Corporate Governance, Business Ethics, Risk ent ~ and istersal Cenerol . 2019-2020 Edition MA. ELENITA BALATBAT CABRERA BBA MBA CPA CMA PRESENTLY: Academic and Business Consultant President and CEO, CLA Consultancy and Training Center, Inc. FORMERLY: \Vice Chairman and Examiner, Professional Regulatory Board of Accountancy World Bank Consultant Dean, College of Business Administration, Lyceum University of the Philippines CPA Review Director & Reviewer, Professional Review and Training Center, inc. Professor of Accounting & Finance, University of the East, Far Eastem University, ‘Do La Salle University, Centro Escolar University, St. Scholastica’s College Audit Staff, SGV and Co., CPAs GILBERT ANTHONY B. CABRERA BBA MBA CPA PRESENTLY: Vice President - Risk and Finance, Global Insurance Brokerage, USA. FORMERLY: ‘Chief Financial Officer, Food Retail Conglomerate, USA. Senior Auditor, SGV and Co., CPAS Accounting Instructor | University of Maryland, Robert Smith School of Business University of the East, ManilaPhilippine Copyright, 2019 by MA. ELENITA BALATBAT CABRERA GILBERT AMA UOBYB.CABRERA Any copy of this book not bearing the signature of the author(s) shall be considered as proceeding from an illegal source. The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate endorsement by the authors or GIC Enterprises & Co., Inc, and they do not guarantee the accuracy of information. presented at these sites. ALL RIGHTS RESERVED ISBN: 978-621-416-073-0 Published & Printed by: GIC ENTERPRISES & CO., INC. *National Book Development Board Registered 2017 C. M. Recto Avenue, Manila PhilippinesAbout the Authors Ma. Elenita B. Cabrera BBA MBA CPA CMA Dean Cabrera graduated Magna Cum Laude from the University of the East with a degree of Bachelor of Business Administration, major in Accounting and was one of the topnotchers when she passed the CPA Licensure Board Examination. She eared her Master in Business Administration major in Financial Management from the University of the Philippines and is a candidate for Doctor of Education at the University of the East. She.is a holder of a Certificate in Management Accounting from the Institute of Certified Management Accountants of Victoria, Australia, Dean Cabrera worked with SGV & Co. as Staff Auditor. She taught Financial Accounting, Financial Management, Management Advisory Services, Auditing Theory and Practice in various colleges and universities and authored books in these subjects. She previously held the position of Dean of the College of Business Administration at the Lyceum of the Philippines University. A former Vice Chairman of the Professional Regulatory Board of Accountancy, she was the BOA representative to the Financial Reporting Standards Council (FRSC), Philippine Interpretations Committee (PIC) and Auditing and Assurance Standards Council (AASC). She served as the Chairman of the PRC CPE Council for Accountancy and Chairman of the CHED Technical Committee for Accountancy Education. She was a World Bank Project Consultant on the creation of an Accounting Oversight Board in the Philippines. ‘She was a recipient of the Philippine Institute of Certified Public Accountants (PICPA) awards as Outstanding CPA in Education, Honorary Life Membership, Distinguished Accountancy Author and 2018 Accountancy Hall of Fame. Gilbert Anthony B. Cabrera BBA MBA CPA Gilbert received hig bachelor’s degree in Accountancy from the University of the East, Cum Laude. He obtained a Master in Business Administration degree with concentrations on International Finance and Accounting from the University of Maryland, College Park, Robert H. Smith School of Business. A certified public accountant, he has public accounting experience with SGV & Co. (Emst and Young Member Firm) and teaching experience with the University of the East, Manila and University of Maryland, Robert H. Smith School of Business. Presently; he is ~ Vice-President, Risk and Finance, of Global Insurance Brokerage in California, USA. An ‘active member of the Association of Filipino Finance Managers in California, he is also a former Board Member of Bay Area Red Cross.Preface The business environment continues to change in dramatic ways and university graduates joining the corporate worid or entering the accountancy profession, whether il be in the public practice sector, management accounting practice, internal audit or accounting information system management, must be prepared for a high standard of responsibility. This textbook on Corporate Governance, Business Ethics, Risk Management and Internal Control, aims fo equip its readers the basic knowledge, skills and perspective that are necessary in facing this challenge. Having a solid understanding of fundamental business, its governance, risk management, ethical practices and intemal control will become even more important in a world of advancing technology. While businesses in different industry have strikingly different characteristics, most have some fundamental characteristics in common. A fundamental widely accepted model of business consists of govemance, objectives, strategies, business processes, risks, controls and reporting, This book is organized to provide authoritative, practical and contemporary content as follows: Unit I- Corporate Governance This unit describes Corporate governance and the parties involved in it. It discusses the structure that specifies the distribution of rights and responsibilities among different participants in a corporation. It also spells out the rules and procedures for making decisions on corporate affairs. Unit Il- Business Ethics This unit discusses the various forms of unethical business practices. It also articulates how to institutionize integrity in all aspects of business process and how business with integrity enjoys competitive advantage in both government and private transactions. Unit Ill - Risk Management This unit emphasizes the nature, forms and basic management of risks related to business. Unit IV Internal Control: A Vital Tool in Managing Risk This unit articulates the nature, scope, elements and importance of internal control. It also covers extensive discussion of what how fraud can be prevented, detected and reduced if not fully eliminated in an enterprise. The end of chapter materials have been thoroughly chosen and streamlined to be much more user friendly. Special thanks to our families for their continued support and encouragement. &. @. é. G28.if Preface UNIT Chapter Chapter Chapter Chapter UNIT Chapter Chapter