparency
and strengthen the correlation between the interests of the company’s executives and the
interests of shareholders.
This matter has also been addressed in the banking and finance sector internationally by
the Financial Stability Board (FSB), which was established under the auspices of the G20
nations. The FSB publishes a range of documents, including internationally recommended
implementation standards that relate to its ‘Principles for sound compensation practices’
(FSB 2009; note that in US terminology, ‘compensation’ is the equivalent of ‘remuneration’).
These standards reflect the types of approaches we are considering at present but with a
significant addition—the concept that within financial sector institutions, it is important for
boards and management to identify persons who are ‘material risk-takers’ and to enact special
procedures in relation to remuneration for these people.
Reward structures should be designed so that self-seeking executives cannot damage corporations
by seeking early reward with high-risk deals that have dubious long-term consequences. MODULE 4
Public examples
A criticism of many organisations is that, despite poor performance during and after the
GFC, remuneration levels for executives were often unaffected. Bonuses paid to executives
of organisations who were performing very poorly led to public anger and frustration.
Many executives who experienced a remuneration decline were even able to renegotiate
their contracts to ensure they did not suffer as badly. Headlines at the time were scathing and
highly personal.
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It is hardly surprising therefore that, internationally, there was a flurry of regulatory changes.
The following examples provide further insight in this area. BHP Billiton is an example of a
corporation that arguably is fully in touch with modern regulatory good corporate governance.
Note its emphasis on clearly defined KPIs (including non-financial) that link to shareholder value.
Also, note the fact that it clearly defines that ‘severance payments’ should not result in unjustified
payments. First, we look at some headlines and discussion.
1. John Chambers
Company: Cisco Systems
Total compensation: $18 871 875
Change in stock price: –31.4% (FYE: 7/30/2011)
Cisco (NASDAQ: CSCO) was once considered the most well-run large company in Silicon Valley.
That has changed in the last year as it has become clear that Chambers, a dean of Valley CEOs,
diversified that company too far beyond its core router business. Margins in the new set-top box, WiFi,
and video conference businesses do not match those of routers. Chambers has begun a retreat from his
M&A [Mergers & Acquisitions] strategy, trying to refocus the company. He has had only limited success
so far. Cisco has also announced that its rapid growth will slow considerably in the next two years.
Source: McIntyre, D. A. 2011, ‘America’s most overpaid CEOs’, 24/7 Wall Street, 20 October, accessed
October 2015, http://247wallst.com/2011/10/20/america%E2%80%99s-most-overpaid-ceos/3.
The example above identifies the CEO of Cisco as the most overpaid CEO in terms of
remuneration (compared with stock performance).
Cisco agreed to pay USD 5 billion for controversial News Corp subsidiary NDS in early 2012
and its market capitalisation recovered to above USD 100 billion in August 2012. There are
many examples in the press illustrating the nature of the problem. Commonly, the reports are
accompanied by highly emotive language that illustrates the feelings held by many where
‘corporate excesses’ are represented. These excesses are most commonly represented by
excessive remuneration and that is where the most attention arises. Interestingly, other issues can
be of concern too—including the extent to which some executives and directors seem to seek
power and/or self-publicity—although controls on these additional excesses are as yet few.
In determining the policy, the Committee will take into account all factors which it deems
necessary. The objectives of the policy will be to:
• support the execution of the Group’s business strategy in accordance with a risk framework
that is appropriate for the organisation;
• provide competitive rewards to attract, motivate and retain highly skilled executives
willing to work around the world;
• apply demanding key performance indicators including financial and non-financial
measures of performance;
• link a large component of pay … to the creation of value for the Group’s shareholders …;
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• ensure remuneration arrangements are equitable and facilitate the deployment of human
resources around the Group; and
• limit severance payments on termination to pre-established contractual arrangements
that do not commit the Group to making unjustified payments in the event of non-
performance (BHP Billiton 2013).
➤➤Question 4.3
A publicly listed corporation’s remuneration committee is interested in the forms of remuneration
that can be offered to management to motivate them to maximise value for the shareholders.
(a) In the context of remuneration (and related agency issues), what are the benefits to be
obtained by the appointment of independent directors?
(b) To which performance measures could different forms of remuneration be linked?
(c) How can shareholders be confident that managers are paid appropriately?
Operational issues
A board is responsible for ensuring that appropriate policies are set for its activities. It is the
responsibility of management to implement these policies on behalf of the board and the
shareholders and, as observed in Module 3, management will assist in developing policies
that are ‘set’ by the board. It is not possible to look at every one of the operational areas
where policies are important. Here, we consider some matters not dealt with at length in this,
or other, subjects—beginning with a general comment on employees. We then briefly discuss
occupational health and safety, pay and working conditions, and family and leave entitlements.
Another important area of development in recent years affecting employees (and others) has
been ‘whistleblower’ protection. We consider whistleblower protection in greater detail later in
this module.
Employees generally
Employees are central stakeholders in any organisation. For good governance, it is crucial that
policies are in place to ensure that appropriate relationships exist between the corporation as
employer and every employee. We should not forget that executives are also employees.
The crucial understanding that we must appreciate is that boards cannot simply leave all the
responsibility to management. Boards have a duty to be aware of the issues and to be sure that
these issues are being appropriately addressed within the organisation, according to policies
that are set at board level and are consistent with legal obligations and community standards.
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For example, laws recognising the importance of employees as stakeholders (e.g. in the EU
and Australia) make it even more important for corporations advertising employment positions
to get it right. It is significant that the protections effectively apply to the whole community,
as they apply not only to existing employees but to every potential employee. The Australian
Consumer Law (Schedule 2 of the Competition and Consumer Act 2010 (Cwlth) (Competition
and Consumer Act) creates the Australian version of this new type of ‘employee’ protection.
Clearly, directors and managers of corporations need to comply with (or exceed) the
requirements of the law in the way they treat the whole pool of potential employees—
and contractors’ employees. If they do not, they will damage both the corporation’s value
and the shareholders’ interests.
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From a corporate governance perspective, a common national approach makes it easier for
boards to set appropriate policies and for management to implement policies.
It is to be expected that large corporations, wherever they operate, should pay attention to
employees as stakeholders.
Both boards and managers must ensure that employees are paid appropriately, which will
engender efficiency and loyalty to the business. It may be wise to identify some additional reward
payments relative to superior performance. As with executive payments, performance-based
payments need to be carefully considered and have an emphasis on motivation rather than just
reward for past performance.
This aspect, as part of the performance component of corporate governance, is also looked at in
some detail in the subject Strategic Management Accounting.
are designed to ensure that employees are adequately funded into retirement.
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Different jurisdictions prescribe different amounts of leave. In the United States, two weeks of
annual leave is common (but is not a legal requirement). In Australia and the United Kingdom,
four weeks of leave is the standard legal minimum. In Singapore, however, leave entitlement
is on a sliding scale, with the maximum 14 days’ leave applying only after eight years’ service.
Additionally, in most jurisdictions, employees receive an amount of legislated public leave.
Full‑time employees are paid at normal rates of pay for prescribed leave.
Some business owners resent such impositions, but it is important to be aware that corporate
governance standards express society’s wishes and expectations and these cannot be
ignored because society at large is a crucial stakeholder to which corporations must pay
appropriate attention.
We should also note that, just as employers have ethical obligations to employees, so do
employees towards employers. Employees have the obligation of loyalty that carries with
it such concepts as regular attendance, confidentiality of employers’ secrets and intangible
property, care of employers’ tangible property, and respect of fellow workers and their rights.
As indicated earlier, it is also apparent that employers must be aware of how their contractors
treat their employees.
A well-designed code of conduct, being a corporate policy that gives full and proper attention
to employees, is an important corporate governance component. It should state the rights
of employees and what is expected of employees. Modern codes of conduct also state
requirements imposed on contractors so that contractors treat their employees correctly.
As with all policies, the code of conduct needs to be carefully prepared, communicated fully
to those it is designed to affect and carefully updated as times and expectations change.
The OECD Principles of Corporate Governance (OECD 2004) state that governments should make
laws that protect stakeholders (including employees). They also state that business and other
organisations should be aware of the rights of stakeholders and act accordingly. Example 4.6
seeks to show why the OECD Principles are important and how they can lift standards.
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Example 4.6: O
ECD Principles can create improved
employment standards
When a large international corporation is establishing operations in a developing economy, it commonly
has specific direct obligations to workers imposed on it by the local government, as part of its right
to operate.
These direct obligations may include basic health care, basic working conditions and basic rates of
pay. These direct stakeholder obligations are imposed for two reasons:
1. To protect the workers of the corporation from exploitation. Ensuring proper payment not only
means that the corporation pays its workers properly but also ensures a greater overall return to
the developing economy.
2. To provide a leadership model as the country develops. Over time, and with more development,
this will become a model more widely followed to the long-term benefit of the entire population.
Creating this type of development outcome from international business is a key objective of the
OECD Principles. It is regarded as an inevitable outcome of good corporate governance. That is why
the OECD Principles begin as recommendations to governments (even though they can be, and are,
used by many others as valuable guiding principles).
Almost all of the manufacturing and assembly of Apple products occurs with contractors in overseas
countries, including 352 plants in China. There are recurrent reports of poor employment practices and
health and safety issues arising in the plants in China, which are operated by the contractor Foxconn.
With frequent press reports, Apple is aware of the scale of this problem and has attempted to deal
with it with an extensive series of supplier responsibility audits that are published each year. However,
these audits reveal that although there have been marginal improvements in recent years in the plants,
there remain fundamental problems such as excessive working hours at the times of new product
launches. While there has not been any consumer campaign against Apple as there was against Nike
in similar circumstances, it does appear the company could do more to resolve these issues.
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Source: Adapted from Clarke, T. & Boersma, M. 2015, ‘The governance of global value chains:
Unresolved human rights, environmental and ethical dilemmas in the Apple supply chain’,
Journal of Business Ethics, July 2015.
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Source: Royal Commission on the Pike River Coal Mine Tragedy 2012, Report of the Royal Commission
on the Pike River Coal Mine Tragedy, vol. 1, p. 3; vol. 2, part 2, p. 324, accessed October 2015,
http://pikeriver.royalcommission.govt.nz/Final-Report.
Clearly, one of the major effects of poor employee relations is loss of the corporation’s reputation
and, with an increasingly vigilant media, loss of brand value, share value and the threat of greater
attention from regulators. You will also observe the ability of the law to ‘strike at the agents’—and
this is appropriate because, as observed in Module 3 and using Lord Denning’s words, they are
the ‘directing mind and will’ of the corporation.
These standards and their related rules have become very important in recent years, with a new
focus on audit and audit committees, especially as part of international corporate governance
reforms. These reforms have in fact been under development for a long time. The major
impact of the GFC and the consequent turmoil in the banking sector internationally prompted
further emphasis on the need for changes, which are ongoing. Boards and management in all
corporations must understand the existing rules at any time and also the changes as they occur.
It is noted that internal auditors are also important but they are very different and are not
discussed further in this module as they do not have, and cannot have, the same recognised
actual independence. This lack of independence comes from working as employees within the
company and under the authority of senior management. Boards must realise that this lack of
independence exists and be aware of the potential pressures faced by internal auditors from
other employees and management that may affect their independence. Boards should therefore
consider the measures that can be taken to give the internal audit function some degree of
independence from management.
Note that various audits, including internal audit, are covered in detail in the Advanced Audit and
Assurance subject.
The international auditing standards state that the external auditor (referred to as the
‘practitioner’ in the auditing standards) of general purpose financial statements (annual and
other reports) is required to express an opinion, resulting from a professionally formed judgment,
whether the reports and related information are drawn up in accordance with an identified
financial reporting framework. The reports themselves are prepared by the ‘responsible party’
(the board and senior management, based on proper operations within the corporation,
including the correct operation of the entire accounting system).
The auditor’s report is most importantly addressed to the ‘intended users’—among whom will
be the shareholders and other users that, in the auditor’s professional judgment, objectively
are relevant. The preparation of the reports and the auditing of the reports are both required
to comply with a relevant framework—most commonly IFRS. The company prepares its systems
and accounts so that the information is compliant with the accounting standards.
The auditor then checks the systems and the information that results to ensure that the
accounting standards compliance required has in fact been achieved. Once this is completed,
the auditor will give a statement of their professional-judgment–based opinion, upon which
intended users are entitled to rely. The auditor can be liable for not identifying failures in
the information in the reports. This is why auditors can be liable where materially misleading
MODULE 4
information results in, for example, loss to shareholders. Even so, the fundamental liability for
materially incorrect information being in the reports is that of the board and management.
Beyond this, the board must understand the importance of auditor independence. For example,
when the Enron failure occurred, one of the biggest issues related to the fact that the corporation’s
auditor, Arthur Andersen, counted Enron among its largest clients, billing Enron USD 52 million for
audit (USD 25 million) and non-audit services (USD 27 million) in 2000 (Permanent Subcommittee
2002). The auditing standards now impose obligations on auditors to identify a threat to
independence where fees from one client are unduly large. If a board (or management) seeks to
control or influence auditors in a material way (in the auditor’s judgment), this must be reported—
including in the auditor’s statement in the annual report. Some jurisdictions also require notification
to local corporate regulators.
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The auditing standards require that auditors identify ‘those charged with governance’ within the
organisation. This group should comprise those with whom the auditor communicates on matters
relating to the audit and reporting. Ideally the group would comprise a correctly structured audit
committee that includes only non-executive directors. In some jurisdictions, the non-executive
directors must in fact fully satisfy the independence rules, while in other jurisdictions, a majority
should be independent and the remainder, while still non-executive, may be non-independent.
Since the auditor is auditing executives, such as the chief financial officer and the CEO,
the auditor should not report to these people. To do so would be contrary to the required
independence. The board (and senior management generally) must be aware of these general
rules and that the rules will be enforced by local legislation. Commonly the accounting standards
and the auditing standards are enforced as part of the local laws.
The Centro case (Harper 2012), discussed in Example 4.9, might be thought to involve
relevant principles. This case was discussed in Module 3 and is revisited here to illustrate other
connected issues. Centro, like all similar cases, emphasises the importance of basic good
corporate governance including the need for clear understandings and good policies regarding
disclosure, auditing and related regulations.
Source: Harper, J. 2012, ‘PwC, Centro pitch in for investor losses’, Herald Sun, 11 May, accessed August
2014, http://www.heraldsun.com.au/ipad/pwc-centro-pitch-in-for-investor-losses/
story-fn6bn4mv-1226352454792.
MODULE 4
➤➤Question 4.4
What are some measures the board can undertake to enhance the likelihood of auditor
independence being achieved?
(Note that the auditor has a responsibility to make a statement of independence to ‘those charged
with governance’ for inclusion in the corporation’s reports. Essentially, this question pertains to
the types of measures that can, and should, occur within the corporation to enhance auditor
independence rather than just relying on the auditor’s statement.)
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Our discussion of laws primarily will refer to Anglo-American type common law and corporate
systems as seen in ‘common law’ jurisdictions (e.g. South Africa, Singapore, US, Hong Kong, UK,
Bermuda, Australia, New Zealand, India). In each of these places, modern complex laws are the
result of extensive parliamentary deliberation leading to fairly precise legislative form.
In these common law countries, the courts review these precise legislative forms and, where
appropriate, make interpretive decisions that give additional, and sometimes new, meaning to
the legislation. In these countries, if legislation does not cover a matter, the courts may also make
appropriate law relevant to the circumstances of the particular matter being litigated.
If a matter is not litigated, the relevant law will not be interpreted. Sometimes, court interpretations
are considered very good and may be left untouched by the government—or perhaps the
legislature will write laws restating court decisions in formal laws to be passed by the parliament.
Sometimes the government will not agree with the courts’ approach and will write laws to overturn
the courts’ decision. In either case, parliament may pass more laws seeking further precision so
that the laws are more clearly stated in the legislation and therefore lead to more predictable court
(and community) interpretations. Good laws should achieve good outcomes and should do so
reliably. Very importantly, laws should give predictable outcomes.
Under the Anglo-American system, some of the most important laws that underlie corporate life
include general community-wide laws on:
• the rights of individuals such as employees (as we have already considered);
• contracts;
• negligence;
• property; and
• ownership rights.
These laws all began, at least to some extent, through the common law decisions of the courts
and today have become highly refined as they are subject to additional legislative responses.
MODULE 4
Clearly, it is not possible within this module to provide any detailed analysis of laws in general.
We must note, however, that good corporate governance and the effective operation of
business need these laws to be reliable, predictable and commonly understood. Furthermore,
for any commercial framework to be fundamentally successful in the long term, it is vital that
all participants within the framework can protect their rights and seek redress for any wrongs.
Therefore, a strong and reliable court system is a vital part of the overall corporate governance
framework. We will observe, for example, a very strong demonstration of laws as a part of the
corporate governance framework when we consider the ability of whistleblowers to be protected
by legislation and through the court system.
Corporations must respect the law, understand it and ‘play within the rules’. The legal system is
enormously important as it enables the very existence of corporations and provides the rules and
regulations under which corporations will succeed. Understanding these rules and ensuring that
boards and management have the appropriate awareness and access to detailed knowledge,
when required, are key requirements in building good corporate governance practices.
As always, boards must ensure that appropriate policies are in place to deal with every issue
that is, or may be, material to the interests of the corporation.
We begin our discussion by looking at the way that laws can be regarded as criminal or civil
in nature and the types of consequences that may arise. We look at how those who are ‘in the
wrong’ may be made liable to fix things by compensating those who have been hurt and also at
how measures may exist that are designed to punish and/or prevent continuing unacceptable
conduct. These are matters that boards and management must understand and where caution
must be exercised. If matters are not dealt with correctly, the costs to corporations can be
very high—and in some cases, the individuals involved can be imprisoned and/or face harsh
financial penalties.
A criminal is a person who has been found guilty after being charged with a crime (also called a
‘criminal offence’ or just an ‘offence’). The concept of ‘crime’ has been in existence for centuries.
Crimes such as murder and theft have always carried common law crime status. Criminal cases
are always carried out by agencies of the state and never by individuals or corporations.
Traditionally, in common law countries (which almost always includes those Anglo-American
company law traditions), crimes require the person charged to be subject to a court trial in
which the ‘prosecutor’ has the duty to establish facts proving ‘beyond reasonable doubt’ that
the crime was committed. This includes establishing that the person accused of the crime
had the necessary ‘criminal intent’. If all of this cannot be proved beyond reasonable doubt,
the person will go free. While systems in countries that do not have a common law tradition vary,
the essential nature of crime is the same, with the outcomes of fines and jail after prosecution
being standard.
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In recent decades, there has been a tendency to introduce new crimes in various pieces of
legislation. Laws made this way can reflect whatever the parliament making the law may wish
(e.g. it may lessen the need to prove criminal intent).
Criminal sanctions can take many forms, but most commonly will be in the form of fines and/
or jail sentences. In the United States, competition laws are usually described as anti-trust laws,
and breaches of these laws may be punished by jail sentences of up to 10 years along with
fines. Similarly, in Australia, there are now criminal penalties for ‘cartel conduct’. Australia also
provides penalties of up to 10 years’ jail for individuals (including officers of corporations) and,
under somewhat complex rules about fines, maximum penalties for corporations of up to
AUD 10 million or as much as 10 per cent of group turnover.
It is also common in legislation for other outcomes to be relevant so that criminal actions result
in compensation or damages being payable to those who have been adversely affected by the
crimes. This occurs when the prosecutor requests consideration be given by the court to those
who have been harmed.
An interesting aspect of some legislative schemes is where a criminal prosecution would be hard
to start (e.g. if ‘proof beyond reasonable doubt’ would be very hard to establish) or, once started,
it fails. In these instances, it is possible either to bring a civil action instead, or to do so after the
criminal action has failed. A civil action cannot be commenced after a successful criminal action.
This is because the successful case would have already been proved beyond reasonable doubt
and the level of proof (balance of probabilities) for civil cases is lower, meaning that the outcome
of the civil trial would be already known, therefore wasting the resources of the courts and all
potential parties to such a case.
In a civil case, the court requires each party to argue its case as strongly as possible and the
person with the probably stronger case (i.e. better facts in relation to the relevant law) will win.
The standard applied is ‘proof based on the balance of probabilities’ rather than ‘proof beyond
reasonable doubt’ as in criminal cases. Neither party will be punished by jail or fines in a civil
case, as these penalties apply only in criminal cases. The court may award damages to the
injured party, apply injunctions or make other orders such as rescission (revoking or annulling)
of contracts, many of which may apply at the cost of the losing party. There are many and varied
orders that have developed over the centuries and to which relevant legislation has been added.
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In recent decades, some legislation has been written so that civil wrongdoers are punished.
This is an important development. The concept of civil penalty means that a penalty has
been prescribed within the relevant legislation. Importantly, this will be a penalty in relation
to conduct that requires proof according to the ‘balance of probabilities’ and not ‘beyond
reasonable doubt’. Penalties that apply will be pecuniary penalties payable to the state. The term
‘pecuniary penalty’ is applied in place of the term ‘fine’, as fines are criminal penalties. However,
public statements made by the press and even statutory authorities often refer to these pecuniary
penalties as being fines. Therefore, careful reading is required in order to determine whether,
for example, a corporate officer is in fact guilty of a crime or rather is only a wrongdoer in a
civil case.
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For instance, when a former Telstra director accepted that he had acted incorrectly in civil
proceedings brought by ASIC about his share dealings, the corporate regulator made a possibly
confusing announcement that headlined a civil penalty as being a fine, although the text of the
announcement correctly stated that it was a pecuniary penalty:
Steve Vizard banned for 10 years and fined $390,000
Mr Jeremy Cooper, Acting Chairman of the Australian Securities and Investments Commission
(ASIC), today announced that Mr Stephen William Vizard has been banned from managing any
corporation for 10 years and ordered to pay pecuniary penalties of $390,000.
Justice Finkelstein of the Federal Court of Australia found that Mr Vizard had breached his duties
as a director of Telstra Corporation Limited (Telstra) on three occasions when he used confidential
Telstra information to trade in the shares of three listed public companies, Sausage Software
Limited, Computershare Limited and Keycorp Limited between March and July 2000.
‘ASIC welcomes the length of the banning, which sets a new benchmark for future civil penalty
cases that ASIC brings’, said Mr Cooper.
‘This means that Mr Vizard is disqualified from managing any corporation in Australia until
July 2015.
‘It was a pre-meditated and cynical exploitation of a privileged position held by Mr Vizard and
showed a complete disdain for the confidentiality of the boardroom’, he said.’
Source: ASIC (Australian Securities and Investments Commission) 2005, ‘Steve Vizard banned
for 10 years and fined $390,000’. © Australian Securities & Investments Commission.
Reproduced with permission.
Mr Vizard was not subject to any criminal charges. He also was not subject to an action for insider
trading—on either a criminal or a civil basis. He was taken to court only in respect of civilly
breaching his duties as a director.
Traditionally, laws dealing with civil matters sought only to create civil outcomes and did not lead
to penalties. Almost always, laws that deal with civil issues will provide for compensation and
redress for victims of civil wrongs. This is pursued further in the following discussion.
of agreed damages under a court-approved settlement between the parties rather than a
court decision.
The deliberately non-legal term ‘redress’ is used here to describe generally the ways in which
wrongdoers can be required to correct the harm they have caused. Under modern complex
legislation, the redress of wrongs is covered by provisions that provide for compensation,
injunctions and other actions that are designed to ensure that victims’ rights are addressed
and that any losses or costs are recovered or repaid. Some victims would also regard an order
disqualifying a person from managing a corporation as a form of redress as the victim will feel
better, although others might regard it as a penalty. However, the principal concern here is to
regard redress not as a penalty but rather as part of the process of putting corporate governance
matters right and of keeping these matters in good order for the future.
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‘Damages’ or ‘compensation’ involves having the offender make payments (i.e. pay damages)
to the injured party to compensate for the harm or loss caused. Injunctions are hearings where
courts try to act quickly to prevent wrongs from continuing or becoming worse by getting a
corporation, for example, to stop its anti-competitive conduct. Injunctions can be sought by
any relevant party. Other types of remedy include adverse publicity orders, which require the
corporation to advertise to society at large the wrongs in which it has been involved. Individuals
may also be prohibited from managing a corporation, or from holding important officer or
director roles.
Penalties are different from remedies as they are meant to punish a wrongdoer. Punishment
obviously goes beyond simply redressing wrongs—as well as working in conjunction with redress.
The penalties may have been specifically designed to stop breaches (by acting as a deterrent)
and courts may decide to compensate those who have been harmed by the breaches as well as
impose penalties on the wrongdoers.
In Australia, breaches of corporations law commonly result in criminal fines and civil penalties of
AUD 1 million or more, with individuals potentially subject to large civil penalties, and fines and
jail for criminal breaches.
The Competition and Consumer Act, of which the Australian Consumer Law is a part,
also contains large financial penalties for breaches, applicable both to relevant individuals
and/or the corporation on whose behalf the individuals act. In recent years, cartel conduct has
been made a criminal breach, with individuals subject to jail for breaches (10 years maximum)—
just as they can be for some specific conduct that may damage consumers.
The Australian cartel provisions and other related provisions (the cartel provisions being criminal
as well as civil) have maximum penalties for individuals as high as AUD 500 000. Additionally,
corporations can be heavily penalised for criminal and civil breaches—including fines/pecuniary
penalties that for any corporation can be as high as AUD 10 million dollars, and for larger
corporations can be in the hundreds of millions of dollars (10% of group turnover as a
possible maximum).
and monopolies.
A competitive market is one where enough corporations exist, at arm’s length from each
other, for consumers to have freedom of choice, with a wide range of alternative products
and efficiency-based pricing. By contrast, a monopolistic (i.e. tending towards entirely
uncompetitive) market structure is one where a few powerful corporations, or perhaps even
only one corporation, dominate. Monopolist corporations are able to reduce supply below the
competitive level in order to maximise profits, including through artificially high prices.
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It is generally agreed that competitive markets will have greater ability than other non-
competitive options to efficiently produce goods and services at prices that provide value to
customers—reflecting the fact that customers demand choice and quality as part of that value.
As a relatively small and isolated country, Australia has developed highly concentrated markets
over the years in industries such as grocery retailing, newspapers, shopping centres, banking,
insurance, gaming, telecommunications, building products, aviation, construction and liquor.
Australia also does not have the forced divestiture powers of countries like the United States
and the United Kingdom, where companies may be compelled to sell off parts of their business.
Workable competition
While perfect competition is difficult to achieve, the concept sought by most modern economies
(including through sometimes complex government regulation) is ‘workable’ or ‘effective’
competition within an economy. The requirements of workable or effective competition include
the following:
• There should be a sufficient number of buyers and suppliers so that there are real alternatives.
• No individual trader should have the power to dictate to its rivals or be free of competitive
pressure.
• New traders should be able to enter the market without facing artificial barriers.
• There should be no collusion on prices, customers or trading policy.
• Customers should be able to choose their supplier.
• No trader should have an advantage because of legal or political considerations.
We might note that all of these concepts are dependent on identifying a ‘relevant market’—
a combination of the product market and the geographic market that is not always easy to
identify. While economists might debate what comprises a market, we find that the decision is
a matter to be decided in courts of law. In a relevant case, the court will consider the arguments
of two protagonists in the courtroom and make a rational, balanced judgment (often including
consideration of the views of experts). That judgment will be based on ‘the balance of
probabilities’ according to the court, based on the facts given in evidence. For those who
are not experts or judges, we can make rational, balanced judgments about what comprises
a market—especially if we use the guidance that is available from previous court decisions
(referred to as ‘precedents’).
In the case of Outboard Marine Australia Pty Ltd v. Hecar Investments No. 6 Pty Ltd (1982)
66 FLR 120, the head note to the judgment of Bowen C. J., Fisher J. and Fitzgerald J. states
that ‘the correct approach to determine the state of competition in a market is to undertake
a detailed analysis of the market, the state of competition therein, and the likely effect of the
conduct upon competition in the market’. Being aware that this is how market competition is
determined in respect of any situation or any dispute is valuable knowledge. There are many
cases in various international jurisdictions that demonstrate the approach described in the
Hecar case.
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Consumers are generally hurt by lack of competition because prices are not competitive,
outdated technologies and inefficiencies can prevail and the product range and availability
are directed by the monopolist. The reduction in business opportunities and efficiencies,
combined with potential diminution of overall activity, damages the entire economy.
The Australian Government’s concept of actively creating the NBN monopoly has also been the
subject of international commentary. These commentaries show that many, not simply opposition
members of parliament, believe the deliberate ‘legislated monopoly’ approach of the Australian
Government is not appropriate in an age of market freedom—quite aside from the long-term
possibility of a series of economically and technically inappropriate decisions and outcomes.
The OECD stated very clearly that:
While establishing a monopoly in this way would protect the viability of the government’s
investment project, it may not be optimal for cost efficiency and innovation. Empirical studies
have stressed the value of competition between technological platforms for the dissemination of
broadband services (OECD 2010).
Very commonly, corporations will rely on the law as the ‘arbitrator’ or provider of very clear
rules that establish competition policies within the corporation. Notwithstanding the need to
act ethically within the corporation, relying on the law as it is developed and refined is both
inevitable and wise, as the law creates common standards that apply equally to all corporations
within any jurisdiction. Fortunately, while many detailed rules will differ, internationally there are
broad similarities in the way countries approach competition policy.
Even so, correct balances can be hard to achieve and the laws in individual countries will change
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from time to time. Further, the fact that even a government (as with the Australian NBN) is willing
to protect its own investments through creating a new, artificial monopoly is an indicator that
self‑interest is difficult to overcome if entities are permitted (or feel free) simply to use their
market power, or their ability to breach other competition rules, to their own advantage.
Full awareness of competition policy, laws and regulations is a crucial part of corporate
governance framework. It is necessary to define and understand unacceptable anti-competitive
behaviour so that this can be avoided on all occasions—even though this may be difficult
where governments, who otherwise enforce competition rules, seek to bypass the principles
on occasion. The governance balance is difficult but it must be understood and incorporated
into appropriate board-approved policies as well as into a meaningful compliance program for
competition law and other legal and regulatory risks.
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Table 4.2 provides examples of international competition legislation and regulators. As noted,
legislation is very similar across different jurisdictions. This is inevitable as markets and
competition have become global, so international competition rules and regulations need
to operate consistently.
Australia Competition and Consumer Act 2010 Australian Competition and Consumer
Commission (ACCC)
Indonesia Law No. 5/1999 (Anti-Monopoly Practice Commission for the Supervision of
and Unfair Business Competition) Business Competition
The prohibition on misuse of market power is aimed at preventing powerful entities from taking
advantage of that market power for the purpose of disadvantaging weaker organisations.
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Strategies to increase profits and market share may include lower prices, better products
or greater levels of service. These strategies generate competition and are good for the
consumer. However, some corporations are able to obtain significant market power, for example,
through their size, technology or branding. It is not in the best interests of consumers to allow
these corporations to compete so vigorously that they use their market power to destroy,
eliminate or harm competitors. Therefore, in many jurisdictions, the use of market power for
these purposes is not permitted.
As another example of regulation in this area, Article 102 (formerly Article 82) of the ‘Treaty on the
functioning of the European Union’ (EUR-Lex 2012), prohibits anti-competitive business practices
that threaten the internal market of the EU, harm consumers and small and medium-sized
enterprises, and reduce business efficiency. The relevant EU provisions are operationally almost
identical to the provisions in Australia and the US, and the treaty has strong universal application.
Article 102 provides as follows:
Any abuse by one or more undertakings [organisations] of a dominant position within the internal
market or in a substantial part of it shall be prohibited as incompatible with the internal market
insofar as it may affect trade between Member States.
Such abuse may, in particular, consist of:
(a) directly or indirectly imposing unfair purchase or selling prices or other unfair trading conditions;
(b) limiting production, markets or technical development to the prejudice of consumers;
(c) applying dissimilar conditions to equivalent transactions with other trading parties,
thereby placing them at a competitive disadvantage;
(d) making the conclusion of contracts subject to acceptance by the other parties of
supplementary obligations which, by their nature or according to commercial usage, have no
connection with the subject of such contracts.
Source: EUR-Lex 2012, ‘Treaty on the functioning of the European Union’ (article 102).
© European Union, http://eur-lex.europa.eu/, 1998–2015.
As is apparent from the EU legislative approach, the main principle for establishing abuse of
market power focuses on whether a corporation that has ‘market power’ has used that power
to eliminate a competitor or to prevent a competitor from entering or properly competing in a
market for goods or services.
A specific example of abuse of market power is known as ‘predatory pricing’. Predatory pricing is
the supply of goods or services below cost price over a period of time. While this looks beneficial
to consumers, it is an example of misuse of market power and is covered by specific provisions
in many jurisdictions. Predatory pricing is a prohibited activity because the likely real ambition is
for powerful corporations to eliminate less powerful competitors who cannot sustain the ongoing
losses of competing at artificially low prices. This eventually allows the powerful corporation to
become dominant and then to set higher prices and exploit customers through artificially high
prices based on monopolistic market positioning.
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In Australia, the principal regulator in this area is the Australian Competition and Consumer
Commission (ACCC). The ACCC, even more broadly than similar bodies such as the Hong Kong
Competition Commission, undertakes a number of functions involving regulation, legislation
development, competition law education, prosecution and administrative decision-making
(through its functionally separate tribunal). In this administrative role, the ACCC secured a
record penalty against Cabcharge, as discussed in Example 4.10.
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It was argued by the ACCC that this low cost supply was because taxis with an integrated Cabcharge
payment system and taxi meter would be significantly less likely to deal with Cabcharge’s competitors.
The matter settled on 23 September 2010 and Cabcharge paid a substantial penalty of AUD 14 million
and was ordered also to pay costs of about AUD 1 million. Other parties adversely affected by
Cabcharge’s behaviour, if sufficiently concerned, could also consider bringing actions for damages
under the Competition and Consumer Act. The case was widely reported, resulting in substantial
adverse publicity for Cabcharge, and its share price was reported as being down by 20 per cent after
the case. The share price fall may have been related to adverse publicity, but it was more likely a
market response to its strong market presence potentially being reduced as other competitors gain
easier market entry.
➤➤Question 4.5
Markets work well when fair-dealing businesses are in open, vigorous competition with each
other. With reference to Examples 4.10 and 4.11:
(a) What are the corporate governance implications of these examples for a board?
(b) Do competition laws stifle a corporation’s ability to be competitive?
(c) In what ways can respect for competition law drive competitive advantage for individual
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corporations?
As discussed previously, and illustrated by Example 4.12, approval for a merger and/or
acquisition may rest on a court’s decision as to what is a ‘relevant market’.
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At trial, the ACCC’s argument was rejected. The court found that in addition to being a wholesaler,
Metcash was involved in retail activities through IGA stores. The acquisition would not substantially
lessen competition but would strengthen the capacity of independent retailers operating as IGA stores
to compete vigorously with the major supermarket chains.
It has been common internationally for cartel conduct, like most other anti-competitive conduct,
to be dealt with on a civil basis (in which case compensation and often very large civil pecuniary
penalties occur, based on the ‘balance of probabilities’ standard of proof). However, in recent
years, following the example of the United States, jurisdictions such as Australia have made cartel
conduct also subject to criminal sanctions (based on the ‘beyond reasonable doubt’ standard of
proof). The law still provides for compensation but also for very large criminal fines and even jail
sentences. Note that civil actions, with the lesser standard of proof, are also available.
Attempts by competitors to gain advantage through collusion are heavily controlled (once again
by similar rules in most jurisdictions). The Hong Kong competition law, mentioned previously,
contains specific provisions to stop collusion. Each jurisdiction mentioned in Table 4.2 also has
relevant laws, as does the United States. In the eurozone, EU Article 102, discussed previously,
covers this area.
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Cartel behaviour can be categorised into four different types of conduct, which are individually
addressed in the Australian Competition and Consumer Act:
1. output restrictions;
2. allocating customers, suppliers or territories;
3. bid-rigging; and
4. price-fixing.
The main questions or tests we can ask to assess whether these prohibited behaviours have
occurred are as follows:
1. Has there been a contract, agreement or understanding (i.e. an arrangement)?
2. Has this occurred between competitors?
3. Is the outcome of a type that is simply prohibited or alternatively is the outcome one that
has a significant impact on competition in the market?
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Behaviour or conduct that meets these tests will be in breach of the law. As an example,
Visy Industries Holdings Pty Ltd received a AUD 36 million fine in November 2007 for market
sharing and price fixing. Visy and its competitor, Amcor Ltd, coordinated price rises and swapped
information when negotiating quotes for larger customers to ensure that each would retain
specific customers, thereby maintaining static market shares in the corrugated fibre packaging
(cardboard) industry. On occasions when the collusion was unsuccessful and a customer elected
to swap supplier, another customer contract of around the same value would be exchanged by
the two parties. The regulator granted Amcor immunity from prosecution in return for blowing
the whistle on the cartel under the ACCC Immunity Policy for Cartel Conduct (ACCC 2009).
Boards must have a strong understanding of the nature of the four types of cartel conduct and,
if necessary, gain professional advice regarding the exact details of legislation that may affect
their corporation in any jurisdiction within which it is active. Boards must also understand the
basic character of the issues involved in order to establish and oversee appropriate policies.
Output restrictions
Output restrictions refer to conduct where competitors ‘agree’ to apply restrictions on output
that will cause shortages in markets and thus result in price rises. Such price rises will advantage
suppliers and are the reverse of a competitive situation where competitors help push prices
down. An example of this behaviour is the attempt to restrict the supply of oil to help maintain
prices by the Organization of the Petroleum Exporting Countries (OPEC) cartel. The benefit to
the cartel and the cost to consumers are both immediately apparent.
Bid-rigging
Competitive tenders and quoting are used by customers to let suppliers compete vigorously
against each other to win work. Bid-rigging is where competitors who are asked to tender or
bid for work collude. To ensure that prices are maintained, all competitors may agree to submit
similar pricing, or allow one of the competitors to win the work by having the rest of the cartel
artificially inflate prices.
Price-fixing
Price-fixing is where competitors collude to create common prices. An example of price-
fixing could be two competitors agreeing to supply goods to customers at the same price.
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Effective competition should see consumers receiving lower prices and better-quality goods
and services. By fixing prices, competitors are able to maintain profits and have less incentive to
improve their efforts. This has a significant effect on competition and, as such, the penalties may
be severe.
