Corporate Governance Business Ethics Risk Management and Internal Control by Cabrera 2019 2020 PDF Free

rporate Governance,
Business Ethics,
- !
and Intern ontrol
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
Wortd 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 Eastern University,
De Ls Salle University, Centro Escolar University, St. Scholsstica's College
Audit Staff, SGV and Co., CPAs
GILBERT ANTHONY 8. 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
1
Philippine Copyright, 2019
by
MA..EL , ◄-.
GIL - .......
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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
;4.6out tfie;4.utli.ors
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 earned
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 CabreFa 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 Com.mittee (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 Technic-al 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 Anth·ony B. Cabrera

BBA MBA CPA
Gilbert received his bachelor's degree in A countancy- 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.
(Ernst 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 Me:nber of Bay Area Red Cross.
(preface
business environment continues to change In dramatic ways and uni ersity graduat
s Joinin_g the corporate world or entering the accountancy profession, whether 11 e 1 the pu
llc practice sector, management accounting practice, internal audit or accounting
information
system management, must be prepared for a high standard of responsibility. This text k
on Cor_p rate Governance, Business Ethics, Risk Management and Internal Co trol,
,ms!O equ,p 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 internal 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 governance, objectives, strategies, business
processes, risks, controls and reporting.
This book isorganized 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 di$tribution 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 II - 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 l:)usiness
with integrity enjoys competitive advantage in both government and private transactions.
Unit 111- Risk Management
This unit emphasizes the nature, forms and basic management of risks related to
business.
Unit IV- Internal Control: A Vjtal 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.
ii
Contents in (}3riej
i
Preface
I CORPORATEGOVERNANCE 1
UNIT
Cltapter t INTRODUCTION TO CORPORATE

GOVERNANCE ·2
I
2 CORPORATE GOVERNANCE RESPONSIBILITIES

Cltapter AND ACCOUNTABILITIES .
15
Chapter
3 SECURITIES AND EXCHANGE (SEC)
COMMISSION CODE OF CORP.O ATE
GOVERNANCE 26
Chapter
4 · SEC CODE OF CORPORATE GOVERNANCE,
CONTINUED . 76
UNIT
II BUSINESS ETHICS 93
Chapter
5 INTRODUCTION TO ETHICS 94
Cllapter 6 BU.SJNESS ETHICS 103
Cllapter 7 COMMON UNETHICAL PRACTICES OF

BUSINE S ESTABLISHMENTS 109
Cllapter 8 ETHICAL DILEMMA . 121
Chapter 9 ADVOCACY AGAINST CORRUPTION

128
Chapter 10 INITIATIVES TO IMPR
AND REDUCE CORRU OVE BUSINESS ETHICS
PTION · 146
Ill
'
UNIT I II INTRODUCTION TO RISK
MANAGEMENT 162
Chaptc!r II RISK MANAGEMENT 163
Chopra 12 PRACTICAL INSIGHTS IN REDUCING AND
MANAGING BUSINESS RISKS 180
UNIT IV INTERNAL CONTROL:
A VITAL TOOL IN MANAGING RISK 195
Chapter 13 OVERVIEW OF INTERNAL CONTROL 196
Chapter 14 FRAUD-AND ERROR 217
Cltnpter IS ERRQRS ANO IRREGULARITIES IN THE
TRANSACTION CYCLES OF THE BUSINESS
ENTITY 232
Chapter 16 INTERNAL CONTROL AFFECTING ASSETS 244
Cltnpter 17 INTERNAL CONTROL AFFECTING
LIABILITIES·ANO EQUITY 264
Appendices
Appendix A Code of Ethics for Professional Teachers 273

Appendix B International Standards for the Professional
Practice of Internal Auditing 281
Appendix C International Standards of Ethical Conduct
for Practitioners of Management
Accounting 283
Appendix D Code of Business Conduct and Ethics of a
Telecommunications Company 287
Appendix E Code of Business Conduct and Ethics of a
293
Manufacturing Company
.
Appendix F Code of Business Conduct and. Ethics of
a Commercial Bank 303
Appendix G Partial List of Organizations who are
actively
Participating in the "Integrity Initiative"
Campaign against Corruption 307
References 311
fr
Contents I
Preface i
1
UNIT I CORPORATE GOVERNANCE
Chapter INTRODUCTION TO CORPORATE