Chapter Chapter Chapter Chapter 10 Contents in Brief CORPORATE GOVERNANCE INTRODUCTION TO. CORPORATE GOVERNANCE CORPORATE GOVERNANCE RESPONSIBILITIES AND ACCOUNTABILITIES SECURITIES AND EXCHANGE (SEC) COMMISSION CODE OF CORPORATE GOVERNANCE SEC CODE OF CORPORATE GOVERNANCE, CONTINUED BUSINESS ETHICS INTRODUCTION TO ETHICS BUSINESS ETHICS COMMON UNETHICAL PRACTICES OF BUSINESS ESTABLISHMENTS ETHICAL DILEMMA ADVOCACY AGAINST CORRUPTION INITIATIVES TO IMPROVE B AND REDUCE CORRUPTION ane 26 16 93 94 103 109 128 146UNIT In Chapter W Chapter 12 UNIT IW Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Appendices Appendix A Appendix B Appendix C Appendix D Appendix E Appendix F Appendix G References INTRODUCTION TO RISK MANAGEMENT RISK MANAGEMENT PRACTICAL INSIGHTS IN REDUCING AND MANAGING BUSINESS RISKS INTERNAL CONTROL: A VITAL TOOL IN MANAGING RISK OVERVIEW OF INTERNAL CONTROL, FRAUD-AND ERROR ERRORS AND IRREGULARITIES IN THE TRANSACTION CYCLES OF THE BUSINESS ENTITY INTERNAL CONTROL AFFECTING ASSETS INTERNAL CONTROL AFFECTING LIABILITIES AND EQUITY Code of Ethics for Professional Teachers. International Standards for the Professional Practice of Internal Auditing International Standards of Ethical Conduct for Practitioners of Management Accounting Code of Business Conduct and Ethies of a Telecommunications Company Code of Business Conduct and Ethics of a Manufacturing Company Code of Business Conduct and Ethics of a Commercial Bank : Partial List of Organizations who are actively Participating in the “Integrity Initiative” Campaign against Corruption it 162 163 180 195 196 217 232 244 264 273 281 283 287 293 303 307 311Contents Preface I CORPORATE GOVERNANCE CORPORATE Chapt 1 INTRODUCTION TO a GOVERNANCE UNIT Expected Learning Outeomes What is Governance? Characteristics of Good Governance Corporate Governance: A Overview Purpose of Corporate Governance Objectives of Corporate Governance Basic Principles of Effective Corporate Governance Nlustrative Application of the Basic Principles of Corporate Governance and Best Practice Recommendations Review Questions 2 CORPORATE GOVERNANCE RESPONSIBILITIES AND ACCOUNTABILITIES Expected Learning Outcomes Chapter Introduction Relationship between Shareholders / Owners and Other Stakeholders Parties involved in Corporate Governance Their Respective Broad Role and Specific Responsibilities ° Shareholders Board of Directors Non-Executive or Independent Directors Management Audit Committees Regulators Board of Accountancy External Audit Internal Audit Se eee ee Review Questions MARA Ww © 15 16 17 19 19 19 20 21 22 23 23 24SECURITIES AND EXCHANGE COMMISSION (SEC) CODE OF CORPORATE GOVERNANCE Expected Learning Outcomes The Board's Governance Responsibilities Principles 1107 Disclosure and Transparency Principles 8 to 11 Internal Control System and Risk Management Framework Principle 12 Cultivating a Synergies Relationship with Shareholders Principle 13 Duties to Stakeholders Principles 14 t0 16 Introduction The Code of Corporate Governance Objective Approach Organization Recommendation Explanations Coverage Definition of Terms The Board’s Governance Responsibilities Establishing a Competent Board Establishing Clear Roles and Responsibilities of the Board Establishing Board Committees Fostering Commitment Reinforcing Board Independence “Assessing Board Performance ‘Strengthening Board Ethics ‘Enhancing Company Disclosure Policies and Procedure Strengthening the External Auditor's Independence and Improving Review Questions and Exercises 26 28 28 29 29 29 29 29 29 30 30 30 30 30 30 30 31 31 31 34 34 34 39 49 57 59 65 67 68 1 4 26vi Chapter UNIT Chapter 4 SEC CODE CONTINUED OF CORPORATE GOVERNANCE, Expected Learning Outcomes Increasing Focus on Non-Financial and Sustainability Reporting , Promoting a Comprehensive and Cost-efficient ‘Access to Relevant Information Strengthening the Internal Control System and Enterprise Risk Management Framework Cultivating a Synergic Relationship with Shareholders Respecting Rights of ‘Stockholders and Effective Redress for Violation of Stakeholder’s Rights Encouraging Employees Participation Encouraging Sustainability and Social Responsibility Review Questions IL BUSINESS ETHICS INTRODUCTION TO ETHICS Expected Learning Outcomes Introduction Characteristics and Values Associated with Ethical Behavior Why is Ethical Behavior Necessary? Wy: Why do People Act Unethically? Categories of Ethical Principle The Need for Professional Ethics Review Questions 76 a 7B 7B 83 87 88 90 91 94 95 98 98 99 100 102 16 93 94vii Chapter 6 BUSINESS ETHICS 6 Expected Learning Outcomes 103 Basic Concept of Business Ethics 104 Purposes of Business Ethics 104 Main Purpose 104 Special Purpose ! 108 __ Scope and Impact of Business Ethics 105 Economic Impact 106 Social Impact 106 Environmental Impact ji 106 Impact on Business Managers 106 Ethical Challenges in Today's World 107 Review Questions 108 Chapter 7 COMMON UNETHICAL PRACTICES OF BUSINESS ESTABLISHMENTS 109 Expected Learning Outeomes 109 Common Unethical Practices of Business Establishments 110 Misrepresentation and Over Persuasion , uo Direct Misrepresentation 110 Deceptive packaging 0 Misbranding or mislabeling 110 False or misleading advertisement 110 Adulteration M1 Weight understatement Ml Measurement understatement il Quantity understatement 12 Indirect Misrepresentation 112 Caveat emptor 12 Deliberate withholding of information 112 Passive deception 112 Over Persuasion 113 Corporate Ethics 113 Unethical Practices of Corporate Management 113 Board of Directors 113 Executive Officers and Lower Level Managers 114. Some Unethical Practices of Employees 17 Review Questions ugviii Chapter 8 ETHICAL DILEMMA Expected Learning Outcomes er Introduction i Resolving Ethical Dilemmas 122 Ilustrative Case: Resolving an Ethical Dilemma 122 Ethical Issue 12 Who is Affected and How is each Affected 123 Bert’s Available Alternatives 124 Consequences of Each Alternative 124 Appropriate Action 125 Review Questions and Exercises 126 Chapter. 9 ADVOCACY AGAINST CORRUPTION Expected Learning Outcomes 128 What is Corruption? — 129 What does Corruption Look Like? 130 Why aind how does a Person Become Corrupt? 