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When determining if price-fixing has taken place, we need to focus on identifying an agreement
between suppliers. This is important because there is one price-setting activity that may look
unlawful, but is actually permitted. This is so-called parallel conduct and price-following.
An example of this occurring is evident in parallel pricing, where Company Y sets its selling
price at the same level and at the same time as Company X without collusion. This may seem
improbable, but can in fact be common. Corporate databases are now very sophisticated and
they will have the price of all competitors’ products in all markets, and will employ this data
independently in setting their own prices.
It was found that in the last quarter of November 2001, Metro Brick and Midland Brick had agreed
to apply price rises for clay-brick products on specified dates. It was also established that the two
companies had made an agreement on fixed minimum pricing in relation to tendering for contracts.
The case is an example of how the competitive ‘rush’ by managers can see things go wrong.
It demonstrates how the law applies and it shows how rapid returns to good ethics, including
providing swift assistance to regulators, can reduce harm. By fixing prices, competitors are
able to maintain profits and have less incentive to provide genuine customer value. This has a
strong negative effect on competition generally. Market disruption penalties are very severe,
to discourage this behaviour and to recognise the strong self-interest that may motivate
corporations. Penalties include large fines, disqualification from managing companies and jail.
It provides a strong message that professional accountants’ role in eliminating problems can
be significant if we are aware of relevant laws and apply them with strong professional ethics.
To emphasise the international character of this type of situation, consider Example 4.14.
In June 2012, the ACCC published a report (see below) on the continuing significance of this cartel,
which has also been extensively dealt with under laws in other jurisdictions.
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‘Malaysia Airlines Cargo Sdn Bhd penalised $6 million for price fixing cartel’
The Federal Court in Sydney has penalised Malaysia Airlines Cargo Sdn Bhd $6 million for
price fixing as part of a cartel following action by the ACCC.
‘This penalty sees the total penalties ordered against this international cartel increase to a
record $58 million. These penalties are the highest generated by a single ACCC Investigation,’
ACCC Chairman Rod Sims said.
The ACCC has been pursuing a number of international airlines for cartel conduct relating
to the carriage of air freight. Malaysia Airlines Cargo Sdn Bhd is the ninth airline to settle
proceedings against it.
‘The ACCC’s focus on stopping cartel conduct has sent a strong message. It is crucial for the
proper functioning of business in Australia that the ACCC continues to tackle cartel conduct
with the full force of the law. Cartel conduct is damaging and unlawful because it harms
competition and usually inflates prices for consumers,’ Mr Sims said.
The ACCC instituted proceedings against Malaysia Airlines Cargo Sdn Bhd on 9 April 2010,
alleging that it reached and gave effect to understandings with other international airlines
regarding the level of particular surcharges and fees relating to air freight carriage from
Indonesia. Malaysia Airlines Cargo Sdn Bhd has admitted that it did so in relation to:
• fuel surcharges between April 2002 and September 2005
• security surcharges between October 2001 and October 2005, and
• customs fees between May 2004 and October 2005.
Justice Emmett also made orders restraining Malaysia Airlines Cargo Sdn Bhd from engaging
in similar conduct for a period of five years and to pay $500 000 towards the ACCC’s costs.
Source: ACCC 2012a, ‘Malaysia Airlines Cargo Sdn Bhd penalised $6 million for price fixing cartel’,
media release, 14 June. © Commonwealth of Australia.
There are three core characteristics that apply to regulating exclusive dealing:
1. It is not cartel conduct. This means that the organisation in question decides to do something
unilaterally (i.e. by itself), rather than in collusion with other competitors.
2. The unilateral refusal to deal will be unlawful if, on the balance of probabilities, there is found
to be a ‘substantial lessening of competition in a market’.
3. ‘Third-line forcing’, which is a specific type of exclusive dealing, is perceived to be anti-
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Third-line forcing is ‘per se illegal’. This means, just as with price agreements between
competitors and resale price maintenance, it is not market tested by seeing if competition
in a market is substantially lessened; it simply is not permitted.
Franchises, which are very commonly found internationally, need special treatment regarding
third-line forcing. This is because third-line forcing exists in most franchise agreements.
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As a result, special rules exist in most jurisdictions so that such third-line forcing can be approved
easily—otherwise franchising would be almost impossible under standard anti-competition laws.
The basis for such approvals lies in the fact that effective franchises create business opportunities
that can, on balance, be regarded as opening new markets rather than tightening existing markets.
As with all matters involving complex business arrangements, good governance and the law,
it is important to have good knowledge and understanding so that appropriate balanced
professional judgments can be formed. If boards and management cannot do this alone,
then informed professionals must be available to assist them. Informed professionals, such as
CPAs, have an important part to play—but care must be taken even by CPAs to ensure that they
do not try to become legal advisers. Legal understandings must be provided by professionally
qualified legal advisers with relevant knowledge and experience.
A very powerful corporation might abuse its market power and engage in either vertical or
horizontal anti-competitive behaviour. Competition laws, as they are designed to stop
misconduct, are deliberately drafted broadly.
Two questions may be asked to determine if resale price maintenance has occurred:
1. Has the supplier specified a minimum price?
2. Has the supplier taken action or attempted to enforce this minimum price?
discounting the price of those products below a price Chemform specified, as well as withholding
supply from distributors who were likely to sell its products at a price less than the price it
specified (ACCC 2012b).
A case in this area requires the complainant—who may be an affected party or the regulator
(in Australia, the ACCC)—to prove on the balance of probabilities that the behaviour has
occurred. This needs to be proved only on the ‘balance of probabilities’ as the matter will be civil.
There is no need to prove that there was an effect on competition as the behaviour, once proven,
is automatically in breach of the law because resale price maintenance is typically ‘per se illegal’.
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One exception in this area relates to the concept of loss leading. A ‘loss-leader’ is a product
that is sold below cost price to entice resellers/customers into a selling outlet. ‘Loss leading’
most commonly occurs at the retail level. In the simplest loss leading situation, the supplier
(a manufacturer or wholesaler) supplies to their customer (a retailer) and the retailer in turn sells
to their customer (commonly the final consumer). Retailers may decide to discount greatly some
products to entice customers into their retail outlet. Where the selling price of these products is
discounted below cost price, they clearly sell at a loss, hence the term ‘loss leaders’. Loss leaders
are intended by the retailer to lead customers into the store not only to buy that product but
also, or instead, to buy other products. These other products are sold at normal profit margins.
The problem for the manufacturer or wholesaler of the loss leader product is that the ‘loss
leading’ activity damages their product, not least because other retailers will not want to sell that
product as they cannot competitively do so except by selling it at a loss.
The competition law recognises that loss leading may cause harm to the supplier (i.e. the
manufacturer or wholesaler) where it is a continually ongoing activity. Therefore, to counteract
unlawful loss leading, a supplier is permitted to withhold supply in order to prevent the reseller
from loss leading with the supplier’s products and, therefore, damaging the supplier.
However, if the retailer, or another entity that is loss-leading with their supplier’s products,
is selling below cost price as part of a genuine sale, then their supplier cannot act against the
retailer (i.e. their customer) and cannot withhold supply. If they do so, the supplier is in breach of
competition law. In the absence of unlawful loss leading, such ‘withholding of supply’ is ‘per se
illegal’. A genuine sale where loss leading is permitted would include activities such as short
term discounts to sell excess stock or other genuine discount sales campaigns such as ‘end of
year sales’.
Approvals procedures
As discussed, in many jurisdictions, some anti-competitive behaviour is automatically illegal
(‘per se illegal’), while other behaviour is only illegal if it is shown to have a substantial effect
on competition in the market. As a result, there may be times when behaviour that is good for
competition is ‘automatically illegal’ when it should be permitted. On other occasions, we might
see conduct that appears to lessen competition in a market—but which on another view can be
regarded as pro competition. We observed an example of this in the special treatment that may
be required for franchising.
An example of where ‘per se illegal’ horizontal price-fixing between competitors might be useful
for consumers is setting the price for taxi fares. Instead of having to negotiate a fare each time
you enter a taxi, there is an established pricing structure in place (which in many jurisdictions is
part of industry agreements or regulations). The taxi structure of fixed prices will have been given
regulatory approval through a formal process of authorisation designed to stabilise the industry
and give value to consumers.
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As mentioned, franchisors often require franchisees to accept contractual terms that dictate,
for example, suppliers and products. While third-line forcing is regarded as lessening
competition, the existence of many businesses operating as franchises in fact adds greatly
to overall competition in the economy.
To allow for necessary exceptions and orderly commerce, competition regulations usually provide
the opportunity for companies to apply for permission (called authorisations and notification in
Australia) to perform otherwise potentially unlawful activities without breaching the law.
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Any such ‘exception’ approvals will be formally given by the local competition regulatory
agency. For example, the ACCC in Australia is specifically empowered to approve otherwise
‘anti-competitive’ arrangements on the basis of ‘the public interest’. (The ACCC will regard the
creation of viable and/or competitive markets as a public interest matter.)
Most jurisdictions also provide other exceptions to cartel regulations. These include exceptions
related to the activities of joint ventures, agreements between related bodies corporate and
other collective acquisitions of goods and services. These become very complex and require
detailed legal advice.
The purchasing managers of Shark Ltd (Shark) and Loose Ltd (Loose) arranged to set a fixed price for
similar products they both sold to a customer called Goods Ltd (Goods). They did this without the
knowledge of other officers in their respective organisations. If Goods attempted to negotiate lower
prices with either Shark or Loose, both managers had further agreed that they would not reduce their
selling prices to Goods. Having discovered that the arrangement was in place, Goods was unhappy
with the conduct of Shark and Loose and complained to the government regulator.
➤➤Question 4.6
With reference to Example 4.16:
(a) Identify each individual or entity that may be in breach of the law.
(b) Identify the potential penalties that could apply.
(c) What would be the situation if Shark and Loose had never spoken to each other but,
acting alone, neither company would agree to reduce prices, so Goods stopped buying
(and therefore selling) the relevant product?
• the human resource costs of finding and producing relevant information for regulators,
trials, etc.;
• the cost of legal advice and briefing advisers;
• the impact of negative publicity on employee morale, share prices and profits;
• the diversion of resources and management effort away from core value-building activities;
• managers and other employees undergoing considerable stress, leading them to take time
off work, or even resigning; and
• knowledge gaps and the replacement costs if employees leave.
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It is wise for boards to understand the benefit of careful planning and the need to develop and
implement appropriate ‘due diligence’ policies and approaches. This is particularly important
for legal compliance, and the development of a compliance program has been the subject of
particular attention in the area of competition law in Australia. It is also a part of effective risk
management and is of great interest to insurance companies. Insurance premiums payable by
an organisation are a direct function of the risks in existence and ‘due diligence’ compliance
programs—including legal compliance—are a major factor in achieving reduced corporate risk.
Professor Fels observed that a compliance program is a system designed to assess and reduce an
organisation’s risk of breaking the law. It also promotes a culture of compliance and encourages
‘good corporate citizenship’. A compliance program should never be seen as just an education
or training exercise and must become part of an integrated business system. Procedures need
to be put in place to ensure compliance with the law (a management support system), and these
procedures must be audited and reviewed regularly.
Avoiding harm
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Effective compliance programs should be cost-effective and should lead to reduced risks of
incurring penalties and help limit liability for damages. They may also help avoid other financial
and non-financial costs associated with investigations, prosecutions and their aftermath.
A recent option for a person who thinks that they may have breached the Australian Consumer Law
is to offer the regulator an enforceable undertaking. This undertaking would include that they will
not breach the law again and will improve their compliance regime.
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Source: Fels, A. 1999, ‘Compliance programs: The benefits for companies and their stakeholders’,
ACCC Journal, no. 24, pp. 14–18. © Commonwealth of Australia.
Whistleblower protection
Whistleblowing can be defined as the ‘disclosure by organisation members (former or current)
of illegal, immoral or illegitimate practices under the control of their employers, to persons or
organisations that may be able to effect action’ (Miceli & Near 1984, p. 689). In many instances
of substantial management failures, including major occupational health and safety breaches,
management frauds and other illegality, the reports of whistleblowers have been the only
mechanism that caused an investigation into inappropriate actions or behaviour.
The growing incidence of corporate scandals and crashes over recent decades has resulted in an
international focus on developing laws and policies that encourage and protect whistleblowers.
The whistleblower, however, must take great care to act only within the legal protections
provided by detailed laws. The whistleblower is still at great risk of retribution or ‘payback’.
Action may be taken through the legal system for slander and/or libel, even with the legal
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Without protection, it is also quite likely that a whistleblower would have been considered as
a traitor or disloyal, as a person who in fact deserves retribution for their ‘disloyal’ conduct.
Such people have been subject to campaigns of vilification, dismissal, legal action and
bankruptcy. There are anecdotes suggesting that suicide has even been an outcome.
Whistleblowing laws arose first in the United States, as long ago as the 1863 United States
False Claims Act (revised in 1986)—and they are now found in many countries. Most commonly,
whistleblowing laws have developed to protect government interests (as in the US in 1863)
but they have grown beyond that limited domain. For example, internationally, occupational
health and safety laws protect many employees from victimisation and retribution for reporting
compliance breaches.
In response to corporate failures such as Enron, the US Sarbanes–Oxley Act (2002) provides
for whistleblower protection where an employee of a listed company ‘blows the whistle’ to an
external entity, such as a government body, or within the corporation in relation to fraud against
shareholders (US Congress 2002, s. 806). The protection provided to whistleblowers is against
being discharged, demoted, suspended, threatened, harassed or in any manner discriminated
against by the corporation or any ‘officer, employee, contractor, subcontractor, or agent’ of
the corporation. In addition, the Sarbanes–Oxley Act requires audit committees to establish
procedures for hearing complaints. The Act affects all US ‘stock exchange listed’ corporations
internationally, because even US subsidiaries of these corporations in overseas locations,
and their auditors, must comply with it.
In Australia whistleblower policies now exist in most large corporations, for example the
Westpac Whistleblower Protection Policy states that this:
promotes a culture of compliance, honesty and ethical behaviour within the Westpac Group.
Westpac’s aim is to encourage staff to report any Wrongdoing in good faith and in an environment
free from victimisation so that the Board and Senior Management can adequately manage risk
and cultural issues within Westpac (Westpac Group n.d.).
It is not our task in this subject to consider the many different detailed legal rules that exist
internationally. However, as professional accountants, we must be able to handle the rules,
or seek relevant guidance on them, as they occur in our own jurisdictions. There will be important
differences from one jurisdiction to another. Boards and management must ensure that the rules
are implemented appropriately within the local rules and within the particular corporation.
The rules that apply under the Corporations Act, in common with whistleblower legislation
internationally, attempt to balance the value of whistleblowers and the need to protect their
rights with the rights of the corporation and the importance of confidentiality and good
corporate governance. Equally, while it is important that employees are free to blow the whistle,
it is also important that malicious employees do not have the opportunity to unfairly harm
corporations and other stakeholders including shareholders, other employees and customers.
The legislation prescribes that a person is protected as a whistleblower only if they are:
• an officer of the corporation (this includes senior managers and directors and the
corporation secretary);
• an employee of a corporation; and/or
• a contractor or their employee who has a contract to supply goods or services to
the corporation.
For example, the husband of an employee could not ‘blow the whistle’ and be protected from
retribution in the form of an action by the corporation (e.g. an action for libel damages against
the husband). Furthermore, to gain protection the whistleblower must not be anonymous.
The Act requires that they ‘give their name before making the disclosure’.
Very importantly, a whistleblower does not need proof. It is enough that they have reasonable
grounds to suspect the corporation or an officer or employee has, or may have, contravened the
Corporations Act. Additionally, they must act in good faith—that is, the whistleblower must not
act maliciously.
As whistleblowing does not involve proof but only ‘reasonable suspicion’, it is important that
these initial suspicions are not published or broadcast. Equally, because the suspicions may
apply in respect of any breach of corporations law, the breach could involve, for example,
board members, managers or auditors. Accordingly, the legislation specifies a range of
potential recipients of the information. Whistleblowers are permitted by law to inform any
of the following, but nobody else, or protection is lost:
• ASIC;
• the company’s external auditor or a member of the external auditing team;
• a director of the company, the company secretary, any senior manager of the company; and
• a person specifically authorised by the company to receive whistleblower revelations, such as
the Corporate Counsel or the internal auditor.
The Corporations Act protects legitimate whistleblowers from retaliation, and it also stipulates
that, if any negative consequences occur, or harm has been done to an employee because
of protected whistleblowing, civil rights are made available to the employee under the Act.
These civil rights are enforced through orders against employers and anybody else who has hurt
the whistleblower. Such orders can include reinstatement of employment and compensation.
As observed with the Sarbanes–Oxley Act, criminal prosecutions can also occur under the
Corporations Act against those who abuse whistleblower protection laws.
To understand the context of this rogue trading and the actions of the whistleblower (notwithstanding
personal risks), consider the following statements, which were part of a transcript of a television national
television discussion:
Kerry O’Brien, presenter: ‘Two rogue traders involved in a financial scandal at banking
giant NAB are behind bars tonight after a judge found they’d been enmeshed in a culture
of malleable, profit-driven morality that went off the rails. Senior trader David Bullen was
sentenced today to a minimum of 2.5 years’ jail for his role in creating false profits on NAB’s
foreign currency trading desk, which cost the bank $360 million. And junior trader Vince Ficarra
will serve a minimum of 15 months. They’re the last two men of a trading-room team of four
to receive jail terms over a scandal that severely damaged NAB’s reputation and resulted in
a major internal shake-up. With fascinating insights provided by taped phone conversations
of the dealers at work, Heather Ewart takes a look at their high-risk culture and at whether
other potential cowboys are likely to take a salutary lesson from the outcome’.
Source: Ewart, H. 2006, ‘Former NAB traders jailed’, 7.30 Report (TV program transcript),
Australian Broadcasting Corporation. Reproduced with permission.
Cases like this were important in establishing the need for legislative protection and also resulted
in direct internal ‘whistleblower protection’ policies being established by many corporations.
Note that the NAB case, which followed the collapse of HIH Insurance (which we discussed
in Module 1), can be seen as a factor in substantial changes to the legislation affecting,
and regulation of, the financial sector (i.e. financial institutions of various types), including
banks. These changes may well have helped Australia avoid being seriously affected by the
GFC, as these new approaches meant Australian financial institutions did not have the apparent
freedoms of other countries such as Ireland, Iceland or even the United States.
As you read Example 4.18, consider that in the very tough Enron management environment,
no relevant whistleblower protections were available at the time (i.e. it was before the Sarbanes–
Oxley Act). It is presumed that modern whistleblowing protection would have more easily
allowed people like Sherron Watkins to confront the undoubted risks involved and to take
action with a far greater level of personal safety.
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During the course of her work at Enron as a senior executive, Watkins became aware of some
highly questionable accounting practices involving aggressive revenue recognition practices and
the extensive use of off-balance sheet entities (which enabled Enron to keep significant liabilities
off its balance sheet). In a memo to the chairman (and founder) of Enron, Ken Lay, in August 2001,
Watkins expressed the view that she was ‘incredibly nervous that we [Enron] will implode in a wave
of accounting scandals’. This was also followed up with personal meetings between Watkins and Lay.
Lay ignored these warnings. In December 2001, Enron did indeed implode, becoming the largest
(at that time) bankruptcy in US history. Watkins’ memo was subsequently discovered by investigators
sifting through Enron documents after the bankruptcy and released by a congressional committee
(to which Watkins testified) in early 2002.
Watkins was acclaimed as a whistleblower by some but Ackman, writing in Forbes Journal of her
inaction and failure to blow the whistle despite her knowledge, stated that ‘far from whistle-blowing,
Watkins’ actions actually provide cover for Lay and the Enron board (Ackman 2002).
The fact that Watkins did so little in the face of damning evidence is an indication of the importance of
protecting whistleblowers. Perhaps if Watkins had been protected and had acted quickly, then many
problems of Enron caused in the early 2000s could have been avoided or at least reduced. As it is,
Watkins, who has been criticised for acting late, would have potentially been the target of otherwise
proven ‘wrongdoers’. In fact the initial response of the Enron chair to Watkins’ email warning of the
financial risks Enron faced was to consider dismissing Watkins. Enron’s lawyers counselled against this
course of action primarily because it might bring further publicity regarding the financial position of
the company.
➤➤Question 4.7
Briefly describe ‘whistleblowing’ and explain why whistleblower protection has become an
important component of good corporate governance.
Further, if Watkins was whistleblowing today, and in Australia (assuming at a time where the
information would be valuable), what guidance would you give to her regarding her legal
protection?
also been afforded protection. These business consumers buy goods or services as part of their
business (this may include trading stock). If they are relatively small businesses (the definition will
vary from one jurisdiction to another), they will be afforded ‘business consumer’ protections.
Corporations (as suppliers) recognise that long-term support from consumers (as customers
and/or users) of their outputs will be important for long-term corporate performance. However,
many managers and corporations succumb to the temptation to seek quick profits without care
for consumers and their long-term needs. Sometimes, there are even deliberate attempts to
target vulnerable customers and consumers by deception and dishonesty.
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Consumer protection is designed to work for consumers (and the economy as a whole) even
where there is no direct contractual relationship with suppliers and manufacturers. For example,
under ‘product standard’ protections (such as safety standards), products must meet specified
minimum legal standards. Manufacturers and also retailers may be liable (civilly and/or criminally),
regardless of direct contractual relationships, if they do not comply with these stated minimum
requirements. Consumer laws also seek to protect consumers in relation to particular
contracts where there are direct relationships. We will consider some aspects of consumer
protections shortly.
Today, large corporations’ codes of conduct include the importance of good relationships
with domestic consumers (where there are direct contacts) and will nearly always also focus on
building long-term sustainable relationships with business consumers. They will also be strongly
aware of domestic consumers as final product users. To many, this awareness of customers
and consumers is the very essence of ‘customer value’ required to achieve performance (a key
component of good corporate governance).
The legislation providing these protections is not just focused on consumer protection—it is also
an attempt by governments to ensure good business practices that will lead to business success
and order in society. There are good macro-economic efficiency reasons for ensuring good
products and good standards of warranty, as well as the fact that each business is more likely to
succeed with good products. When consumers are fearful about quality, warranties and fitness
for use, they are less likely to purchase a product. Diminished consumption will harm individual
businesses and their profitability and will hinder the growth and development of an economy.
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This area of law continues to evolve and legislation of this type now exists in most jurisdictions.
Some of the relevant legislation is referred to in the next section. At this point, we are focusing
on the concept that consumers should not be deceived by conduct or statements that are false
or are intended to mislead.
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Table 4.3: S
ome important common approaches to consumer protection and,
in particular, the issue of ‘misleading conduct’
Law Description
Hong Kong: (1) Subject to the provisions of this Ordinance, any person who:
Trade Descriptions (a) in the course of any trade or business-
Ordinance (Cap. 362) (i) applies a false trade description to any goods; or
(1981) (ii) supplies or offers to supply any goods to which a false trade
s. 7 (Ordinance description is applied; or
amended 2013) (b) has in his possession for sale or for any purpose of trade or manufacture
any goods to which a false trade description is applied, commits
an offence.
(2) A person exposing goods for supply or having goods in his possession for
supply shall be deemed to offer to supply them.
(3) Subject to the provisions of this Ordinance any person who disposes of or
has in his possession any die, block, machine, or other instrument for the
purpose of making, or applying to goods a false trade description commits
an offence unless he proves that he acted without intent to defraud.
Japan: In conjunction with other legislation, the Basic Act of 1968 makes illegal
The Consumer misleading information and representation. Other consumer protection
Protection Basic Act legislation deals with matters such as false labelling and false dealings
(1968) in relation to contracts (discussed later in this module under the heading
‘Unconscionable conduct’).
Australia: Provides that ‘A person must not, in trade or commerce, engage in conduct that
Consumer Law 2010 is misleading or deceptive or is likely to mislead or deceive’. This prohibition is
(Cwlth) not limited to the supply of goods or services. It, in common with all the laws in
s. 18 this table, establishes an economy-wide requirement which corporate policies
must recognise—and which will best be included in appropriate corporate
policies, set by boards.
As observed in Table 4.3, one concern of consumer protection law is establishing whether
corporate behaviour or conduct, including advertising, is misleading or deceptive. It is not
enough, for example, to ask: ‘Is what is said the truth?’ The truth can be misleading. It is
necessary to ask questions such as:
• Has a truthful impression been conveyed?
• Would a group of less-informed people be misled or deceived?
• Is the approach I am taking one that is fair or would some people find it deceitful?
For example, to advertise, or otherwise represent, that a product has been laboratory tested
would not be false if such a test has been conducted. However, the advertisement would mislead
consumers if it omitted to say that the product had failed the test. The deliberate use of half
truths or the omission of relevant information limits the accuracy of what is being communicated
and is, therefore, not acceptable.
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Similarly, to briefly describe a real case, Hornsby Building Information Centre Pty Ltd v. Sydney
Building Information Centre Ltd (1978) 140 CLR 216, the retail business HBIC advertised that an
opera singer named Joan Sutherland was to sing outside its premises on a Saturday morning.
However, its competitor (SBIC) complained that the advertisement was misleading and deceptive
or, as the performance had not yet taken place, was likely to mislead consumers. The reason
for the complaint was that a small-time opera singer had changed her name legally to Joan
Sutherland. She was not the real, internationally renowned, Joan Sutherland. The High Court
of Australia found in favour of SBIC, and HBIC, for breaching what is now s. 19 of the Australian
Consumer Law, was (among other outcomes) issued with an injunction ordering that the
advertising cease.
You will notice that action does not need to come from a consumer. It may come from a regulator
or even a competitor. In this situation, the self-interest of SBIC in not having its potential
customers going to HBIC because of its misleading conduct has the fortunate result that the
legislation, by protecting consumers, also has pro-competitive outcomes. This is an interesting
feature of consumer protection, as often the interests of competitors promote actions at no cost
to consumers or the regulator.
The corporate governance perspective that boards and management must understand is that
corporations that pursue their proper rights at law will look after the interests of consumers as
important stakeholders. This will benefit society at large and help to ensure that value builds for
shareholders.
In the example that follows, it seems that Apple management in Australia simply followed
the same international marketing campaign for the ‘4G iPad’ as was instructed by overseas
management. In fact, Apple’s 4G ‘network connectivity’ is not compatible with Australia’s
4G network. Following legal action by the ACCC, in addition to the fine discussed next,
Apple was ordered to email customers, wherever possible, with appropriate advice, and also
to allow full refunds to anyone wishing a refund. It was further ordered to ensure appropriate
signage stating the correct nature of the product.
Justice Bromberg noted that the facts of the case suggest that ‘global uniformity was given
a greater priority than the need to ensure compliance with the ACL’. His Honour warned that
‘Those who design global campaigns, and those in Australia who adopt them, need to be
attuned to the understandings and perceptions of Australian consumers’.
The Court declared that Apple’s conduct was liable to mislead the public as to the
characteristics of the device in contravention of section 33 of the Australian Consumer Law.
Apple agreed to the declaration and consented to the penalties and other orders sought
from the Court.
This judgment follows an undertaking given by Apple to the Court on 28 March 2012 in
response to the ACCC’s decision to institute proceedings.
Apple was also ordered to pay a contribution to the ACCC costs in the amount of $300 000.
Source: ACCC 2012c, ‘Apple Pty Ltd penalised $2.25 million for misleading “iPad with WiFi + 4G”
claims’, 21 June, accessed October 2015, http://www.accc.gov.au/media-release/apple-pty-ltd-
penalised-225-million-for-misleading-%E2%80%9Cipad-with-wifi-4g%E2%80%9D-claims.
© Copyright of Australia.
➤➤Question 4.8
A large beverage manufacturer prepares a point-of-sale poster promoting its brand as ‘the country’s
highest carbohydrate sports drink’ with the claim this will stimulate endurance, and the statement
that this is based on an independent scientific analysis. While the brand in question did have
a higher carbohydrate content than all other brands analysed, the researchers responsible for
the analysis stated in their report that, in terms of improving stamina, any differences between
brands were ‘statistically insignificant’.
Has the advertiser engaged in misleading advertising? Also, would you consider an advertisement
such as this to be ‘misleading conduct’ and/or a misleading ‘statement’ (or likely to mislead or
deceive), and what impact will this have on the potential outcomes?
Puffery
Extreme exaggeration has been found not to be ‘misleading’ in advertising, especially where
the exaggeration does not relate to objective facts. Such extreme ‘subjective’ exaggeration
is sometimes called ‘puffery’. Puffery is acceptable because, if statements or representations
really are puffery, the courts assume that consumers could not possibly treat the exaggerations
as serious, let alone be misled. However, the line between obvious exaggeration and deceitful
communication is not always clear. One illustration where puffery was not allowed was a case
where a car-rental company claimed to be the ‘biggest in luxury car rental’. In fact, it was not,
and being ‘biggest’ is not subjective—it is an objective fact as to whether a company is the
biggest in an area of business.
Regardless of how the message is communicated the message itself should not be ‘misleading or
deceptive’ or ‘likely to mislead or deceive’ … Superlatives and comparatives that are self-evident
exaggeration or puffing are unlikely to mislead anyone … However, representations and claims that
take on a factual character, particularly in quality and price terms, may amount to a breach unless
they are capable of substantiation (Trade Practices Commission 1991, p. 16).
Note: The Trade Practices Commission was the predecessor of the ACCC.
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Unconscionable conduct
An important area of consumer protection comprises laws designed to stop consumers from
being harmed by unfair or unfairly imposed or created contracts. These contracts and the
obligations arising from them will not be allowed where the circumstances make the contracts
or the consequences harsh or unfair and involve a more powerful party taking advantage of
another weaker party. In many jurisdictions, contracts that display these features can be set aside.
Specific laws address this matter.
It was not until 1983 (in the case of Commercial Bank of Australia v. Amadio (1983) 151 CLR 447)
that the Australian High Court applied an important new legal concept of unconscionable
conduct, which had begun to be recognised in various ways internationally. It is a common
law (i.e. courtroom) development, and legislatures in many jurisdictions internationally have
similar legislation.
Stakeholders who are provided protection by this concept include customers (individuals and
business consumers), suppliers, lenders and borrowers.
A summary of the 1983 High Court decision in Example 4.20 is valuable as it tells us the reasons
for the decision and flags the character of the legislation that was later created. It also indicates
the types of concerns that exist in judicial concepts internationally, such as ‘unconscionable
bargains’ in the United Kingdom.
Facts that the High Court found indicative of unconscionable conduct included the following:
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• Mr and Mrs Amadio spoke and understood little English (inability to understand the contract).
• Mr and Mrs Amadio did not seek independent advice and no such advice was suggested by the
bank (taking advantage of power).
• The bank was aware that the son’s business was in a difficult financial position at the time he sought
the guarantee and was also aware that Mr and Mrs Amadio did not know this (misuse of power
relationship and withholding relevant information).
• The bank did not advise Mr and Mrs Amadio of the true extent of the guarantee and that their
liability was unlimited. Mr and Mrs Amadio believed the liability was limited to AUD 50 000 (misuse of
power relationship and withholding relevant information).
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This type of conduct is not limited to transactions with end consumers. It can also occur
in business-to-business transactions. In fact, a significant number of complaints relating to
unconscionable conduct have arisen out of contracts for services and goods including:
• commercial tenancy arrangements;
• relationships between building contractors and sub-contractors;
• franchising; and
• financial services contracts, including loan guarantees, small business loans and financial
institutions dealing with small business.
The tests for unconscionable conduct in the case of an ordinary domestic agreement include
the following:
• What was the relative strength of the bargaining power of the corporation and the consumer?
• Were the conditions imposed on the consumer reasonably necessary to protect the
legitimate interests of the corporation?
• Was the consumer able to understand any of the documents used?
• Was any undue influence or pressure exerted on, or were any unfair tactics used against,
the consumer?
• Was the amount paid for the goods or services higher, or were the circumstances under
which they could be acquired more onerous, when compared to the terms offered by
other suppliers?
There is a fine line between aggressive bargaining and conduct that leads to one-sided, harsh or
onerous terms being imposed on a party. One possible solution for businesses (and ordinary
consumers) to protect themselves is to ensure that they obtain independent advice. For example,
it has become common practice for banks and other lenders to ensure that guarantors obtain
a certificate from a solicitor certifying that the nature and effect of the guarantee has been
explained to the guarantors. In other words, it is important that the other party has a proper
understanding of the transaction and that appropriate ‘balances’ exist within the overall contract.
Importantly, this will be a civil matter only—so an afflicted consumer will only need to establish
‘on the balance of probabilities’ that the stronger corporation has acted unconscionably. There is
no requirement that all, or even most, of the tests need to have been breached—it is just how it
appears on balance in the court room based on the arguments of the parties involved.
a complaint:
• whether the supplier’s conduct towards the business consumer was similar to that
of other suppliers;
• applicable industry codes;
• any intended conduct of the supplier;
• the extent to which the supplier was willing to negotiate terms and conditions;
• the conduct of the supplier and business consumer in complying with the terms
and conditions;
• whether the supplier had the right to unilaterally vary the contract; and
• whether the supplier and business consumer acted in good faith.
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There are many more matters in relation to consumer protection. They all need careful attention
by boards and management, in correctly structured organisational policies. Any failure can result
in substantial harm to the consumer, the corporation and many stakeholders across society—
including shareholders. Such corporate governance failures are unnecessary and disappointing.
Individuals within corporations need to realise that breaches can also create personal costs, as
penalties that corporations incur can also be replicated at the personal level. Some types of
breaches (e.g. consumer safety regulations) can result in individual managers and directors being
sent to jail for criminal breaches.
However, there are many pressures exerted on the public sector, with changes in policy and
practice occurring with changes in government. Also, encountering almost unlimited demand for
services (e.g. in health care), the resourcing of the public sector is often stretched to the limits.
The public sector is complex and often challenging to management and employees.
The public sector also experiences governance and fraud problems as in the private sector.
The boards of directors of public agencies have to be as informed and vigilant as boards in the
private sector.
Based on their Global Economic Crime Survey about fraud and fraud risks, PwC reports:
• Government and state-owned enterprises on average experienced a higher incidence of fraud
than listed private entities. More than one-third (37%) of respondents from government and
state-owned enterprises said they experienced economic crime in the previous 12 months.
• Government and state-owned enterprises reported that 69% of the fraud they suffered related
to the misappropriation of assets and this category of fraud needs to be a focus for senior
executives.
• Staff members perpetrated more than half (57%) of fraud reported by government and state-
owned enterprises, compared to only 25% for financial services organisations.
• Senior staff are more likely to commit fraud in government and state-owned enterprises than in
any other industry.
• More than one-third (39%) of New South Wales government agencies told the state Auditor-
MODULE 4
General their fraud risk assessments were not effective and senior executives need to
understand why this is the case in their organisation.
• Government appears to be lenient on perpetrators of fraud, with only 51% of internal fraudsters
at government and state-owned enterprises being dismissed from their jobs. This compares to
60% across all industries.
Source: PwC 2011, Fighting Fraud in the Public Sector, PwC, p. 4. This paper was current at the time
of its publication. For PricewaterhouseCoopers most up-to-date materials please refer to their website.
Article accessed September 2015, https://www.pwc.com/en_GX/gx/psrc/pdf/fighting_fraud_in_the_
public_sector_june2011.pdf.
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The public sector, as with most organisations, is reluctant to publicise incidents of fraud and
corruption when they occur. However, the fact that even the most established of public sector
institutions can be tainted by corruption was revealed when the Reserve Bank of Australia was
called to explain allegations how its wholly owned subsidiary Note Printing Australia (NPA),
which had contracts for bank-note printing throughout countries of Asia, was involved widely
in bribery and corruption. In 2011, the Australian Federal Police charged NPA and former NPA
employees with paying bribes in foreign countries to advance their business (Joye 2013, p. 7).
The PwC analysis examined the causes of fraud and determined:
From our experience, Australian government and state-owned enterprises are most susceptible to
fraud when:
• they have large, demand-driven spending commitments driven by policy, which do not allocate
enough time and resources to assess risk or implement controls to detect, investigate and
mitigate fraud.
• power is centralised unduly; for example, when a single individual has the power to make
decisions on procurement, contracting and approval.
• standard contracting procedures are bypassed using the justification of ‘addressing urgent
business needs’. This temporary approach may then be extended to avoid the checks and
balances of procurement policies.
• policies and rules to minimise fraud and corruption are not applied with the same rigour in
remote operations as in the head office.
• an excessive focus on outcomes can result in increased pressure to improperly modify results,
a loss of accountability and poor maintenance of associated business records.
• when fraud is suspected, if processes are flawed and associated records are inadequate,
this may lead to insufficient evidence being available to mount a successful investigation
or prosecution. It may also result in the agency concerned being unable to instigate civil
recovery action.
• as leaders within their organisation, senior executives have a critical role to play in controlling
fraud in the government sector. It is important that they set the right tone from the top.
Source: PwC 2011, Fighting Fraud in the Public Sector, PwC, p. 4. This paper was current at the time of
its publication. For PricewaterhouseCoopers most up-to-date materials please refer to their website.
Article accessed September 2015, https://www.pwc.com/en_GX/gx/psrc/pdf/fighting_fraud_in_the_
public_sector_june2011.pdf.
It is apparent that the public sector demands as keen attention to governance, accountability and
risk management, and fraud detection as large, complex corporations in the market sector.
responding to a growing demand with limited funds. Many surveys highlight the growing
strengths of the governance of this sector (Grant Thornton 2014).
However, it has to be remembered that these sectors are large and important in many countries.
In Australia there are 67 000 charities registered, generating an estimated AUD 107 billion
in revenue, with assets of AUD 176 billion and employing almost one million people in 2014
(ACNC).
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Although the sector is known for robust and effective governance, this is not always the case.
In 2015 the Australian Charities and Not-for-profits Commission (ACNC) issued a notice to the
effect that 4000 charities listed on the register had failed to lodge financial reports, and a further
5500 had their charity status revoked after failing to complete their reporting for two consecutive
years. As Ferguson in the Australian Financial Review reported:
Over the past 20 years there have been numerous inquiries into the charities sector. All agreed the
sector was complex, lacked transparency and accountability and needed a dedicated regulator.
In 1995, the Industry Commission (now the Productivity Commission) found there was ‘a lack
of consistent data, a lack of access to public information and a lack of standardised financial
reporting’. It made a series of recommendations, including the introduction of an accounting
standards for the sector and better public access to information.