I 2
GOVERNANCE
2
Expected Learning Outcomes
Whal is Governance?
Characteristics of Good Governance 3
Cmporate Governance: A Overview 5
Purpose of Corporate Governance 6
Objectives of Corporate Governance 6
Basic Principles of Effective Corporate Governance 7
Illustrative Application of the Basic Principles of
Corporate Governance and Best Practice
Recommendations 9
Review Q11estio11s 12
Chapter 2 CORPORATE GOVERNANCE RESPONSIBILITIES

AND ACCOUNTABILITIES 15
Expected Learning Outcomes 15
Introduction 16
Relationship between Shareholders I Owners and
Other Stakeholders 17
Parties involved in Corporate Governance 19
Their Respective Broad Role and Specific
Responsibilities
• Shareholders 19
• Board of Directors 19
• Non-Executive or Independent Directors 20
• Management 21
"' • Audit Commillees 22
• Regulators Board of Accountancy 22
• External Audit . 23
• Internal Audit 23
Review Questio11s 24
V
Chapter 3 SECURITIES ANO EXCHANGE COMMISSION

EC)CODEOFCORPORATEGOVERNANCE 26

The Board's Governance Responsibilities 28
Principles I to 7 28
Disclosure and Transparency 29
Principles 8 to / I 29
Internal Control System and Risk Management
Framework 29
Principle 12 29
Cultivating a Synergies Relationship with
Shareholders 29
Principle 13 29
Duties to Stakeholders JO
Principles 14 to /6 30
Introduction 30
The Code of Corporate Governance 30
Objective 30
Approach 30
Organization 30
Recommendation 31
Explanations 31
Coverage· 31
Definition a/Terms 34
The Board's Governance Responsibilities 34
Establishing a Competent Board 34
Establishing Clear Roles and Responsibilities of
the Board 39
Establishing Board Commillees 49
Fostering Commitment 57
Reinforcing Board Independence 59
Assessing Board Performance 65
Strengthening Board Ethics 67
Enliancing Company Disclosure Policies and
Procedure 68
Strengthening the External Auditor's Independence
and Improving 71
Review Questio11s all(/ Exercises 74

vi
Chapter 4 s c CODE OF CORPORATE GOVERNANCE,

CONTINUED 76
Increasing Focus on f!on-Financia/ and
Sustainability Reporting 77
Promoting a Comprehensive and Cost-efficient
Access to Relevant Information 78
Stiengthening the Internal Control System and
Enterprise Risk Management Framework 78
Cultivating a Synergic Relationship with
Shareholders 83
Respecting Rights of Stockholders and Ejfect(ve
Redress for Violation of Stakeholder 's Rights 87
Encouraging Employees Participation 88
Encourag_ing Sustainability and S o c _i aRl esponsibility 90
Review Q11estio11s
91
UNIT n BUSINESS ETHICS
93
Chapter 5 INTRODUCTION TO ETHICS
94
Expected Learhing Outcomes
94
Introduction
Characteri tic.t and Values Associated with Ethical 95
Behavtor
Why is Ethical Behavior Necessary? 96
Why do f!eople_ Act Unethically? · 98
Categones of Ethical Principle 98
The Need/or Professional Ethics 99
100
Review Questions
102
•
vii
Chapter 6 BUSINESS ETHICS 103

Basic Concept of Business Ethics 104
Purposes of Business Ethics 104
Main Purpose 104
Special Purpose . 104·
Scope and Impact of Business 105
Ethics Economic Impact 106
Social Impact 106
Environmental Impact 106
Impact on Business Managers 106
Ethical Challenges in Today's 107
World
108
Review Questio11s ·
Chapter 7 COMMON UNETHICAL PRACTICES OF