131 Ul Effects of Corruption 131 Characteristics of Corruption 133 The Philippine Corruption Report 137 Judicial System Police Be Public Services ed Land Administration io Tax Administration 4 Customs Administration i Public Procurement a Natural Resources uo Prevention of Corruption 4) Clear Business Process a ‘olicy on Gifs and Enterta bn Decorating Coen ig ‘onvenient Corr ‘ ae Efforts to Curb Conmupnion Tp stem 142 Vigilance of Civil Sociery rough Legislation 142 143 Review Questions 145Chapter 10 INITIATIVES TO IMPROVE BUSINESS ETHICS AND REDUCE CORRUPTION 146 Expected Learning Outcomes 146 Introduction 147 The Integrity Initiative Campaign 147 Corporate Values 148 Need for a Code of Conduct l49 The Unified Code of Conduct for Business 150 Top Management 150 Human Resources 150 Sales and Marketing 150 Finance and Accounting 13) Procurement 1 Logistics 152 Implementation and Monitoring 152 Bishops-Businessmen’s Conference Philippines — Code of Ethics for the Philippine Business 153 Survey of Laws Advocating Business Ethics 159 Review Questions 160 UNIT III INTRODUCTION TO RISK MANAGEMENT tex Chapter 11 RISK MANAGEMENT 163 Expected Learning Outcomes 163 Introduction 164 Risk Management Defined 164 Basic Principles of Risk Management 165 Process of Risk Management 165 Elements of Risk Management 166 Relevant Risk Terminologies 167 1. Risk Associated with Investments 167 I. Risks Associated with Manufacturing, Trading and Service Concerns 170 IIL Risk Associated with Financial Institutions 71 Potential Risk Treatments 1m ‘Areas of Risk Management 1B Risk Management Framework 174 Steps in the Risk Management Process 175 Review Questions 178x L INSIGHTS IN REDUCING AND ICA! Chapter 12. PRACTIC. NESS RISKS MANAGING BUSI Expected Learning Outcomes Understand the Nature of Risk fentify» and Prioritize Risks Coulter the Acceptable Level of Risk Understand Why Risks Become Reality Apply a Simple Risk Management Process Risk Assessment and Analysis Risk Management and Control Avoiding and Mitigating Risks Create a Positive Climate for Managing Risk Overcoming the Fear of Risk Controlling and Monitoring Enterprise-wide Risk Practical Considerations in Managing and Reducing Financial Risk Improving Profitability Assessment of Market and Exit Barries Break-even Analysis Controlling Costs Practical Techniques to Improve Profitability Avoiding Pitfalls Review Questions and Exercises UNIT IV INTERNAL CONTROL: ‘ A VITAL TOOL IN MANAGING RISK Chapter 13. OVERVIEW OF INTERNAL CONTROL Expected Learning Outcomes Nature and Purpose of Internal Control Internal Control System Defined Elements of lmernal Control A. Control Environment B. Entity’ Risk Assessment Process C. Information System, including the Business Processes, Relevant to Financial Reporting and Communication D. Control Activities E. Monitoring of Controls Review Questions and Exercises 180 181 181 183 183 184 184 185 186 186 187 187 188 188 189 189 190 191 192 194 196 197 197 198 198 198 203 205 210 2il 195 196Chapter 14 FRAUD AND ERROR 217 Expeeted Learning Outcomes a7 Introduction 218 Types of Misstatemenis 218 Misstatements arising from Misappropriation of Assets 218 Misstatements arising from Fraudulent Financial Reporling 219 The Fraud Triangle 219 Incentives or Pressure to Commit Fraud 220 Opportunities to Commit Fraud 220 Rationalizing the Fraud 221 Risk Factors arising from Misappropriation of Assets 223 Risk Factors arising from Fraudulent Financial Reporting 224 Responsibility for the Prevention and Detection of Fraud 7 226 Review Questions and Exercises 227 Chapter 15 ERRORS AND IRREGULARITIES IN THE TRANSACTION CYCLES OF THE BUSINESS ENTITY 232 Expected Learning Outcomes 232 Sales and Collections Cycle 233 Errors in Recording Sales Collections Transactions 233, Frauds in sales and Collections 233 Acquisition and Payments Cycle 235 Errors in the Acquisitions and Payments Cycle 235 Frauds in the Acquisitions and Payments Cycle 236 Payroll and Personnel Cycle 231 Errors 237 Frauds involving Payrol! 2a Review Questions and Exercises 239ait INTERNAL CONTROL AFFECTING ASSETS 244 Chapter 16 244 Expected Learning Outcomes snirol over Cash Transactions 245 al Misstatements — Cash Receipts 246 Potential Misstatements — Cash Disbursements 248 Internal Control over Financial Investments 249 Potential Misstatements — Financial Investments 250 Internal Control over Receivables 251 ‘Sources and Nature of Notes Receivable 251 Internal Control of Accounts Receivable and Revenue 251 Control Environment 252 Potential Misstatements — Revenue / Receivables 252 Internal Control over Notes Receivable 254 Internal Control over Inventories and Cost »f Goods Sold 255 Sources and Nature of Inventories and Cost of Goods Sold 255 Potential Misstatements - Inventory / Cost of Goods Sold 256 Internal Control over Property, Plant and Equipment 257 Potential Misstatements ~ Investments in Property, Plant and Equipment 259 Review Questions and Exercises 260 Chapter 17 INTERNAL CONTROL AFFECTING LIABILITIES AND EQUITY 264 Expected Learning Outcomes 264 Internal Control over Accounts Payable 265 Potential Misstatements ~ Accounts Payable 266 internal Control over Other Debts 267 Internal Control over Debi Authorization by the Board of Directors 267 Use Of an Independent Trustee 268 imerest Payments of Boards and Notes Payable 268 ¢nternal Control over Owners’ Equity ou 268 Internal Control on Equity a Control of Share Capital Transactions by the Board of Directors 269 Independent Registrar and Stock Transfer Agent 269 Internal Control over Dividends 270 Review Questions and Exercises aAppendices Appendix Appendix Appendix Appendix Appendix Appendix Appendix References Code of Ethics for Professional Teachers International Standards for the Professional Practice of Internal Auditing International Standards of Ethical Conduct for Practitioners of Management Accounting Code of Business Conduct and Ethics of a Telecommunications Company Code of Business Conduct and Ethics of a Manufacturing Company Code of Business Conduct and Ethics of a ‘Commercial Bank Partial List of Organizations who are actively Participating in the “Integrity ‘a Campaign against Corruption 273 281 283 287 293 303 307 311 altiUNITI CORPORATE GOVERNANCE Chapter 1 Introduction to Corporate Governance 2 Corporate Governance Responsibilities and Accountabilities 3 Securities and Exchange Commission (SEC) Code of Corporate Governance 4 SEC Code of Corporate Governance, ContinuedChapter INTRODUCTION TO CORPORATE GOVERNANCE Expected Learning Outcomes After studying the chapter, you should be able to ... ia 2. Describe what governance involves Enumerate the different contexts in which governance can be applied . Name and explain the characteristics of good governance Explain the meaning, purpose and objectives of corporate governance Know and describe the principles of effective