There still isn’t a standardised financial reporting that charities must comply with. This means
there is no way to detect how efficient a charity is in the delivery of service because there is no
accounting standard to benchmark charities. There have also been attempts to investigate whether
the tax arrangements are appropriate.
Source: Ferguson, A. 2015, ‘Opaque charity sector under fire for accounting failures’,
Australian Financial Review, 17 August, accessed September 2015, http://www.afr.com/business/
accounting/charities-under-crackdown-for-dodgy-accounting-20150816-gj01zy.
The ACNC reviews the governance of charities and not-for-profits and states:
Our ongoing analysis consistently reflects that poor governance … is the main issue for charities
that leads to ACNC compliance activity. Many involve charities that are relatively new (less than
five years old), and affects charities of all sizes and locations … Governance concerns can result
in charities no longer being not-for-profit, or pursuing their charitable purpose. For example, the
ACNC is particularly concerned if charitable assets of funds are used inappropriately (for example,
for private accumulation or to purchase private assets). We will also look particularly at failures of
responsible persons to meet their duties, or where a charity is not providing information and being
accountable to its members.
The ACNC’s Overview of Compliance Activity highlights the primary concerns reported to it
concerning the governance of charities (Figure 4.1).
25%
Source: ACNC 2014, An Overview of the First Year of Compliance Activity, 28 January 2014.
© Commonwealth of Australia 2014.
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The ACNC offers a further detailed breakdown of these governance, fraud and private
benefit concerns:
Governance
• A conflict of interest between a charity’s board members and the operational decisions
made regarding the charity
• The charity is not following its constitution
• Financial mismanagement
• Lack of, or inadequate policies and procedures
Private benefit
• Charity resources used for personal use
• Inappropriate personal expenses
• Corporate sponsorship used for personal, rather than charitable purpose
Other
• A charity soliciting funds when it is not carrying out any charitable activities
• Insolvency
• Harm to those who benefit from the charity.
Source: ACNC 2014, An Overview of the First Year of Compliance Activity, 28 January 2014.
© Commonwealth of Australia 2014.
The ACNC offers three case studies illustrating problems of fraud, governance and private
benefit in charities, indicating that there can be multiple causes of concern.
The ACNC contacted the charity’s board about the allegations, and commenced working with the
charity as part of its investigation. As an initial step, the board removed the individual alleged to
have made the purchases, the purchases were admitted and the individual repaid some of the debts.
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However, the ACNC investigation found that the theft of funds was more extensive and significant
than initially identified. The charity worked with the ACNC throughout the investigation, committed
to dealing with the matter and continuing their charitable endeavours. With the support of the ACNC,
they worked through the issues of governance that had allowed the theft to occur, and sought to
implement changes to address the identified vulnerabilities. At the ACNC’s behest the charity filed
a report to the police so that the alleged fraud could be investigated by the appropriate authority.
Source: ACNC 2014, An Overview of the First Year of Compliance Activity, 28 January 2014.
© Commonwealth of Australia 2014.
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The complainant alleged that the couple illegally changed the charity’s constitution, redirected funds
for their own personal gain, and initiated the sale of the charity’s assets, without the knowledge or the
authority of its members. They also transferred large amounts of cash from the charity’s bank accounts
to personal accounts offshore.
The ACNC’s investigation into this charity suggests serious problems with the charity’s governance,
including failure to invite members to meetings, failure to hold discussions or votes regarding changes
to the charity’s constitution and selling the charity’s assets. It also found that records of meetings were
incomplete or inaccurate.
The charity is no longer operating on a day-to-day basis and the individuals who are the subject of
the complaint have left Australia; they have no intention of returning. The ACNC is liaising with the
relevant authorities overseas, as well as working to ensure control of the charity is returned to its
members and the assets protected.
Source: ACNC 2014, An Overview of the First Year of Compliance Activity, 28 January 2014.
© Commonwealth of Australia 2014.
These cases clearly illustrate that governance and fraud problems do occur in the charity and not-for-
profit sectors and that rigorous governance standards financial reporting and accountability are as
imperative here as in corporations working in the market economy.
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Source: ACNC Compliance, An Overview of the First Year of Compliance Activity, 28 January 2014.
© Commonwealth of Australia 2014.
334 | GOVERNANCE IN PRACTICE
Many ‘financial services’ exist within financial markets and, accordingly, there are overlapping
financial market rules and financial services (consumer) rules. Regardless of the way the rules
apply and who they may protect, the existence of modern corporations depends on effective
financial markets. We will now briefly review some market considerations and some market rules.
Role of markets
Financial markets are most clearly identified as the places where ownership (and other) rights in
corporations are traded. Terms such as ‘stock market’ and ‘securities market’ are used to describe
them. Commonly, we hear terms such as the ‘Hang Seng’, ‘Dow’, ‘FTSE’ and ‘Shanghai composite’
in relation to stock exchange activity in particular share market movements as recognised by
relevant indexes. So important are international stock exchanges that most financially literate
people know that these terms relate respectively to key trading indexes of Hong Kong, New York,
London and Shanghai. Note that within any exchange, there are always many other less publicised
indexes, as well as many indexes in other stock exchanges around the world.
Financial markets are complex, people-driven creatures and perhaps one of their greatest
strengths is that nobody understands them fully—so it is hard to take advantage of markets
when acting ethically. The fact that many financial markets are increasingly based on electronic
platforms and driven largely by algorithms adds further to their complexity, and makes the
ultimate human agency underlying digital markets more difficult to ascertain. We will not
attempt a detailed analysis of financial markets here, but will discuss general aspects that
apply internationally.
Two basic corporate governance observations are important for managers of corporations that
are listed on the stock market:
1. Shareholders require a satisfactory return on their investment (this is arguably at the centre of
the director’s duty to act in good faith in the interests of the corporation).
2. Managers need to ensure that corporations perform well. If they do not, then sales of shares
by shareholders will exceed demand for purchases of shares and the stock price will fall.
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In extreme circumstances, prices will eventually fall to a point where other potential owners
in the market believe the assets can be employed more productively under (their) new
ownership and the corporation will be subject to a takeover (which often results in the old
managers being replaced by new and better managers).
We must appreciate that ‘the market’ is susceptible to rumour, manipulation, fake information,
secret information, misuse of secret information, self-serving motivations, fraud, theft and
unethical conduct of almost limitless potential. Accordingly, there are many rules and regulations
in this area. A dynamic and complex regulatory framework exists, with variations between
countries regarding the nature and effectiveness of regulation and the quality of surveillance.
While the themes are fairly similar, local detailed rules will vary and must be understood by
professional accountants—especially those working in an international environment. Even in the
EU, where harmonisation is being sought, we find that detailed rules and approaches vary from
one country to another.
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Crucially, the media (print and electronic, including the internet) is a powerful force in relation to
financial markets. The media transmits information from other intermediaries and also creates
information (and even rumours) itself on occasion. The effect of media reports (e.g. on share
prices) can be remarkable. The concept of financial market manipulation as a topic in its own
right is discussed shortly. However, the 2012 David Jones event, described in Example 4.21,
shows how the media, including the internet and blogs, is a market force that the market and
boards must better appreciate.
In 2012, a rumoured takeover was reported on an obscure UK blog site and as a consequence,
the company received requests from the media for further information about this possible takeover.
DJs issued a statement to the ASX. Although this statement did no more than note the existence of the
already known internet news, a rapid surge in DJs’ share price followed after the takeover suggestions.
The DJs board was in a very difficult situation. As observed, to do and say nothing would have allowed
the UK blog site to continue to make market-related statements without challenge or comment by
the DJs board. On the other hand, if the DJs board made a statement, it could perhaps be perceived
as in some way legitimising the takeover suggestions stated on the blog site. The DJs board clearly
thought that it was better to make a statement—and one that merely noted the unknown status of the
proposals in order not to encourage share market speculation. The fact that some speculation based
on the ASX statement might occur, driving up share prices, was surely a lesser risk than allowing the
market to take information from an unknown blog. Clearly, the board of DJs would have considered
the matter carefully, and acted carefully and correctly in the circumstances as known at the time.
Even so, following the disclosure by the board, Smith in the Australian Financial Review commented:
Conspiracy theories have ranged from shell companies to a hedge fund stunt. The Australian
Securities and Investments Commission is understood to be looking into the matter.
David Jones admits it has no details of the … financial capacity [of the party making the
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approach] or its management and has made clear the circumstances surrounding the approach.
It will have to do some fast talking if the approach turns out to be a fake (Smith 2012).
There are difficulties in the suggestion that, rather than disclose fully, the DJs board should have
simply said it had ‘not received any serious approach from a credible buyer’. The ‘continuous
disclosure obligations’ requirements of the local stock exchange rules (in Australia, the ASX Listing
Rules) do require disclosure. This disclosure is especially important where the share price may be
affected—and takeovers nearly always drive changes in share prices. Failure to disclose would
potentially be an offence, and recently shareholders have successfully sued for damages against
corporations that have not fully satisfied the ‘continuous disclosure’. Given the circumstances, it is
understandable that DJs’ board acted in the way that it did by cautiously disclosing what, with the
benefit of full hindsight, we now can see was apparently a ‘fake’ takeover bid.
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In short, we see in Example 4.21 that it seems highly likely that the DJs board did the correct
thing. Even so, the public debate is good for all boards to consider when constructing responses
to circumstances that may challenge good governance. The DJs case provides an interesting
illustration of the way that the internet (in this case, a foreign blog) can add to the work of boards
and the difficulties of maintaining good corporate governance in all circumstances.
Many examples demonstrate that media publicity can have profound effects on markets
and prices. It can sometimes impose pressure on corporations to improve their corporate
governance. Boards and managements of corporations are often fearful of criticism in the press.
When asked which forces have the greatest effect on governance and governance improvements,
managers typically respond that the media has the greatest immediate effect and that market
responses from institutional shareholders are impossible to ignore.
Another illustration of the role of media and publicity in relation to improving markets is perhaps
far more important—even today. More than 10 years ago, the Enron and WorldCom scandals
raised questions about the role of external auditors as reliable participants in markets and
governance generally. As observed earlier in this module, the response from the accounting
profession, governments, regulators and auditors has led to building new approaches and
rebuilding reputations.
Public disclosure, public commentary and free debate are all very important to good corporate
governance. Much earlier in this module we observed this in respect of remuneration issues.
We see now that financial markets, which exist for the good of society at large and are populated
by shareholders of all types and many other interested parties, also benefit from transparent
public debate and commentary. This is relevant to the discussion so far, and it also applies to
the role of ratings agencies and other concepts that follow.
Ratings agencies
Intriguingly, the spectacular problems of the GFC have raised doubts, not yet fully resolved,
about the role of the key market-rating agencies (Fitch, Standard and Poor’s, and Moody’s) as
well as other significant consultants and advisers (especially those dealing with risk assessment
and remuneration).
As yet no major changes have taken place regarding ratings agencies but the EU presents a
strong example of international concerns given its proposed regulatory controls on the three
major US-based ratings agencies. A UPI report (2012) links the credit problems within the
EU, the potential downgrade of entire economies within the EU and the power of the ratings
agencies. Although we are not considering broad financial sector issues generally, they do arise
here—but note also that these are the same ratings agencies that place value on corporations
and therefore affect interest rates and share prices.
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There is one focus regarding laws that are specifically designed to protect financial markets.
Unlike, for example, laws that apply to directors (only) or to directors and other officers (only)
unless otherwise stated, the rules designed to protect financial markets apply to everyone.
In other words, to break the rules, you do not need to be a director, an employee or an
accountant—merely a person who breaks a relevant market protection rule.
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Directors and other officers (especially senior managers) of corporations have legal
responsibilities under the rules that apply to those positions and capacities. For example,
a director or other officer must act in good faith in the best interests of the corporation.
A director or other officer must also act so that the power held as a result of the position is
always used for objectively assessed proper purposes.
Consider a director who makes use of secret company information and buys shares on the market
using that information. The director will have breached two different types of rules and will
have broken two laws, so potentially faces two sets of punishment. In respect of the first type of
breach, the director will have traded using inside information, and, as such, will have breached
a market protection rule that exists in many jurisdictions. The second type of breach relates to
being a director. The director has breached the director’s duties of acting in good faith and for
proper purpose, and, by improperly using the position and information, has not complied with
the duty to avoid conflicts of interest.
This example shows that it may well be easier to break a market rule if you are involved with
a company in some way. Through the corporation, you may be more closely involved with the
market or have more market-sensitive information. It is important that managers and directors
understand their duties in full, including those that require understanding of the market. We must
also protect the market as being central to the existence of every large corporation. In every
respect, the market is an important stakeholder and must be treated as such.
Most market protection rules are designed to provide strong responses to breaches along with
the potential for cases to be resolved expeditiously where required. Accordingly, many legislative
provisions may provide for court cases that may be civil or criminal. Criminal cases may result in
jail, fines and/or automatic disqualification from managing a corporation. Such laws are generally
crafted so that whether a civil or a criminal case occurs, compensation will be paid to parties that
have been harmed. One of the most important market protection rules is the prohibition against
insider trading.
Insider trading
As discussed in Module 3, a key feature of public corporations is their separation of management
and ownership. Despite the requirements for continuous disclosure of relevant information,
commercially sensitive, proprietary or confidential information will not be made available to the
market until the appropriate time. This inevitably leads to an information gap between those
with inside knowledge and the public (including existing and potential owners). People with
inside knowledge (i.e. market-sensitive information that is not generally available to the market)
may include:
• share brokers;
• underwriters;
• managers;
• directors;
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• bankers;
• advisers from law or accounting partnerships; and
• anybody who gains inside knowledge by any means, including by communications
with any of the above people.
The potential problems can be seen, for example, during the preparation phase of a corporate
takeover, when a large amount of information obviously must not be publicly disclosed or
the planned event will never come to fruition. All of the people involved in the planning and
preparation will have access to potentially highly valuable information. There is nothing wrong
with having such information, but large firms who may have staff working for both the target and
the acquirer will need to establish special internal information restriction protocols (so-called
‘Chinese walls’) to stop information flows that breach confidences.
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Huge gains can be made from insider trading, so the rules are very strict and are intended to
have a wide operation.
The key tests in determining insider trading are based on the following criteria:
• identifying the information (which can be very broad—e.g. rumours about events or
likely events);
• identifying whether the information has been disclosed in such a way that it is available to
investors in relevant markets (i.e. it has become public knowledge—with enough time for
the information to become known to the market); and
• identifying whether a person who understands markets would buy or sell a security were
they to know that information—in which case the secret information is considered to have a
material impact on the price of a security.
If these criteria are met, the information is called ‘inside information’. A person who possesses
inside information must not use it or disclose it, as such use or disclosure is what actually
comprises insider trading. The onus is on the discloser to know the status of the recipient of the
information. Examples of insider trading include:
• purchasing or selling securities based on inside information;
• having a related party purchase or sell securities on behalf of the person, based on the inside
information; and
• communicating the inside information to any person (often called tipping) when the discloser
knows or ought to know that such disclosure is not permitted.
➤➤Question 4.9
Paroo is a director of Oorap Ltd, a listed corporation. In this capacity, she learned that Oorap
was about to be subject to a takeover bid. Paroo immediately started buying shares in Oorap
so as to be well placed when the market learned of the bid. She is now being investigated by
the regulator.
Discuss the key problems faced by Paroo.
Understanding the rules is important, as financial markets operate under two governing theories:
efficiency of markets and investor confidence. ‘Efficiency’ is measured by the speed with which
information provided to market participants is reflected in the share price. ‘Investor confidence’
revolves around the concept of a ‘level playing field’ (where everyone has an equal opportunity
to compete in the market).
When people with non-public, price-sensitive information use that information to trade in
securities in a market, this non-transparent conduct arguably promotes short-term efficiency in
the market, as market prices very quickly become a reflection of security value. This efficiency
is at a high cost to ethical investors, given those engaging in this form of market misconduct
enter and then exit the markets at prices that give them unfair gains based on their special
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Insider trading will also inevitably reduce investor confidence in the market. In fact, markets
in which investors have little confidence are likely to have a variety of defects. Internationally,
insider trading legislation imposes rules designed to ensure both investor confidence and market
efficiency, and to allow the development of good corporate planning involving appropriate use
of confidential information.
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Every country with a significant market for securities has rules and procedures designed to
prevent insider trading, and significant penalties apply where the rules are found to be broken.
These rules and procedures have a range of common features and ambitions, including
the following:
• fairness in the market price, by giving all market participants equal access to timely
information about shares and other securities;
• preventing insider trading from damaging market integrity—that is, bringing the reputation
of the market into disrepute because of unethical conduct; and
• preventing financial disadvantage to entities that issue securities, and their key stakeholders,
including existing and potential shareholders, and bondholders.
Source: Moran, S. 2012, ‘ASIC’s focus on insider trading pays off in Hanlong case’, The Australian,
1 August, 2012, accessed September 2015, http://www.theaustralian.com.au/business/markets/banker-
admits-to-insider-trading/story-e6frg916-1226439829858.
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Market manipulation
We looked briefly at the 2012 David Jones market events in Example 4.21. As discussed,
this was an example of market manipulation. You will note that Example 4.22 was discussed in
the media as a type of market manipulation. As Zhu was principally involved in insider trading,
we can say that he was an inside trader. However, given that Zhu misused information to make
personal gains, it is understandable that even insider trading is sometimes considered to be
‘market manipulation’.
For our purposes, it is better to consider insider trading as a separate wrong. So, excluding
insider trading, it is important to understand the nature of market manipulation and at least some
of the ways in which it may occur.
Market manipulation, like insider trading, may take place from inside a corporation or by those
outside the corporation. Either way, it is generally unlawful and, as it can have a major impact
on any corporation, boards must understand it fully as another key corporate governance
responsibility. To emphasise this point, note that in the DJs case, we saw the difficulties that
confronted the board in dealing with forces from overseas apparently seeking to manipulate DJs’
share market prices through rumours on a blog. We now will look at some principles that apply
in respect of market manipulation.
Market manipulation can arise in many forms and the range of various ‘schemes’ or approaches is
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seemingly endless. Some general forms (for which most jurisdictions have controlling legislation)
include where manipulators set in place mechanisms that are designed to achieve, or do achieve:
• artificial prices or perceptions of artificial prices;
• artificial trading volumes or perceptions of these volumes;
• the provision of false or misleading information including through disclosure that is
incomplete; or
• false transactions including through persuading others to buy or sell as a result
of misinformation.
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Working definition
We can see that market manipulation may be defined as existing where there are actions and/
or information (including a series of such actions and/or information) that are created with the
intention of influencing, or in fact do influence, the market in relation to shares (and related
securities)—including in relation to price or activity.
Where directors (or sometimes major shareholders) of a corporation are involved in manipulating
the market, the intention may be to artificially inflate the ‘market price’ of shares in the corporation.
This may be for a number of reasons related to the corporation, including preventing takeovers
and relieving pressure exerted by shareholders selling shares. If, for example, a corporation has
a major loan that is repayable if its share price collapses (as was a common feature during the
GFC), then the board may fall into the trap of unlawfully seeking to maintain the share price
through market manipulation. Where a corporation seeks to achieve this artificial price inflation,
the directors may secretly cause shares in the corporation to be purchased by a third-party entity
associated with the corporation, without this association being common knowledge. The secrecy
and the manipulation are easily seen—and this leads to both market manipulation and insider
trading being highly likely as legal breaches.
Note that such manipulation may also simply be for personal reasons, as any significant
shareholder (including directors) may seek to use any resources and/or power available to them
to inflate prices to maintain their own market-based wealth.
The market has given commonly used names to some frequently seen and usually prohibited
market manipulation activity, as discussed in the following sections.
Churning
‘Churning’ involves the placing of buy and/or sell orders for shares with the object of artificially
increasing the market turnover. This increased activity will stimulate market interest and often
will be successful in creating an activity-driven price surges. For example, consider a market
participant (which can include corporations and their boards) who uses strategies of selling and
then repurchasing the same securities in a similar quantity, with the intention of creating a false
and misleading appearance of active trading. Another possibility is that, as stock brokers are
paid commissions based on activity, they may have an interest in creating rumours designed to
boost activity.
Pools
‘Pools’ are organised groups of investors who agree to buy the shares of particular corporations
and, as prices rise due to growing market interest, to sell at a time before the market price
collapses. Given that the prices were ‘induced up’ by the pool, large profits may be derived
at the expense of the other buyers in the market. To make the pool effective, it is common
for the pool to appoint a single manager to trade as instructed on behalf of the entire pool.
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Note that a single very wealthy person could achieve the same outcome acting alone. Either way,
the manipulation will be unlawful—but perhaps more easily identified if it is a conspiratorial pool.
Runs
‘Runs’ involve groups of market participants who work together (which can increase returns
and/or reduce risks) with the intention of creating market effects (often price rises) in a share by
either buying shares, or disseminating rumours in order to attract new buyers into the market.
Sharp increases in the share price can be a direct result.
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Internet discussion boards are often used to generate interest in a stock. As people watch
the rapid rise, they move quickly to buy the shares, only to discover later that they have been
deceived. Directors are sometimes tempted to do this by issuing media releases indicating
significant events. Once the share price rises, directors may sell shares at the higher price before
indicating to the market that the events were not as significant as previously thought.
In the 1980s, a well-known example involved the Guinness beer company. A group of investors
deliberately set about inflating the share price so that Guinness would be regarded by the market
as having the financial strength necessary to take over the major corporation Distillers Ltd. This is
a fascinating example as it demonstrates the various complex motivations that may exist. It also
demonstrates that such activity can involve billions of dollars—as in the Guinness case, which has
been called the best-known stock market scandal in Britain. The Guinness case had a number of
complexities and was finally discussed in the European Court of Human Rights (2000).
Fundraising documents
When raising new debt or equity funds, the use of fundraising documents is required unless
special arrangements are in place about so-called ‘sophisticated investors’. The document
involved is often referred to as a prospectus. (In Australia, interested candidates can access the
prospectus rules at s. 612 of the Corporations Act.)
The temptation is for directors to overstate the benefits of the investment outlined in
the fundraising document. However, false or misleading information in such documents,
including the omission of significant issues and matters that become incorrect during the life of
the prospectus, are treated harshly by regulators, with possible criminal outcomes and major
personal liability for anybody even mentioned in a prospectus.
The role of a prospectus is important. In addition to the actual losses suffered by investors due to
the actions of those who abuse the prospectus rules, the broader damage to market confidence
and destruction of market efficiency (i.e. through false or incorrect information) are completely
unacceptable. If investors are fearful that they will be abused, raising new funds becomes
increasingly difficult and expensive.
Example 4.23, taken from a newspaper report, provides fascinating insight into market
manipulation and its links with insider trading, and the observations in court rooms about
greed and its connection with unwarranted levels of remuneration.
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‘Paying $350 000 to a recent graduate of 21 years of age carrying out a task of modest
responsibility underlines the extent to which the values which underpin our society can be
compromised,’ Justice McClellan said.
The court was told that Hartman had repaid $1.59 million of the more than $1.9 million he
netted from his trading activity, in accordance with the Proceeds of Crimes Act.
The offender’s father, obstetrician Keith Hartman, cried as his son was sentenced and led from
the court to serve time in a ‘special management section’ of prison.
He was sentenced to a maximum of four and a half years’ jail and [was] eligible to apply for
parole in December 2013.
Source: Drummond, A. 2010, ‘Stocks dealer jailed for insider trading’, Sydney Morning Herald,
2 December 2010, accessed September 2015, http://news.smh.com.au/breaking-news-national/stocks-
dealer-jailed-for-insider-trading-20101202-18hf7.html.
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➤➤Question 4.10
In Example 4.23, the judge noted that John Hartman was highly remunerated as an employee.
Discuss this factor and its potential relationship to the market manipulation involved. Why is
insider trading a relevant factor in this case?
Bribery
Corruption is a problem that all countries have to confront. Solutions, however, can only be
home grown.
World Bank President James D. Wolfensohn (1996)
There are many ways in which bribery (internationally one of the most significant forms of
corruption) may originate and be structured. Generally, however, it involves the payment of
money or the provision of benefits, undertaken with a degree of secrecy, and intended to
obtain benefits of some kind. Importantly, the person(s) receiving the benefit uses their position
or knowledge to make a personal gain, by acting in the interests of the person making the
payment instead of acting according to their duty under their contract of employment or other
relevant contracts. To put it another way, the party paying the bribe seeks a benefit by paying
the recipient of the bribe, so that the recipient will act in the payer’s interests rather than acting
correctly in respect of a third party.
An example would be where a supplier of flat screen television panels provides benefits to the
purchasing officer of a television manufacturer in order to induce the purchasing officer to buy
flat panels—perhaps at an inflated price—on behalf of their employer. The purchasing officer
accepts a personal gain from the flat panel supplier and in return, negotiates purchasing terms
that are detrimental to the employer.
Unfortunately, bribery creates effects that are worse than a single economic event. To start with,
the employee (or other person) accepting a bribe becomes part of a conspiracy that creates
further likelihood of bribery. For example, the flat panel supplier might threaten the purchasing
officer with disclosure unless the activity is repeated. Obviously, the effects of bribery can
grow and enmesh many people. In some countries, it has become an unfortunate common
feature of business and commercial relationships across the whole society. It can then extend
internationally—eventually leading to the situation where corrupt business transactions are
almost expected.
Obviously, bribery and corruption can detrimentally affect corporate and personal reputations
and can even affect the trading and business reputations of entire countries. Most countries
have enacted specific legislation making bribery criminal in nature, as it is a form of corruption,
usually involving conspiracy. It can attract substantial penalties including jail, large fines and
obligations to compensate those harmed by this criminal behaviour.
MODULE 4
Bribery and corruption can occur in all forms of organisations and wherever there is economic
activity of any kind. Not-for-profit organisations also experience these problems; in 2013 the
Washington Post reported that from 2008 to 2012 more than 1000 not-for-profit organisations
disclosed hundreds of millions in losses attributed to theft, fraud, embezzlements and other
unauthorised uses of funds and organisational assets. A study cited by the Post stated that
religious organisations and not-for-profits suffered one-sixth of all major embezzlements,
second only to the financial services industry (cited in Venable 2013).
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Internationally, new approaches to bribery control are being introduced, with stronger controls
on all forms of bribery—including facilitation payments. The OECD Working Group on Bribery in
International Business Transactions and the UN Convention Against Corruption both demonstrate
increased global awareness of the enforcement and investigation of bribery. This is especially
relevant for bribery by corporations in foreign jurisdictions. Under the UK Bribery Act 2010,
all corporations based in the United Kingdom are in breach of UK law if they pay any bribe,
including facilitation payments, anywhere in the world. (Interested candidates can see UK FCO
2011 for the text and a discussion of the Act.)
Even large corporations, with household names and brands that rely on reputational value,
can become involved in highly publicised bribery and corruptions, sometimes as the result
of decisions by individual managers or contractors acting as agents. Even the Australian
Reserve Bank has recently become enmeshed in an internationally reported bribery scandal in
relation to contracts to print currency notes for overseas economies, as reported, for example,
in Business Insider (Richter 2012).
Example 4.24 provides part of an article from The Lawyer (Griffiths 2011) explaining a widely
reported bribery event that affected Shell Oil internationally. We discuss some of the approaches
implemented by Shell, which were designed to prevent further bribery and corruption events.
Source: Griffiths, C. 2011, ‘Bribery/Anti-corruption: Shell’, The Lawyer, 18 March, accessed August 2014,
http://www.thelawyer.com/bribery/anti-corruption-shell/1007290.article.
In 2015 the Australian Senate began an inquiry into overseas bribery allegations regarding
Australian corporations. This included interviewing executives from Leighton Holdings
and BHP Billiton, with the view that the legislative frameworks for enforcement of an
anti‑foreign bribery regime were more effective in the United States and United Kingdom
(McKenzie & Baker 2015).
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The fight against corruption is difficult, especially where offshore, possibly self-interested,
contractors act on behalf of international corporations. Boards need to understand the
issues involved in establishing and ensuring sound corporate governance, including
corruption compliance, otherwise the impact on reputation and performance can be very
high. With reference to Example 4.24, note that as early as 1999, Shell had in place a group-
wide, well written policy titled Dealing with Bribery and Corruption: A Management Primer
(Shell 2003). It includes a large amount of advice and numerous statements of Shell policy,
including recognition of the benefits of not being involved in any form of bribery. If the document
had been properly used and understood by its contractors, Shell would have confronted no
problems. The fact that a contractor perhaps was not aware of or ignored Shell policies created
the problem faced by Shell.
There are strong international laws—for example in the United Kingdom where all bribes payable
by British corporations anywhere in the world are banned. Not even minor facilitation payments
are allowed.
Rogue trading
Rogue trading is discussed only briefly as it is a complex field. It is perhaps of more concern
to financial institutions than to boards in general—although it could happen in relation to a
corporation’s finance risk control (including hedges and options) or trades by or in a corporation’s
own shares. Therefore, boards should understand the issue as a matter of corporate governance
generally, especially relating to finance functions. This area is considered in some detail in the
Financial Risk Management subject.
A rogue trader is normally an employee (or other authorised person) who engages in
unauthorised trading. The motivation may be personal gain or simply hubris—that is, excessive
pride. Whatever the motivation, rogue traders can sometimes create mayhem in financial
markets generally.
One of the highest profile rogue trading events of all time related to the collapse of the
centuries-old Barings Bank. There, a single rogue trading employee (Nick Leeson in the
Singapore office) was able to run his own deals in his own way without any effective oversight
from London. His losses on the bank’s behalf were huge—totalling over USD 1.3 billion. It seems
that Leeson was not forestalled in his actions in any timely way. The main Barings Bank board
was in London, far from the scene of Leeson’s trades; they were too impressed by his apparent
trading success, not knowledgeable enough about the trades he was making, and too willing
to accept his assurances. As a result, Barings Bank, one of the oldest banks in the world,
was ‘bankrupted’ by the losses Leeson generated.
However, the assumption that ‘rogue traders’ have acted alone, without the knowledge or
acquiescence of senior executives, is sometimes misleading. When failures occur, both financial
institutions and the courts often attach fault to particular individuals rather than the systems and
MODULE 4
culture of the institution itself. The attempt to do this by the UK Financial Conduct Authority and
JP Morgan Chase in the London Whale case revealed how difficult those systems and culture
are to resist. Action was dropped in August 2015 against the trader Bruno Iksil, whose bets on
complex derivative contracts cost JP Morgan Chase USD 6.2 billion in losses. Iksil acquired his
oceanic nickname due to his trades that swamped the markets. In the backwash, JP Morgan
Chase agreed to pay USD 920 million to resolve litigation in New York and London that they had
misstated financial information, and due to a lack of internal controls prevented traders from
‘fraudulently overvaluing investments’ (Stewart 2015).
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Iksil was not convicted because, while he had engaged in high-risk trading, he did not conceal
his positions and had repeatedly discussed strategy with higher ranking executives. He had
grown increasingly uncomfortable with the favourable valuations the bank was reaching, and was
recorded by the bank referring to his boss stating ‘I can’t keep this going. I don’t know where
he wants to stop, but it’s getting idiotic. Now it’s worse than before. There’s nothing that can
be done, absolutely nothing that can be done. There’s no hope. The book continues to grow,
more and more monstrous’ (Stewart 2015).
Ponzi schemes
Ponzi schemes are named after Charles Ponzi who was involved in a very high-profile and
widespread fraud (using a mechanism that had earlier origins). At their simplest, Ponzi schemes
involve earlier investors (potentially including through share-based transactions) being given a
return by simply diverting the capital contributions of later investors to the earlier investors. In the
early stages of a Ponzi scheme, amidst the excitement of receiving returns that are surprisingly
high, earlier investors are very happy and later investors join in by investing their money so they
can also obtain these large returns.
In fact, so happy are earlier investors that they often invest further sums and/or reinvest the actual
returns received. There comes a point, however, where new investors are too few to sustain the
returns. At this point, investors commonly start seeking payments of their capital. The fraud
becomes evident as there is no remaining capital and the accounts underpinning performance
(which might have done so for many years) are proven to have been fraudulent. At this time,
it usually becomes apparent that the creator of the scheme and key associates (who typically are
the only people aware of what was really happening) will have taken steps to enrich themselves
by further frauds—including the personal use of large amounts of cash from the scheme.
The fact that these schemes occur somewhere every few years shows the impact of greed and
gullibility on investing communities. The reality of Ponzi schemes and the fact that they can harm
individuals, corporations, markets, and even have economy-wide impact, must be understood by
directors and boards as part of overall corporate governance knowledge.
According to those charged with recovering the victims’ money, Madoff’s investment operation was
probably never legitimate. Almost USD 65 billion was missing from client accounts, including fabricated
gains. Actual losses to investors was estimated by the trustee to be approximately USD 20 billion.
MODULE 4
Madoff’s business, began deteriorating after the global financial crisis when clients requested a total of
USD 7 billion back in returns––and he only had USD 200 to USD 300 million left to give back to them.
One reason Madoff managed to remain undetected for so long––even though several people had
filed reports to the SEC expressing their fear that he may be operating a Ponzi scheme––was due to
his wide reputation and respected position in the financial industry. He had founded his own market-
maker firm in 1960, and assisted in the launching of the NASDAQ Stock Market. Madoff also sat on
the board of the National Association of Securities Dealers, and advised the Securities and Exchange
Commission on trading securities.
It is generally agreed that 70-year-old Madoff knew exactly what he was doing when he defrauded his
clients over several decades. Madoff was sentenced to 150 years in prison on 29 June 2009.
348 | GOVERNANCE IN PRACTICE
Phoenix companies
Internationally, a problem for corporate regulators relates to directors (and sometimes larger
shareholders, who control companies as de facto directors without actually being appointed)
who deliberately use limited liability to avoid liabilities. Usually, this applies only within smaller
corporations—normally private corporations.
Typically, what occurs is that the directors/managers of the original corporation allow it to fail,
owing large amounts of money (often to tax authorities). A new corporation, operated by the
same directors/managers, is then created to carry on the existing business activity. The new
corporation rises from the ashes of the old and, using a term from Egyptian mythology, these
new corporations are commonly referred to as ‘phoenix companies’.
The directors/managers of the failed corporation step away from and leave unpaid the debts
of the old company. It is quite common for the ‘phoenix company’ to be given a trading name
that is similar to the old failed corporation—meaning that the trading reputation remains intact.
Clever implementation of these arrangements means that care is taken not to hurt important
business relationships. Therefore, while some third parties who are not important to the new
entity are afflicted badly, including tax authorities, the new corporation successfully carries on
the old business. However, where the old corporation’s name and therefore reputation are poor
among its business partners and customers, the phoenix company will trade under an entirely
different name.
In short, phoenix companies involve the deliberate misuse of the legal protections related to
limited liability, meaning that the corporation owes money and the shareholders (usually also
being the directors) have ‘limited liability’. So they escape the debts of the first corporation only
to start again with renewed limited liability in the new corporation that trades again in the same
way—perhaps only to fail again in the same way and to be replaced yet again.
Research as well as logic indicates that directors involved in phoenix corporate activity
demonstrate an increased risk of soon being involved in failures (e.g. corporate administrations)
where creditors are badly hurt. Research from Dun & Bradstreet (2009) ‘shows that Directors
on the board of a business that has gone into external administration are 250 percent more likely
to be involved in an insolvent wind-up at some stage in the next twelve months’.
Importantly, two new pieces of legislation that were passed in Australia in 2012 allow stronger
responses to phoenix companies. Both of them amend the Corporations Act. The first
amendment operates so that some corporations can be de-registered more easily. The second
amendment provides for directors of new corporations with highly similar names to previously
failed corporations (in which they were involved) to be specifically and personally liable for the
debts of the old corporation (which the new corporation effectively replaces).
While it can be seen that disqualification of directors (as discussed early in this module) involved
MODULE 4
in multiple insolvencies is one way of dealing with phoenix companies, clearly, other measures
are necessary. This is because disqualification alone has not ‘caught’ a sufficient number of
misbehaving directors. Australia’s approach is typical of measures in many jurisdictions that are
designed to prevent the abuse of limited liability by directors who take advantage of corporate
entities and of their appointment to and departures from their boards.
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Representation
Throughout this module, we have discussed corporate governance relationships and rules and
approaches to make corporate governance better—both in conformance and performance.
We have seen that the most influential stakeholders within an organisation can be considered
to be the board and senior managers of the corporation. However, there are many other
stakeholders, as seen in Module 3. The concept of shareholders and who they are has been
discussed at some length, and on many occasions the implicit question of ‘representation’ of
shareholders in corporate decision-making has arisen.
Interestingly, shareholders, who are regarded by the law as the ultimate owners with a variety of
rights, are in one sense correctly regarded as ‘insiders’—with connections with management and
control. However, this correct legal presumption is often not correct in practical terms, in spite of
some increased power given to shareholders in recent times (e.g. the two-strikes rule considered
in this module).
The fact is that, in a large corporation, small shareholders have remarkably little influence on the
direction of the corporation and no real control, as individuals, over the decisions made by the
board and management. The opposite is true of large shareholders. They do have influence and
often real control through board positions and/or potential voting power at general meetings
of the corporation. For example, in the United States over the past decade, hedge funds have
played an increasingly important and high-profile role in the market, by taking sizeable stakes
in undervalued or struggling corporations and then agitating for change—typically at the board
and senior management level.
Therefore, while the small shareholders can be regarded as being ‘outside’ the corporation,
the large shareholders are able to exert their influence ‘inside’ the corporation. So significant is
this fact that there is a model called the ‘outsider model’, which recognises that large numbers of
small shareholders are owners, but still ‘outside’ in terms of any real control, since they have little
representation in real terms.
By contrast, the ‘insider system’ (as seen in Module 3) looks at those who have real power in
the corporation. It especially refers to those who may have influence and/or power through
relationships, as can be seen commonly in European and Asian business structures. Interestingly,
substantial shareholders (in large and small corporations) tend to look more like ‘insiders’ as
they have real, share-based power, and therefore tend to be better represented in corporate
decision making.