BUSINESS ESTA.BLISHMENTS 109
Expectec;I Learning Outcomes 109
Common Unethical Practices of f!usiness Establishments 110
Misrepresentation and Over Persuasion 110
Direct Misrepresentation 110
Deceptive packaging 110
Misbranding or mislabeling 110
False or misleading advertisement 110
Adulteration· 111
Weight understatement 111
Measurement understatement 111
Quantity understatement 112
Indirect Misrepresentation 112
Caveat emptor 112
Deliberate withholding of information 112
Passive deception 112
Over Persuasion 113
Corporate Ethics 113
Unethical Practices of Corporate Management 113
Board of Directors I13
Executive Officers and lower level Managers 114
Some Unethical Practices of Employees 117
Review Questi<>ns 119

"
viii
121
' ETHICAL DILEMMA
Cltap te 8
r 12
Introduction 122
Resolving Ethical Dilemmas 122
/1/ustrative Case: Resolving an Ethical Dilemma 122
Ethical Issue 123
Who is Affected and How is each Affected 123
Bert's Available Alternatives 124
Consequences of Each 124
Alternative Appropriate Action 125
Review Questirms and Exercises 126
Chapter 9 ADVOCACY AGAINST CORRUPTION

128 .
Expected L arning Outcomes
128
Whal is Corruption?
What does Corruption look like? 129
130
Why and how does a Person Become Corn1pt? 131
Ill Effects of Corr.up/ion 131
Characteristics o/Corruption . 133
The Philippine Corruption Report 137
Judicial System 137
Police 138
Public Services 138
land Administration 139
•
Tax Administration 139
Customs Administration 140
Public Procurement 140
Natural Resources 141
Prevention of Corruption 141
Clear Business Process 141
olif on_ Gifts and Entertainment 142
c ec ara.lron of Confl'tc/ oif Interest
onvement Corn,ptio R . 142
Efforts toCurb Co eportmg 142
System
Vigilance of Civil ;:i:;n Through legislation 142
143
Review Q11estiol1s
145
ix
Chapter 10
INITIATIVES TO IMPROVE BUSINESS ETHICS
AND REDUCE CORRUPTION 146

Introduction 147
The lntt4grity Initiative Campaign 147
Corporate Values 148
Need for a CodeoJConduct 149
The Un({ied Code of Conduct for Business 150'
Top Management 150
Human Resources 150
Sales and Marketing 150
Finance and Accounting 151
Procurement 151
logistics 152
Implementation and Monitoring 152
Bishops-Busirlessmen's Confere ce 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 162
Chapter II RISK MANAGEMENT 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
I, Risk Associated with Investments 167
11. Risks Associated with Manufacturing,
Trading and Service Concerns 170
Ill. Risk Associated with Financial Institutions 171
Potential Risk Treatments 172
Areas of Risk Management 173
Risk Management Framework 174
Steps in the Risk Management Process 175
Re1•iew Questions 178

X
Chapter PRACTICAL IN IGHTS IN REDUCING AN

12 MANAGING BUSINESS RISKS 180
' 180
Expected L arning Outcomes
Understand the Nature of Risk 181
!denttfji and Prioritize Risks . 181
Consider the Acceptable level of Risk 183
Understand WI )' Risks Become Reality 183
Apply a Simple Risk /o.1anageme 1t Process 184
Risk Assessment and Analy.Hs 184
Risk tvlanageme.nt and Control 185
Avoiding and Mitigating Risks 186
Create a Positive Climate.for Managing f.isk 186
Overcoming the Fear of Risk 187
Controlling and tvfor.,ito,ring Ente,prise-wide Risk 187
Practical Considerations in Managing and Reducing
Flnancial Risk 188
Improving Prq/itability 188
Assessment qf tvlarket and Exit 189
Barries
Break-even Analysis 189·
Controlling Costs 190
Practical Techniques to linprove Profitability 191
Avoiding Pitfatls 192
Review Q11eslio11s "'"'£'1:ercises 194
UNIT IV INTERNAL CONTROL:

A VITAL TOOL IN MANAGING RISK 195
Chapter 13 OVERVIEW OF INTERNAL CONTROL 196
Nature and Purpose of Internal Control 197

Internal Control System Defined 197
Elements of Internal Control 198
A. Control Environment- 198
B. Entity's Risk. Assessment Process 198
C. Information System, including the Business
Processes, Relevant to Financial Repnrting
and Communication 203
D. Control Activities 205
£. Monitoring of Controls 210
Review Questio11s anti Exercises 211

xi
Chapter 14 FRAUD AND ERROR 217

Introduction 218
Types of Misstatements 218
Misstatements arising from Misappropriation
of Assets 218
Misstatements arisingfrom Fraudulent
Financial Reporting 219
The Fraud Triangle · 219
Incentives or Pressure to Commit Fraud 220
Opportunities to Commit Fraud ·220
Rationalizing the Fraud 221
Risk Factors arisingfrom Misappropriation of
Assets 22i
Risk Factors arisingfrom Fraudulent
Financial Reporting 224
Responsibility for the Prwention an,d
Detection of Fraud 226
Review Questions and Exercises 227
Chapter IS ERRORS AND IRREGULARITIES IN THE

TRANSACTION CYCLES OF THE'BUSINESS
ENTITY 232
'
Errors in Recording Sales Collections Sales
Transactions Frauds in
and Collections sales and Collections
Cycle 233
Acquisition and Payments Cycle 233
Errors in the Acquisitions and Payments Cycle
/ 235
Frauds in the Acquisitions and Payments Cycle
235
Payroll and Personnel Cycle 236
Errors 237
Frauds involving Payroll 237
237
Review Q11eslio11s a11d Exercises
239
xii
Chapter 16 INTERNAL CONTROL AFFECTING ASSETS 244

Internal Control over Cash Trdnsactions 245
Potential Misstatements - Cash Receip(s 246
Potential Misstatements - Cash Disbursements 248
Internal Control over Financial Investments 249
Potential Misstatements - Financial Investments 250
lntemal Control over Receivables 251
Sources and Nature of Notes Receivable • 251
Internal Control of Accounts Receivable and Revenue 25 I
Control Environment 252
Potential Misstatements - Revenue I Receivables 252
lnternpl Control over Notes Receivable 254
Internal Control over Inventories and Cosi ,,f Goods Sold 255
Sources and Nature of Inventories and Cost of
Goods Sold . 255
Potential Misstatements - lnvento,y I Cost of
Goods Sold 256
Internal Control over Property, Plant and Eqilipment 257
Potential Misstatements - Investments in
Property, Plant and Equipment· 259
Review Quej•tio11s and Exercises 260
Chapter Intern s
al
Contr
17 INTERNAL CONTROL AFFECTING ol a
LIABILITIES AND EQUITY over
D n
. d
Expected lear11i11g Outcomes d
Internal c:ontr I over Ac:counts Pcryable £
Potenlial Misstatements -Accounts Payable R 1
Internal Control over Other Debts e :
Internal Control over Debi v e
Auth0rization by the Board of Directors i r
Use of an Independent Trustee e c
Interest Payments of Boards and Notes w i
Payable s
1nternal Conirol over Owners, Equity Q e
Internal Conirol on Equity u s
Control ofS ha r c . e
. e apu a1 Transactions by
s
1he t
. Board of i
IndependentDirectors
Reois1t. o
t- ar an Siock Transfer Agenl u
264
264
265
266
267
267
268
268
268
269
269
269
270
271
xiii
Appendices
Appendix A ·Code of Ethics for Professional Teachers 273

Appe1U/ix B International Standards for the Professional
Practice of Internal Auditing 281
C International Standards of Ethical Conduct
Appendix for Practitioners of Management
Accounting 283
Appe11dix D Code of Business Conduct and Ethics of a
Telecommunications Company 287
Appe11dix E Code of Business Conduct and Ethics of a
Manufacturing Company 293
Appe11dix F Code of Business Conduct and Ethics of a
Commercial Bank 303
Appe11dix G Partial List of Organizations who are actively
Participating in the "Integrity Initiative"
Campaign against Corruption 307
•
References 311
IJNIT I CORPORATE GOVERNANCE.
l ·introduction to Corporate
Governance
2 Corporate G.overnance
Responsibilities
and
Accountabilities
3 Securities and Exchange