corporate governance Understand how the principles of ane aes princip| a good corporate governance QU yCHAPTER 1 INTRODUCTION TO CORPORATE GOVERNANCE WHAT IS GOVERNANCE? Generally, governance refers to a process whereby elements in society wield Power, authority and influence and enact policies and decisions conceming public life and social upliftment, It comprises all the processes of governing — whether undertaken by the government of a country, by a market or by a network — over a social system and whether through the laws, noims, power or language of an organized society. Governance therefore means the process of decision-making and the process by which decisions are implemented (or not implemented) through the exercise of power or authority by leaders of the country and / or organizations. Governance can be used in several contexts such as corporate governance, international governance, national governance and local: governance. The focus of this book is on Corporate Governance. CHARACTERISTICS OF GOOD GOVERNANCE Whatever context good governance is used, the following major characteristics should be present: Participation Rule of Law | "Accountabilty 6000 Effectiveness & Transparency Governance “Efficiency responincres’ | auraincser Cansendis Oriented _4 Chapter l eh thy These characteristics are briefly described as follows: n by both men and women is a key cornerstone ernance. Participation could be either direct or te institutions or representatives. It is it that representative democracy does n that the concern of the most vulnerable in society would not be taken into consideration in decision making. Participation needs to be informed and zed. This means freedom of association and sion on one hand and an organized civil society on Participatior of good gov through legit important to point ou not necessarily “meal Participation organi: expres the othér hand. Rule of Law Good governance requires fair legal frameworks that are enforced impartially. It also requires full protection of human rights, particularly those of minorities. Impartial enforcement of laws requires an independent judiciary and an impartial and incorruptible police force. Transparency ‘Transparency means that decisions taken and their enforcement are done in a manner that follows rules and regulations. It means’ that information is freely available and directly accessible to those who will be affected by such decisions and their enforcement. It also means that enough information is provided and that it.is provided in easily understandable forms and media. Good governance requires that institutions and processes try to serve the needs all stakeholders within a reasonabl timeframe. Responsiveness Consensus Oriented Good governance requires mediation of the different interests in society to reach a broad consensus on what is in the best interest of the whole community and how this can be achieved. It also requires a broad and long-term Perspective on what is needed for sustainable human development and -how to achieve the goals of such development. This can only result from an understanding of the historical, cultural and social contexts of a given society or community,Introduction to Corporate Governance _ 5 Equity & Ensures that all its members feel that they have a stake in it Inclusiveness and do not feel excluded from the mainstream of society. This requires all groups, but particularly the most vulnerable, have opportunities to improve or maintain their well being, Effectiveness Good governance means that processes and institutions &Efficiency produce results that meet the needs of society while making the best use of resources at their disposal. The concept of efficiency in the context of good governance also covers the sustainable use of natural resources and the protection of the environment. Accountability Accountability is a key requirement of good governance. Not only governmental institutions but also the private sector and civil society organizations must be accountable to the public and to their institutional stakeholders. Who is accountable to whom varies depending on whether decisions or actions taken are internal or external to an organization or institution. In general, an organization or an institution is accountable to those who will be affected by its decisions or actions. Accountability cannot be: enforced without transparency and the rule of law. CORPORATE GOVERNANCE: AN OVERVIEW Corporate governance is defined as the system of rules, practices and processes by which business corporations are directed and controlled. It basically involves balancing the interests of a company’s many stakeholders, such as shareholders, management, customers, suppliers, financiers, government and the community. Corporate governance is a topic that has received growing attention in the public in recent years as policy makers and others become more aware of the contribution good corporate governance makes to financial market stability and economic growth. Good corporate governance Is all about controlling one’s business and so is relevant, and indeed vital; for all organizations, whatever size or structure.The corporate governance structure specifies the distribution o Tat and responsibilities among different participants in the sorporanen, sucl He is ‘ joard. managers, shareholders, and other stakeholders, and spel pee iis ru . an procedures for making decisions on corporate affairs. By one re it al ot provides the structure through which the objectives are set and the means o! attaining those objectives and monitoring performance. PURPOSE OF CORPORATE GOVERNANCE The purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver long-term success of the company. ln simple terms, the fundamental aim of corporate governance is to enhance shareholders’ value and protect the interests of other stakeholders by improving. the corporate performance and accountability. It is also about what the board of directors of a company does, how it sets the values of the business firm. 6 Chapter I OBJECTIVES OF CORPORATE GOVERNANCE The following are the basic objectives of corporate governance: 1. Fair and Equitable Treatment of Shareholders A corporate governance structure ensures equitable and fair treatment of all shareholders of the company. In some organizations, a group of high- net-worth individual and institutions who have a substantial proportion of their’ portfolios invested in the company, remain active through occupation of top-level positions that enable them to guard their interest. However, all shareholders deserve equitable treatment and this equity is safeguarded by a good governance structure in any organization. 