The degree to which shareholders are represented is an area of some concern. You will recall
from Module 3 that decisions by boards are required to be ‘in the interests of the corporation as
a whole’. This means, in a democratic sense, that they are made in good faith for the majority of
shareholders, with no decisions made for the express purpose of harming or advantaging any
MODULE 4
For individual shareholders, rights stated in the OECD Principles that are commonly protected
by detailed legislation include:
• the right to attend and vote at all general meetings;
• the right to relevant information;
• the right to buy and sell shares freely (at least in listed corporations);
• the right to not be abused as shareholders; and
• the right to protect ‘property interests’ in shares—indeed there is a large range of rights
with corollary obligations on directors and other officers.
Table 4.4 describes some of the ways in which shareholder representation and ‘power’ may occur
within a corporation.
Representation—
some forms Description and examples
General meetings Each shareholder has a guaranteed right to attend and vote at the general
meeting of shareholders—including, commonly internationally, rights to vote in
respect of executive remuneration.
Nominee director A director appointed to represent the interests of a large shareholder or a particular
group of shareholders. Such a person is unlikely to satisfy ‘independence’ criteria.
They will also be faced with conflicts of interest, as their duty must be to the office
of director and not to the person who arranged their place on the board. Nominee
directors will eventually need to be voted onto the board by the shareholders,
and their duty will be to ‘act in good faith in the best interests of the company as a
whole and to act for proper purposes’. Nominee directors commonly face difficult
conflicts of interest as they in fact represent a single large interest and the law
requires them to act for all shareholders.
Examples include:
• Australian Shareholders’ Association (ASA)
• New Zealand Shareholders’ Association (NZSA)
• Investment and Financial Services Association (IFSA)
Research and These firms typically conduct independent research and analysis on the corporate
advisory firms governance and financial position of a corporation, as well as surveys of
shareholders, customers and suppliers. Publication of the results in mainstream
media provides a form of shareholder representation. They can also be what are
termed ‘ratings agencies’. These are also ‘intermediaries’ in markets.
MODULE 4
Examples include:
• Institutional Shareholder Services
• Glass Lewis & Co
Study guide | 351
Representation—
some forms Description and examples
Institutional investor Some investors actively seek corporate governance, personnel, strategic or
capital management changes to improve the performance of their investments.
While such investors are undoubtedly acting in their own best interests,
their representations are made on behalf of all shareholders in the quest
to add long-term, sustainable value. Their real role is open to very strong
questioning. Under what legitimate source of authority does a single high-wealth
organisation, managed by a group of professional managers with only limited
accountability to the owners of the wealth, stand as a credible arbiter of what
comprises good corporate governance?
Examples include:
• California Public Employees’ Retirement System (CalPERS)
• Hermes Investment Management
In 2007, the ISC published a supplement, Statement of Principles (ISC 2007), which sets out
best practice for institutional shareholders and/or agents in relation to their responsibilities in
respect of investee companies. The IIC is developing materials and information designed to
create better understandings and sound corporate governance practices between corporations
and institutional investors, given the importance of the latter as major providers of funding
to corporations. The role of the IIC no longer includes developing statements of principles
for institutional investors generally (like those of 1991 and 2007) as the FRC’s Stewardship
Code (FRC 2012) gives the relevant rules and principles. Even so, the IIC identifies a number
of important roles, including that of presenting ‘a single voice for the institutional investment
industry on matters affecting its role as investors in companies’ (IIC 2011).
little doubt that the basic motivations behind such approaches are sound. Also, the overall
approaches of CalPERS do not seem to demonstrate any failings. However, as professionals
we need to look carefully at organisations such as CalPERS. It is likely that decisions and
approaches by such organisation towards corporate governance preferences will be driven by
the perceptions and preferences of the current managers within the relevant organisation at
any time.
352 | GOVERNANCE IN PRACTICE
We need to be aware that these managers are at the same time, it seems, seeking returns for
the wealth owners and also seeking to influence global approaches to corporate governance.
Difficulties—including potential conflicts of interest—seem likely to arise, at least sometimes.
However, where a group or groups of large institutional investors pool their capabilities in
order to develop ‘industry standards’, the likelihood of valuable generic outcomes surely must
be greater. An example of this is the Financial Services Council’s ‘Blue Book’—Corporate
Governance: A Guide for Fund Managers and Corporations (IFSA 2009)—which sets out
important guidance for investment managers (i.e. institutional investors).
Whether or not large institutional investors will always be best placed to comment on corporate
governance matters, in general there is no doubt that they can and do fill a valuable role as
shareholders. Their relative size in the market generally, and their ability to comment where
less powerful shareholders could not, can be seen in Example 4.26. That example deals with
some publicly reported matters occurring within News Corp. There, CalPERS is the (institutional)
shareholder reported as expressing major concerns. CalPERS states reservations about the
approaches of the board of News Corp. The independent directors of News Corp however
state that they do not share the concerns so strongly felt by CalPERS.
As background to CalPERS’ concerns about News Corp, it is noted that an Australian Financial
Review article identified that CalPERS ‘owns 5.49 million News Corp Class A (limited voting) and
1.38 million Class B (full voting) shares, worth about USD 110 million. The Murdoch family controls
39 per cent of News Corp’s 798 million voting shares’ (Potter 2011). The report also identifies that
there are a further 1.82 billion non-voting shares on issue by News Corp, of which the Murdoch
family own relatively few. ‘Reduced’ or ‘no voting’ share rights are addressed by CalPERS in its
suggestion that there is a ‘corrupt’ voting structure.
Notwithstanding CalPERS’ stated concerns, we may assume that an entity buys shares with
full knowledge of their rights, including voting rights. Perhaps CalPERS’ stated concerns
therefore may be considered ‘in principle’ concerns relating to News Corp structures, as it may
not seem valid to complain about a specific circumstance that was voluntarily accepted with
full information.
As you read Example 4.26, you are expected to employ professional judgment in considering the
facts. For example, the independent directors of News Corp fully reject the criticisms of CalPERS,
and we should not dismiss this independent judgment as being of no importance.
Example 4.26: N
ews backs Murdoch despite shareholder
threat
‘News backs Murdoch despite shareholder threat’
The independent directors of News Corporation gave their unequivocal backing to the
MODULE 4
management team headed by Rupert Murdoch, even as one of the company’s largest
shareholders threatened to take action to address the ‘corrupt’ voting share structure that
entrenches the Murdoch family’s control of the company.
The endorsement came hours after News Corp chairman and CEO Rupert Murdoch and his
son James, the deputy chief operating officer and chairman of News International (the British
newspaper operating company at the heart of a phone hacking scandal that threatens to
engulf the company) endured a three-hour grilling at the hands of a UK Parliamentary select
committee.
Study guide | 353
Independent director Viet Dinh said in a statement on behalf of the independent directors
that the ‘News Corporation Board of Directors was shocked and outraged by the allegations
concerning the News of the World, and we are united in support of the senior management
team to address these issues.’ … ‘In no uncertain terms, the Board and management team
are singularly aligned and committed to doing the right thing,’ the statement said.
The Australian Financial Review reported on Tuesday that some directors had raised the idea
of Mr Murdoch stepping down as CEO in favour of Chase Carey, the highly regarded chief
operating officer, and remaining chairman. Bloomberg reported similar plans but said they
were contingent on how Mr Murdoch fared before the UK select committee.
News Corp director Thomas Perkins scotched the reports, saying Mr Murdoch enjoyed the
full support of the board and the existing succession plan had not been brought up in light
of the hacking scandal at the now defunct News of the World tabloid.
However, one of News Corporation’s largest shareholders threatened to take action to
address the ‘corrupt’ voting share structure that entrenches the Murdoch family’s control of
the company, as Rupert and James Murdoch parried a British parliamentary select committee’s
questions.
Californian Public Employees Retirement Scheme senior portfolio manager Anne Simpson said
the News Corp voting structure ‘pervert(s) the alignment of ownership and control’ and warned
that the USD 237 billion fund did not intend to be a spectator in the hacking scandal that had
slashed USD 8 billion from the company’s value before Tuesday’s select committee hearing.
Ms Simpson, who heads CalPERS’ corporate governance program, said, ‘The situation
(the hacking scandal) is very serious and we’re considering our options. We don’t intend to be
spectators—we’re owners’ … ‘The market reaction shows how seriously this is being taken—
to the tune of USD 8 billion at the moment. I can’t say what the options are at the moment,
but we have strong experience in governance reform,’ Ms Simpson told The Australian
Financial Review in an email … Ms Simpson, meanwhile, hit out at what she described as the
‘corruption’ of governance processes at News Corp. ‘News Corp does not have one share
one vote. This is a corruption of the governance system. Power should reflect capital at risk.
CalPERS sees the voting structure in a company as critical,’ Ms Simpson said. ‘One share one
vote’ is a CalPERS core principle, because we believe that the control of a company should
reflect its ownership. That’s capitalism—it’s a design feature that’s vital. Dual class voting is
one way to pervert the alignment of ownership and control.’
Rupert Murdoch, who in another lapse from strict corporate governance standards is both
chairman and CEO, told the select committee he wasn’t responsible for the phone-hacking
at New Corp’s News of the World newspaper and that the blame lay with ‘the people that I
trusted to run it’. James similarly deflected responsibility.
Source: Potter, B. 2011, ‘News backs Murdoch despite shareholder threat’, Australian Financial Review,
21 July, accessed September 2015, http://afr.com/p/business/marketing_media/news_backs_
murdoch_despite_shareholder_B6xxfH5AabSN8RDwLv6CxL.
After surviving the immediate media storm following the revelations regarding the phone
hacking scandal in the United Kingdom, and the closure of the News of the World newspaper
at the centre of the controversy, Rupert Murdoch initially faced down the repeated market calls
MODULE 4
for him to step down as CEO of News Corp (remaining in the role of the chair) and demands to
separate the newspaper interests and television and film interests of News Corp. Then, in 2013
Murdoch responded to the calls and formed two companies with most of its television and film
assets being included in a new company, 21st Century Fox. The remaining 130 newspapers
(including the Wall Street Journal and the Times of London), educational businesses and other
assets were established in a new company with the old name of News Corp (Economist 2013).
354 | GOVERNANCE IN PRACTICE
The reluctant splitting of the conglomerate media corporation into two more focused media
concerns led to a dramatic increase in the price of 21st Century Fox shares and the stabilisation
of the newspaper companies shares. With his Midas touch apparently returned, Rupert Murdoch
now felt able to address the two related problems that had damaged the corporate governance
reputation of the company for a considerable time: firstly the concentration of power in his
hands, and secondly the apparent lack of any convincing succession strategy (Clarke 2016).
In a complicated governance manoeuvre (the final outcome of which is unclear) 21st Century
Fox announced in 2015 that James Murdoch would become CEO, while Rupert Murdoch
would remain as Executive Chairman, and Rupert’s other son, Lachlan Murdoch, would become
Co‑Executive Chairman (with the long serving Chase Carey stepping down as Chief Operating
Officer). At News Corp, Rupert Murdoch remained as Executive Chairman, with Lachlan Murdoch
as Non-Executive Chairman and Robert Thomson as Chief Executive. Commentators suggested
that these arrangements had more to do with dynasty than governance, and the fact that
no place could be found for Rupert’s daughter Elizabeth (widely acknowledged as the most
talented and independently successful of Murdoch’s children from her success as a UK television
entrepreneur) revealed it was not the most robust dynastic settlement.
Source: Knight, E. 2015, ‘No Berth for Elisabeth in Murdoch’s 21st Century Fox Empire’, Sydney Morning
Herald, 13 June), accessed September 2015, http://www.smh.com.au/business/comment-and-analysis/
no-berth-for-elisabeth-in-murdochs-21st-century-fox-empire-20150612-ghmldn.html.
➤➤Question 4.11
Refer to Example 4.26.
Explain why ‘normal’ small shareholders (not institutional shareholders) in News Corp may have
concerns about Murdoch family control when in fact the family does not hold a majority of shares.
Also explain why institutional shareholders will have concerns. With whom does CalPERS more
readily align, given that at the time it held 1.38 million Class B (full voting) and 5.49 million Class
A (partial voting rights) shares, of the total of 738 million voting shares?
Expanding ethics
It is becoming increasingly common for business codes of conduct to specify ‘good business
ethics’. These codes of conduct do not apply only to employees and managers. Codes of
conduct need to deal with a vast array of relationships and business matters.
One interesting expansion taking place is that many purchasers now insist that suppliers must
display at least minimum ethical standards. A powerful example occurred more than 10 years
ago when the Finnish company, Nokia, began sourcing large volumes of inputs from factories
in developing economies. Nokia took the approach that employees who worked in overseas
factories to make goods that would be bought and used by Nokia must work in good, safe
working conditions and be paid appropriately. If a supplier could not meet the minimum
MODULE 4
standards required by Nokia, then Nokia would not do business with them. As was highlighted
earlier, in 2015, Apple Inc, currently the richest company in the world, is apparently challenged in
assuring the same adherence to safe working conditions for the employees in its 352 contractors
plants in China (as are many other IT manufacturers) (Clarke & Boersma 2015). Although Apple
conducts an annual survey of its suppliers’ responsibility, the results of the audit are often deeply
disappointing for a company that prides itself on the perfection of its products (Apple 2015).
It is interesting to note that a responsible and ethical approach is a valuable extension of the
ambitions to improve societies that we observed in the OECD Principles.
Study guide | 355
An extensive example of a code of ethics that has a broad array of internal and external
stakeholder governance requirements can be seen in HSBC’s ‘Ethical and environmental code
of conduct for suppliers of goods and services’ (HSBC 2012). Included in this code, for example,
is a set of employment conditions that suppliers need to comply with. As professional
accountants, we can immediately see the importance of meeting HSBC’s ethical rules if the
supplier is to continue supplying to HSBC.
It is clear that good governance practices protect boards, management, shareholders and
many other stakeholders, including the financial markets and the economy. HSBC’s focus on
ethical conduct is part of the company’s commitment to meeting expectations, not only of
its shareholders, but also of its customers, regulators and society as a whole—that is, being a
responsible corporate citizen (the subject of Module 5). Poor ethics, combined with unlawful
behaviour, can damage corporations dramatically. For example, recent public statements about
Olympus Corporation have focused on impropriety within the corporation and subsequent
shareholder losses, as shown in Example 4.27.
The Olympus case study illustrates the way that boards can mismanage dramatically—and the
fact that this mismanagement hurts corporations, shareholders and indeed entire economies by
damaging financial markets. The Financial Times article is one of many reports identifying that
the board of Olympus was involved in a major scandal. A fundamental cause appears to be the
absence of independent directors on the board (a practice that was widespread in the Japanese
corporate governance system, though now the Japanese code recommends companies accept
at least one independent director). Even worse, the report suggests that there is an apparent
reluctance in Japan to lessen the power of entrenched non-independent board and management
structures. But, as with other countries, lessons have been learned from the Olympus case and
other corporate scandals in Japan and the important questions that go to the heart of ethical
corporate governance are being asked:
As the drive for change in Japanese corporate governance accelerates, fundamental questions are
being asked presently in Japan … Whose interests should a company serve? Is it the property of
shareholders, for them to do whatever they want with it, or does it have a wider social purpose?
(Seki & Clarke 2013, p. 717).
Olympus has admitted to falsifying its accounts to cover up Y130 billion in losses incurred
through bad investments dating back to the 1990s.
Japanese police arrested three former executives of Olympus, including its former chairman,
who are suspected of involvement in the fraud, while Tokyo prosecutors last month indicted
Olympus on violation of the Financial Instruments and Exchange Law.
The Olympus scandal has shaken the Japanese business community and undermined foreign
investor confidence in the country’s capital markets.
Tsutomu Okubo, an upper house parliamentarian who chairs a ruling Democratic Party
committee on corporate governance reform, said earlier this week: ‘It is a serious matter.
The Olympus affair attracted much attention … and it is said that thinking on corporate
governance in Japan is lax.’
The Democratic Party is preparing to submit legislation aimed at improving corporate
governance but it has been watered down due to opposition from the powerful business
lobby Keidanren.
Speaking to the media, Mr Woodford said the choice of Olympus’s new chairman and other
board members and the process whereby new directors have been nominated indicated
governance had not been reformed at Olympus.
Two key appointees have close ties with Olympus’s main bank, Sumitomo Mitsui, while another
has had a long career with Bank of Tokyo Mitsubishi, making them insufficiently independent,
he said.
‘The Olympus scandal would have been a wonderful opportunity to really get it right.’ Instead,
he said, investors hesitate to invest in Japan and question the integrity of company accounts.
‘Japan is seen to be having more and more question marks,’ Mr Woodford said.
Source: Nakamoto, M. 2012, ‘Former Olympus chief warns on governance’, Financial Times, 19 April.
Used under licence from the Financial Times. All Rights Reserved.
MODULE 4
Study guide | 357
Review
If you consider a bicycle wheel, the hub is nothing without the spokes, securely connected to the
rim. The rim is the visible working edge that transmits power to the road and drives the machine
forward. The wheel will weaken if individual spokes fail and will collapse if more than a few fail.
The hub is where the gears are located and where central forces are at the greatest.
In a corporation, we might regard the board and senior management (the directing ‘mind and
will’) as the hub where strategies, major policies and overall control emanate. The rim represents
the ongoing ‘roll’ of the successful corporation.
The many rules and expectations confronting corporations, along with the relationships that must
be understood and managed, are equivalent to the spokes of the bicycle wheel. It is important
that each spoke (i.e. each important consideration, relationship and rule) is understood and
looked after carefully and appropriately to ensure the ongoing success of the corporation.
The precise importance of each ‘spoke’ in the wheel is hard to determine and ensuring the right
attention to the right ‘spoke’ at each time is a question of judgment. The best corporations do
this very well. The secret of a great company is the ability of its board and senior management to
assess these issues and to make decisions that achieve the correct balance over time. While the
best corporations do this well, poorer corporations do it less effectively and those that do it
worst almost inevitably cease to exist. The remainder of this summary deals not with the rim of
the corporate wheel nor with the hub; rather it deals with some of the many ‘spokes’ that must
be identified and dealt with correctly—remembering that if even a few spokes are not dealt with
when problems arise, then the whole wheel will fail.
We have reviewed the internationally significant ‘balancing act’ that confronts modern
corporations and those who advise or deal with them. In this module, we have discussed
corporate and personal responsibilities in relation to conformance expectations and performance
requirements. As we have strongly identified, both conformance and performance are central
components of corporate governance. Both aspects of corporate governance must be satisfied
so that diverse international societies achieve effective utilisation of the capital resources
employed in their enterprises.
We explored rights and relationships of employees of corporations, such as health and safety,
working conditions, holiday entitlements and trade union operations. We also considered
the role of ‘whistleblower protection’. While this might be thought of as ‘merely compliance’,
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this is an area where the most junior employee may ‘look after’ their corporation (including its
performance, profitability and reputation) by acting promptly and relevantly as whistleblowers,
to identify and stop the excesses of ‘megalomaniac managers’ who can greatly damage a
corporation if not checked.
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The module discussed aspects of the legal system and penalties which exist for legal breaches.
We considered the nature of markets for goods and services, and international approaches
to competition law as well as modern international approaches to the legal protection of
consumers. We also explored the rules that directly affect financial markets and how these rules
need to be understood by corporations and individuals, regardless of whether the individual has
a connection with a particular corporation. Once these rules are understood, the significance
of the civil and criminal legal outcomes that can occur and the relevant penalties that can apply
become immediately apparent.
Importantly, the module provides many examples, propositions and ideas for consideration.
As stated in the introduction to this module, successful corporations (especially their boards
and management) must appreciate the complexities of the modern international corporate
environment. They must ‘get the balance right’ in many ways. CPAs, as moral agents who
understand at least some of these complexities, are a crucial component in the international
development and operation of better corporate governance. Perhaps, in the best of all worlds,
CPAs will have a role in turning the pedals that make the wheel go round.
We leave the discussion in this module in order to look at other spokes in the wheel as we
move on to Module 5. There, we see the importance of developing clear understandings
and our own individual professional judgments about the important area of corporate
accountability and all that this ever-broadening domain means to modern international
corporate governance and ethics.
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Suggested answers | 359
Suggested answers
SUGGESTED ANSWERS
Question 4.1
The two-strikes rule provides a new type of power to shareholders who are dissatisfied with the
remuneration report. This report, as part of the corporation’s annual report, discloses the salaries
paid to senior executives. If shareholders are unhappy, the first strike may occur at the next AGM,
if at least 25 per cent of the eligible shareholders vote against accepting the remuneration report.
(Shareholders ineligible to vote include managers, directors and any associated shareholders.)
The second strike may occur a year later at the next AGM, if the next remuneration report is
similarly rejected by at least 25 per cent of the eligible shareholders. Following the second strike,
the whole board (except the managing director) is subject to a spill vote. The spill vote takes
place the same day and only eligible voters are involved in that voting. The spill occurs only if
50 per cent of eligible voters vote in favour of the spill, because the big step of dislodging the
whole board should not be decided by only 25 per cent of eligible voters.
The old ‘spilled’ board continues until the next shareholders’ meeting, which must take place
within 90 days in order to elect a new board. Candidates can include new potential directors
nominated by shareholders so the old board can be largely replaced. The vote for the new board
involves all shareholders, including the previously ineligible shareholders, who now vote for the
new board. This has the potential to allow their often very large voting power to reinstate all
the old board. However, the message sent by the eligible shareholders about who should be
members of the new ‘post-spill’ board of directors will be powerful and hard to ignore.
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Note also that at least (any) two of the old ‘spilled’ directors must continue as directors in
addition to the ‘unspilled’ managing director. (We will not explore further how these directors
may be selected and the complexities that may arise if shareholders do not vote for at least two
old directors.)
360 | GOVERNANCE IN PRACTICE
Question 4.2
A disqualified person is not permitted to hold an office in a corporation, which includes not being
permitted to act as a director or be a senior manager. To act as an officer while disqualified is an
offence and is subject to criminal punishments.
Automatic disqualification means that the disqualified person is not necessarily informed that
they are disqualified. For example, a person involved in corporate crime, or even a non-corporate
crime that involves dishonesty and is not just a minor wrong, is most likely to be ‘automatically’
disqualified merely because they are criminally open to punishment. Accordingly, officers need to
be aware of the possibility of automatic disqualification if they are ever found guilty of an offence.
Five years is usually the period of automatic disqualification.
Where a court (or a regulator such as ASIC) orders disqualification, it will be because a
legislated wrong has occurred. This can include civil wrongs where proof is ‘on the balance of
probabilities’. Periods of disqualification are commonly up to 20 years (and sometimes more).
Note that the disqualified person is advised clearly of the period, when the court or regulator
applying the disqualification states the outcome as an order to the relevant person. Aside from
disqualification, such orders are often in conjunction with civil or even criminal penalties.
Question 4.3
(a) Ideally, independent directors (who, by definition, are also non-executives of the corporation)
are not paid any performance bonuses. They should receive only flat payments, in accordance
with an overall payment policy approved by shareholders. As such, they are not personally
influenced by levels of pay. Independent directors should not be on a board too long (as also
discussed in Module 3) so that they are able to stay independent and free from external
influence.
Independent directors can, therefore, make decisions that are for the good of the
‘company as a whole’ (which of course is a specific legal formula about the relationship
between the board and shareholders) from a more objective stance than directors who are
not independent. Non-independent non-executive (NINE) directors are less able to make
unbiased decisions (and certainly appear more biased to ordinary shareholders) as they have
relationships that deny independence. Obviously, executive directors should not be allowed
to make decisions regarding their own remuneration.
(b) This is a difficult question to answer in detail as every corporation is different and the
remuneration committee in each corporation will look at many complex factors. Below are
two possible methods:
–– Perhaps the CEO bonus should be based on achieving a certain return on investment
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(ROI), or a percentage linked to achievement above a certain ROI. Care must be taken
not to allow the remuneration incentive to overcome organisational priorities and great
care must be taken to ensure that excessive risk is not accepted in the hope that great
remuneration may result.
–– Perhaps the bonus should be paid partly in cash to emphasise an immediate return for
current performance and partly in share options (with perhaps a two year exercise date)
to encourage the CEO to stay in their current position and continue to build share value.
In two years the options will be worth more and will be exercisable, giving a good reward
after two years.
This approach could also apply to senior managers. The possible concepts and approaches
under this question are numerous and form a key part of the determinations of a good
remuneration committee.
Suggested answers | 361
(c) Shareholders rely on the deliberations of the remuneration committee and its
recommendations to the board. Shareholders may question remuneration in annual
meetings—including through the two-strikes rule in Australia and related measures
developing in other jurisdictions. It is apparent that the major considerations need to be
carefully analysed and undertaken by the remuneration committee and by the board,
in the absence of executive directors who are the recipients of the remuneration decisions.
The shareholders should be able to rely on good boards and active and diligent independent
directors for good remuneration decisions.
Question 4.4
A board may do many things to help ensure that the relationship between the corporation and
the external auditor is independent. One important item for which auditors are responsible is a
statement of independence that they must make to the corporation. This audit statement must
be a part of the corporation’s annual report, along with the actual audit report itself.
Apart from including the auditor’s statement of independence in the annual report, the board
can consider other important measures that will help to make independence easier to achieve.
We have not looked at every such measure but they include clearly stated policies and practical
procedures which:
• ensure an independent auditor is engaged to perform the audit;
• establish a correctly structured audit committee so that this body can be identified easily
by the auditor as comprising ‘those charged with governance’;
• ensure that the audit committee understands that it is the body through whom all audit
communications are normally expected to take place; and
• define the way management should behave when their activities are the subject of audit
activities (this, importantly, will include the CEO and the CFO).
In addition, appropriate measures should be in place to ensure that employees’ interactions and
dealings with the auditor are at arm’s length.
Question 4.5
(a) In Examples 4.10 and 4.11 the ultimate responsibility for decision-making rests with the
board, therefore the boards of both corporations were lax in allowing anti-competitive
practices to go on. For example, Intel, the largest computer chip maker in the world, used its
status to stifle its competition and to unfairly pressure customers into doing business with
it. Indeed, it can be argued that the directors breached their fiduciary duties by allowing
such anti-competitive behaviour. In either case it might be difficult to demonstrate that
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the board had actual or constructive knowledge of the wrongdoing to the extent that its
failure to respond to the alleged red flags was a breach of its fiduciary duties to properly
monitor corporate compliance; nonetheless, compliance oversight is a key role of the board,
so the directors should have systems in place to prevent or at least warn them of these anti
competitive practices.
Corporate governance should ensure the constructive use of market power. Effective
board oversight of legal compliance can strengthen the corporation today and into the
future, and allow it to avoid accusations of wrongdoing with respect to domestic or global
competition law. The board can be assisted in doing this by establishing a strong and
impartial ‘compliance committee’ that consists of independent directors and by instituting
appropriate compliance policies, procedures and programs.
362 | GOVERNANCE IN PRACTICE
Directors should ask themselves to what extent they are prepared to bear the negative
consequences of non-compliance. They should also check which early warning systems and
processes have been put in place for ensuring that the corporation’s practices are not anti
competitive, since the impact, both in terms of reputation and bottom line, can be extremely
damaging when a corporation fails to live up to its regulatory compliance duty.
(b) Companies form strategies to make profits, and eliminating competitors or pursuing anti-
competitive action may help achieve those profits. So, from this perspective, competition
laws may stifle an aggressive corporation’s ability to be competitive.
(c) To distinguish themselves from their competitors and thus gain an advantage that is not anti
competitive, corporations can initiate policies to develop and maintain customer relations
through, for example, the provision of comprehensive before- and after-sales services or
continuing to offer innovative products at competitive prices. Corporations can also establish
a reputation for honesty and integrity and engender customer loyalty through the provision
of excellent service. In other words, meeting and exceeding competition and consumer laws
is a way to drive competitive advantage without resorting to the types of anti competitive
practices illustrated in Examples 4.10 and 4.11.
Question 4.6
(a) The purchasing managers of both Shark and Loose would likely be in breach of laws that
prohibit cartel conduct including this highly visible ‘price-fixing’. In addition to the purchasing
managers, the corporations themselves would also be in breach, as the actions of employees
are also those of the corporation. Notwithstanding that the purchasing managers may have
been acting contrary to corporate policy, and not informing the corporations, they are still
acting on behalf of their corporation. This will lead to the corporation also being accountable
for its conduct.
(b) Potential penalties would include individual jail terms and fines, and fines for the corporations,
which could be as high as USD 10 million or more (e.g. in Australia, the US and the EU).
In addition to penalties, compensation would also be payable to Goods Ltd as the affected
party. Compensation may be very large, depending on the economic damage suffered by
MODULE 4
Goods Ltd. Note that if the misconduct is not established as a crime (proven to the ‘beyond
reasonable doubt’ standard of proof), it is likely that the matter would be held ‘on another day
in another court’ as a civil matter. The civil ‘balance of probabilities’ standard of proof is easier
to satisfy. While a civil wrong does not establish a crime, it can result in a financial ‘pecuniary
penalty’ which may be at exactly the same level as the criminal ‘fine’ would have been.
(c) Acting alone, there would be no collusion and therefore no cartel conduct. There is simply
no ‘agreement or understanding’ between competitors. Here, an individual corporation has
decided to deal with a certain customer in a certain way. This type of ‘unilateral’ decision-
making is generally not a problem, and on the facts stated, Shark and Loose should be ‘safe’.
Suggested answers | 363
Question 4.7
‘Whistleblowing’ describes the action of a person who discovers behaviour that they believe or
reasonably suspect is ‘wrong’ and then brings their concerns to the attention of the appropriate
people. Ideally, the appropriate people will investigate the suspicions and, if proven correct,
will take the necessary action to address and/or rectify the situation. This concept is important
in governance as whistleblowers are now protected by legislation (where whistleblowers act in
ways defined by relevant local legislation). Even junior employees can make their concerns known
without risk of punishment or legal action as long as they act consistently with the law protecting
them. This means that senior and junior managers are more open to inquiry and this openness
not only discloses wrongs but makes wrongs less likely to occur.
We would advise Watkins that in Australia today she would be protected by specific legislation.
However, she must ensure that she satisfies prescribed rules to obtain that protection,
which include that she can only be a protected whistleblower if she is:
• an officer of the corporation (this includes senior managers and directors and the
corporation secretary);
• an employee of a corporation (Watkins will satisfy this requirement); and/or
• a contractor or their employee who has a contract to supply goods or services to
the corporation.
She must also make her allegations known only to specified recipients of that information,
which include the following:
• ASIC;
• the company’s external auditor or a member of the external auditing team;
• a director of the company, the company secretary or any senior manager of the company; and
• a person specifically authorised by the company to receive whistleblower revelations, such as
the Corporate Counsel or the internal auditor.
If all these requirements are met then Watkins today would be protected in Australia under the
whistleblowing provisions of the Corporations Act.
Question 4.8
The conduct is misleading or is likely to mislead. To make a specific statement about an objective
matter is acceptable if it is essentially correct. The problem is that there is an objective matter
that has been ignored and that makes the specific statement objectively invalid. The advice
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received by the beverage manufacturer clearly states that the higher carbohydrate content
is ‘statistically insignificant’ with respect to the drink’s ability to improve endurance. Ignoring
this objective fact and using only that which was favourable to the drink maker constitutes
misleading conduct.
Where misleading conduct is found, a range of outcomes may apply, such as compensation
orders, injunctions or adverse publicity orders.
364 | GOVERNANCE IN PRACTICE
Question 4.9
Financial market protection rules apply to everyone who breaches a market protection rule.
To break the rule, you do not need to be a director, an employee or an accountant—merely a
person who breaks a rule that applies to you as a person ‘meddling’ with the market. If a director
is involved, which is common because they often hold secret market sensitive information,
then they also may easily breach other laws relating to directors’ duties.
It is clear that:
• Paroo has information (knowledge of the takeover bid);
• the information has not been disclosed and is not readily available in the market; and
• the information will have a material impact on the share price once it is released.
The information about the takeover is therefore inside information. As such, Paroo is not
permitted to act upon this information or disclose it. By purchasing shares, Paroo has been
engaged in insider trading, deliberately using knowledge not known to the market in order to
acquire shares at a price that would encourage others to buy those shares had they been privy
to the information.
Paroo has also misused her position as a director and has misused information gained as a
director. She has also not acted in good faith for the best interests of the corporation and has
not used her powers for proper purposes.
Question 4.10
Justice McClelland, the judge in the case, commented on Hartman’s ‘immaturity’ and his lack of
values. He stated, ‘paying $350,000 to a recent graduate of 21 years of age carrying out a task
of modest responsibility underlines the extent to which the values which underpin our society can
be compromised’.
We need to understand the role that greed and self-interest can play in creating circumstances
that may cause poor corporate behaviour to flourish. In this instance, Hartman had high
expectations of rewards due to him. It seems that he decided to increase his rewards by secretly
(from the market) manipulating aspects of the market known to him and then using the secret
information as an insider, which is also insider trading.
The market manipulation related to the fact that, as the judge stated, ‘in the course of buying
and selling in significant volumes, the offender came to appreciate that large-volume trading
could have the effect of raising or lowering the price of a stock within a short timeframe’.
Hartman, recognising that the market would be manipulated by this activity, used his secret
inside information by telling others that this manipulation would occur and by trading
MODULE 4
An interesting aspect of these circumstances is the fact that large volume trading itself, if done
in order to drive prices up or down, will be unlawful. If a large volume is bought or sold as a
simple trade without the intention to drive prices, then there is not necessarily anything unlawful
occurring. We can see in Hartman’s case that he treated his ability to be involved in these
‘price inducing’ large trades as a known manipulation activity. He attained his benefit from the
actual insider trading. The case demonstrates the way that markets can be subject to misdealing.
We saw this also with the Calvin Zhu and David Jones cases, and there are many such examples.
Suggested answers | 365
Question 4.11
The Murdoch family holds slightly less than 40 per cent of the shares in News Corp. This is not
a majority. However, as no other voting group holds anything close to this percentage, it means
that News Corp in many ways is controlled by the Murdoch family. This can be seen in the fact
that family members hold dominant executive management positions as well as board positions.
At the time of the report (2011), the phone-tapping scandal involving News Corp was at its height
and the CEO and Chairman of the Board were both the same person—Rupert Murdoch.
Normal small shareholders, whose individual votes provide no real power in many corporations,
will be able to exert even less influence where a single, closely aligned group of shareholders
(i.e. the Murdoch-aligned votes) has dominance of the type described.
We see here that the institutional investor CalPERS is offended by the nature of the board
structure, by reported corporate activities and by the way that the voting system is organised.
The voting system concern, if relating to ‘non-voting’ and ‘partial-voting’ shares, arguably may
not be justified. This is because CalPERS presumably bought shares aware of the voting rights.
If it wishes all of its shares to have voting rights then it is free to sell its non-voting shares and
acquire in their place only voting shares. If CalPERS’ concerns relate to the absence of power
available to voting shares because of the Murdoch family’s ‘voting block’, then the concerns
are more understandable. It is also a concern that cannot be corrected unless corporations
laws change dramatically. A fundamental feature of all corporate governance is that those who
own the shares (including the Murdoch family) have the right to vote those shares. Even so,
it is the duty of all directors to act in the interests of the corporation as a whole. That means
decisions must be made for the benefit of all shareholders—not to the advantage of a few or to
deliberately hurt any shareholders.
CalPERS, as an institutional investor, has about 1 per cent of the voting (partial and full)
shares. We also see strong animosity from CalPERS towards the voting and power structure
within News Corp. Accordingly, we might expect CalPERS to more readily align with other
disgruntled shareholders. Indeed, the impact of shareholder demands for News Corp to be split
into 21st Century Fox for the film and television interests and News Corp for the newspaper
interests was eventually heeded by Murdoch, and for several years proved a highly successful
strategy. However, Rupert Murdoch has not listened to shareholders’ complaints regarding the
governance and management structure of both companies, and in 2015 was resolved to continue
with the Murdoch family firmly in control (with his sons James and Lachlan holding the controlling
positions with himself), despite wide concerns among shareholders and other commentators that
this might prove an unstable succession strategy.
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MODULE 4
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MODULE 4
ETHICS AND GOVERNANCE
Module 5
CORPORATE ACCOUNTABILITY
* CPA Australia gratefully acknowledges the many authors who have contributed to this module.
376 | CORPORATE ACCOUNTABILITY
Contents
Preview 379
Introduction
Objectives
Teaching materials
Overview and introduction to key elements 382
The evolution of corporate accountability
History of CSR reporting
Environmental sustainability
Social sustainability
Economic sustainability
Linking environmental, economic and social sustainability
The board’s responsibility for sustainability of the organisation and
organisational initiatives
Introduction to the key elements
Drivers of increased business accountability 391
The importance of climate change and its relevance to CSR reporting
The Global Financial Crisis (GFC) and the recognition of market and ethical
failures: a case for accountability and transparency
Other incentives tied to maximising the value of the organisation and
shareholder wealth
Corporate identity and accountability
The shareholder primacy perspective
Externalities and potential government intervention
Linking to ethical theories 402
Enlightened self-interest
Stakeholder theory
Organisational legitimacy
Institutional theory
Summary
What can be measured and reported? 408
What is measurable?
Limitations of traditional financial reporting 411
Scope of reporting
Elements of financial reporting
The practice of discounting future cash flows
Reliable measurement and probability
Focus on short-term results
The entity assumption
Reporting and guidelines 415
What is required? (Mandatory reporting)
Guidelines and non-mandatory reporting
Other initiatives
Current reporting practice 441
Surveys of current reporting practice
Examples of best practice and innovative reporting
International initiatives on climate change 444
Climate change accounting techniques
Accounting for the levels of emissions
Current developments 451
Socially responsible investments
Natural capital accounting
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CONTENTS | 377
Review 455
Readings 457
Reading 5.1 457
Reading 5.2 459
Reading 5.3 460
References 475
Websites monitoring progress
MODULE 5
MODULE 5
Study guide | 379
Module 5:
Corporate accountability
STUDY GUIDE
Preview
Introduction
Organisations are entrusted with significant assets and power, and have the ability to have a
significant effect on the economy, community and the environment. As such they need to be
accountable for their actions, and reporting is one method for discharging this accountability.
Traditionally, corporate accountability has been discharged via annual reports. Annual reports
are made up of many components that together demonstrate the organisation’s action
and accountability. But, in most circumstances, the part of the report that receives the most
emphasis is the financial report, especially the accounting profits. However, financial reporting
is not designed to communicate to a broad range of users, and specifically focuses on the
shareholders and debt-holders. As such, these reports are commonly criticised as being narrow
in scope in that they emphasise historical accounting profit, and do not tell the full extent of
the value creation story of the organisation or of the organisation’s broader impacts.
In addition to being accountable for the resources in their care and for their behaviour and
actions, companies are also expected to be sustainable in the way they operate, and also in the
way they consume raw materials and produce finished goods. Dwindling resources, damaged
ecosystems and exploited labour are three reasons to encourage and pursue social and
environmental sustainability.
Organisations are increasingly making additional disclosures to meet information needs that
are not satisfied by the reporting requirements of financial accounting as reflected in financial
statements. This aligns with increasing stakeholder expectations of sustainability (commonly
referred to as corporate environmental, social and governance (ESG)) responsibilities.
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380 | CORPORATE ACCOUNTABILITY
These expectations have been addressed through a significant growth in companies producing
stand-alone or web-based corporate social responsibility or sustainability reports over the last
10 years (KPMG 2013). The disclosure of information about sustainability performance and
processes has become so common that it is now considered mainstream reporting by most major
corporations around the world.
The increase in reporting by businesses about their social and environmental impacts and
performance has been accompanied by a recent increase in associated regulation worldwide.
This means that for some organisations, corporate accountability has changed from being
desirable to being expected, and from being expected to being required.
Some examples of new regulations include the European Parliament announcing the adoption
of a directive on disclosure of non-financial and diversity information for organisations with more
than 500 employees. Such organisations will have to disclose additional information regarding
‘policies, risks and results in respect of environmental matters, social and employee-related
aspects, respect for human rights, anti-corruption and bribery issues, and diversity on boards of
directors’ (EC 2014). In addition, a number of stock exchanges throughout the world, including
Johannesburg, Sao Paulo, Singapore, Kuala Lumpur and Copenhagen, require listed companies
to submit an integrated report (discussed later in this module) or report on their sustainability
issues, or explain why they have omitted this information.
One of the reasons for desiring greater corporate accountability is so we have a sustainable
future, and sustainable development is a central concept in this module. As such, it is useful
to provide a working definition. For the purpose of this module, sustainable development is
defined as:
Ensuring that the needs of today’s world are met while at the same time ensuring that the ability for
future generations to meet their own needs is not compromised. (WCED 1987, p. 16)
This definition is derived from the report Our Common Future (WCED 1987), also known as the
Brundtland Report, and was presented in 1987 by the World Commission on Environment and
Development chaired by Gro Harlem Brundtland, then the Norwegian prime minister.
In this module we introduce you to the key elements of corporate accountability. We then discuss
drivers for greater accountability. These include climate change, the global financial crisis (GFC),
and placing greater emphasis on a concept of value creation for improving shareholder wealth
that is broader than accounting profit. We link this to ethical theories and examine the extent
to which some of these broader concepts are capable of being quantifiably measured.
We also demonstrate that there is a variety of reporting approaches that have recently
evolved to ensure greater corporate accountability. We identify the main mandatory reporting
requirements that have developed, and discuss some of the more widely adopted or higher
profile non‑mandatory reporting initiatives. These include the G4 Sustainability Reporting
Guidelines (G4 Guidelines) of the Global Reporting Initiative (GRI) (2013a) and the International
Integrated Reporting <IR> Framework (IIRC 2013). The module will conclude with a review of
current reporting practices and current developments, including international initiatives on
climate change, social responsibility investing and natural capital accounting.
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Study guide | 381
Objectives
After completing this module, you should be able to:
• explain the concept of social and environmental responsibility and its relevance to
governance;
• describe the obligations of corporations in relation to their social and environmental
behaviours;
• discuss the different theoretical perspectives about what motivates organisations to
present social and environmental information;
• identify the components of corporate social responsibility or sustainability reports;
• identify the limitations of conventional financial accounting in relation to the recognition
of social and environmental costs and benefits;
• describe the mandatory reporting requirements for social and environmental
performance reporting;
• describe the elements and frameworks of non-mandatory reporting for social and
environmental performance reporting;
• discuss the reasons why an entity would use non-mandatory reporting;
• explain the relevance of climate change to corporate accountability, and identify some
related measurement issues; and
• evaluate the role of corporate governance mechanisms in enhancing an organisation’s
social and environmental performance.
Teaching materials
• Readings
Reading 5.1
‘Further views about the social responsibilities of business’
L. de Kretser
Reading 5.2
‘Westpac named world’s most sustainable company at Davos’
G. Liondis
Reading 5.3
‘Social responsibility in eye of beholder’
J. Bhagwati
• Case Study
Case Study 5.1
‘Drilling into disaster: BP in the Gulf of Mexico’
(available on My Online Learning) MODULE 5
382 | CORPORATE ACCOUNTABILITY
This highlights the fact that definitions of corporate accountabilities typically extend the
responsibilities of corporations beyond their shareholders alone, and incorporate activities
over and above those relating to the usual provision of goods and services. However,
whether corporations, which are owned by shareholders, can realistically be expected to
balance the needs of other stakeholders—many without any financial power or influence—
with the fundamental quest of maximising the wealth of shareholders is a question that will
evoke a different reaction from different people. These tensions are discussed in Adams and
Whelan (2009).
Many people believe that corporations have to earn a social licence to operate and have a
responsibility to make choices that benefit society and the environment. There are others
who continue to believe that the fundamental quest of corporations to maximise profits and
shareholder value can be achieved with little consideration of broader stakeholder interests.
Still others, such as Unilever, firmly believe that social responsibility and minimising environmental
impacts are essential to long-term growth and returns to shareholders. It is unrealistic and
even dangerous to leave social responsibilities in the hands of organisations that are guided
by ‘enlightened self-interest’. As you will see in this module, there is an increased emphasis on
regulation worldwide, and the corporate accountability imperative now extends beyond a few
enlightened organisations.
The underpinning philosophy is that corporations have a social and environmental impact in
addition to their economic impact and these can enhance or diminish the collective good or
wider societal progress. These new accountabilities are being demanded by civil societal groups
with business leaders often responding to, rather than leading, the debate.
Corporate accountability is closely linked to the other four modules in this subject. This broad
view of corporate accountability demonstrates how the professional accountant can have
a positive impact on society (Module 1). It shows the importance of the accountant having
knowledge of ethics and the tools that can be used to resolve complex ethical dilemmas
(Module 2), as well as the key concepts and principles that underpin corporate governance
approaches (Module 3). It is also a demonstration of the balancing act that the accountant can
be involved in, as different organisations will have a different balance between the objective
of maximising the wealth of shareholders and the responsibility of making choices that benefit
society and the environment (Module 4).
CSR reporting is a process whereby an organisation publicly discloses information about its
interactions with, and impact on, the various societies and environments in which it operates.
As we will see, the nature of this reporting can vary widely between organisations, and across time.
While there is a history of some organisations making CSR disclosures, within the Australian
context, the practice of CSR reporting became more widespread in the early 1990s. At that time,
many mining companies, some water and energy utility organisations and some organisations
in other industries began releasing stand-alone reports (often referred to as environmental
reports) that documented various aspects of their environmental performance. They did this
on a voluntary basis as there were no laws or regulations in place at that time compelling them
to do so.
In the mid-1990s, various organisations started producing more information about their social
performance. More recently, most leading companies are producing reports—often referred to
as ‘Sustainability reports’ or ‘Corporate social responsibility reports’ (these labels are often used
interchangeably)—that incorporate various aspects of their economic, social and environmental
performance. Again, there are no laws or regulations that compel organisations to release
publicly available CSR or sustainability reports.
Environmental sustainability
Environmental sustainability involves making responsible decisions and taking action that are in
the interests of protecting the natural world, with particular emphasis on preserving the capability
of the environment to support human life.
There are several compelling arguments for environmental sustainability. From a humanistic
perspective, environmental sustainability is critical because humans rely on the natural
environment for survival and therefore have a responsibility to address the problems they cause.
The intergenerational argument contends that not being sustainable is an unfair burden to
place on future generations, who ultimately will have to live with the consequences of our current
behaviour. The naturalistic argument claims that nature has an intrinsic value, and deserves
preservation for its own sake. While you may find some of these arguments more convincing
than others, they are mutually reinforcing and together make a compelling case for pursuing
environmental sustainability.
The role of business in environmental sustainability has been highlighted by a series of high
profile environmental disasters that have had a vast effect on the environment, ecology and
our society.
These environmental incidents are shocking, and have received considerable interest from
society, the media and government. However, it is not just disasters that have piqued society’s
interest in environmental sustainability. We are increasingly aware of the resource constraints and
limitations of the world we live in. For example, fresh water is a finite resource that is critical to
life, but also underpins the productivity of industrial, mining, agricultural and urban development.
We are increasingly aware that our water resources are limited; this represents a huge risk to
human life and commercial activity. It is important to note that although businesses contribute
to these problems they may also have tools to address these complex problems.
• Climate change: The change in global and regional climate patterns is associated with more
intensive emission of atmospheric carbon dioxide and other greenhouse gases resulting from
the use of fossil fuels. Climate change represents one of the most challenging market failures
ever known, and the role of business in resolving this problem is critical.
• Pollution: Businesses create pollution when production processes lead to the introduction of
substances or contaminants into the natural environment that can cause harmful effects.
• Biodiversity: This refers to ‘the variety of life on Earth. It is the variety within and between
all species of plants, animals and micro-organisms and the ecosystems within which they live
and interact.’ (WWF 2014). Ecosystems are complex and interdependent, so when a business
affects one element of an ecosystem, this can result in profound changes to other parts of
that system.
Social sustainability
Social sustainability can be understood as the ability of a system to continue to function at
a reasonable level of social well-being. Thus an organisation is socially sustainable when its
activities not only meet the needs of its current stakeholders but also support the ability of future
generations to maintain healthy communities.
Traditionally, social sustainability has been considered the role of government; however, there is
a growing acceptance that companies also have an important role to play. Socially sustainable
activities of an organisation may include maintaining mutually beneficial relationships with
employees, customers, the supply chain and the community.
As with environmental sustainability, there are many examples of when companies have not
demonstrated their commitment to social sustainability. One prominent example of this is the
2013 collapse of the Rana Plaza building in Bangladesh, where 1138 people died, many of whom
were poorly paid garment makers who worked extremely long hours in very unsafe conditions.
The disaster caused international outrage, and some responsibility for the conditions of the
workers was placed on the western retailers who sold the garments. The Rana Plaza disaster
showed that as an increasingly globalised and interdependent world, we are becoming more
aware of the linkages between companies, markets and complex global problems such as
poverty and inequity. Some topical issues in social sustainability include the following:
• Child labour: The employment of children in business or industries is illegal in most parts of
the world, yet remains a widespread practice, with an estimated 215 million child labourers
worldwide. It often places children at risk of harm and interrupts their education. World Vision
argues child labour ‘deprives children of their childhood, their potential and their dignity’
(World Vision 2012).
• Ethical trading: This includes operating in markets with integrity and legality. Unethical
trading practices may include corruption, anti-competitive behaviour, bribery, aggressive or
predatory pricing, unethical marketing or unfair uses of power in markets.
Social sustainability is not just a global issue. It also relates to local communities, as the following
example illustrates.
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The WACOSS Social Sustainability Assessment Framework has informed the development of WA State
Budget recommendations and is based on five principles:
• equity
• diversity
• quality of life
• inter-connectedness
• democracy and governance.
Economic sustainability
The economic dimension of sustainability concerns organisations’ impact on the economic
conditions of its stakeholders and on economic systems at local, national and global levels.
In the case of an organisation, it means using available resources to their best advantage
(both efficiently and responsibly) so the organisation can continue to function over a number
of years at a given level of activity. The idea is to promote the use of those resources in a way
that does, and is likely to continue to, provide long-term benefits.
• Long-term viability of businesses: Our reporting and financial systems are geared more
towards the short term. Some argue that this leads to myopic decision-making and an
institutionalised failure to manage businesses for the longer term (Bair 2011). This has
generated demands for more attention to be paid to the performance and activities of
businesses in the long term.
• Stability of the economic system: The GFC, like other economic crises before it, showed
how complex and interconnected our economic systems are. Further, economic systems are
an integral part of human communities, and breakdowns can have widespread consequences.
Corporate behaviour can play a large role in creating a stable economic system.
Sustainability
Environmental
Economic
Social
Most national and international initiatives, and many advocacy efforts, focus on only one
pillar at a time. For example, the United Nations Environmental Programme (UNEP) and the
environmental protection agencies (EPAs) of many nations focus on the environmental pillar.
The World Trade Organization (WTO) and the Organisation for Economic Cooperation and
Development (OECD) focus mainly on economic sustainability. A company or other reporting
organisation that focuses on one pillar in isolation risks its sustainable future and reputation.
There may of course be different emphases that are appropriate, but an organisation should
consider all three pillars in its sustainable business strategy.
As the GFC demonstrated, weakness in one pillar can have consequences for the other pillars.
As a result of the GFC, many nations and states cut back or postponed stricter environmental laws
or investment, since their budgets were running deficits. Many environmental non governmental
organisations (NGOs) saw their income fall, and income spent on social programs also declined.
These three pillars of sustainable development are often included in CSR reporting. Many
organisations, in their CSR reporting, will discuss their sustainability initiatives in accordance
with these three pillars. As we will see later in this module, the most widely used guidelines
for sustainability reporting, the Global Reporting Initiative (GRI), structure their sustainability
indicators so as to provide insights into an organisation’s significant economic, environmental
and social impacts.
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388 | CORPORATE ACCOUNTABILITY
One important element of the business case, and a reflection of the increased demands from
society, is that specific regulations are asking organisations to report more broadly than financial
performance and position. For example, as discussed later in this module, in March 2014,
the Australian Stock Exchange Corporate Governance Council included a new best practice
requirement that an entity disclose any material exposures to economic, environmental and
social sustainability risks and that if this is the case then the entity needs to provide explanations
for how it manages these risks. Also, across the world we see that climate change initiatives are
becoming a significant driver of the costs and benefits to business. For example, in Australia,
large businesses that exceed relevant thresholds are required to report to the government their
greenhouse gas emissions, greenhouse gas projects, energy use and production under the
National Greenhouse and Energy Reporting Act 2007 (the NGER Act).
In addition to the direct effects of specific regulations, the business case for sustainability
considers other effects on the business, from changing relations with customers, suppliers and
other stakeholders, to the costs and risks of doing business. There is evidence of a positive
relationship between a business’s credibility on sustainability issues and its ability to win and
retain customers, as in Hopwood, Unerman and Fries (2010). Their research also draws links
between a focus on sustainability and increasing competitive advantage through innovation
and new products, and the business’s ability to attract, motivate and retain staff. The business is
also likely to manage risk better if it has a conscious focus on sustainability risks, and to reap the
rewards of direct cost reductions through operational efficiencies and avoiding waste, travel and
regulatory costs. The increase in business profitability and ability to manage risks will benefit
the business’s reputation and brand, including its licence to operate and its ability to raise
external funds.
There is a growing sense that traditional financial reporting is not sufficient. The landscape
for non-financial reporting has changed at different speeds in different countries and regions.
Governments are making policy changes and the consequential procedural changes impose new
reporting requirements on companies. In fact, KPMG in their 2013 survey analysed the reports of
more than 4100 companies globally—including the world’s 250 largest companies—concluding
that ‘The high rates of CR (corporate responsibility) reporting in all regions suggest it is now
standard business practice worldwide’ (KPMG 2013, p. 11). They also identified that much of this
increase was associated with increased regulatory requirements. In addition, some company
managers are voluntarily adopting new reporting practices in response to the desire for better
information for a wider range of stakeholders.
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As we outline later in this module, in response to these concerns, we have seen a significant
development in the evolution of corporate reporting, the integrated reporting initiative.
Integrated reporting provides a broader accountability of an organisation’s resources and
relationships than does financial reporting, by requiring a consideration of all resources and
relationships (including social and environmental) that impact the value creation activities of
the organisation.
An example of this new organisational form are the companies that are recognised as
B-Corporations. A B-Corporation involves a certification process that recognises ‘a new type
of company that uses the power of business to solve social and environmental problems’
(B-Corp n.d.). In 2015 there were 1307 registered B-Corps from 41 countries. Companies that
have been certified by BCorporation are able to distinguish themselves from other companies
by offering a positive vision of a better way to do business.
In 2014, Natura from Brazil become the first publicly listed B-Corp. Natura is a cosmetics business
based on a direct selling model, which has approximately seven thousand employees in Brazil.
It currently has more than 1.6 million Natura consultants (NCs) in Brazil and internationally.
In explaining why the company wanted a B-Corp certification, they stated:
More than contributing to society with the adoption of sustainable practices, we wish to promote
a growing movement of awareness and search for solutions to a more balanced and fair future
with a social, economic, and environmental perspective. Being part of the B Corp movement
strengthens our belief that we indeed must seek profit, which is the basis of our operation, but this
should not be the sole purpose of our existence. (Natura 2014).
Accountability
Central to this module and directly tied to the decision to report information (whether it be CSR
or financial information) is the concept of ‘accountability’. We can define accountability as the
duty to provide a report, or an account, of the actions and decisions made about those areas of
activity for which an organisation is deemed to be responsible. These may be financial or non
financial and usually focus on the use of resources that have been entrusted to an organisation’s
care. If we are to accept that an entity has a responsibility (and a duty of accountability) for its
social and environmental performance, then we, as accountants, should provide ‘an account’
(or report) of an organisation’s social and environmental performance—perhaps by releasing a
publicly available CSR report, including additional information in the annual report or disclosing
information online.
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Therefore, a central aspect of corporate accountability and the role of corporate reporting is
to inform relevant stakeholders about the extent to which actions for which an organisation
is deemed to be responsible have been fulfilled. Reporting, whether it be CSR reporting or
otherwise, is a vehicle for an organisation to fulfil its requirement to be accountable.
CSR
For the purposes of this module we base our discussion of CSR on the following definition
by the Commission of European Communities (CEC), which states that CSR is:
A concept whereby companies integrate social and environmental concerns in their business
operations and in their interaction with their stakeholders on a voluntary basis. Being socially
responsible means not only fulfilling legal expectations, but also going beyond compliance
and investing more into human capital, the environment and the relations with stakeholders
(CEC 2001, p. 6).
The above definition is consistent with the definition of CSR provided by the World Business
Council on Sustainable Development (WBCSD n.d.):
‘Corporate social responsibility is the continuing commitment by business to behave ethically and
contribute to economic development while improving the quality of life of the workforce and their
families as well as of the community and society at large.’ (WBCSD, p. 3)
In practice, CSR can refer to a wide range of activities that an organisation can undertake,
from making donations to selected charities to undertaking sustainable activities, including
reducing carbon emissions from their operations. Commonly, the terms ‘CSR reporting’ and
‘sustainability reporting’ are used interchangeably.
Sustainability
There are many and varied definitions of sustainability but the concept addresses the ongoing
capacity of the earth to maintain all life. To be sustainable, the needs of the current generations
must be met without compromising the ability of future generations to meet their needs.
Actions to improve sustainability are both individual and collective endeavours, shared across
local and global communities. They necessitate a renewed and balanced approach to the way
humans interact with each other and the environment (ACARA 2014).
Sustainability reporting
Sustainability reporting is the process of producing a sustainability report (published by an
organisation) about the economic, environmental and social impacts caused by the organisation’s
everyday activities. Other aspects that are commonly expected of an organisation’s sustainability
report include information about the organisation’s values and governance model, and links
between its corporate strategy and its commitment to a sustainable global economy.
Natural capital
Natural capital can be understood as the world’s stocks of natural assets. It includes air, water,
land, soil, geology and biodiversity. It is a finite resource, and the demands of a growing and
increasingly prosperous global population means that escalating demands are being placed on
an already overstretched resource.
Integrated reporting
Integrated reporting is a process founded on integrated thinking (see below) that results in
a periodic integrated report by an organisation about aspects of its value-creation process.
Bringing together the main parties involved in corporate reporting, the International Integrated
Reporting Council (IIRC) has produced a conceptual framework for the preparation of a concise,
user oriented corporate report entitled an ‘integrated report’, which captures an organisation’s
resources and relationships using a ‘six capitals concept’ and requires a description of a
company’s business model, allowing a better communication of its value creation proposition
over the short, medium and longer term.
Integrated thinking
An important component of integrated reporting is ‘integrated thinking’, which is ‘the active
consideration by a company of the relationships between its various operating and functional
units and the capitals that the organisation uses and affects’ (IIRC 2013, p. 2). Some of the
expected advantages that an organisation gains from undertaking integrated thinking are that
it advances the alignment of the organisation’s strategic focus with both its financial and non
financial performance. With greater comprehension of how a company creates value and of the
social and environmental impact of its activities, it is more likely that management will recognise
the imperative of integrating sustainability concerns into business strategies.
Had organisations been charged an expense for their emissions in their pursuit of profits in a
market-based economic system, this might have encouraged them to develop ways to reduce
their emissions—and their costs. The introduction of carbon taxes and emission-trading schemes
in some parts of the world has meant that many organisations will now have to internalise aspects
of the environmental impact of their business that would previously have been treated as an
externality and ignored. Motivated by efforts to improve corporate profitability, companies will
focus on reducing emission levels, and therefore, the amount of (carbon) taxes they are required
to pay.
Climate change is obviously an issue attracting much attention globally, and one that we would
expect organisations to address in their CSR reports. Indeed, many organisations consider it to
represent one of their biggest risks.
One or two decades ago, many companies challenged the science associated with climate
change, but now there is a general acceptance that human activity is changing the climate.
We return to the issue of climate change later in this module. At that point we provide a brief
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explanation of the science of climate change as well as insights into how to account for climate
change, and in particular, how to account for carbon-related taxes.
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There appears to be general agreement that the major contributing factors to the GFC included
the following:
(1) High leverage, which was sustainable only under conditions of increasing asset prices and
investor confidence.
(2) Inadequate governance, accountability and remuneration practices within financial institutions.
(3) Uncontrolled (and not well recognized) liquidity creation due in part to global current account
imbalances and the willingness of surplus countries to invest in financial assets being created in
deficit countries.
(4) Growth of a largely unregulated ‘shadow banking’ sector and the construction of complex
financial instruments and techniques which saw risk spread throughout the world and
significant interdependencies created.
(5) A lack of public information about the level and distribution of risk in the financial system
(Davis 2011, p. 4).
The GFC significantly changed how people thought about business, and the wider society’s trust
in business leaders was seriously diminished as a result. As the GFC demonstrated, weakness in
one of the pillars of sustainability can directly weaken the other pillars. This means that society
will increasingly come to expect greater disclosure of environmental and social impact, as well as
governance information. This is often described as becoming part of the social contract. A social
contract is an implied (i.e. not official) agreement between an organisation and society, and the
terms of the social contract are the ways in which society expects the organisation to operate—
this concept is also frequently referred to as the community licence to operate.
There is an expectation that ongoing business decisions will need to incorporate sustainability-
related considerations. Society will expect to be provided with information about how
organisations, governments and other entities have performed in these areas. The accounting
profession will need to continually adapt to these growing expectations.
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The statement of financial position can also be affected through, for example:
• impairments in the value of land as a result of contamination;
• plant write-offs as a result of changes to clean production capacity;
• changes in the net realisable value of stock related to consumer preferences for
environmentally harmless products; and
• liabilities (through remediation requirements).
The WBCSD (Williams 1998) pointed out that chief financial officers in many companies have,
for a number of years now, been assessing environmental issues and their effect on operational
costs and shareholder value. For example, Shell experienced a loss of 30 per cent of its market
share in Germany during a period of discontent with its planned disposal of the Brent Spar oil-
storage facility. It is likely that companies that are not perceived to be committed to sustainability
will be at a competitive disadvantage. The potential effects of such changes on global finance
markets illustrate the imperative of developing a sound basis for a broader concept of
accountability reporting.
In 2009, members of WBCSD produced a report entitled Vision 2050, which shows how it
is possible for nine billion people to live well without exhausting the natural capitals of the
world (WBSCD 2009). They discussed a range of market and fiscal incentives and mechanisms,
as well as changes in social values that would be needed to meet the Vision 2050 goals.
An organisation’s reputation can be essential to economic survival, as it affects relationships
with key stakeholders that help an organisation not only survive but also prosper. For example,
in the context of environmental performance, the image of an organisation can affect both its
access to green markets, such as consumers who care about the environmental performance
of companies and products, and its relationships with supply chain and business partners.
Improving corporate reputation, as well as better identifying risks and opportunities in a
resource-constrained world with changing societal expectations, is also one of the key drivers
behind the integrated reporting initiative (discussed later in this module), which emphasises the
benefits of organisations telling their unique value-creation story.
Walmart in the US has been heavily criticised for its workplace practices in its home market.
In 2012 the National Employment Law Project (NELP) published the ‘Chain of Greed’ report
(Cho et al. 2012) into Walmart’s worker exploitation in the US. Also, some responsibility for
the conditions of the poorly paid garment makers in Bangladesh has been placed on the
western retailers who sold the garments, after the collapse of the Rana Plaza building caused
international outrage.
Since the GFC, and amid a lingering recession that has intensified pressure from shareholders,
companies are devising new CSR models that are more aligned with their core business
goals and services. For example, blue-chip companies such as Visa and Unilever are creating
new markets in the developing world by closely aligning social causes with their overarching
corporate strategies.
For the more easily quantified risks, social and environmental information by an organisation
helps with the negotiation of lower insurance premiums and lower financing costs. Direct-cost
impositions resulting from legislation include clean-up orders, levies and remediation expenses.
Indirect costs range from loss of business to increased risk, resulting in higher insurance
and financing costs, and the opportunity costs of waste production, treatment and disposal.
Both direct and indirect environmental costs, as well as the risks associated with tarnishing brand
and reputation (as discussed previously), affect profitability. One of the aims of CSR reporting is
to enable information users to assess these costs and predict what their future effect might be.
Reducing risk is an additional economic incentive for transparent reporting. Insurance coverage
of environmental risks can represent a major cost to companies. Thus, reducing information risks,
and showing how these risks are being identified and managed by reporting on non-financial
performance, may result in economic benefit by reducing financing expenses.
As climate change becomes an accepted business reality, the insurance industry is increasingly
interested in the possible exposure that organisations face regarding greenhouse gas (GHG)
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emissions. This could be in the form of understanding emission levels, strategic position, and the
geographic location of operations, given changing weather patterns.
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Various stakeholders, including investors, will increasingly consider risks associated with
climate change when making investment decisions. Stephanie Maier, head of research at
Experts in Responsible Investment Solutions (EIRIS), reported the results of a survey undertaken
of the world’s largest 300 companies. Maier found that some of the highest-risk companies
(in industries such as cement production and coal mining) are not adequately responding to
risks or opportunities. In relation to disclosures, she found that over a quarter of the companies
in the global 300 had either no or limited disclosure on climate change:
Focusing on very high or high impact companies we see that over three quarters (81%) of
companies disclosing either absolute (73%) or normalised (70%) carbon dioxide (CO2 ) or
GHG emissions data. However a closer look at this data reveals that only 36% of it is verified
by an external party—and only 38% of companies disclose any indication of scope of data or
methodology used. The Greenhouse Gas Protocol (GHG Protocol) is an international accounting
tool to quantify GHG gas emissions, developed by the World Resources Institute (WRI) and World
Business Council for Sustainable Development (WBCSD)—only 9% of companies disclose the
scope of their emissions against the GHG Protocol (Maier 2008, p. 4).
There will be a demand for company-specific information on how climate change has affected,
and will affect, the organisation in question. Further, there is a growing trend for investment
funds (including leading international pension funds) to invest in corporations operating outside
their own country. As such, climate change and social issues such as working conditions in
supply chains will affect not only local investment, but conceivably also foreign investment to
a significant extent.
This has been examined with respect to CSR reporting by Dhaliwal et al. (2011), who find that
there are cost of capital benefits for companies disclosing CSR reports.
There are extremes in perspectives about the perceived responsibilities and accountabilities
of business. Organisations need to explicitly consider to whom they believe they owe a
responsibility, and for what aspects of their performance, before they decide what information
they will report, and how and to whom they report. Determining to whom the organisation
owes a responsibility involves considering who has specific rights (e.g. investors) compared
to those who have a more general interest in the organisation (e.g. broader stakeholders).
For example, shareholders are claimants who have specific rights, such as a right to dividends.
The shareholders gain the right to dividends when they invest, and they give up participation in
management in exchange for obtaining limited liability protection. This combination of claimants
having rights and stakeholders with interests has led to the approach described by the famous
economist Milton Friedman.
The views of Friedman are one extreme. He argued that the single role of business is to increase
its profits (within the rules of the game). Specifically, he stated that in a freely operating market:
There is one and only one social responsibility of business and this is to use its resources and
engage in activities designed to increase its profits as long as it stays within the rules of the game,
which is to say, engages in open and free competition, without deception or fraud (Friedman 1962,
p. 133).
Consistent with the views of Friedman and the shareholder school of thought (discussed in the
next section) are those of many corporate managers, who believe that maximising corporate
profits is the main priority. Perhaps this focus on profits is further strengthened by the fact that
many corporate managers are directly remunerated on the basis of profits (e.g. it is very common
for managers to be rewarded by being given a specified percentage of profits as part of their
bonus structure). People who believe that the concentration on profits has not waned in many
organisations—even as the apparent emphasis on CSR has heightened—are often cynical of
corporate claims about being socially responsible.
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An alternative view to that of Friedman is that organisations, public or private, earn their right to
operate within the community. This right is provided by the society in which they exist, and not
solely by those parties with a direct financial interest (such as the shareholders who directly
benefit from increasing profits), or by government. In addition to this right to operate provided
by society, the privilege of incorporation, which may provide limited liability and the ability to
raise capital from the public, is not guaranteed but granted by the state. The state, in turn,
can dictate the terms and controls on operating the business.
This view holds that organisations do not have an inherent right to resources and must not just
focus on maximising the welfare of one stakeholder group (e.g. shareholders) to the possible
detriment of others. Society also determines whether an organisation shall have access to natural
resources, and whether and how it is permitted to hire employees and dispose of waste products.
Therefore, from this perspective, for the community to continue to allow such organisations to
exist, the benefits generated by an organisation must be perceived to exceed their costs to
society as a whole.
Leading modern-day business advisory firms such as McKinsey & Company and the ‘big four’
accounting firms have built a strong business case for the importance of the management of
sustainability to overall business success. For example, McKinsey’s report on sustainability and
resource productivity (2014) presents compelling arguments for business leaders to move with
the times and respond to the critical environment and social issues of the day as part of good
business practice.
➤➤Question 5.1
If corporate managers adopted views consistent with those of Milton Friedman, do you think that
any quest towards sustainable development would be realistic? Give reasons for your answer.
Divergent views on the responsibilities (and accountabilities) of business are nothing new.
The opinions reproduced in Table 5.1 were given during a debate in the 1930s; comments
from this debate were reproduced in a report issued by the Corporations and Markets
Advisory Committee in 2006. They contrast the views of Professor Adolf Berle, who embraced
the shareholder primacy perspective, with those of Professor Merrick Dodd, who embraced
the view that organisations survive to the extent that they comply with the ‘social contract’
negotiated between the organisation and society (Table 5.1).
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Investors, by way of their investment, are the group Due to the protections and privileges provided
risking their own capital. Therefore, it is only fair that by the act of incorporation (e.g. limited liability
the directors answer to them and to them only. and perpetual succession), the duties owed by the
organisation should not just be to shareholders.
Attempts to broaden responsibilities to a wider There is also a duty to the broader community,
group of stakeholders may lead to reducing and it is fair to say that society should expect
the level of legal responsibilities directors owe the corporation to behave in the general public
to anyone. interest, rather than in a purely self-interested,
profit-focused manner.
A disparity of views still exists. There are many individuals who support a shareholder primacy
perspective of corporate operations just as there are many who support a more socially
constructed perspective of business operations. An increasing number of corporate leaders
believe that delivering long-term financial returns to shareholders depends on taking into
consideration the concerns of a wider range of stakeholders.
It should be noted that Australian corporations law has only recently required corporations
to consider social and environmental impacts when making particular decisions. There are
environmental reporting requirements in s. 299(1)(f) and, arguably, in s. 299A Corporations
Act 2001 (Cwlth). Also, in March 2014, the ASX Corporate Governance Council included a
new recommendation, 7.4, which requires that an entity disclose any material exposures to
economic, environmental and social sustainability risks and, if it does, how it manages these risks.
These requirements are discussed in a later section of this module, which looks at mandatory
reporting requirements.
The major guiding legal principle pertaining to the responsibility of corporate officers in
terms of the strategies used to run a business is provided by s. 181(1) of the Corporations Act.
This section, often referred to as the ‘good faith requirement’, requires that:
A director or other officer of a corporation must exercise their powers and discharge their duties:
(a) in good faith in the best interests of the corporation; and
(b) for a proper purpose (Corporations Act, s. 181(1)).
Central to this requirement is that the strategies employed by an organisation need to be in the
best interests of the organisation. Is social and environmental responsibility and an associated
consideration of a broad group of stakeholders in the best interests of an organisation? Perhaps
company directors believe there needs to be a clear link between the actions and the likelihood
that corporate profits and value will be positively influenced. Clearly, the good faith requirement
provides some uncertainty for corporate managers in determining the extent to which they
can adopt policies that are perhaps only indirectly in the best interests of the corporation.
This limited approach to recognising broader accountability can be contrasted with the more
positive approach taken in the latest version of directors’ duties stated in UK corporate law.
These laws were updated in 2006 to include specific reference to employees, the community
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and the environment.
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There are alternative views about whether corporate managers are legally allowed to use
shareholder funds for non-business social endeavours. (The term ‘non-business’ does not
encompass CSR related initiatives, which are clearly aligned with corporate strategy and
expected to improve efficiency, reputation and contribute to growth.) One view is that the
best interests of the company necessarily require corporations to consider the needs of a
broad group of stakeholders and the environment, otherwise the community will not support
the organisation. This view would suggest that s. 181(1) does not discourage sound social and
environmental behaviour.
The counter view is that s. 181(1) actually discourages companies from considering the needs of
stakeholders (other than shareholders) and of the environment. That is, companies are legally
bound to maximise profits to shareholders. This view would suggest that, by publicly embracing
CSR, companies can publicly promote their social ‘values’, while in reality keeping their value in
focus—this being the company’s share price.
You should now read Case Study 5.1, ‘Drilling into disaster: BP in the Gulf of Mexico’, available on
My Online Learning. Please note: This specific case study is in a booklet called ‘Corporate Governance
Case Studies’. You do not need to read the other case studies. The case study starts on page 162 of
the PDF booklet.
At the end of this case study, there is a set of reflective questions that aim to help you establish your
own opinions about how particular issues should be addressed. There is no single correct answer to
these questions and no solutions are provided.
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However, compiling these measures is not always easy. The activities of organisations
create many social and environmental impacts. Some attributes of an organisation’s social
and environmental performance will be relatively easy to measure, while others will be
relatively difficult.
An externality can be defined as an impact that an entity has on parties that are external to
the organisation where such external parties did not agree or take part in the actions causing,
or the decisions leading to, the cost or benefit.
Externalities can be viewed as positive (benefits) or negative (costs). In most market transactions,
the prices paid for goods or services do not fully reflect all the costs and benefits generated by
their production and consumption (which in itself brings into question measures of performance
such as corporate profits). The implication of this is that the cost of goods or services might be
understated and, as a result, a greater amount of a particular good or service might be produced
and consumed than might be the case if the overall costs to society were considered.
For example, if the air is treated as a ‘free good’ and a heavily polluting organisation does not
pay, or incur liabilities, for the pollution it creates, then its measure of profit—based on generally
accepted accounting principles—may be considered inflated compared to what it would be if
costs were assigned to the pollution. In a freely operating market that does not place a cost on
pollution, there is the obvious implication that production will increase, profits will rise and, at the
same time, the environment will become degraded.
Government intervention can be employed as a means of placing costs on the use of resources
that might otherwise go unrecorded. For example, we can consider the potential introduction
of carbon-related taxes, where organisations are taxed on the basis of the amount of carbon
dioxide released into the atmosphere. Such releases would otherwise be free. By placing a
cost on emissions, a government effectively acts to internalise costs that would otherwise be
externalities. This can in turn motivate profit-seeking organisations to find ways to reduce their
emission levels. The higher the price per tonne of carbon dioxide emissions, the harder we might
expect organisations that are affected by the tax to try to reduce their level of emissions.
➤➤Question 5.2
Explain the nature of an externality. Think about an organisation you know and ask:
(a) What is at least one positive and one negative externality generated by the organisation and
who are the affected stakeholders?
(b) Would these externalities directly affect the income or expenses (and therefore profit) of the
organisation?
(c) In your opinion, is the failure to recognise externalities a fundamental limitation of our current
financial reporting requirements?
(d) In your opinion, what might be the ethical implications of not accounting for business
externalities?
While we might attempt to describe various costs and benefits generated by an entity in
qualitative terms, many costs and benefits will not be recorded in financial terms. Because
corporate profits do not incorporate many externalities, we must treat such financial numbers
with caution when considering the overall performance of an entity.
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Perhaps we can question whether a profitable company is also necessarily a ‘good’ company
or extend our assessment to include both its short-term and long-term profitability prospects
if it is deemed by critical stakeholders to be profiting at the expense of society. For example,
a large financial institution may close many smaller regional branches to reduce financial costs,
which might improve financial performance (e.g. reported profits). This measure of performance
(profits) will not reflect many of the externalities caused by the decision to close regional
branches (e.g. the costs associated with unemployed workers thereafter receiving benefits from
government, or the inconvenience caused to regional communities from no longer having a
local bank).
At this stage, however, we should appreciate that in developing a CSR report, an organisation
should consider the various externalities caused by its operation and how it will disclose
information about these externalities. This will also involve identifying the potential stakeholders
and how they are being affected.
The broad objectives driving any organisation to undertake sustainability reporting are wide
ranging. At one end, there could be an ethically motivated desire to be transparent about various
aspects of its performance as it affects various classes of stakeholders. At the other end is an
economically focused motive to use social and environmental reporting to protect or enhance
shareholder value. The underlying motives will directly shape the style of report that is presented
and the audience it is intending to satisfy.
Once it is determined why an organisation decides to report, this decision will, in turn, inform the
decision as to whom any related information will be directed. Management could determine
that the report is produced to provide information for the interests of its shareholders, or for
the interests of a broader stakeholder community.