2. Self-Assessment Corporate governance enables firms to assess their behavior and actions before they are scrutinized by regulatory agencies. Business establishments with a strong corporate governance system are better able to limit exposure to regulatory risks and fines. An active and independent board can successfully point out deficiencies or loopholes in the company operations and help solve issues internally on a timely basis.—_ Introduction to Corporate Governance 7 Increase Shareholders Wealth Fee ey carmerate governanee's main objective is to protect the long- ee tersts of the shareholders. Fim with song eorporate pheresiay aa ucture are seen to have higher valuation attached to their sinessmen. This only reflects the positive perception that g00d corporate governance induces potential investors to decide to invest in a company, 4. Transparency and Full Disclosure Good corporate governance aims at ensuring a higher degree of transparency in an organization by encouraging full disclosure of transactions in the company accounts. BASIC PRINCIPLES OF EFFECTIVE CORPORATE GOVERNANCE Effective corporate governance is transparent, protects the rights of shareholders and includes both strategic and operational risk management. It is concerned in both the long-term earning potential as well as actual short-term earnings and holds directors accountable for their stewardship of the business. ‘The basic principles of effective corporate governance are threefold as presented below: Transparency and Full Disclosure Is the board telling us what is going on? Accountability Is the board taking responsibilty? Good and Effective Governance Corporate Control Is the board doing the right thing?sitive answers to the following questions indicate a firm i compliance with the basic principles of good corporate governance: ‘Transparency and Full Disclosure the information ¢. Does the board meet needs of investment communities Does it safeguard integrity in financial reporting? Does the board have sound disclosure policies and practices? > Does it make timely and balanced disclosure? > Can an outsider meaningfully analyze the organization's actions and performance? B. Accountability © Does the board clarify its role and that of management? Does it promote objective, ethical and responsible decision making’ > Does it lay solid foundations for management oversight? > Does the composition mix of board membership ensure an appropriate range and mix of expertise, diversity, knowledge and added value? > Is the organization’s senior official committed to widely accepted standards of correct and proper behavior? C. Corporate Control ¢ Has the board built long-term sustainable growth in shareholders’ value for the corporation? © Does it create an environment to take risk? > Does it encourage enhanced performance? Does it recognize and manage risk? > > Does it remunerate fairly and responsibly? > Does it.recognize the legitimate interests of stakeholders? > Are conflicts of interest avoided such that the organization's best interests prevail at all times?Introduction to Corporate Governance 9 ILLUSTRATIVE APPLICATION OF THE BASIC PRINCIPLES OF CORPORATE GOVERNANCE AND BEST PRACTICE RECOMMENDATIONS Principles of Good Corporate Governance Best Practice Recommendations 1. Acompany should lay solid foundation for management and oversight. It should recognize and publish the respective roles and responsibilities of board and management. Ta, Formalize and disclose the functions reserved to the board and those delegated to management 2. Structure the board to add value. Have a . board of an effective composition, size and commitment to adequately discharge its responsibilities and duties. , 7a, Aboard should have independent directors 2b. The roles of chairperson and chief executive officer should not be exercised by the seme individual. 2b, The board should establish a nomination committee Promote ethical and responsible decision- making. Actively promote ethical and responsible decision-meking. 3a, Establish a code of conduct to guide the ciectos, the chief executive officer (or equivalent), the chief financial officer (or equivalent) and any other key executives as to: © The practices necessary to maintain confidence in the company's integrity; and © The responsibilty and accountability of individuals for reporting and investigating reports of unethical practices 3-b. Disclose the policy conceming trading in, company securities by directors, officers and employees.10 Chapter t Safeguard integrity in financial reporting. Have a structure to independently verify and safeguard the integrity of the company's financial reporting. Fa, Require the chief executive of (or equivalent) and the chief financial officer (or equivalent) to state in writing fo the board that the company's financial reports present a true and fair view, in all material respects, of the company's financial condition and operational results and are in accordance with relevant accounting standards. 4-b, The board should establish an audit committee. 4-c, Structure the audit committee so that it consists of: « Only non-executive or independent directors; « — Anindependent chairperson, who is not chairperson of the board; and © Atleast three (3) members. ‘Make timely and balanced disclosure. Promote timely and balanced disclosure of all material matters concerning the company. 5-a. Establish written policies and procedures designed to ensure compliance with IFRS. Listing Rule disclosure requirements and to ensure accountability at a senior management level for compliance. Sb, s Respect the rights of shareholders and facilitate. the effective exercise of those rights. Design and disclose a communications strategy to promote effective communication with shareholders and encourage effective participation at general meetings. Request the external auditor to attend the annual general meeting and be available to answer shareholder Questions about the audit. 6a. ® &b. sIntroduction to Corporate Governance _\1 7. Recognize and manage risk Establish @ sound system of risk oversi ight and ‘management and internal control, 7-2, The board or appropriate board comritiee should establish policies on risk oversight and management. 2a, The chief executive officer (or equivalent) and the chief financial officer (or equivalent) should state to the board in wring that + Thestalement given in accordance with best practice recommendation 4-a (the inlegity of financial statements) is founded on a sound system of risk management and internal compliance and control which implements the policies adopted by the board; and © The companys risk management and internal compliance and contol system is operating efficiently in all material respects, Encourage enhanced performance. Fairy review and actively encourage enhanced board and management effectiveness. Bea. Disclose the process for performance evaluation ofthe board, its committees and individual directors, and key executives. Remunerale fairly and responsibly. Ensure that the level and composition of remuneration is sificient and reasonable ‘and that its relationship to corporate and individual performance is defined. 9-a, Provide disclosure in relation to the ‘company's remuneration policies to enable investors to undérstand: © — The costs and benefits of those policies; and ¢ The link between remuneration paid to directors and key execiitives and corporate performance. 9-b. The board should establish a remuneration committee. Clearly distinguish the structure of non- executive director's remuneration from that of executives. Ensure that payment of equity-based executive remuneration is made in accordance with thresholds set in plans approved by shareholders. 9. 8 912_Chapter 1 10-a, Establish and disclose a code of i timate interests of d m Setting recon legal and other SN wa legal ligati jit ders. an obligations to all legitimate stakehol peer . REVIEW QUESTIONS Questions 2. What does governance mean? Explain whether the following statement is trae or false. “Governance is exercised only by the goverriment of a country”. Explain how governance can be used in the following contexts and give appropriate examples: a. national governance b. local governance ©. corporate governance d. international governance Explain briefly the eight (8) basic characteristics of good governance. Transparency and accountability are synonymous. Explain whether the statement is correct or not. Explain whether the following statement is true or false. “Responsiveness usually results to effectiveness and efficiency”. Define corporate governance. What does corporate govemance structure involve? State the purpose of corporate governance. . Explain the basic objectives of corporate governance. Explain the three basic principles of effective corporate governance.Introduction to Corporate Governance 13 Multiple Choice Questions L The basic principle of “transparency and full disclosure” for effective corporate governance responds positively to the following questions except. a. Does the board of directors safeguard integrity in financial reporting? b. Does the board meet the information needs of investment communities? ©. Can an outsider meaningfully analyze the firm’s actions and performance? d. Has the board -built long-term sustainable growth in shareholders’ value for the corporation? The basic principle of “accountability” for effective governance answers the following questions positively, except a. Does the board recognize and manage risk? b. Does the board lay solid foundations for management oversight? ¢. Does the’ composition mix of board membership ensure an appropriate range and risk of expertise diversity, knowledge added value? d. Does the board promote objective, ethical and responsible decision making? “Transparency and full disclosure” principle advocates the following except a. Sound disclosure policies and practices b. Solid foundations for management oversight ¢. Meeting the information needs of investment communities d. Safeguards integrity in financial reporting The ‘tights of shareholders can be effectively upheld through the following measures except : a. By establishing an audit committee b. By designing and disclosing a communications strategy to: promote affective communication with shareholders. ; c. By encouraging active participation at general meetings, d. By requiring the external auditor to attend the annual general meeting and to answer questions about the audit.14 Chapt 5. To safeguard integrity in financial reporting, the business firm should do the following except a. Establish an audit committee . b. Request the external auditor to attend the annual general meeting ¢. Disclose the functions reserved to the board and those delegated to management d. Disclose the policy concerning, tra: directors, officers and employees. ding in company securities by 6. To encourage enhanced performance by the board and management, itis recommended that the following should be adopted except Disclosure of the process for performance evaluation of ‘the board, its committees, individual directors and by executives. b. A remuneration committee c. Distinguish between non-executive director’s remuneration from that _ of executives, d: Establish policies on risks oversight and management a. 7. The characteristic of good governance where fair legal framework are enforced impartially is a. Participation b. Rule of Law c. Equity d. AccountabilityChapter CORPORATE GOVERNANCE RESPONSIBILITIES AND ACCOUNTABILITIES Expected Learning Outcomes After studying the chapter, you should be able to... 1. Explain the relevance of good governance to both large publicly-listed companies and SMEs 2. Know the relationship between shareholders or owners and other stakeholders . 3. Identify the parties involved in Corporate Governance 4. Describe the respective broad rate and specific responsibilities of the different parties in a corporate setting WoBesCHAPTER 2 CORPORATE GOVERNANCE RESPONSIBILITIES AND ACCOUNTABILITIES INTRODUCTION Many of the characteristics of good governance described in Chapter | are relevant to both SME's and large listed public companies. AS an organization grows in size and influence, these issues become increasingly important. However, it is also important to recognize that good corporate governance is based on principles underpinned by consensus and continually developing notions of good practice, There are no absolute rules which must be adopted by all organizations. "There is no simple universal formula for good governance". Instead emphasis is many localities, has been to encourage organizations to give appropriate attention to the principles and adopt approaches which are tailored to the specific needs of an organization at a given point in time. When corporate governance is discussed, it is often spoken of in terms of a company's corporate governance framework. The key elements within an effective governance framework, and the issues relating to each element, are set out on the following pages and are relevant to organizations large and small, in both the private and the public sectors. The table provides a useful structure for any company to consider its own approach to corporate governance and the matters which may assist it to achieve its strategic objectives. Many of the matters listed may not be directly relevant in all situations and some may not, in particular circumstances, be within the board's control, but it provides a useful context in which any organization can consider its governance needs so that they might be most appropriately addressed. The essence of any system of good corporate governance is to allow the board and management the freedom to drive their organization forward and to exercise that freedom within a framework of effective accountability.