Once the target recipients of the report have been determined, management can then consider
the information demands or needs of these particular stakeholders. This will inform what
information will be disclosed and what issues the social and environmental reporting should
address. Identifying what issues an entity is held responsible and accountable for involves
dialogue between the organisation and its identified target stakeholders. Identifying the target
stakeholders requires management to reflect in an open way on the underlying motivations
driving them to report: are they based on an accountability approach, a managerial approach or
somewhere in between?
➤➤Question 5.3
Explain how any assessment undertaken by management about why they are reporting will have
an effect on the audience for the reports (i.e. to whom they are reporting).
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Further, while the theories considered in Module 2 reviewed ethical decision-making for
individuals, the following theories have been developed from a different perspective by looking
at the behaviour of organisations and groups of organisations. There are some links, however,
between individual and organisational ethics, and these are pointed out.
Enlightened self-interest
The theoretical approach of enlightened self-interest is linked to the shareholder primacy
perspective about the role of corporations in society, but explains the circumstances under which
CSR-related activities may be considered. As outlined earlier, this perspective argues that the
best outcomes for society come about when individual firms are allowed the freedom to pursue
their own interests and maximise their utility in free markets. These arguments tend to reflect the
teleological positions of utilitarianism and ethical egoism (see Module 2).
From the perspective of enlightened self-interest, CSR activities are at least considered and will
be undertaken if they result in an overall increase to shareholder value. Therefore, CSR could
and should be undertaken if there is a business case for that activity or if it is in the interests of
the shareholders. A good part of the literature on CSR has been devoted to demonstrating the
ways in which CSR improves shareholder value and therefore makes business sense. Some of
these include:
• improved employee recruitment, motivation and retention;
• greater learning and innovation;
• better customer confidence and reputation;
• improved risk and governance profile and risk management;
• enhanced competitiveness and market positioning;
• avoiding costs and risks of regulation;
• greater operational efficiency;
• increased analyst interest and accuracy, affecting valuation;
• attracting investors and other capital providers, and achieving lower costs of capital; and
• preserving a licence to operate in communities.
Proponents argue that corporations will voluntarily adopt those CSR practices that offer their
business some kind of benefit.
This theory represents a dominant view of the role of corporations in societies. However, in recent
decades, this dominant approach has been questioned on many levels. Some argue that free
markets create many of the social and environmental issues that led to demands for corporate
accountability in the first place, mainly because of externalities associated with the activities of
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the organisation. Others criticise this approach from a teleological perspective—that we cannot
separate values and ethics from economic activities. Some of these criticisms have coalesced
around alternative theories of CSR, which are reviewed in the following sections.
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➤➤Question 5.4
In the introduction to this module we defined sustainable development as:
Ensuring that the needs of today’s world are met while at the same time ensuring that
the ability for future generations to meet their own needs is not compromised.
This definition is derived from the report, Our Common Future (WCED 1987, p. 16), also known
as the Brundtland report. If organisations are guided in their CSR obligations by enlightened
self‑interest, could such organisations also be seen as embracing sustainable development in the
way it has been defined above, based on the Brundtland report? Are the two concepts compatible?
Stakeholder theory
Stakeholder theory offers a different perspective on why organisations should and do practise
CSR. This approach was first articulated in 1984 by Freeman, and since has produced a
diverse literature and a number of approaches. In the following sections we first look at what a
stakeholder is and then at two branches; a normative branch (which embraces broad notions
of accountability) and a managerial branch (which embraces the view that managers act to
maximise shareholder value).
There are many potential groups or agents that could be considered stakeholders for a given
organisation. Stakeholders often include diverse groups such as employees, management,
shareholders, communities, society, government and the state, and even the environment
and future generations. In practice, organisations usually have considerable scope in defining
who their stakeholders are, and further scope in deciding how these stakeholders should
be managed.
➤➤Question 5.5
Three examples of how leading corporations define their stakeholders are included below:
Toyota Australia:
‘Our stakeholders are those groups who are affected by or affect Toyota Australia. Our
stakeholders have been identified as: our shareholder the Toyota Motor Corporation,
employees, customers, dealers, suppliers, community groups and government. Our code
of ethics provides a statement of duty specific to each group outlining the behaviours
expected when engaging with different stakeholders.’ (Toyota 2014).
BHP Billiton:
‘Our stakeholders can be defined as those who are potentially affected by our operations
or who have an interest in, or influence, what we do.’ (BHP Billiton 2014).
Imperial Tobacco:
‘We define our stakeholders as those with whom we have a financial relationship or who
are directly affected by, or have a direct interest in, our business operations. Stakeholders
include investors, employees, customers, consumers, suppliers and governments. Others
include supply chain communities, competitors, non-governmental organisations and the
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As this theory is normative in nature, it emphasises what organisations should do and provides
prescriptions about behaviour. This is not how organisations actually act—but rather an ideal of
behaviour. In practice, a more managerial focus may be embraced by researchers to explain the
activities of corporate management. This is also associated with different ethical justifications and
is known as managerial stakeholder theory.
As a result, stakeholders who are regarded as more important or powerful in their ability to
influence shareholder value will attract additional effort and attention from managers. Power
in itself will be specific to the particular stakeholders of an organisation. It may be tied to such
things as the command of limited resources (finance, labour), access to influential media,
ability to legislate against the company (e.g. particular governments or regulatory bodies) or
ability to influence the consumption of the organisation’s goods and services.
This theory therefore takes fewer cues from deontological theory, as it tends to see stakeholders
as the means to an end, rather than an end in themselves. In reality, organisations will often show
both types of justification for their reporting.
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➤➤Question 5.6
Following are two excerpts from the annual reports of two of Australia’s largest companies.
Consider the differences in how they view stakeholders:
Rio Tinto:
‘Delivering value for our stakeholders
Rio Tinto’s primary focus is on the delivery of value for our shareholders. We balance
disciplined investment with prudent management of our balance sheet and cash returns
to shareholders. We offer a long-term investment opportunity, and commit to sustainable
growth in cash returns to shareholders through our progressive dividend policy. As we
work, fixed on this core aim, our activities also give us the opportunity to create value
for our other stakeholders, in a variety of ways’ (Rio Tinto 2015, p. 13).
Stockland:
‘Stockland was founded in 1952 with a vision to “not merely achieve growth and profits
but to make a worthwhile contribution to the development of our cities and great
country”. We have a long and proud history of creating places that meet the needs of
our customers and communities’ (Stockland n.d.).
Are these approaches more consistent with the enlightened self-interest theory or the normative
or managerial stakeholder theory?
Organisational legitimacy
Within legitimacy theory, legitimacy itself is seen as a resource on which an organisation depends
for survival. It is something that is conferred on the organisation by society, and it is something
that is desired or sought by the organisation. It is a resource that the organisation is thought to
be able to influence or manipulate through various disclosure-related strategies.
This means that corporations do not necessarily have a clean slate to do whatever maximises
shareholder value, but must instead keep within the bounds of reasonable or expected behaviour
and activities in a community. For example, minerals and resource companies in particular are
sensitive to their own social contract, particularly in the wake of controversial coal seam gas
developments of the last few years. Origin Energy points to this in the following quote:
The scale of our operations affects neighbouring communities − sometimes positively and
sometimes in ways that create challenges requiring careful management. People living near our
operations can be affected by increases in traffic, noise and dust. They may also be affected
by socio-economic factors resulting from our presence, such as increased housing costs and
competition for labour. Origin must manage these issues sensitively and acknowledge the loss of
control and power people in the community may feel as a result of our large-scale infrastructure
projects (Origin Energy 2015).
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Legitimacy theory
The main premise of legitimacy theory is that an organisation will take action to manage
community perceptions in order to survive. Corporations need to at least appear to be operating
within the established rules of society, that is, within the bounds of the social contract. When
there is disparity between what the organisation appears to be doing and the terms of its social
contract, there will be a threat to its legitimacy, and therefore to its future survival and success.
In this context, CSR is one strategic tool that organisations can use to influence the community’s
perceptions of them. Lindblom (1994) suggests a number of courses of action that organisations
can take to obtain, maintain or repair legitimacy:
• Change and inform—perform activities in a manner that is appropriate, given the
expectations of society, and then inform the relevant stakeholders about these actual
behaviour changes, as well as the performance results;
• Change perceptions without actual change—convince those who are evaluating the
organisation that change has occurred without actually changing performance, activities or
behaviour;
• Deflect attention and manipulate perceptions—switch the focus away from areas of
concern to other issues where the organisation is performing well, and use emotional
symbols and rhetoric to influence expectations; or
• Change criteria for evaluation—try and influence the levels of performance expected, and
attempt to highlight that certain criteria used by society are unreasonable (Lindblom 1994).
Reading 5.1, ‘Further views about the social responsibilities of business’, provides various views
about the responsibilities of business.
➤➤Question 5.7
Consider Reading 5.1 and answer the following:
Community expectations are changing and there are growing expectations that organisations
should accept responsibilities beyond those towards their shareholders. With legitimacy theory
in mind, what are the implications of a corporation’s failure to consider a broader group of
stakeholders?
Institutional theory
Institutional theory is an approach that has emerged as a result of dissatisfaction with the
preceding approaches. It adopts a different perspective on corporate accountability that focuses
on explaining why organisations tend to appear more similar over time. Institutional theory looks
not only at individual organisations, but at organisational fields (e.g. industries). Compared with
those theories, institutional theory is less normative and not so grounded in ethical theory,
focusing more on explaining real-world behaviour.
Institutional theory is useful because the practice of CSR has changed considerably over the
last decades. Consider the difference between these two statements from KPMG as it reviews
developments in CSR:
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[In 2002 CSR] is becoming mainstream for big corporations with 45% of Global Fortune Top 250
companies now publishing [a CSR] report (KPMG 2002, p. 6).
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Summary
In the discussion above we introduced a variety of theories of CSR and how they are linked to
different views on the role of the corporation in society. Table 5.2 provides a summary of some of
the key differences between these theories.
However, it is important to realise that these theories are often complementary, and many
overlap each other. Indeed, they are frequently invoked together by corporations to explain
their approach to corporate accountability. Finally, it is also important to realise that theories are
always subject to interpretation.
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However, the reality is that measuring many social, environmental and sustainability issues is very
challenging. Unlike financial reporting, where we have generally accepted ways of measuring and
reporting financial value, our ability to measure social, environmental and sustainability issues
is considerably less developed, and is still very much a work in process. Issues to be resolved
include dealing with indeterminacy (or uncertainty), as well as interdependencies between
pieces of information. One of the difficulties in this area is understanding how all of the different
components interact and the effect they have on each other. Accordingly, it may be helpful to
think of reporting for social, environmental and sustainability issues as comprising:
• quantification: expressing an issue or change in numerical terms (e.g. 75% of staff feel they
have adequate training and development opportunities);
• monetisation: converting a quantified value into currency as a standard unit of measurement
(e.g. ‘we invested $1 million in staff development and training’); and
• narrative reporting: expressing an issue in qualitative form (e.g. what is the management
approach or strategy to staff development?).
You may be familiar with each of these as they reflect similar approaches in financial reporting.
There are also a wide variety of approaches to measuring and reporting social, environmental
and sustainability issues—they vary considerably in the degree to which they adopt these
elements. This provides scope for organisations to report in different ways on their social,
environmental and sustainability activities. Further, it is important to remember that all of these
types of measurement are in a constant state of development and refinement. How companies
measure their social, environmental and sustainability impact in 10 years’ time will undoubtedly
look very different from what is reported in corporate accounts today. In the following sections we
provide a sample and discussion of some key challenges in each of these areas.
There can be quite a range of information available to organisations when they are identifying
their available CSR information. Quite often companies collect data for other mandatory
reporting requirements, such as work health and safety (WHS) obligations, or to comply with
environment regulations, such as greenhouse gas and energy consumption requirements,
and this information, which is usually quantified (and sometimes monetised), is relevant for CSR
reporting. In fact, most information used to report on other mandatory requirements could be
considered in the information set as being potentially relevant to stakeholders. One important
practical consideration is whether the data is in an easily accessible format that can be collated
and reported in a systematic fashion. Organisations often have separate systems located in
different departments that capture all the different types of data that have been mentioned.
Therefore, there are real challenges in being able to collate and integrate this data in one place.
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What is measurable?
Social reporting
In general, there are some areas for which we have better-developed measures for social issues.
This includes areas such as:
• labour practices and workplace—including diversity and equal opportunity, employment
standards and turnover, training and development;
• human rights—including compliance with human rights Acts, policies and management of
issues such as freedom of association, collective bargaining, child labour and forced labour;
• society—including investments in local communities, anti-corruption and anti-competitive
behaviour; and
• product responsibilities—including customer health and safety, product labelling and
ethical marketing.
Further, many corporations often collect much of this information as standard practice anyway,
particularly in the areas of workplace and staff. This may include compliance with international
labour standards such as International Labour Organization (ILO) conventions, and some
components of balanced scorecards.
There are some areas in which social reporting and measurement is much harder:
• Social issues involve quality and subjectivity that can be hard to capture in quantitative
or monetised approaches. For example, a mining company may report that they provide
education to 80 per cent of employees’ children in a mining community. However, this figure
provides no indication of the quality of that education, whether it meets the educational
needs of children, or whether it remains culturally acceptable. Nor does it inform us of why
the remaining 20 per cent have not received an education and what the implications are.
• In CSR reporting, the concept of entity is relaxed. That is, corporations often need to report
on value created outside the organisation rather than just captured within the organisation.
It can be hard to identify what issues can be attributed to a particular organisation and not
to others. For example, consider the supply chain of a large corporation such as Walmart.
How many of the social issues that emerge from this whole supply chain is Walmart
responsible for? What are the implications of this?
• Time is an important measure for social issues. There is often a significant lag between an
activity and when the impact of the activity is felt in a community or society (e.g. the effect
of education). This can be hard to capture when simply measuring indicators and KPIs.
In particular, the SROI figure is contingent on a large number of judgments, assumptions and financial
proxies and is thus far less reliable than comparable financial figures. It is also relatively time and
resource intensive to undertake, and is most usefully applied to a particular project or activity, rather than
mapping all the many possible issues a large corporation is dealing with. Some, such as Arvidson &
Lyon et al. 2010, also argue that it is not appropriate to place dollar values on social issues.
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Environmental reporting
Environmental reporting accounts for how corporations draw from and affect the natural
environment. In recent years, there have been important advances in developing standardised
methodologies for accounting for certain environmental aspects of business, such as greenhouse
gas emissions. Nonetheless, understanding and measuring environmental impact can be a
very complex process. Further, there are significant differences in the environmental impact of
different industries.
The areas that have seen greater development of measurements and indicators include:
• materials usage and product resource consumption;
• resource usage—including energy and water;
• emissions, effluents and waste;
• transport usage; and
• compliance with and breaches of mandatory and voluntary environmental regulations.
Some of these areas have relatively well established approaches; for example, the
Intergovernmental Panel on Climate Change has produced detailed methodological guidance
for reporting on greenhouse gas emissions.
Environmental reporting is still a complex and challenging area, and some areas that have been
identified as needing further development include the following.
• Reporting on biodiversity (flora, fauna and ecosystems) is very challenging, particularly as there
is no generally accepted unit of measurement and reporting systems are often exploited.
• Similar to social reporting, environmental reporting includes measures of impact beyond the
control of the organisation. Measuring the environmental effect of supply chains increases
the level of complexity and scope of reporting.
• Many environmental estimates include discount rates for future impact (similar to discounting
for the time value of money). In an environmental context, applying a discount rate to future
environmental impact has ethical implications—that is, it suggests that future generations are
less important than current generations.
• Environmental impact measurement is often confined to and ‘siloed’ in particular areas
(e.g. water use and greenhouse gas emissions) and there is a need to determine how these
different measures fit together to provide an overall assessment of environmental impact.
➤➤Question 5.8
Consider the differences in the environmental impact of a mining firm (e.g. BHP Billiton) compared
with that of a professional services firm (e.g. Ernst & Young).
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Economic reporting
The final element of CSR refers to the sustainability of an organisation’s economic performance.
This includes financial performance measured by generally accepted accounting principles,
but this by itself may be too limited. What is often unreported, but is frequently desired by
users of sustainability reports, is the organisation’s contribution to the sustainability of a larger
economic system. This can include a wide variety of non-financial performance indicators
and narratives, and is usually aimed at economic performance, market presence and indirect
economic impacts—the three categories of economic sustainability used by the GRI in their
G4 sustainability reporting guidelines. A study by Cohen and colleagues (2012) identified the
indicators most commonly reported in large public corporations. These include (in order of their
decreasing frequency):
• market share: referring to the percentage or size of market share for the company, division,
unit or particular products;
• quality rankings: such as prizes or performance against particular benchmarks;
• customer satisfaction: including describing customer service initiatives, loyalty, awards or
campaigns;
• employee satisfaction: comparison of loyalty and awards and comparison to competitors;
• turnover rates: employee turnover compared with competitors and industry averages; and
• innovation: describing innovations introduced across the organisation’s value chain.
Innovation is sometimes measured in monetary terms, such as the amount spent on research
and development, or it can be quantified, such as the number of patents awarded (Cohen &
Wood et al. 2012).
➤➤Question 5.9
Marks & Spencer, a UK-based retail company, produces an annual report based on its sustainability
strategy, known as ‘Plan A’. Review it here: http://planareport.marksandspencer.com.
(a) Identify one issue that Marks & Spencer reports on in the following areas:
(i) economic
(ii) social; and
(iii) environmental.
(b) Identify one of each of the following:
(i) a monetised measure;
(ii) a quantified measure; and
(iii) a narrative on sustainability.
Scope of reporting
The objective of financial reporting is described by the Conceptual Framework as follows:
The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to existing and potential investors, lenders and other creditors in
making decisions about providing resources to the entity. Those decisions involve buying, selling or
holding equity and debt instruments, and providing or settling loans and other forms of credit
(Conceptual Framework OB 2, p. A27).
This demonstrates that inherent in the nature of financial reporting is the focus on the rights
of shareholders, specifically those who are not involved in management, and who have limited
power to obtain information about the organisation. As such, shareholders, along with debt
capital providers, are the main audience for financial reporting, and they are named the primary
users in paragraph OB 5. The Conceptual Framework also states that other users (such as
members of the general public) are not the focus of this reporting (OB 10).
By emphasising the financial information relevant to capital providers, the Conceptual Framework
reflects a shareholder primacy perspective (discussed earlier in this module). This implies a very
narrow interpretation of accountability, restricting reporting only to those aspects associated
with financial performance. However, focusing on financial results alone has its limitations.
For example, financial reporting alone cannot answer important questions about social and
environmental performance that we have discussed previously, including:
• How high is employee morale and turnover?
• Are customers being supplied with appropriate products and services?
• Is the supply chain operating ethically?
• Are the rights of Indigenous people being respected?
• How is the organisation contributing to climate change?
Some manufacturing processes, for example, use clean air or water and return it to the
environment in a form that is of reduced quality. As these environmental ‘assets’ are not
being recognised by the reporting entity, any reduction in the quality of such assets is not
recognised by the entity (unless fines are imposed).
A second example is expenses. For financial reporting purposes, the Conceptual Framework
defines expenses as:
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decreases in economic benefits during the accounting period in the form of outflows or depletions
of assets or incurrences of liabilities that result in decreases in equity, other than those relating to
distributions to equity participants (para. 4.25(b)).
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When the concept of discounting is applied to social and environmental issues, ethical problems
arise. Many social and environmental issues involve very long time frames (consider climate
change, as one example). Discounting the cost of something that will occur in the future may
be seen as shifting the problems of one generation on to future generations—something that is
arguably not consistent with the sustainability agenda. Secondly, if we discount obligations that
may arise in the distant future in the current period then they may not be considered material
even if, ethically, they are highly material.
For example, if the organisation was anticipating that the activities would lead to a clean-up bill of
$100 million in 30 years’ time, and with a normal earnings rate of 10 per cent, the current expenses
to be recognised in the financial statements under generally accepted accounting principles would
be $5.73 million.
A reduction in the discount rate to 6 per cent would see this liability increase to $17.4 million. Using a
discount rate of 1.4 per cent (this figure was used in The Stern Review on the Economics of Climate
Change, authored by economist Nicholas Stern, a report released by the British Government in 2006)
would change this amount considerably to $65.9 million in present value terms.
For all the five elements of financial accounting, both probability and measurability are key
considerations. This has significant ramifications for many similar sustainability issues. As we
saw in the earlier section, measurement of sustainability issues is complex and often difficult,
and questions are raised over the reliability of many of the measures that are currently used
compared with the standards of measurement we use in financial accounting.
Take the example of a potential environmental liability such as clean-up after a chemical spill.
If the corporation argues that it cannot be reliably measured, it may be left off the balance
sheet. If it is not recognised as a liability, then associated expenses will also not be recognised.
The implication is that if it is not easily and reliably measured, then it cannot be important.
Nonetheless, that chemical spill may be very important indeed to many of the organisation’s
stakeholders as it may result in the increased likelihood of a loss of revenue and increased costs
(of capital, staff changes, fines, etc.) due to reputational damage.
➤➤Question 5.10
Identify some of the limitations of financial reporting practices as they apply to CSR reporting and
provide an opinion about whether you consider that financial reporting practices have contributed
to problems such as climate change.
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In this section we outline the increased mandatory reporting requirements that organisations
are facing. This is a reflection that regulators are driving change. In Australia, this includes
requirements within and additional to the annual report. This is a worldwide trend. We also see
that organisations are increasingly likely to make additional CSR disclosures, as evidenced by
the significant growth in companies producing stand-alone sustainability reports over the last
10 years (KPMG 2013). In fact, we mentioned earlier that this type of reporting has evolved from
being desired, to being expected, to now being virtually mainstream for most major corporations
around the world. In this section we also cover the major voluntary guidelines and non-
mandatory reporting requirements against which organisations report.
The accounting profession and the professional accounting bodies have played a critical role
in driving the move to increased reporting of CSR information. For such reporting to become
generally accepted, there has to be a generally accepted framework, and the accounting
profession is very heavily involved in developing these frameworks. This helps the actions
and behaviours to become legitimised.
There has also been the recognition that the information is useful not only for external
purposes, but for internal decision-making, to help recognise the risks and opportunities facing
an organisation and make better, more informed decisions. If you pick up most organisations’
corporate reporting information, you will see increased emphasis on CSR information.
CPA Australia is no exception, and in fact is leading the way in its journey to implement
integrated reporting.
From 2013, CPA Australia has published an integrated report that follows the principles and guidelines
of the International Integrated Reporting Council’s framework for integrated reporting. Please refer to
the CPA Australia 2014 Integrated Report to review this approach: cpaaustralia.com.au/annualreport.
A report by KPMG, the United Nations Environment Programme (UNEP), the GRI and the Centre
for Corporate Governance in Africa (KPMG et al. 2013), examining the mandatory and voluntary
CSR reporting practices in 45 countries, found the following:
• There are 134 mandatory policies and a further 53 voluntary policies covering different
aspects of CSR reporting.
• Many of the compulsory policies are on a comply (apply) or explain basis.
• CSR reporting has become a listing requirement on several stock exchanges in non-OECD
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In Australia there are additional CSR reporting requirements that have recently been incorporated
into the Corporations Act and accounting standards. In addition, we have heightened imperative
and additional required regulatory disclosures around climate change, as evidenced in Australia
by the NGER Act, and in Europe by the European Union Emission trading scheme (EU ETS).
Earlier, we identified other areas of change, including a number of stock exchanges establishing
requirements to report on sustainability issues, and the European Parliament’s directive on non
financial and diversity disclosures for companies with more than 500 employees.
Figure 5.2 outlines the sections of an annual report where current mandatory reporting
requirements of a social and environmental nature embodied in the Corporations Act and
accounting standards are normally reflected.
Figure 5.2: Sections of an annual report where mandatory social and environmental
reporting requirements are normally reflected
Financial statements
Section 299A of the Corporations Act is also relevant. Under this provision, listed companies are
required to include in the directors’ report any information that shareholders would reasonably
require to make an informed assessment of the company’s:
• operations;
• financial position; and
• business strategies and prospects for future financial years.
In March 2013, the Australian Securities and Investment Commission (ASIC) released a regulatory
guide on enhancing companies’ consistent conformity with operating and financial review (OFR)
reporting requirements under s. 299A(1) of the Corporations Act. Of specific interest is that
an OFR should include a discussion about environmental and other sustainability risks where
those risks could affect the entity’s financial performance or the outcomes disclosed, taking into
account the nature and business of the entity and its business strategy. For example, it may be
that environmental risks would be more likely to affect a mining company’s financial prospects
than those of a bank.
Corporations in Australia must comply with accounting standards by virtue of s. 296 of the
Corporations Act, which requires company directors to ensure that the company’s financial
statements for a financial year comply with accounting standards. Two accounting standards of
direct relevance to our discussion are IAS 37 and IAS 16.
According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, obligations relating
to environmental performance could be included in either ‘provisions’ or ‘contingent liabilities’,
depending on the circumstances. The defining characteristic of a ‘provision’ as opposed to
other ‘liabilities’ is that the timing and amount of the ultimate payment are uncertain. However,
as mentioned earlier, it would appear that many organisations elect not to quantify certain
environmental obligations (such as those relating to remediating contaminated sites) because
they question the probability of the ultimate payment or believe they cannot measure the
obligation reliably.
IAS 16 Property, Plant and Equipment requires that the cost of an item of property, plant and
equipment include the initial estimate of the costs of dismantling and removing the item and
restoring the site on which it is located. The entity incurs this obligation either when the item is
acquired or as a consequence of having used the item during a particular period for purposes
other than to produce inventories during that period. Therefore, if the construction of a particular
plant or its use (other than in producing inventory) causes any contamination to land, there is
an expectation that an estimate of this cost would have been made when the asset was put in
place ready for use. This cost is to be included as part of the total cost of the property, plant and
equipment, with an equivalent amount being included in the liability provisions of the entity.
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This disclosure is on a comply or explain basis (or an ‘if not, why not’ basis) in the directors’
report section of an annual report. The inclusion of this recommendation reflects growing
recognition of the importance of sustainability risks to investors’ medium- to long-term decisions.
While this new disclosure will be easier to achieve for those entities undertaking sustainability
reporting, it will encourage other entities to put into place systems and processes to identify and
measure these risks and consider their implications for the entity.
The first annual reporting period began on 1 July 2008. Under the NGER Act, businesses are
required to apply for registration with the CER if they:
• are a constitutional corporation; and
• meet a reporting threshold for greenhouse gases or energy use or production for
a reporting (financial) year.
The NGER Act requires the ultimate Australian holding company of a corporate group to apply
for registration if its corporate group exceeds any one or more of the following thresholds for
a financial year as provided in Table 5.3.
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2010–11 and
subsequent financial
Reporting year 2008–09 2009–10 years
The data must generally be provided on behalf of the corporate group by its registered holding
company (known as the ‘controlling corporation’).
Aggregated greenhouse gas emissions and energy consumption data for the group will be
published by the CER for each reporting period (financial year) on a website by 28 February in
the following year. In addition, the CER may choose to publish such information for each member
or business unit of the group. Individual companies may also decide to publish this information
on their corporate websites.
Reporting under the NGER Act was expected to lead to a carbon tax that was established
under the Clean Energy Act 2011 (Cwlth) (CE Act). However, following the 2013 federal election,
the Australian Government announced that it would implement a Direct Action Plan to ‘efficiently
and effectively source low cost emissions reductions’ (Department of the Environment n.d.).
This plan included the Emissions Reduction Fund to provide incentives for organisations to
reduce their emissions. New legislation was introduced to parliament to repeal the CE Act,
and the carbon pricing mechanism was abolished, effective 1 July 2014.
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Even though the carbon tax was repealed, the reporting of emissions remains. A failure to report
in accordance with the NGER Act exposes the reporting entity to fines of up to $340 000 (2000
penalty units) for failure to apply for registration, and daily fines of up to $17 000 (100 penalty
units) for each day of non-compliance. It also exposes the executive officers of the corporation to
be liable for a civil penalty, at least where the officer knew the failure would occur (or was reckless
or negligent as to whether it would), was in a position to influence the conduct of the corporation
relating to the failure, and failed to take all reasonable steps to prevent the contravention.
This approach, of imposing liability on management for contraventions of environmental-related
legislation (which is also seen in other public good legislation such as health and safety, and
competition legislation), is increasingly common.
The NPI requires industrial facilities operating in Australia to estimate emissions of 93 substances
exceeding a specified threshold amount (substances reportable under the NGER Act are not
required to be reported under the NPI). The NPI reporting period is from 1 July to 30 June each
year and most reporting facilities have to lodge their reports with the NPI by 30 September
each year. The relevant state or territory environment protection agency will then assess the
reports and forward them to the federal government for inclusion on the publicly accessible
NPI database.
While the above Australian requirements have been discussed because of their associated
reporting requirements, it is also worth noting that legislation is increasingly requiring regulators
to make decisions that take into account social and environmental considerations.
For example, in Australia, the New South Wales (NSW) Independent Pricing and Regulatory
Tribunal regulates the prices that suppliers of government monopoly services in NSW (such as
public transport and water or sewerage services) may charge. Under s. 15(1) of the Independent
Pricing and Regulatory Tribunal Act 1992 (NSW), the tribunal, in making a price determination,
is required to take into account (among other things):
• ‘the need to maintain ecologically sustainable development … by appropriate pricing
policies that take account of all the feasible options available to protect the environment’
(s. 15(1)(f)); and
• ‘the social impact of the determinations and recommendations’ (s. 15(1)(k)).
Further examples include the NSW Energy Savings Scheme (established under the Electricity
Supply Act 1995 (NSW), Part 9) which supports the development and installation of electricity-
saving equipment such as ultra-low-flow showerheads, and the Commonwealth Renewable
Energy Target Scheme (established under the Renewable Energy Act 2000 (Cwlth)), which
supports the installation of renewable energy generators (e.g. wind, solar, biomass, tidal).
Similarly, the Australian Energy Regulator, which regulates the prices electricity distributors
may charge, has developed demand management incentive schemes (as contemplated by the
National Electricity Rules) to encourage distributors to take measures to reduce peak demand
on their infrastructure rather than simply build more infrastructure to accommodate increasing
peak demand.
Social procurement is another trend in which social impacts are taken into account in government
decision-making. Social procurement requires public bodies to consider the social value created
in procurement contracts, which may help social enterprises and charities to compete with larger,
established providers. For example, in October 2010, the Victorian Department of Planning and
Community Development launched Social Procurement: A Guide for Victorian Local Government
to assist councils in their efforts to secure procurement contracts with positive social impact.
The above regulatory mechanisms are in place in Australia. One high-profile overseas regulatory
process relates to the European Union emissions trading scheme.
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Central to the EU ETS cap-and-trade scheme is the creation of emission allowances. One
allowance represents the right to emit one tonne of CO2. The limit or ‘cap’ on the number of
allowances allocated creates the scarcity needed for a trading market to emerge. This means
that companies that generate the highest value from emitting greenhouse gases will be willing
to pay the most for those allowances, whereas companies that generate a lower value from
their emissions-producing activities will seek to reduce their emissions to avoid the need to
buy allowances. This ensures that emissions are reduced in the most cost-effective way.
The EU ETS includes a strong compliance and reporting framework. Article 14 of the EU ETS
Directive (Directive 2003/87/EC) requires the European Commission to adopt guidelines for
the monitoring and reporting of greenhouse gas emissions under the ETS. In relation to the
requirements, it states:
Installations must report their CO2 emissions after each calendar year. The European Commission
has issued a set of monitoring and reporting guidelines to be followed. Installations’ reports have
to be checked by an independent verifier on the basis of criteria set out in the ETS legislation,
and are made public. Operators whose emission reports for the previous year are not verified as
satisfactory will not be allowed to sell allowances until a revised report is approved by a verifier
(EU 2005, p. 13).
As stated by the Commission Regulation (EU) No 601/2012 of 21 June 2012 on the monitoring
and reporting of greenhouse gas emissions pursuant to Directive 2003/87/EC:
The complete, consistent, transparent and accurate monitoring and reporting of greenhouse
gas emissions, in accordance with the harmonised requirements laid down in this Regulation,
are fundamental for the effective operation of the greenhouse gas emission allowance trading
scheme established pursuant to Directive 2003/87/EC.
We address some of these guidance documents and further discuss the GRI and the G4
Guidelines. We then consider some industry guidelines that have been produced in Australia
before focusing on a number of other international guidelines that have been developed.
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In Figure 5.3 we outline how these guidelines and schemes relate to economic, environmental
or social sustainability. Although we have separated out the three main pillars, they are slowly
becoming more intertwined, as shown by the GRI and the integrated reporting approaches.
Although this figure provides quite a structured description of how these items are inter-related,
you should consider these concepts as evolving and subject to considerable change.
CSR reporting
Integrated reporting
OECD guidelines
CDP
UNGC
AA1000
Equator principles
GHG protocol
Trucost
Our discussion, while comprehensive, does not mean that we have referred to all the economic,
environmental and social sustainability reporting frameworks that are available.
The GRI comes in several forms of guidance. The first reporting guidelines, released in 2000,
are revised regularly and are used by many organisations globally. The latest version of the
guidelines—the G4 Guidelines—was published in 2013, and is available online at no cost.
The G4 Guidelines, together with other information about the GRI and its role and function,
are available online at: http://www.globalreporting.org.
Protocols are included and provide detailed reporting guidance to help improve reporting
comparability. According to the GRI website, protocols are the ‘recipe’ behind each indicator
in the G4 Guidelines and include definitions for key terms in the indicator, compilation
methodologies, intended scope of the indicator, and other technical references. The guidelines
provide details on report content, quality and scope.
The GRI also provides sector guidance in the form of industry-specific guidance documents.
For example, the guidance for the mining and metals industry includes issues such as site
rehabilitation (GRI 2013b), while for the banking industry the social and environmental impact
of lending practices is examined (GRI 2013c).
External factors
In defining material topics, an organisation should take into account external factors such as:
• main sustainability interests and indicators raised by stakeholders;
• main topics and future challenges for the sector reported by peers and competitors;
• relevant laws, regulations, international agreements or voluntary agreements with strategic
significance to the organisation and its stakeholders; and
• reasonably estimable sustainability risks or opportunities (e.g. global warming, HIV/AIDS,
poverty).
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Internal factors
Internal factors include:
• key organisational values, policies, strategies;
• interests of stakeholders specifically vested in the success of the organisation
(employees, shareholders and suppliers);
• significant risks to the organisation;
• critical facts for enabling organisational success; and
• core competencies of organisations and how they can be applied to contribute to sustainability.
The guidelines show the required standard disclosures (GRI 2013a). The general standard
disclosures are as follows:
• Strategy and analysis—description of the organisation’s strategic relationship and
report context.
• Organisational profile—overview of the reporting organisation’s structure, activities and
countries of operation.
• Identified material aspects and boundaries—details of the reporting period, experience
and scope. This is to include details of GRI usage and assurance processes if used.
• Stakeholder engagement—description of the process for including stakeholders during the
reporting period.
• Report profile—overview of the basic information about the report, the GRI content index,
and the approach to seeking external assistance.
• Governance—description of governance structures and details of accountability for
sustainability matters, and commitments to external initiatives.
• Ethics and integrity—overview of the organisation’s values, principles and norms, and its
policies and process for managing ethical and lawful behaviour (GRI 2013a, p. 12).
Many organisations incrementally increase the number of indicators reported as their information
systems improve. The GRI has established a system of self-assessment from A to C to help report
readers understand the extent to which the guidelines have been adopted. External verification is
identified as a ‘+’. As such, ‘A+’ denotes a fully compliant report that has been externally verified.
While the G4 Guidelines provide the most comprehensive guidance on sustainability reporting,
they by no means cover every situation. The underlying test is linked to the principle of materiality,
so that items that influence the decisions of stakeholders or that have a significant impact are
included in the report. Earlier in this module we discussed externalities created by organisations.
Taking the example of the negative health impact caused by tobacco products, such externalities
could include the illness and death of product consumers, family suffering, use of public resources
to care for smokers and to encourage people to stop smoking, and so forth. The G4 Guidelines
do not provide specific guidance in relation to such health issues, and there is no sector
guidance for the tobacco industry. However, the G4 Guidelines do provide some very general
suggestions under the titles of ‘customer health and safety’ and ‘product labelling’ (part of
the ‘product responsibility indicators’, which in themselves are part of the broader category
of ‘social performance indicators’).
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Many organisations in Australia report in accordance with the GRI reporting guidelines. Apart
from these guidelines, a number of Australian industry bodies have also released their own
CSR reporting guidance (and many of these make specific reference to the GRI Guidelines).
Among the Australian industry bodies that have released reporting guidance are the:
• Australian Minerals Industry, in a document titled Enduring Value: The Australian Minerals
Industry Framework for Sustainable Development (MCA n.d.);
• Energy Supply Association of Australia, in a document titled Sustainable Practice Framework
(ESAA 2009); and
• Property Council of Australia, in a document titled A Guide to Corporate Responsibility
Reporting in the Property Sector (PCA 2009).
We can only speculate as to why industry bodies such as those mentioned would develop
documents or codes requiring public sustainability reporting. One perspective might be
that requiring public reporting and developing guidelines for its members could mean that
mandatory (and perhaps more onerous) reporting would not be imposed on the industry by
government regulation. In a sense, industry might have sought to capture the regulatory process.
Another reason why particular industries introduce codes and associated reporting requirements
could be that industry leaders believe they have a responsibility to disclose information to
the public about how organisations use the environmental resources entrusted to them.
That is, organisations might believe they have an accountability that should be observed.
Another possible (related) perspective is that industries seek to legitimise their practices,
and ensure that they can maintain their social licence to operate and keep within the bounds
of reasonable or expected behaviours in a community.
Having considered the GRI and some Australian industry guidance, we now discuss other
international guidance or initiatives that organisations might choose to voluntarily adopt.
Integrated reporting
As a result of the recognition of the failings of traditional financial reporting, we have seen
a significant development in the evolution of corporate reporting, the integrated reporting
initiative. The International Integrated Reporting Committee (IIRC) was created in August 2010
as a joint Initiative of the Prince’s Accounting for Sustainability Project and the GRI (IIRC 2010).
According to the International <IR> Framework of the IIRC, ‘An integrated report is a concise
communication about how an organisation’s strategy, governance, performance and prospects,
in the context of its external environment, lead to the creation of value in the short, medium and
long term’ (IIRC 2013).