——_____“etporate Ge nance Responsibilities and Aecommabilities RELATIONSHIP BETWEEN SHARE 5 OTHER STAREHOLD oe SHAREHOLDERS / OWNER(S) AND he relations The relationship between the shareholders / owners, management and other stakeholders in a corporation is shown below: Public Corporation Stakeholders Board of Shareholders | Directors Owners i Executive External legate Management Auditors ‘Shareholders / Owners "| Responsibiities | [— Operational Ragulalors Management intemal Society and Auditors Others Governance starts with the shareholders/owners delegating responsibilities through an elected board of directors to management and, in turn, to operating, units with oversight and assistance from internal auditors. The board of directors and its audit committee oversee management and, in that role, are expected to protect the shareholders’ rights. However, it is important to recognize that management is part of the governance: framework, management can influence who sits on the board and the audit committee as well as other governance controls that might be put into place. In return for the responsibilities (and power) given to management and the board, governance demands ‘accountability back through the system to the shareholders. However, the ‘accountabilities do not extend only to the shareholders. Companies also have responsibilities to other ‘stakeholders, Stakeholders can be anyone who is influenced, whether directly or indirectly, by the actions of a company. Management and the board have responsibilities to act within the laws of society and to meet various requirements of creditors, employees and the stakeholders.18 Crapeer 2 A broad group of stakeholders has an interest in the quality of corporate govemance because it has 2 relationship to economic performance and the quality of financial reporting. For example, it is likely that many employees have significant funds invested in pension plans. Those pension plans are designed to protect the financial interests of those employees in their retirement. We use the word society in the diagram to indicate those broad interests. In a similar fashion, employees and creditors have a vested interest in the organization and how it is governed. Regulators are a response to society's wishes to. ensure that organizations. in their pursuit of returns for their owners, act responsibly and operate in compliance with relevant laws. While shareholders / owners delegate responsibilities to various parties within the corporation. they also require accountability as to how well the resources “that have been entrusted to management and the board have been used. For example, the owners want accountability on such things as: © Financial performance * Financial ransparency — financial statements that are clear with full disclosure and that reflect the underlying economics of the company. * Stewardship, including how well the company protects and manages the resources entrusted to it. * Quality of internal control * Composition of the board of directors and the nature of its activities, including information on how well management incentive systems are aligned with the shareholders’ best interests. ‘The owners want disclosures from management that are accurate and objectively verifiable. For instance, management has a respensibility to provide financial Feports, and in some cases, reports on internal control effectiveness. Management has always had the primary responsibility for the accuracy and completeness of wani: inancia! statements. From a financial reporting perspective, it is management's responsibility to: * Choose which accounting Principles best portray the economic substance of company transactions. © Implement a system of intemal control that assures completeness and accuracy in financial reporting. ¢ Ensure that the financial statements contain accurate and complete disclosure.Corporate Governance Responsibilities ahd Accountabilities 19 PARTIES INVOLVED IN CORPORATE GOVERNANCE: THEIR RESPECTIVE BROAD ROLE AND SPECIFIC RESPONSIBILITIES Corporate governance and financial reporting reliability are receiving considerable attention from a number of parties including regulators, standard setting bodies, the accounting profession, lawmakers and financial statement ‘users. Party ‘Overview of Responsibilities 1. Shareholders Broad Role: Provide effective oversight through election of board members, approval of rigjr initiatives such as buying or selling stock, annual reports on management compensation, from the board. 2, Board of Directors Broad Role: The major representative of stockholders to ensure that the organization is run according tothe organization's charter and that there is proper accountability. Specific activities include among oth 4. Overall Operations _ Establishing the organization's vision, mission, values and ethical standards. © Delegating an appropriate level of authority to management. © Demonstrating leadership, ‘© Assuming responsibilty for the business relationship with CEO including hs or her appointment, succession, performance remuneration and dismissal ‘© Overseeing aspects of the employment of the management team including management remuneration, performance and succession planning, «Recommending auditors and new directors to shareholders. ‘© Ensuring effective communication with shareholders other stakeholders. + Crisis management. Appointment of the CFO and corporate secretary20 Chapter 2 2. Performance : © Ensuring the organization's long term viability and enhancing the financial position. A Formulating and overseeing Implementation of corporate strategy. ; Approving the plan, budget and corporate policies, Agreeing key performance indicators (KPIs) Monitoring / assessing assessment, performance of the organization, the board itself, management and major projects. Overseeing the risk management framework and monitoring business risks. ‘ Monitoring developments in the industry and the operating environment. ‘© Oversight of the and organization, including its control and accountability systems. Approving and monitoring the progress of major capital expenditure, capital management and acquisitions and divestitures. 3. Compliance / Legal Conformance * — Understanding and protecting the organization's financial position. ¢ Requiring and monitoring legal and regulatory compliance including compliance with accounting standards, unfair trading legislations, occupational health and safety and environmental standards, ‘* Approving annual financial reports, annual reports and other public documents / sensitive reports, ‘e Ensuring an effective system of internal controls exists and is operating as expected, 3. Non-Executive or Independent Directors Broad Role: The same as the broad role of the entire board of directors Specific a iclude among others: * to Understand the organization, its business, its operating environment and its financial Position, © {0 apply expertise and skils in the organization's best interests, _ * — toassist management to keep performance objectives at the top of its agenda,Corporate Governance Responsibilities and Accountabilities 24 © to understand that hisfher role is not act as auditor, nor lo act as a member of the management team, . * torespect the colleatve, cabinet nature of the board's decisions, © toprepare for end attend board meetings, ‘© toseek information on a timely basis to ensure that helshe isin a positon to contribute to the discussion when a matter comes before the board, or alert the chairman in advance to the need for further information in relation to @ particular matter, and « _to.ask appropriate questions relative to operations. Management Broad Role: Operations and accountability. Manage the organization effectively, provide accurate and timely reports to shareholders and other stakeholders. Specific activities include among others: recommend the strategic direction and translate the strategic plan into the operations of the business manage the company’s human, physical and financial + resources to achieve the organization's objectives — run the business assume day to day responsibilty for the organization's conformance with relevant laws and regulations and its compliance framework develop, implement and manage the organization's risk rmnagement and internal control frameworks develop, implement and update policies and procedures be alert lo relevant trends in the industry and the organization's operating environment provide information to the board ‘act as conduit between the board end the organization developing financial and other reports that meet public, stakeholder and regulatory requirements.22_Chaprer 2 5. Audit Committees of the Board of Directors Broad Role: Provide oversight of the internal and external audit function and the process of préparing the annual financial statements as well as Public reports on internal control. Specific activities include among others: * Selecting the external audit firm ‘© Approving any non-audit work performed by the audit firm © Selecting and / or approving the appointment of the Chief Audit Executive (Intemal Auditor) * Reviewing and approving the scope and budget of the internal audit function * Discussing audit findings with internal auditor and extemal auditor and advising the board (and management) on specific actions that should be taken 6. Regulators a. Board of Accountancy Broad Role: Set accounting and auditing standards dictating underlying financial reporting and auditing concepts; set the expectations of audit quality and accounting quality. Specific activities include among others: Conducting CPA Licensure Board Examinations Approving accounting Principles Approving auditing standards Interpreting previously issued standards implementing quality control processes to ensure audit quality Educating members on audit and ‘accounting requirements .b. Seourtios ond Exchange: Commission Corporate Governance Responutbiliies and Accountabllities 23 Broad Rolo: Ensure the accuracy, timeliness and fairngas of public reporting of financial and other information for public companies. ‘Shecific activities include among others: © Reviewing flings vith the SEC © Interacting vith the Financial Reporting Standards Gounci in seling accounting standards © Specilying independance standards required of auditors that report on public financial statements: [dently corporate frauds, investigate causes, and suggest remedial ations | 7. External Auditors Broad Role: Perform audits of company financial statements fo ensure tat the ‘statements are free of material misstatements including misstatements that may be due to fraud, Specific activities include among others: ‘+ Audit of pubic company fnencial statements + Audits of nonpublic company financial statements + Other services such 3s tax or consulting 8. Internal Auditors Broad Role: Perform audits of companies for compliance with company policies and laws, audits to evaluate the efciency of operations, and periodic evaluation and tests of contrals. Specific activities include among others: + Reporting results and analyses to management (including operational management) and audit committees + Evaluating internal controls | | | ‘24 Chapter 2 REVIEW QUESTIONS Questions lL b o> * a 8. “Small business enterprises do not need good governance Do you agree? Explain. Does good governance require absolute rules that must be adopted by all organizations? What is the essence of any system of corporate governance? Where does the board of directors derive its authority? To whom is the board of directors accountable? On what aspects do shareholders demand accountability from the board of directors? What is management’s responsibility as far as financial reporting is concerned? Describe the broad role of the shareholders in a corporation. Describe the broad role of the Board of Directors. What are the specific activities of the board of directors? le Choice Questions Approving annual financial reports and other public documents “are specific responsibilities of a, Management b. Board of directors c. Shareholders d. Employees