Many organisations produce an annual report with various items of financial information as
required by accounting standards, corporations law and securities exchange listing requirements
together with a separate CSR report. But there is often little or no connection between the
various reports in order to tell the coherent, concise value-creation story of the organisation.
Integrated reporting is consistent with numerous developments that are taking place in corporate
reporting around the world. It is a response to the limitations of traditional financial reporting
that we discussed earlier in this module. We are seeing greater demands for a broader set of
information relevant to stakeholders, consistent with a move away from the shareholder primacy
perspective. A lot of this is environmental and sustainability information that has been mandated,
as discussed earlier in this information. But integrated reporting is broader than this, and reflects
an organisation’s drawing from and interaction with all the resources and relationships that are
important to that organisation in creating value.
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It is effectively argued by the IIRC that there is a need to transform corporate reporting so that
various types of relevant information for assessing and evaluating a company’s performance
are reported in a comprehensive and integrated way. Corporate reporting should follow
directly from an organisation’s corporate strategies and targets which in themselves need to be
clearly elaborated. Integrated reporting is not simply about combining the annual report with
a CSR report—sustainability will need to be clearly anchored in the overall business strategy
and incorporated within key performance indicators.
Source: Copyright © December 2013 by the International Integrated Reporting Council (‘the IIRC’).
All rights reserved. Used with permission of the IIRC. Contact the IIRC (info@theiirc.org) for
permission to reproduce, store, transmit or make other uses of this document.
The last point made above is the importance of integrated thinking for an organisation,
which was defined earlier in this module. It is believed that a lot of the benefits of the integrated
reporting initiative are due to the improvement to internal decision-making from adopting
integrated thinking. Integrated thinking in an organisation leads to integrated decision-making
and encourages management to undertake actions that affect the ability of an organisation to
create value over time (Adams 2013).
In December 2013, following extensive consultation and testing by businesses and investors in
all regions of the world, the IIRC released its integrated reporting framework. The purpose of the
framework is to establish guiding principles and content elements that govern the overall content
of an integrated report, and to explain the fundamental concepts that underpin them.
Source: OECD 2011, OECD Guidelines for Multinational Enterprises, 2011 Edition, OECD Publishing,
Paris, accessed October 2015, http://www.oecd.org/corporate/mne/48004323.pdf.
Within the OECD Guidelines, it is stated that enterprises should take into account the established
policies of the countries in which they operate and consider the views of other stakeholders.
Enterprises should contribute to economic, environmental and social progress with a view to
achieving sustainable development. In relation to the environmental obligations, the OECD
Guidelines state:
Enterprises should, within the framework of laws, regulations and administrative practices in
the countries in which they operate, and in consideration of relevant international agreements,
principles, objectives, and standards, take due account of the need to protect the environment,
public health and safety, and generally to conduct their activities in a manner contributing to the
wider goal of sustainable development.
Source: OECD 2011, OECD Guidelines for Multinational Enterprises, 2011 Edition, OECD Publishing,
Paris, accessed October 2015, http://www.oecd.org/corporate/mne/48004323.pdf.
The ‘OECD Guidelines for Multinational Enterprises’ are available online at: http://mneguidelines.
oecd.org. Interested candidates can review the guidelines to see which aspects relate to CSR issues.
The view of the CDP is that carbon emissions and climate change represent significant business
risks and, therefore, an organisation’s policies and performance in relation to climate change
should be factored into investment decisions. Further, the CDP holds the view that information
about greenhouse gas emissions is useful to investors, corporations and regulators in making
informed decisions that take into account corporate risk from future government legislation,
possible future lawsuits and shifts in consumers’ perceptions towards heavy emitters.
The overall organisational goal of the CDP is promoted as being to reduce the problem of global
warming, and according to the CDP website:
CDP is an international, not-for-profit organisation providing the only global system for companies
and cities to measure, disclose, manage and share vital environmental information. We work with
market forces to motivate companies to disclose their impact on the environment and natural
resources and take action to reduce them (CDP 2014a).
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A special project of CDP is the Climate Disclosure Standards Board. It has developed a climate
change reporting framework that is intended for use by companies making climate change
disclosures in their mainstream financial reports. It is about linking financial and climate-change-
related reporting to give policy makers and investors clear, reliable information for robust
decision-making. The framework has a similar objective to the integrated reporting initiative but
focuses on a specific issue.
For reference, the Climate Disclosure Standards Board climate change reporting framework is
available at: http://www.cdsb.net/sites/cdsbnet/files/cdsbframework_v1-1.pdf.
Organisations wishing to publicly report their greenhouse gas emissions and climate change
strategies can do so through the CDP, and interested parties can conduct searches on the
CDP website by company name. Researchers within the CDP also use the Carbon Disclosure
Leadership Index to score company responses based on the quality of their reporting to CDP.
According to the CDP website, the scores provide a valuable perspective on the range and
quality of companies’ responses.
➤➤Question 5.11
The CDP website features a quote from Douglas Flint, group chairman of HSBC Holdings plc,
in which he states:
For HSBC, climate change is a cornerstone of our ongoing business strategy … The
reporting framework that CDP has pioneered over the past decade has helped us both
as a respondent and a signatory, to improve our understanding of the strategic risks and
opportunities in this area (CDP 2014b).
Evaluate this statement.
Businesses become signatories to the United Nations Global Compact and demonstrate actions
to support the 10 principles by submitting formal ‘Communications on progress’ on an annual
basis. The United Nations Global Compact’s 10 principles are derived from:
• the Universal Declaration of Human Rights;
• the International Labour Organization’s Declaration on Fundamental Principles and
Rights at Work;
• the Rio Declaration on Environment and Development; and
• the United Nations Convention Against Corruption.
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The United Nations Global Compact asks companies to embrace, support and enact, within
their sphere of influence, a set of core values in the areas of human rights, labour standards,
the environment and anti-corruption.
Human rights
Principle 1: Businesses should support and respect the protection of internationally proclaimed
human rights; and
Principle 2: make sure that they are not complicit in human rights abuses.
Labour
Principle 3: Businesses should uphold the freedom of association and the effective recognition
of the right to collective bargaining;
Principle 4: the elimination of all forms of forced and compulsory labour;
Principle 5: the effective abolition of child labour; and
Principle 6: the elimination of discrimination in respect of employment and occupation.
Environment
Principle 7: Businesses should support a precautionary approach to environmental challenges;
Principle 8: undertake initiatives to promote greater environmental responsibility; and
Principle 9: encourage the development and diffusion of environmentally friendly technologies.
Anti-Corruption
Principle 10: Businesses should work against corruption in all its forms, including extortion and
bribery (UNGC 2011, p. 6).
At the centre of AccountAbility’s work is the AA1000 Series of Standards, which, according to
its website, is based on the following principles:
• Inclusivity—people should have a say in the decisions that impact on them.
• Materiality—decision-makers should identify and be clear about the issues that matter.
• Responsiveness—organisations should be transparent about their actions
(AccountAbility n.d.).
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The AA1000 series has been designed with the intention of helping ‘organisations become more
accountable, responsible and sustainable’. Currently, the AA1000 series consists of:
• The AA1000 AccountAbility Principles Standard 2008 (AA1000APS), which provides a better
‘framework for an organisation to use in order to better identify, understand, prioritise and
respond to its sustainability challenges’ (AccountAbility 2008).
• The AA1000 Assurance Standard 2008 (AA1000AS), which is a leading international standard,
used to provide assurance on publicly available sustainability information, particularly CSR or
sustainability reports (AccountAbility 2008).
• The AA1000 Stakeholder Engagement Standard 2015 (AA1000SES) (currently under revision
for public comment), which provides the basis for building robust and responsive stakeholder
engagement processes (AccountAbility 2015).
Equator Principles
When an organisation seeks to establish a particular project, it often requires project-specific
financing. As such, there is a view among many people that the organisation providing the
finance (typically a financial institution) should take some responsibility and leadership in how the
funding is being used and the social, environmental and economic impact associated with the
project. With this perspective in mind, the Equator Principles (EPs 2013) were developed.
The Equator Principles are a voluntary set of standards for determining, assessing and managing
social and environmental risk in project financing. Project financing is defined in the Equator
Principles as:
a method of financing in which the lender looks primarily to the revenues generated by a
single Project, both as the source of repayment and as security for the exposure. This type of
financing is usually for large, complex and expensive installations that might include, for example,
power plants, chemical processing plants, mines, transportation infrastructure, environment,
and telecommunications infrastructure. (EPs 2013, p. 19).
Equator Principles Financial Institutions (EPFIs) commit to not providing loans to projects where
the borrower will not or is unable to comply with the respective social and environmental policies
and procedures that are incorporated into the Equator Principles.
The Equator Principles apply to all new project financings globally, with total project capital costs
of USD 10 million or more, across all industry sectors. In addition, while the Equator Principles
are not intended to be applied retrospectively, EPFIs will apply them to all project financings
covering expansion or upgrade of an existing facility where changes in scale or scope may
create significant environmental and/or social impact, or significantly change the nature or
degree of an existing impact.
The intended consequences of adopting the Equator Principles are expressed in the guidance
document accompanying the principles (version III was released in 2013 and titled ‘The Equator
Principles: A financial industry benchmark for determining, assessing and managing environmental
and social risk in projects’) as follows:
We, the Equator Principles Financial Institutions (EPFIs), have adopted the Equator Principles
in order to ensure that the Projects we finance and advise on are developed in a manner that
is socially responsible and reflects sound environmental management practices. We recognise
the importance of climate change, biodiversity, and human rights, and believe negative impact
on project-affected ecosystems, communities, and the climate should be avoided where
possible. If these impacts are unavoidable they should be minimised, mitigated, and/or offset
(EPs 2013, p. 2).
For details of the 10 principles, interested candidates can refer to the Equator Principles website:
http://www.equator-principles.com/resources/equator_principles_III.pdf.
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The GHG Protocol standards were designed with the following objectives in mind:
• To help companies prepare a GHG inventory that represents a true and fair account of their
emissions, through the use of standardised approaches and principles.
• To simplify and reduce the costs of compiling a GHG inventory.
• To provide business with information that can be used to build an effective strategy to manage
and reduce GHG emissions.
• To increase consistency and transparency in GHG accounting and reporting among various
companies and GHG programs (WRI & WBCSD 2005, p. 3).
The GHG Protocol consists primarily of four separate but linked standards.
The Corporate Accounting and Reporting Standard (Corporate Standard) provides methodologies
for businesses and other organisations to report all of their GHG emissions. It covers the
accounting and reporting of the six greenhouse gases covered by the Kyoto Protocol:
• CO2 (carbon dioxide)
• CH4 (methane)
• N2O (nitrous oxide)
• HFCs (hydrofluorocarbons)
• PFCs (perfluorocarbons)
• SF6 (sulphur hexafluoride).
The Corporate Standard was amended in May 2013 to include a seventh greenhouse gas,
nitrogen trifluoride (NF3 ).
The second, the Project Accounting Protocol and Guidelines (Project Protocol), is designed to
calculate reductions in GHG emissions from specific GHG-reduction projects. According to the
GHG Protocol, the Project Protocol is the most comprehensive, policy-neutral accounting tool for
quantifying the greenhouse gas benefits of climate change mitigation projects.
The third is the Corporate Value Chain (Scope 3) Accounting and Reporting Standard,
which allows companies to assess their entire value-chain emissions impact and identify the
most effective ways to reduce emissions. Scope 3 emissions refer to other indirect emissions
generated in the wider economy as a consequence of an organisation’s activities but which are
physically produced by others. An example would be emissions caused by airline travel for staff
of an organisation. The new standard allows for the accounting for emissions from 15 categories
of scope 3 activities, both upstream and downstream of their operations, and also supports
strategies to partner with suppliers and customers to address climate effects throughout the
value chain.
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The fourth is the Product Life Cycle Accounting and Reporting Standard, which can be used to
evaluate the full life cycle emissions of a product. This is the first step towards more sustainable
products, as organisations can measure the greenhouse gases associated with the full life
cycle of products, including raw materials, manufacturing, transportation, storage, use and
disposal. The standard is also expected to help organisations respond to customer demand
for environmental information and make it easier to communicate the environmental aspects
of products.
Trucost
Another interesting approach to accounting for CSR-related effects is provided by the
organisation known as Trucost. Trucost was established in 2000 with the aim of assisting
organisations, investors and governments to understand the economic consequences of natural
capital dependency. According to its website, a key to its approach is that it not only quantifies
environmental impacts but also puts a price on them. It claims that in this way, Trucost helps
its clients to:
identify natural capital dependency across companies, products, supply chains and investments;
manage risk from volatile commodity prices and increasing environmental costs; and ultimately
build more sustainable business models and brands. (Trucost n.d.)
Trucost draws on a range of sources in its analysis, including financial information from sources
such as Dun & Bradstreet, to establish the business activities of an organisation and then
apportion the organisation’s revenues to those activities. It then uses the organisation’s own
external CSR reporting, or proxy information when the CSR information is not available, such
as fuel use or expenditure data. Its analysts then standardise reported figures in an endeavour
to ensure the data covers the total operations of a company and the impacts are categorised
according to acknowledged reporting standards. Each analysed company is then invited to verify
or refine the environmental profile Trucost has created. Trucost analysts validate and authenticate
any amendments or further disclosures made by the company (Trucost n.d.).
Dow Jones SI
The Dow Jones Sustainability World Index was launched in 1999 and provides a global
sustainability benchmark that tracks the share performance of the world’s leading companies in
terms of economic, environmental and social sustainability. A number of indices (at the global,
regional or country level) serve as benchmarks for investors who wish to integrate sustainability
considerations into their portfolios. The index uses a ‘best in industry’ approach rather than
excluding particular industries, as is the case with techniques such as socially responsible
investments, which will be discussed later in this module.
Each year, the 2500 largest companies in the Standard & Poor’s Global Broad Market Index
are invited to participate in a corporate sustainability assessment, which requires completing a
questionnaire (consisting of approximately 80 to 120 questions on financially relevant economic,
environmental and social factors) and a media and stakeholder analysis. About half the
assessment is about how the organisation deals (in terms of standard management practices
and performance measures) with major global sustainability challenges such as human capital
development, and risk and crisis management. The other half of the questionnaire covers
industry-specific risks and opportunities that focus on economic, environmental and social
issues relevant to that industry (DJSI).
➤➤Question 5.12
This section has discussed a number of major reporting frameworks. Identify which of the
guidelines and non-mandatory initiatives constitute reporting frameworks, and outline the benefit
of such frameworks.
Other initiatives
Social audits
Earlier in this module, we discussed the importance of organisations complying with community
expectations and the necessity for organisations and industries to comply with the social
contract. We noted that failure to comply with community expectations can have significant
implications for the profitability and survival of an organisation.
With the above in mind, many organisations undertake a ‘social audit’ (which should not be
confused with an audit or verification of an organisation’s social and environmental impact or
CSR report). A social audit can be seen as representing the process an organisation undertakes
to investigate whether it is perceived, by particular stakeholder groups, to be complying with
the social contract. This definition of a social audit is consistent with Elkington (1997), who states
that the purpose of social auditing is for an organisation to assess its performance in relation to
society’s requirements and expectations. Any such assessment requires the direct involvement
of stakeholders, which might include employees, capital providers, customers, contractors,
suppliers and local residents interested in the organisation. Social audits provide a basis
for assessing the extent to which an organisation appears to be living up to the values and
objectives to which it has publicly committed.
The results of a social audit often form an important component of an entity’s publicly
released social report, which in itself might form part of a broader CSR or sustainability report.
The outcomes of social audits can be considered an important part of the ongoing dialogue
with various stakeholder groups.
One company that has undertaken social audits in Australia is The Body Shop. Arguably,
because The Body Shop relies relatively heavily on its reputation for superior social and
MODULE 5
2011 saw us complete our 7th Social Audit cycle whereby we surveyed our Employees, At Home
Consultants, Suppliers, Values Partners and Customers. Thank you to everyone who participated
…. We have now commenced preparation for our 2013 Social Audit which will take place later
this year ….
Our social audit process is based on feedback from our key stakeholders about our company
values, social and ethical performance. All stakeholders invited to participate are anonymous.
We are one of the very few companies in Australia to conduct a stakeholder perception social
audit process that is independently audited and publicly disclosed.
Why do we do this?
• It’s the right thing to do—businesses should report on their social and ethical performance.
• For continuous improvement—we want to get better at what we do.
• To lead by example—we want to be a role model to our companies to follow suit
(Body Shop 2012).
Their social audit involved market research questionnaires and focus groups with key stakeholder
groups: staff, customers, suppliers, values partners and The Body Shop at home consultants.
For the 2011/2012 social audit, more than 9000 people were consulted. The results of the
2011/2012 social audit regarding their employees are contained in Figure 5.4.
Figure 5.4: The social statement of The Body Shop regarding employees
EMPLOYEES
Inspiring and developing our people
Ours has always been a business that puts a high value on our People. We are committed to treating
our staff in a fair, considerate and supportive way. As you would expect, this means we have forward
thinking policies on issues like diversity and equality, because we believe passionately that it’s not your
background, race, sexuality, gender, or disability that defines who you are, but the talent you have and the
commitment you’re prepared to give.
In the last few years we’ve formalised most of our People policies. These cover recruitment and on
boarding, learning and development, performance appraisal, reward and engagement and career
development. There are detailed tools and processes supporting all of these and they’re underpinned
by the basic principles we follow in all our dealings with our teams, which are transparency, dialogue,
and mutual commitment.
Good News
(above The Body Shop’s 70% benchmark)
93% of staff believe there’s something special and unique about working for the organisation
89% of staff trust the business to always act ethically in business dealings
86% of staff trust the business to make a difference
83% of people are proud of the achievements of the organisation
80% of staff believe it’s a truly great place to work
Hot Spots
(below The Body Shop’s 70% benchmark)
59% of staff believe workloads are fair & equitable
67% of staff believe there is a strong sense of purpose and direction
63% of staff rate The Body Shop well on the amount of environmental information available
62% of staff are satisfied with opportunities for professional/personal development
Targets
To achieve 80% and more across all indicators related to staff satisfaction with their employment, in
particular across workload, development and environmental responsibility.
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Source: Body Shop 2012, The Body Shop Australia’s Social & Environmental Report 2011/2012,
accessed June 2015, http://www.thebodyshop.com.au/cms/Assets/Images/
The%20Body%20Shop%20Social%20WEB%20public%20Report.pdf.
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At this point, we reflect on the question of whether the results reported in The Body Shop report
(2012) represent accounting results. The answer to this returns to the link between accounting
and accountability. If an organisation believes it is accountable to particular stakeholder groups
for certain aspects of its performance, it would seem sensible to engage the stakeholders to
find out whether they are satisfied with the organisation’s performance, and the results of this
engagement would form part of the organisation’s account of its social performance.
Reflecting the interest in social accounting and social auditing, Social Accountability International
released a social accounting standard entitled the Social Accountability 8000 International
Standard (SAI 2014), which focuses on issues associated with human rights, health and safety,
and equal opportunities. SA8000 is a voluntary standard that can be assured against, based on
the principles of the UN Universal Declaration of Human Rights, the International Labour
Organization conventions, international human rights norms and national labour laws.
The above approach can be contrasted with the approach adopted by The Body Shop. The Body
Shop tends to structure its social audit on issues developed in-house, rather than considering
issues specified by an external body such as those responsible for the development of SA8000.
➤➤Question 5.13
(a) What is a social audit and why would an organisation undertake one?
(b) Would the results of a social audit be incorporated in an organisation’s CSR report?
Companies can put in place formal structures that have a strong sustainability focus. For example,
many organisations now have formal board committees dedicated to sustainability issues and also
appoint environmental managers who report directly to the board.
Another relevant release from the ISO is ISO 26000, Guidance on Social Responsibility,
which provides guidance on social responsibility for all types of organisations. This includes
guidance on:
(a) Concepts, terms and definitions related to social responsibility;
(b) Background, trends and characteristics of social responsibility;
(c) Principles and practices relating to social responsibility;
(d) Core subjects and issues of social responsibility;
(e) Integrating, implementing and promoting socially responsible behaviour throughout the
organisation and, through its policies and practices, within its sphere of influence;
(f) Identifying and engaging with stakeholders; and
(g) Communicating commitments, performance and other information related to social
responsibility (ISO 2010, p. 7).
Arguably, a sound corporate management system should also link executive rewards to key social
and environmental performance indicators. That is, rather than focusing on reward structures
that are tied to measures of financial performance only (paying senior executives a bonus tied
to profit, sales, return on assets, and so forth), management’s bonuses could also be tied to
social and environmental performance indicators, for example, a reduction in emission levels or
workplace injuries. The reporting of a link between employee remuneration and performance
on social and environmental issues is still found to be rare for the largest 250 companies in
the world.
Companies that clearly link employee remuneration to performance on social and environmental
issues send a strong signal to employees, investors and other stakeholders that they are serious
about CR [corporate responsibility] performance and ensuring the long term viability of the
company. Yet only 10% of the world’s largest companies (G250) currently provide a clear explanation
in their reporting of how remuneration is linked with CR performance.
This suggests that in most of these companies CR is still not considered a critical business
performance indicator to factor in to executive remuneration, despite around a quarter of them
stating that the company board has ultimate responsibility for CR.
Source: ‘Linking CSR performance with pay sends clear sustainability signal’, Yvo de Boer,
The Guardian, 13 December 2013, Copyright Guardian News & Media Ltd 2015.
It is eye-opening to learn that worldwide so few companies link CSR performance to executive
remuneration, especially given the potential for social and environmental issues to affect the
supply chain, financial performance, reputation and the ultimate brand value of companies.
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An organisation that commits itself to a broad social responsibility agenda should consider
putting in place a suite of policies and procedures that help it achieve those objectives.
These procedures can relate to a variety of issues such as reporting policies, stakeholder
engagement policies, employee remuneration policies, waste management policies and so
forth—all of which have been discussed.
In a study of the disclosure of climate change-related governance practices, Haque and Deegan
(2010) developed a best practice guide to describe the corporate governance practices a
company might put in place to address climate change. In developing the best practice guide,
the authors referred to various climate change guidance documents released by a number
of NGOs and research bodies. Their synthesised list of best practice corporate governance
practices to address climate change is provided in Table 5.4. This list identifies the types of
board and senior management practices that an organisation could implement.
Board oversight 1. The organisation has a board committee with explicit oversight
responsibility for environmental affairs.
2. The organisation has a specific board committee for climate change and
GHG-related issues.
3. The Board conducts periodic reviews of climate change performance.
Senior management 4. The CEO/chairperson articulates the organisation’s views on the issue
engagement and of climate change through publicly available documents such as annual
responsibility reports, sustainability reports, and websites.
5. The organisation has an executive risk management team, dealing
specifically with GHG issues.
6. Some senior executives have specific responsibility for relationships with
government, the media and the community with a specific focus on climate
change issues.
7. The organisation has a performance assessment tool to identify current
gaps in GHG management.
8. The executive officers’ and/or senior managers’ compensation is linked to
attainment of GHG targets.
Source: Adapted from Haque, S. & Deegan, C. 2010, ‘Corporate climate change related governance
practices and related disclosures: Evidence from Australia’, Australian Accounting Review,
vol. 20, issue 4, p. 324.
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While it would not be expected that a company would implement all of the above processes,
it would be expected that a company serious about addressing climate change would
incorporate a number of the above policies in its corporate governance system.
➤➤Question 5.14
Identify five corporate governance policies that could act to enhance an organisation’s social
and environmental performance and explain how linking such policies to executive remuneration
would generally be in the best interests of the organisation and its key stakeholders.
To assess costs correctly, it is important to collect both financial and non-financial data
(e.g. materials use, personnel hours and other cost drivers). Environmental management
accounting places a particular emphasis on materials and materials-driven costs because the
use of energy, water and materials, as well as the generation of waste and emissions, is directly
related to many of the effects organisations have on their environments.
Many organisations purchase energy, water and other materials to support their activities.
For example, in a manufacturing organisation, some of the purchased material is converted into
a final product that is delivered to customers. But most manufacturing operations also produce
materials that were intended to go into the final product but became waste instead because
of issues such as operating inefficiencies or product quality issues. Manufacturing operations
also use energy, water and materials that are never intended to go into the final product but
were to manufacture the product (such as water to rinse out chemicals). Many of these materials
eventually become waste streams that must be managed.
One of the first steps required when implementing an environmental management accounting
system is to define which environmental costs will be accounted for (or managed). These costs
can be restricted to those currently recognised by an organisation pursuant to ‘conventional’
accounting practices or they could be extended to include externalities. Where focus is on costs
currently being recognised, it might be that the way they are currently being accounted for is
impeding efforts to improve an organisation’s operations.
The accumulation of various costs (overheads) in overhead accounts is something that many
of us have been taught as part of our accounting education despite the fact that doing so can
impede our ability to manage the consumption of various, all of which may have environmental
consequences. That is, the practice of using overhead accounts can counter other initiatives
implemented to address CSR. Where a variety of costs are being accumulated in overhead
accounts, subsequent allocation of the accumulated costs to particular products are frequently
made in terms of such bases as sales volume, production output, floor space occupied by
particular departments, machine hours or labour hours. This might, however, be an inaccurate
way to allocate some typical environmental costs.
While making the task of cost allocation easier, using such simplistic allocation bases as those
identified above may lead to the misallocation of many costs, including those relating to the
environment. An example would be hazardous waste disposal costs, which could be high
for a product line that uses hazardous materials and low for one that does not. In this case,
the allocation of hazardous waste disposal costs on the basis of production volume would be
inaccurate, as would be product pricing and other decisions based on that information.
Different approaches can be taken to resolve the issue of hidden environmental costs.
One common solution is to set up separate cost categories for the more obvious and discrete
environmental management activities. The less obvious costs that will still appear in other
accounts will need to be more clearly labelled as environmental so they can be traced more
easily. An assessment of the relative importance of environmental costs and cost drivers of
different process and product lines, in line with the general practice of activity-based costing
(ABC), can help an organisation determine whether the cost allocation bases being used are
appropriate for those costs.
From the above discussion, we can see that simply changing the way we accumulate and allocate
costs can provide us with an enhanced ability to control various environmental costs. Apart from
the way we accumulate costs, opportunities relating to reducing such things as waste can also be
enhanced if we classify particular costs differently. What should be understood at this point is that
relatively inexpensive changes to an entity’s accounting system can be made that might lead to
real changes in the ability to control resource usage.
Given the current infancy of environmental management accounting, the design of a particular
system is really about incremental progress. The case studies discussed by Deegan (2003)
suggest that a number of benefits can follow from introducing environmental management
accounting. These benefits can span from being direct to indirect and include:
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• More informed decision making: explicit consideration of particular costs that are otherwise
obscured by traditional accounting approaches;
• Uncovering opportunities: an analysis of environmental costs might reveal opportunities,
some of which might lead to revenues through recycling, or use of ‘waste’ in other activities;
• Improved pricing of products: explicit consideration of particular costs will enable more
informed pricing of products;
• Assist with internal and external reporting: identifying environmental costs will help organisations
collect data about their environmental impact for internal and external reporting purposes;
• Increased competitive advantage: given the infancy of environmental management accounting,
explicit consideration and associated publicity, might provide an organisation with a
competitive advantage;
• Improved reputation: efforts to reduce environmental costs and related impact will have
reputation implications;
• Staff retention and attraction: it has also been argued that by showing that an organisation is
trying to manage and account for the environmental implications of its operations, this may in
turn enable it to retain and attract better staff, as well as improve staff morale; and
• Generation of societal benefits: efforts to reduce environmental costs and impact (which will
assist in creating a cleaner environment) will generate human benefit.
What should be appreciated is that we, as accountants, can make relatively minor modifications
to our current accounting systems to assist our organisations to act in a more environmentally
responsible manner. Apart from enabling better management within an organisation, such
modifications will also enable us to provide a better account of certain costs (e.g. waste)
to external stakeholders.
Asia−Pacific region.
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• More than half of the organisations for all industry sectors reported on CSR, meaning
reporting could be considered standard global practice irrespective of industry. In the 2011
KPMG survey, less than half of the sectors had reporting rates above 50 per cent.
• Worldwide, more than half (51%) of the reporting companies included CSR information in
their annual financial reports (KPMG 2013, p. 11). This was a significant increase over the
previous two surveys. In 2011 only 20 per cent reported this way, while in 2008 only 9 per
cent reported this way. This emphasised the increasing importance given to this information
and, as KPMG stated, this type of reporting could arguably be considered standard
global practice.
• However, including CSR information in the annual report does not imply that companies have
embraced the concept of integrated reporting (discussed earlier in this module). Integrated
reports are published by only one in 10 companies that report on CSR (KPMG 2013, p. 12).
This is because integrated reporting is an evolving practice involving iterative application by
companies that have sought to apply the Framework.
While the survey results were interesting, they fail to reflect that organisations can, and do,
report information selectively. Given the predominantly voluntary nature of CSR reporting in
many countries, some organisations might only elect to report typically favourable information
about their economic, social and environmental performance. Therefore, we must be careful not
to get too excited about claims that of the 250 largest global companies, 93 per cent now report
on their CSR activities.
However, the survey does, unsurprisingly, show that the extent of disclosure in countries with
mandatory disclosure requirements tends to exceed disclosures in other countries:
CR reporting has traditionally been voluntary, however, governments and stock exchanges around
the world are increasingly imposing mandatory reporting requirements. CR reporting regulations
are seen in several countries that have almost 100 per cent reporting rates, including France,
Denmark and South Africa. Regulation is also behind a significant increase in reporting rates
in Taiwan.
Alongside government regulation, new guidelines and standards from stock exchanges and
other organisations are also having an impact. For example, in Singapore, the introduction of the
Singapore Stock Exchange (SGX) Sustainability Reporting Guide for listed companies and a revised
Code of Corporate Governance (which makes consideration of sustainability issues part of the
board’s remit) has influenced the 37 percentage point rise in reporting rates (KPMG 2013, p. 24).
The KPMG report (2013) also raised a number of issues that remain to be addressed adequately,
including the lack of comparability between organisations in respect of the information they
are producing, and uncertainties about the most appropriate mode of reporting. It is important
that appropriate and generally accepted reporting frameworks, as discussed earlier in this
module, be developed. Also, it should be recognised that the financial reporting framework
has the advantages associated with double-entry accounting (debits equals credits), and the
mathematical and systems rigour associated with this.
Most of the issues involved in CSR reporting are not dealt with rigorously. However, it should be
recognised that CSR reporting frameworks are evolving and hopefully maturing. For the sake of
comparability (with prior year CSR information for the same company), this can result in restating
comparative prior year information. High rates of restatement can put the perception of the
quality of the CSR information at risk. As stated by KPMG:
As companies seek to integrate reporting and present relevant CR data to investors alongside
established metrics for financial disclosure, it is more important than ever that CR data is
robust. High levels of restated data year upon year risks eroding confidence in company data,
reporting systems and processes (KPMG 2013, p. 34).
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One approach we can adopt to identify cutting edge CSR reporters is to review the results of
annual CSR or sustainability reporting awards. In 2014, Westpac was ranked the world’s most
sustainable company. The bank was handed the prestigious prize at the World Economic Forum
in Davos, Switzerland. This is discussed in Reading 5.2.
Reading 5.2, ‘Westpac named world’s most sustainable company at Davos’, highlights the benefits
of companies undertaking CSR reporting.
A leading example of one of these awards is that run by Australasian Reporting Awards Limited
(ARA n.d.), an independent not-for-profit organisation supported by volunteer professionals
from the business community and professional bodies concerned about the quality of financial
and business reporting. The awards provide an opportunity for organisations to benchmark their
reports against the ARA criteria, and are open to all organisations that produce an annual report.
The winners of the 2015 ARA Report of the Year Awards were Woodside Petroleum Limited
and CSIRO.
The ARA judges said that Woodside Petroleum, Australia’s largest independent oil and gas
company, had achieved its stated objectives of both meeting its compliance and governance
obligations, and providing stakeholders with easy-to-read information about the company’s
operations and performance. They said the company had ‘provided a visually attractive report’
that provides stakeholders with easy-to-read information that clearly describes the organisation’s
activities and performance. High quality information is provided throughout’ (ARA n.d.).
The ARA judges said that the CSIRO award-winning report ‘is well-presented and easy-to-read
and to comprehend despite the wide range of topics it covers. The use of relevant pictures
and explanatory captions capture attention and encourage the reader to read the whole story’
(ARA 2015).
These awards might also serve to motivate organisations to improve the quality of information
provided and increase the number of companies making such disclosures. The awards aim to
identify and reward innovative attempts to report CSR-related information. The judging criteria
of such awards can be used as guidance in determining what and how to report.
The integrated reporting initiative also has an Emerging Integrated Reporting Database
(IIRC n.d.) that brings together extracts of reports that illustrate emerging practices in integrated
reporting. This database can be searched by industry, year or component of an integrated
report. It is worthwhile accessing this database and identifying the types of reporting extracts
that are leading to best practice.
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➤➤Question 5.15
The Westpac Sustainability and Community ‘Reporting our performance’ is located at: http://
www.westpac.com.au/about-westpac/sustainability-and-community/reporting-our-performance/
stakeholder-impact-reports.
Review this website, including the latest ‘Annual review and sustainability report’ and evaluate
its ability to communicate Westpac’s economic, social and environmental credentials.
The above discussion shows the variety of reporting approaches being adopted to provide
information about the sustainability-related performance of organisations. Many decisions are
required to be made, which can be contrasted with financial reporting, where the extent of
regulation means that there is relatively limited scope for experimentation or innovation.
As the IPCC’s Fifth Assessment Report emphasises, such temperature rises are likely to have
dramatic economic, environmental and social effects.
The international community has become increasingly concerned with the adverse effects of
climate change. In Rio de Janeiro, in June 1992, many countries joined an international treaty,
the United Nations Framework Convention on Climate Change (UNFCCC). As of June 2014,
the UNFCCC has a membership of 195 countries (UNFCCC 2014a).
The UNFCCC established an institutional framework at the international level within which
countries were to begin reducing emissions (known as ‘mitigation’) and adapting to the effects of
climate change (known as ‘adaptation’). It also required, for the first time, countries to measure,
account for and report their aggregate emissions of a range of greenhouse gases (as well as
estimates of greenhouse gases stored in ‘sinks’ such as new forests) across all sectors of their
economies. The overall objective of the treaty was to stabilise greenhouse gas concentrations in
the atmosphere in order to avoid dangerous human interference in the climate system. However,
the treaty did not set any mandatory limits on greenhouse gas emissions for individual countries,
nor did it contain any enforcement mechanisms (UNFCCC 2014a).
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These elements were introduced later, when parties to the convention met in Japan in 1997
and agreed to the Kyoto Protocol. The protocol commits industrialised countries to reduce
their emissions by specific quantities within prescribed timeframes. Thirty-seven industrialised
nations agreed to legally binding reductions in greenhouse gas emissions of an average of below
5 per cent against 1990 levels during the first commitment period, spanning 2008 to 2012.
The protocol left it to those countries to determine the best means by which to achieve
their targets, while allowing their domestic emissions reductions to be ‘supplemented’ by
internationally traded offset credits. Recognising that developed countries are principally
responsible for the current high levels of greenhouse gas emissions as a result of more than
150 years of industrial activity, the protocol places a heavier burden on them compared to the
developing countries.
In November 2013, at the 19th session of the UNFCCC COP in Warsaw, governments agreed to
negotiate a new international climate treaty for adoption at the 21st COP in Paris in December
2015. This forthcoming agreement is intended to take effect from 2020 and to replace the
Kyoto Protocol by setting new binding national emissions reduction targets to limit the global
temperature rise to no more than 2°C. New pledges will need to be more ambitious in light of
World Bank estimates that the emissions reduction pledges in the Kyoto Protocol are no longer
sufficient to prevent a 2°C temperature rise. Further, any new agreement will need to include key
emerging economies such as China, Brazil, India and Russia and developed countries will need to
provide technology, finance and capacity-building support for developing countries to start on a
clean-growth trajectory.
For example, we can embrace a PSR to change the amount of energy we consume (and to
some extent, the amount of energy we use that comes from renewable sources). We can also
consider the necessity for particular travel and the mode of travel being used. Similarly, we can
consider the amount of waste we are generating and how we can reduce that waste. Additionally,
the extent to which we really need to satisfy all our wants, particularly those wants that contribute
highly to climate change, should be reconsidered.
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The emphasis here is that tackling issues such as climate change requires the community to
also embrace the need for change and not simply rely upon (or blame) organisations for the
necessary improvements. Organisations are key contributors to various environmental issues but,
within the capitalist system that dominates world economies, organisations typically respond to
the demands of individuals. As consumers of products and services manufactured or generated
by organisations, individuals must accept some responsibility for the environmental issues that
organisations create.
Reading 5.3, ‘Social responsibility in eye of beholder’ by J. Bhagwati provides certain perspectives
about the social responsibilities of corporations and individuals.
You should read this now and then answer question 5.16.
➤➤Question 5.16
Reading 5.3 provides certain perspectives about the social responsibilities of corporations and
individuals. Consider the following questions:
(a) Should CSR be de-emphasised in favour of personal social responsibility?
(b) Is CSR an effective defence strategy against powerful stakeholders?
(c) Is CSR really only undertaken to generate added revenue?
The predominant mechanisms to price carbon are taxation, and ‘cap-and-trade’ or emissions
trading schemes (ETSs). Our focus in this section is on ‘cap-and-trade’ systems, which are
designed as a market-based approach to dealing with carbon emissions. This builds on the
discussion in previous sections about specific cap-and-trade schemes, such as the European
Union Emissions Trading Scheme (EU ETS). It is the failure of the market to recognise many social
and environmental externalities which, at least in part, is being blamed for the current challenge
posed by climate change.
The concept of an emissions trading market is based on giving carbon a price per tonne so
that products can be more fully costed and the costs of emissions internalised. As emissions
become an internal cost, they also highlight the need for more specific and consistent reporting,
while providing significant incentives for firms to improve operations. This will mean that,
depending on the individual industry and method of operation, there will be both winners
and losers in the market. Those organisations that produce products generated through
carbon-intensive processes will find that their costs will rise compared to other less carbon-
intensive producers and this would conceivably mean that, through passing on the higher costs,
they would lose customers.
This economic sensitivity is the reason why the establishment of a carbon market can be
contentious. It will mean that certain industries will find their costs rising more than other less
carbon-intensive industries. It might also create an international disadvantage if other countries
do not place a cost on carbon.
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Clearly, requiring the recognition of costs that have not previously been recognised will require
many industries to adapt and change. The intention of placing a price on carbon emissions is
to create change in the way we do things because what we have been doing until now (i.e. not
accounting for carbon) is not sustainable. This will create some economic hardship for some
organisations and individuals. However, this would seem to be a non-issue when the greater
good (which is paramount), is achieved.
Under a cap-and-trade system, ‘allowances’ or ‘credits’ are used to provide incentives for
companies to reduce emissions by assigning a monetary value to pollution. In the EU, each
carbon allowance permits the holder to emit one tonne of carbon dioxide (CO2). The ‘cap’ phase
of the program begins when a government or regulatory body establishes an economy-wide
target for the maximum level of aggregate emissions permitted by companies in a specified time
frame. Then, a specific number of emissions allowances equal to the national target is allocated
(or auctioned) to participating companies based on a formula that generally includes past
emissions levels. Over time, it is expected that the amount of permits (or units) made available
will be reduced by the government in line with the quest to reduce carbon emissions.
The ‘trade’ aspect of the program occurs when a company’s actual emissions are greater or less
than the number of allowances it holds. Companies that emit less than the number of permits
they hold will have excess allowances; those whose emissions exceed the number of permits they
hold must acquire additional allowances. Additional (or excess) allowances can be purchased
(or sold) directly between companies, through a broker or on an exchange. Excess allowances
can be ‘banked’ and used to satisfy compliance requirements in subsequent years. It is argued
that cap-and-trade programs provide companies with added flexibility to choose the most cost
effective way to manage their emissions.
To date, 17 cap and trade programs operate throughout the world at regional, national and
sub‑national (states, provinces, cities) levels. The most active carbon market at the transnational
level is in Europe where the EU ETS began in 2005. In 2013 it moved into Phase III with more
stringent emissions targets to keep on track for a 60−80 per cent reduction by 2050. Despite
its flaws, Phase II of the EU ETS reduced greenhouse gas emissions by an estimated 2.5 to
5 per cent per year. Asia is being described as ‘the new hot spot for emissions trading’ given
that nine new ETSs have been launched in that region in the past three years. Specifically,
China’s national carbon program will start in 2016, based on seven sub-national pilot programs,
which together represent the world’s second largest carbon market after the EU ETS. In the
United States, the most robust legislative attempt to pass a federal carbon price was the
American Clean Energy and Security Act (HR 2454), which passed through the Lower House
in 2009 but was defeated in the Senate the following year. Due to Republican opposition,
there is no national-level price on carbon, despite the Obama Administration’s original pledge
to implement an ETS by 2016; however, cap-and-trade regulation has been enacted at the
sub‑national level (e.g. California). Moreover, there is a national EPA Greenhouse Gas Reporting
Program, which requires certain greenhouse gas-intensive facilities to provide annual emissions
reports to the US EPA.
Scope 1—emissions directly occurring from sources that are owned or controlled by an
institution, including:
• combustion of fossil fuels;
• mobile combustion of fossil fuels in vehicles owned or controlled by the organisation; and
• fugitive emissions.
Scope 3—all other indirect emissions that are a consequence of the activities of the organisation,
but occur from sources not owned or controlled by the organisation, such as:
• commuting;
• air travel for work-related activities;
• waste disposal;
• embodied emissions from extraction, production and transportation of purchased goods;
• outsourced activities;
• contractor-owned vehicles; and
• line loss from electricity transmission and distribution.
In Australia, entities and corporate groups that meet the reporting thresholds (i.e. large emitters)
must report their Scope 1 and Scope 2 emissions under the NGER Act (discussed earlier).
However, companies that do not meet the reporting thresholds under the NGER Act are not
subject to any direct regulation of emissions accounting, reporting or offsetting in Australia,
including in relation to the role of offsets—though companies are prohibited by s. 18 of the
Australian Consumer Law (which is a schedule to the Competition and Consumer Act 2010
(Cwlth)) and its state equivalents from making misleading or deceptive claims, including in
relation to carbon offsetting, carbon neutrality and ‘green marketing’.
Having said this, such companies can choose to account for and report their emissions and
offsets in accordance with any one of a number of existing voluntary standards. The reporting
framework that is the most frequently used and forms the reporting basis of many of the
regulatory carbon reduction schemes is the GHG Protocol (WRI & WBCSD 2005) discussed
earlier in this module. The Carbon Disclosure Standards Board (CDSB 2014), also discussed
earlier in this module, serves as a widespread and authoritative framework for disclosure of
GHG emissions by such companies in an annual report.
Some examples of emissions trading schemes and reporting regulations are provided in Table 5.5.
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International
aviation
(since 2012)
Waste and
synthetic
greenhouse
gases (2013)
Source: ICAP (International Carbon Action Partnership) 2015, Emissions Trading Worldwide: ICAP Status
Report 2015, accessed June 2015, https://icapcarbonaction.com/status-report-2015.
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Current developments
The field of corporate accountability is developing at a rapid pace, and new developments are
constantly emerging. Two important new initiatives related to corporate accountability include
socially responsible investments and natural capital accounting, which are reviewed below.
SRI responds to a variety of different investor needs. Some investors look to sustainability factors
to provide information about the long-term health and stability of their investments and the
market as a whole. Others take this further still and regard SRI as ‘an ethos about the way money
is used’—one way for people to combine their personal values with the resources available to
them (Nicholls & Pharoah 2008). This can also mean that investment can be used to direct capital
towards better-governed and better-managed companies that are positioned to contribute
to the goals of sustainable society. It was estimated in 2012 that at least USD 13.6 trillion of
professionally managed assets incorporate sustainability factors (Global Sustainable Investment
Alliance 2013).
In many ways, the initiative has similar aims to the integrated reporting initiative discussed earlier
in this module. It aims to provide the investor (or the financial capital provider) with additional
information about sustainability factors (or resources and relationships), which will provide
information about the long-term stability of their investments, and the value-creation activities
of the organisation.
There are many different approaches to SRI. It is helpful to think of some of these approaches as
a spectrum of capital options (Bridges Ventures 2012).
Source: Adapted from Bridges Ventures 2012, Sustainable & Impact Investment: How We Define
the Market, accessed June 2015, Bridges Ventures: London, p. 3, http://bridgesventures.com/
wp-content/uploads/2014/07/BV004-Bridges-Ventures-report-UPDATE.pdf.
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Responsible investment
Often based on concerns about risk, responsible investment considers a wide range of
sustainability factors. This can involve negative screening—avoiding investment in industries that
have a negative impact on society and the environment.
For example, the AMP Capital responsible investment leaders’ funds demonstrate negative
screening by avoiding any investment in companies within sectors recognised to have high
negative social impact. This includes companies with a material exposure (i.e. 10% of their total
revenue) to:
• tobacco;
• nuclear power (including uranium);
• armaments;
• gambling;
• alcohol;
• pornography; or
• intensive fossil fuel usage (AMP Capital 2014).
Sustainable investment
Sustainable investment involves more of a focus on investment opportunities that create both
social and economic value. This may involve ‘best-in-class investment’ where investments
are selected both for their ability to generate economic returns and to perform better on
sustainability indicators compared with their peers in the same industry. It may also involve
shareholder activism—where investors use an equity stake in a company to change behaviour
and decisions made in a company.
For example, Australian Ethical Super (2013) offers an Advocacy Fund and Advocacy Super
option, and claims that:
We view active shareholder ownership and advocacy as the responsibility of ethical investors and
key to creating positive, sustainable change. The growing collaboration between like-minded
groups on key issues will have a dramatic impact on future corporate behaviour and performance in
Australia and around the world (Australian Ethical Super 2013).
To achieve this, Australian Ethical Super uses tools such as divestment, policy engagement and
purchasing small numbers of shares to actively engage with corporations.
Thematic investment
Thematic investment is investment that focuses on one issue or a cluster of issues where
commercial growth opportunities are created from social or environmental needs.
Leap Frog Investments demonstrates this approach. Leap Frog considers itself a ‘profit with
purpose investor’ that targets investments in financial products for underserved consumers.
This includes microfinance and microinsurance in developing countries. They ‘seek investments
in companies which deliver superior financial and social returns’ (Leap Frog Investments 2014).
Impact investment
Impact investment focuses on placing capital to actively create a social or environmental benefit.
This may require some financial trade-off.
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A recent example of an Australian impact investment comes from the 2013 pilot Social Benefit
Bond in NSW. The Commonwealth Bank of Australia and Westpac Institutional Bank partnered
as investors in an impact investment to establish the Family Preservation Service, delivered by
Australia’s first charity, the Benevolent Society. The service will focus on reducing the number of
family breakdowns and children placed in the foster care system in New South Wales.
As investors seek to integrate information on sustainability factors into their investment decisions,
this has accounting implications, including the need for robust and reliable indicators of these
factors. SRI is also one area of key demand for reporting frameworks that allow organisations
to demonstrate how they deliver economic, social, environmental or other types of value.
Integrated reporting is one approach to meeting this need for investors.
➤➤Question 5.17
Islamic Finance can also be considered a socially responsible investment. You should now explore
the website of Crescent Wealth: http://www.crescentwealth.com.au/index.php/media-resources-
more-about-islamic-investing.
What is its investment approach? What form of socially responsible investment do you think this is?
However, our natural capital is a finite resource, and the demands of a growing and increasingly
prosperous global population means that escalating demands are being placed on an already
overstretched resource. A recent study argued that we are already ‘drawing down’ on 50 per cent
more natural capital a year than the earth can replenish (CIMA 2014).
Natural capital therefore represents a risk to companies, but also an opportunity for innovation,
building stakeholder relationships and growing new markets. The Chartered Institute of
Management Accountants (2014) has argued that:
Natural capital will become as prominent a business concern in the 21st Century as the provision of
adequate financial capital was in the 20th Century (CIMA 2014, p. 1).
Despite the importance of natural capital to human well-being and economic prosperity, it rarely
features in corporate decision-making. Instead, our economic and financial systems emphasise
the short term, and are based on the flawed assumption of infinite resources and ecosystem
equilibrium.
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Initiatives such as the Natural Capital Coalition are also developing standardised methodologies
for quantifying or pricing natural capital in ways that can be easily integrated into existing
organisational practices and decision-making. Our ability to account for different types of capital
remains variable at this stage (refer back to the section ‘What can be measured and reported’),
but thinking is advancing rapidly. Accountants are playing a critical role in the development
of these methods. The Natural Capital Coalition led a consortium of partners in a project to
develop a harmonised evaluation framework (including measurement, management, reporting
and disclosure aspects) for natural capital in business decision-making called the Natural Capital
Protocol, which was released in 2014.
Review
This module has highlighted the evolving focus on CSR and associated reporting. There is no
doubt that this aspect of an organisation’s reporting, both internally and externally, will become
more important over time. Issues of sustainability and the environment in particular are challenges
that will not dissipate despite the present lack of a binding global agreement to deal with
climate change. CSR reporting is at the heart of enabling us to measure and monitor our CSR
impact, which is why governments and the international community are increasingly expecting
organisations to report this in a reliable and comprehensive manner.
As we have outlined, along with an expanded view of their corporate and social responsibilities,
organisations are increasingly likely to make additional CSR disclosures, as evidenced by the
exponential growth in companies producing stand-alone sustainability reports over the last
10 years (KPMG 2013). In fact, disclosing information about various aspects of their sustainability
performance has become so common that it is now considered virtually mainstream reporting by
most major corporations around the world.
This broader accountability has also been accompanied by a recent increase in associated
regulation worldwide, so that for some organisations the CSR reporting imperative has gone
from being desirable to now being required. We have seen this in Australia with increased
CSR disclosures in directors’ reports and corporate governance disclosures in annual reports,
as well as disclosures outside annual reports, such as the reporting of greenhouse gas emissions
required under the NGER legislation. This trend is also worldwide as evidenced by the European
Commission’s recent announcement of the adoption of a directive on disclosure of non-financial
and diversity information for organisations with more than 500 employees, and a number of
stock exchanges throughout the world now requiring listed companies to either report on
their environmental, social and governance issues or provide an explanation for omitting
this information.
At the same time we have seen initiatives such as the development of the international
integrated reporting <IR> framework, which attempts to make this CSR information more
mainstream. It aims to concisely incorporate the financial and non-financial information in the
one corporate report to more effectively tell an organisation’s value creation story.
The area of CSR reporting provides abundant opportunities for accountants of the present and
future. Accountants combine raw data into meaningful, useful information, and by effectively
communicating information to support decisions, accountants add value. By supporting
that process with analysis and recommendations, the accountant moves from being a pure
information provider to being a strategic support partner.
Readings
READINGS
Reading 5.1
Further views about the social responsibilities of business
Leela de Kretser
But that’s exactly what Microsoft genius Bill Gates faces at home after suggesting to his fellow
billionaires at Davos that the free market is failing the world’s poor—and that it’s time to
introduce a little bit of creative capitalism.
According to the one-time richest man on the planet, it’s possible for a business to make profits
and also improve the lives of others who don’t necessarily benefit from market forces.
But—and with all good speeches the ‘but’ often contains the main point—Gates said profits are
not always possible when business tries to serve the very poor.
In such cases, there needs to be another incentive, and that incentive is recognition.
Many of us may not find the concept of companies being socially responsible all that shocking,
but you wouldn’t have known it reading blogs and newspapers this week.
Gates was basically accused of burning the bible—otherwise known as The Social Responsibility
of Business is to Increase Profits by Milton Friedman—by suggesting that corporations should
consider philanthropy for philanthropy’s sake.
Gates’ desire for companies to dedicate their top people to poverty could prove disastrous for
MODULE 5
Foster and his band of free-market-worshipping buddies accused Gates of taking the power of
philanthropy out of the hands of the people who deserve it most—shareholders and employees.
Espousing the views of the great Friedman, these commentators argue that the best way for
corporations to contribute to society is to increase their bottom lines, and therefore increase
the amount of money going into shareholders pockets and employees in the form of wages.
Let these individuals—and not a bumbling middle manager or a bureaucratic machine—be the
ones to decide how to donate money to the poorest people, Foster said.
Many of these columnists used the large amounts of money individual Americans donate
to charities every year.
CNET’s Declan McCullagh points out that while the US Government only gave $900 million for
tsunami relief, individuals donated about $2 billion.
In total, he says, about $260 billion from American pockets goes to 1.4 billion charities every year.
The problem with this argument is that it doesn’t take into account that individual donors in the
US aren’t equipped with the ability to target the money where it’s needed most in the world.
The US contributes only 0.34 per cent of its national income to foreign aid, well behind the
United Nation’s target of 0.7 per cent and leaders such as the Dutch, who give 2.44 per cent of
their national income to the poorest countries in the world.
Those arguing against creative capitalism also fail to see the benefits that people like Gates,
through his charities, have already brought to business.
Perhaps they need to think back to 1999 when major riots marred the WTO meeting in Seattle
and contrast that with the relative peace of Davos.
Source: de Kretser, L. 2008, ‘Copping flak over corporate socialism’, Herald Sun, 29 January, p. 30.
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Reading 5.2
Westpac named world’s most sustainable company at Davos
George Liondis
Westpac has been ranked the world’s most sustainable company in a major global coup for the
Australian bank.
The bank was handed the prestigious prize at the World Economic Forum in Davos, Switzerland,
where Westpac chief Gail Kelly is attending alongside global business and political leaders,
including Prime Minister Tony Abbott.
Speaking from Davos, Mrs Kelly said Westpac had been recognised for its commitment to social,
environmental and economic responsibility.
‘I am delighted that Westpac’s sustainability performance has been rated so highly on the global
stage,’ Mrs Kelly said.
Westpac topped the list ahead of US biotech firm Biogen, Finnish mining technology and capital
goods company Outotec Oyj and Norwegian oil giant Statoil.
ANZ Banking Group, Commonwealth Bank of Australia, Stockland and Wesfarmers were the only
other Australian companies on the list and were ranked at number 19, 25, 32 and 92 respectively.
The list is compiled every year by Corporate Knights, a research company based in Toronto,
Canada.
‘Westpac has a long history of leadership and innovation in corporate sustainability. It was the
first bank to join the Australian government’s Greenhouse Challenge Plus and the first financial
institution in Australia to create a matching donation program,’ Corporate Knights said in
a statement.
As part of its ‘2017 sustainability strategy’, Westpac has committed up to $6 billion for lending
and investment in clean technologies and environmental services.
It will also make up to $2 billion available for lending and investment in social and affordable
housing.
‘It is wonderful recognition of the work of our people to help create a sustainable future and
deliver long-term value for our customers, employees, shareholders and the community,’
Mrs Kelly said.
Corporate Knights chief executive Toby Heaps said the world’s 100 most sustainable companies
had outperformed the broader market by an average of 3.2 per cent over the past year.
‘The results speak for themselves. Topping a well-diversified benchmark is not easy, but the
Global 100 has managed to squeak out marginal outperformance across a turbulent period in
the history of the capital markets,’ he said.
‘We attribute this excess return to the growing investment relevance of core sustainability themes,
including water scarcity, rising energy prices and growing competition for human capital.’
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Source: Liondis, G. 2014, Sydney Morning Herald, 23 January, accessed October 2015,
http://www.smh.com.au/business/banking-and-finance/westpac-named-worlds
-most-sustainable-company-at-davos-20140123-31ab3.html.
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Reading 5.3
Social responsibility in eye of beholder
Jagdish Bhagwati
Many companies view corporate social responsibility as an effective defensive strategy against
activist NGOs.
Increasingly, corporations are under pressure, often from activist non-governmental organisations,
to take on specific corporate social responsibility or CSR, obligations. But the fact that CSR is
being demanded, and occasionally conceded, does not ensure clarity about either its rationale
or the ways in which it should be undertaken.
CSR can be divided into two categories: what corporations should do (say, contribute to a
women’s rights non-governmental organisation or build a school) and what they should not
do (say, dump mercury into rivers or bury hazardous materials in landfills). The latter is wholly
conventional and subject to regulation (and recently to questions about how corporations should
behave when there are no host-country regulations).
But are CSR obligations really good practice? Milton Friedman and other critics often asked if it
was the business of businesses to practice corporate altruism. Before the rise of the corporation,
there were mainly family firms, such as the Rothschilds. When they made money, it accrued
principally to the family. Altruism, where it existed, also was undertaken by the family, which
decided how and on what to spend its money. Whether the firm or its shareholders and other
stakeholders spent the money was beside the point. With the rise of the business corporation,
large family firms have generally disappeared. But that does not mean that a corporation is the
right entity to engage in altruism, though its various stakeholders obviously can spend any portion
of the income they earn from the corporation and other sources in altruistic ways. Instead of CSR,
we should have PSR (personal social responsibility).
One can also argue for PSR on the grounds that asking for CSR becomes a way of ‘passing
the buck’—evading personal responsibility for doing good. This is the flip side of blaming
corporations for everything from obesity to scalding from spilled coffee—both the subject of
lawsuits in recent years.
There is also an added advantage in replacing CSR with PSR: there is virtue in diversity of
approaches to altruism. Mao Zedong wanted a hundred flowers to bloom, but only so that
he could cut them all off at their roots. But PSR is more like President George Bush senior’s
metaphor of a ‘thousand points of light.’
Moreover, it is hard to see how a corporation’s stakeholders can always arrive democratically at a
common position on how the corporation should engage in social responsibility on their behalf.
Each will consider his or her CSR view the best.
But there are strong arguments in favour of CSR as well. First, the political reality is that society
treats corporations as if they were persons, which is often also a legal reality for many purposes.
Society increasingly demands that these ‘corporate citizens’ be altruistic, just as people are.
Given this reality, corporations want to give simply because it is expected of them. Such CSR
builds the firm’s image as a ‘good’ corporation, just as giving by Bill Gates and Warren Buffet
builds their image as ‘good’ billionaires.
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Second, many corporations view CSR as an effective defensive strategy against powerful activist
non-governmental organisations such as Greenpeace, that have taken to using online agitation,
boycotts, and other means to ‘blackmail’ targeted corporations into acceding to the activists’
demands. The more CSR a company can point to, the less such efforts will succeed, or even
be mounted.
Consider the contrasting experiences of Coke and Pepsi. Coke has been targeted by
non‑governmental organisations for alleged lapses in labour and environmental standards.
By contrast, Pepsi, which once teamed up with AT&T and the CIA to oust President Salvador
Allende in Chile, smells like a rose nowadays, because it has distributed CSR largesse to several
causes that influential non-governmental organisations embrace.
That is a lesson that Wal-Mart has since learned. In 2005, the Service Employees’ International
Union created Wal-Mart Watch, with an annual budget of $5 million. The purpose was to
make Wal-Mart a ‘better employer, neighbor, and corporate citizen,’ and Wal-Mart eventually
capitulated on some of the union’s specific demands as well.
Finally, CSR can be simply a matter of advertising. In this case, the choice of CSR spending is
focused directly on generating added revenue, much like advertising, and is aimed at sales much
the way advertising is. A benign example is Adidas’s sponsorship of tennis tournaments. A malign
example is Philip Morris’s donation of money to museums, symphony orchestras, and opera
houses, cynically aimed at buying off artists who might otherwise work to ban cigarettes.
All these rationales for CSR suggest that it should be left to each corporation to determine,
just as PSR leaves altruism to each individual’s conscience and sense of what needs supporting.
The attempt by some non-governmental organisations and activists to impose a straitjacket on
CSR, reflecting their priorities, is misguided and must be rejected. Instead, the model should
be former United Nations Secretary General Kofi Annan’s initiative, the Global Compact.
What Annan has done is to embrace ten wide‑ranging guiding principles while leaving
signatory corporations free to choose which they wish to support actively.
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Suggested answers
SUGGESTED ANSWERS
Question 5.1
This will be a matter of opinion but, arguably, if corporate managers adopt Milton Friedman’s
view (i.e. that as long as organisations operate within the rules or laws, they should act
only to maximise shareholder wealth), then sustainable development is not a realistic goal.
Sustainable development requires current generations not to concentrate on maximising their
own wealth, but to consider the needs of all people currently on the planet as well as future
generations. It also requires due consideration to be given to the environmental impact of an
organisation’s operations.
However, as will be shown by a number of the corporate accountability initiatives in this module,
maximising shareholder wealth does not have to be inconsistent with a broader sustainability
focus. With a broader community interest in sustainability issues, a broader sustainability focus by
management can identify risks and opportunities that can preserve or increase shareholder value
(especially long-term shareholder value) and/or maintain or enhance corporate reputation.
Question 5.2
(a) An externality is defined as an impact that an entity has on parties that are external to the
organisation where such external parties did not agree or take part in the actions causing,
or the decisions leading to, the cost or benefit. Depending on the organisation in question,
you may have identified a number of positive and negative externalities.
would include local communities, the environment and future generations); and
464 | CORPORATE ACCOUNTABILITY
–– the retrenchment of staff, thereby causing social costs inclusive of welfare payments
paid by government (stakeholders affected here would include the former employees,
their families, local communities and government).
Positive externalities could include the creation of products or services that have widespread
social benefits. For example, an organisation might breed endangered species and release
these to the environment.
(b) Most externalities would not directly affect an organisation’s profit or loss, although indirectly
they might. From an indirect perspective, poor social and environmental performance could
impact on an organisation’s compliance with its social contract and this in turn might affect
the demand for its products as well as the availability of factors of production—such as
labour (i.e. if an organisation has created a poor reputation for its social or environmental
performance, it might have difficulty attracting employees, capital and so forth).
(c) You will have your own opinion about whether the failure to recognise externalities represents
a failure of current financial reporting systems. This module will expose you to current
corporate reporting systems that have broader reporting mandates and will identify and
report on certain externalities in accordance with their objectives.
(d) Possible ethical implications of business not being held accountable for its externalities are
wide ranging and have both short-term and long-term implications such as:
–– When businesses chase the lowest cost manufacturing sites around the world and the
lowest employee costs, they typically destabilise the local society and when they move
on, it leaves large-scale unemployment in the neighbouring communities.
–– Local governments and local communities typically have to pick up the costs of business
externalities such as the clean-up costs associated with abandoned mines, the medical
costs of treating people who suffer from lung cancer as a result of cigarette smoking,
and the costs for asbestos sufferers and sufferers of other workplace-related diseases.
–– Consumers can be physically harmed and die prematurely from toxic industrial wastes
that are not adequately disposed of.
–– The global commons can be polluted and degraded from over-intensive commercial
farming and arable land turned into dustbowls.
–– Developing countries can be deprived of access to water where mining and other
companies overuse local water supplies.
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Question 5.3
The first phase of the reporting process should start with management clearly articulating ‘why’
they are reporting. The answer to the ‘why’ question will then provide important information for
the rest of the reporting process.
Reporting might be undertaken for a range of reasons. For example, an organisation might
decide that it needs to provide (report) particular information because particular (and perhaps
powerful) stakeholders are demanding or expecting such information. This information might be
disclosed because such information might be viewed positively by the powerful stakeholders,
therefore encouraging the stakeholders to further support the organisation by contributing the
resources required by the organisation. This would be referred to as a ‘managerial’ approach
to reporting.
As indicated, this type of reporting is more commonly being required nowadays, and the
requirement will specify how, and to whom, the report should be addressed.
When the reporting is voluntary, how an organisation reports will depend on how management
defines or prioritises its stakeholders. Managers adopting a managerial focus would restrict
their focus to the demands of those parties (stakeholders) who ‘can affect’ the organisation,
whereas those managers that adopt an ‘ethical, accountability-based’ perspective would
consider those stakeholders ‘who can affect’ the organisation, as well as those ‘who are
affected by’ the operations of the entity.
Once the entity has determined whose information requirements they are addressing,
they will be better placed to determine what they will report and how that information should
be disclosed.
While the above discussion has briefly discussed reporting approaches based on either
managerial or ethical reasoning, it should be stressed that different organisations will operate
along a continuum and operate somewhere between these two positions.
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Question 5.4
If corporate actions are driven by enlightened self-interest, organisations will do the ‘right thing’
if these actions are perceived to lead to benefits that maximise shareholder value. Doing the
right thing will be directly tied to whether stakeholders who can affect the organisation will
penalise it if managers adopt particular strategies. Under this approach, if a particular strategy
negatively affects some members of society or irreversibly damages the environment, but its
financial benefits are deemed by managers to exceed any related financial costs, then that
strategy will be pursued. This assumes that managers have an understanding of the costs and
benefits of doing—and not doing—the right thing. Generally they do not.
Question 5.5
The Toyota definition is very similar to the definition suggested by Freeman (1984) as a party
that is affected by, or has an effect upon, the organisation in question. They also refer to a list
of groups, including the broader stakeholders of community groups and government—these
represent organisations that do not have financial stakes in the firm.
While the BHP Billiton definition is fairly similar in including stakeholders that are ‘potentially
affected’ by the organisation, it also includes stakeholders that have an interest in, or influence,
what we do rather than just ‘have an effect upon’, as is the case for Toyota. There is a wide variety
of parties that may ‘have an interest’ in BHP—so this definition could be quite broad.
Imperial Tobacco, however, adopts a more restrictive definition. It appears that it divides
stakeholders into those with more direct influence—those with a financial relationship—who
must be managed more closely. They appear to view ‘others’ differently—and possibly manage
them differently.
The three companies belong to different industries, which may have an impact upon how
they view stakeholders. Toyota has a relatively controlled supply chain and a clear product.
They may find it easier to identify their stakeholders. Compare this with the mining industry for
BHP Billiton—the organisation may adopt a broader interpretation of stakeholder because their
operations extend into communities. Imperial Tobacco is in a very contentious industry that
is under constant threat of regulation and legal implications. Companies may adopt different
positions based on which stakeholder perspective they tend to respond to.
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Question 5.6
Rio Tinto is more closely aligned with an enlightened self-interest approach by arguing that
‘Rio Tinto’s primary focus is on the delivery of value for our shareholders’. Creating value for
stakeholders is only a secondary concern to Rio Tinto. They are primarily interested in financial
returns. If the company did interact with stakeholders, it would be according to managerial
stakeholder theory.
Stockland, on the other hand, seems to adopt a stakeholder perspective. The excerpt shows that
shareholders are seen as only one of a variety of stakeholders that the company is managed for.
Their emphasis on stakeholders for their intrinsic value (rather than their ability to generate profit
for shareholders) is more consistent with normative stakeholder theory.
Question 5.7
Within legitimacy theory, there is a view that the terms of the social contract will change over
time, and organisations will have to adapt to the changing expectations. A successful manager
will be one who keeps abreast of changing community expectations and responds accordingly.
These expectations will be influenced by various sources, including the media, and also by
the disclosures being made by the organisation. Corporate disclosure has been shown to be
responsive to legitimacy threats.
If community expectations have changed, this can cause a ‘legitimacy gap’ (where there appears
to be a lack of correspondence between how society believes an organisation should act and
how it is perceived that the organisation has acted). This might occur for an organisation,
even though it has maintained the same policies and procedures that had previously been
acceptable for decades.
Proponents of legitimacy theory argue that managers must continually assess whether community
demands and expectations are changing and respond accordingly. Therefore, if the community
expects an organisation to embrace responsibilities towards a broad group of stakeholders,
organisations that are seen to be motivated solely by ‘enlightened self-interest’ or who appear to
embrace a ‘shareholder primacy’ approach to operations will struggle to survive in the long run.
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Question 5.8
A mining firm such as BHP has a large and diverse number of environmental impacts. There are
many direct environmental impacts of their activities—consider the environmental impact of
opening a mine, the operation of the mine (often over a very long period of time) and the
remediation required when a mine closes. There are also more indirect effects of the firm’s
activities that may be harder for BHP to map and potentially measure. This includes the supply
chains for the products it uses (such as its trucks and equipment) or the environmental impact
that comes about from the use of all of its products. This is potentially very large, as BHP’s
products are often the input for other production processes.
Question 5.9
(a) There are many examples for this question, but some examples include:
(i) Economic
Reporting and transparency, what we sell, how we sell (summarised p. 10).
(ii) Environmental
Climate and GHG emissions, energy, transport, waste, packaging, water efficiency,
sustainable buildings (summarised p. 10).
(iii) Social
Employment and diversity, employability programs, training and development,
health and wellbeing, community (summarised p. 12).
(b) There are many examples for this question, but some examples from the Marks and Spencer
(M&S) report: http://planareport.marksandspencer.com include the following.
(i) A monetised measure
|| [Indicator: Community donations, p. 28] £8.2m cash, £1.6m time, £3.3m in-kind
contributions made in 2014/2015
|| [Indicator: Customer clothes recycling, p. 13] ‘through our Shwopping clothes
recycling initiative, helping us raise an estimated £1.75m for Oxfam (last year £3.2m)’
|| [Indicator: Supporting charities, p. 27] ‘The total amount raised for health and
wellbeing charities totalled £2.45m. That’s £5.35m over two years so far’.
Source: Marks & Spencer 2015, Plan A Report, accessed October 2015,
http://planareport.marksandspencer.com.
Question 5.10
In the module, we identified a number of limitations of traditional financial reporting practices as
they relate to CSR reporting, due to factors such as the following:
• How we define and recognise the elements of financial reporting acts to restrict the
recognition of externalities. Many environment-related obligations might not be reported
due to considerations associated with the ‘probability’ of the ultimate resource flow and the
‘measurability’ of such resource flows.
• How we measure the elements of financial reporting. For example, the practice of
discounting liabilities tends to make many future obligations—such as those related to
remediating contaminated sites—become immaterial from a financial perspective and,
therefore, not reportable (even though the environmental consequences of the current
actions might be significant).
–– The entity assumption requires the accountant to ignore events that do not directly affect
the financial position and financial performance of the organisation.
–– The practice of dividing the life of the organisation up into short periods—such as
12 months—acts to potentially prioritise short-term performance over and above
long-term performance. The implication is that things such as investments in cleaner
technologies, which might have a pay-back period of many years, might be overlooked in
favour of projects that provide results in the short term.
Whether we believe that generally accepted financial accounting practices have contributed
to problems such as climate change is a matter of opinion. However, because current financial
accounting practices emphasise measures such as profits (which traditionally ignore greenhouse
gas emissions) efforts to maximise profits may conceivably contribute to climate change.
Further, many senior managers will be paid bonuses tied to financial measures such as profits,
and this will further encourage them to undertake actions which will not necessarily be consistent
with reducing their organisation’s impact on climate change.
Question 5.11
The quote shows how important climate change is to the business. HSBC has recognised it as
a business risk and an important part of its strategy. This could also be seen as an attempt to
secure a licence to operate in the face of a legitimation crisis facing banks (i.e. public trust in
banks has been very low, especially since the global financial crisis). It also clearly demonstrates
how important the development of the CDP framework has been, not only as a contributor,
but also because the information produced has improved their internal decision-making.
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Question 5.12
The reporting frameworks that are contained in the ‘Guidelines and non-mandatory reporting’
section of this module include the following:
• GRI G4 Guidelines: the most widely accepted CSR or sustainability reporting guidance.
It gives a reporting framework for the production of a comprehensive CSR report.
• <IR> framework: a newly developed corporate reporting framework that combines both
financial and non-financial information into a concise communication about how an
organisation’s strategy, governance, performance and prospects, in the context of its external
environment, lead to the creation of value in the short, medium and long term.
• Climate Disclosure Standards Board (CDSB): has developed a climate change reporting
framework that is intended for use by companies making climate change disclosures in their
mainstream financial reports.
• AA1000 AccountAbility Principles Standard: provides a framework for an organisation
undertaking CSR/sustainability reporting.
• Equator Principles: provide a framework for assessing and managing social and
environmental risk in project financing.
• Greenhouse Gas Protocol (GHG Protocol): is one of the most widely used international
accounting frameworks for quantifying greenhouse gas emissions.
The benefits of the frameworks are that they provide the criteria against which to report.
As such they give us the basis and measurement of the subject matter, and aid comparability
of information across organisations.
Question 5.13
(a) A social audit can be seen as the process that an organisation undertakes to investigate
whether it is perceived by particular stakeholder groups to be complying with the social
contract negotiated between the organisation and the respective stakeholder groups.
The reason why an organisation might undertake a social audit can be explained in
conjunction with a consideration of legitimacy theory. A breach of the social contract can
create significant costs for an organisation and, therefore, organisations often undertake
social audits to examine whether their operations appear to be conforming with the
expectations of particular societies or particular stakeholders.
(b) The results of a social audit often form an important component of an entity’s CSR/
sustainability report. The module provides the example of The Body Shop Australia,
which has a report that is centred on its social audit.
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Question 5.14
You might have identified any five of the following governance policies that could be employed
to enhance an organisation’s social and environmental performance (the governance policies are
extracted from Haque & Deegan 2010, p. 324).
From the following eight best practices listed in Table 5.4 you may have identified:
1. The organisation has a board committee with explicit oversight responsibility for
environmental affairs.
2. The organisation has a specific board committee for climate change and greenhouse gas
(GHG) related issues.
3. The Board conducts periodic reviews of climate change performance.
4. The Chairman/CEO articulates the organisation’s views on the issue of climate change through
publicly available documents such as annual reports, sustainability reports, and websites.
5. The organisation has an executive risk management team, dealing specifically with GHG issues.
6. Some senior executives have specific responsibility for relationships with government,
the media and the community with a specific focus on climate change issues.
7. The organisation has a performance assessment tool to identify current gaps in greenhouse
gas management.
8. The executive officers’ and/or senior managers’ compensation is linked to attainment of
GHG targets.
You may have also deemed the following from other parts of the module:
• Developing executive remuneration plans that reward managers on the basis of additional
performance indicators such as those tied to social and/or environmental performance.
• Implementing a policy of regular social audits.
• Implementing an environmental management accounting system.
• Implementing a policy of regular CSR reporting.
• Appointing an environmental manager who reports directly to the board.
• Undertaking audits of the supply chain to ensure suppliers comply with certain environmental
performance standards.
Linking such policies to remuneration will have the effect of requiring managers to consider risks
and opportunities to their organisations more broadly than financial profit. As a lot of the risks
and opportunities associated with environmental and sustainability are more long term, it will
help if managers take a longer-term perspective of the organisation, rather than concentrating on
the short term.
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Question 5.15
The Westpac 2014 Annual Review & Sustainability Report (http://www.westpac.com.au/about-
westpac/sustainability-and-community/reporting-our-performance/stakeholder-impact-reports)
is a combined financial review and sustainability report. It thus provides a concise snapshot of the
organisation for a broad range of stakeholders. The report is supported by a website with more
detailed information, including Westpac’s annual report and further sustainability information.
Westpac has also released a 2015 interim sustainability report. You will be able to identify a
number of enhanced reporting features as you peruse the website and the report.
Question 5.16
(a) For society to be able to effectively tackle problems such as climate change, third world
poverty, poor labour conditions and so forth, individuals and business organisations both
have a role to play. Individuals’ investment and consumption decisions will directly affect what
corporations produce and how they produce it. Therefore, it would seem that both personal
social and environmental responsibility and corporate social and environmental responsibility
have a role to play.
(b) Consistent with ethical theories, such as stakeholder theory, it is commonly argued that
corporations undertake particular CSR initiatives to win the support of powerful stakeholders.
Hopefully, this is not the only reason that corporations embrace CSR initiatives.
(c) What motivates corporations to voluntarily undertake CSR-related activities is a matter of
personal opinion, but it would seem somewhat cynical to believe that corporations only
undertake CSR activities to increase revenue. Some managers will do it because it is simply
the right thing to do.
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Question 5.17
Crescent Wealth (http://www.crescentwealth.com.au/index.php/media-resources-more-about-
islamic-investing) calls its approach ‘ultra-ethical’, as it is compliant with Islamic investment
principles. It argues that its ‘investment philosophy is grounded and bound by Islamic finance
principles, which aim to the meet the financial needs of participants with justice, equity
and fairness’.
The website indicates that Crescent Wealth takes an approach to investment based
predominantly on negative screening. It actively screens out:
• conventional financial services;
• weapons or defence orientated companies;
• tobacco;
• pork and pig products;
• alcohol;
• gambling;
• adult materials; and
• morally hazardous media.
It also indicates that it may undertake some thematic screening by selecting investments that
‘mandate social values and good governance’.
This socially responsible investment fund would be a form of responsible investment, involving
‘negative screening’, that is, avoiding investment in industries that have a negative impact on
society and the environment.
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