Commission (SEC) Code of
•
Corporate Governance
4 SEC Code of Corporate

Governance,
Continued
INTRODUCTION TO
CORPORATE GOVERNANCE
P.x:pectecf Learn£ng Outco"':es

After studying the chapter, you should be able to ...
1. Describe what governance involves
2. Enumerate the different contexts in which governance can be

applied
3. Name and explain the characteristics of good governance
4. Explain the meaning, purpose and objectives of corporate

governance
5. Know and describe the principles of effective corporate

governance
6. Understand how the principles of good corporate governance

can be applied • ·
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 concerning
public life and social upliftment.
It comprises all the processes of governing -·whether undertaken by th·e

govemme.nt of a country, by a market or by a network - over a social system and
whether through the laws, norms, 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

I
Whatever context good governance is used, the following major characteristics

should be present:
' !articlipation;
Rule of Law , '!Accountallilitv
"·· 7"
..,;,,..,
-- l :>....
-
' Transparency -: GOOD
GOVERNANCE -rffectlveness&
.,-: ffici•11cy
', /
!......
I Consensus
, Oriented ,
4 Chapter I
These characteristics are briefly described as follows:

·t· ·pation by both men and women is a key cornerstone
Participatio11 P81 ICdI ' governance. Part1•c1•p' at1•0A cou Idb e. e1ther di.rect or
of goo . .. . t t' .
through legitimate institutwns or represena 1ves. t1 1s
important to point out that representative democracy does
necessarily · mean that the concern of the most
not k . 'd .
lnerable in society would not be ta en into cons, erat1qn
: decision making. Participation needs to be _in:or:med
and organized. This means freedom ?f as o 1at10? and
expression on one hand and an orgamzed civil society on
the other hand.
Good governance ,require fair legal frameworks that are

Rule of Law
enforced impartially. It also requires full protection of
human rights, particularly those of minorities. Impartial
enforcement of laws.requires an indep ndentjudiciary 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.
)
Responsiveness Good governance requires that institutions and processe.s·

try to serve the needs all stakeholders within a reasonable
timeframe.
Consensus Oriented
governance requires mediatioh of the different
Goo· d
!nterests in _society to reach a broad consensus on what is
m-the best mterest of the whole community and how this
can be chieved. 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
de elop ent: This can only result from an understanding
of !he historical, cultural and social contexts of a given
society or community.
Introduction to Co1porate Governance 5
Equity &
b1cf11sive11ess Ensures that all its members feel that they have a stake in
it 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.
Effective11ess
&Efficie11cy Good governance means that processes and institutions
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.
;4.ccountability
Accountability is a key requirement of good governance.
Not only governmental insti.tutions but also the private
sector an<l°civil soGiety organizations must be
accountable to the public and to their institutional
stakeholders. Who is accountable to whom varies
depending on whether decfsions or actions taken are
internal or external to an organization or institution. In
general, an organization or an institution is·accountable
to tho e who will be affected by its decisions or actions.
Accountabi Iity cannot be,
.enforced without transparency and the rule of law. ·
CORPORATE GOVERNANCE: AN O RVIEW
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 polic_ymakers and thers 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.
6 Chapter I
The corporate governance structure specifies the distribution of rights and
responsibilities among different participnnts in the corporation, such as
theboard, managers,shareholders, and othe-rs·takeholders, and spells out the
rules and procedures for making decisions on corporate affairs. By doing
this, it also provides the structure through which the objectives are set and
the means of
attaining those objectives and monitoring performance.
PURPOSE OF CORPORATE GOVERNANCE
The purpose of corporate governance is to facilitate effective, entrepreneuriaI

and prudent management that can deliver long-term success of the company.
In simple terms, the fundamental aim of corporate governaqce 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.
OBJECTIVES OF CORPORATE GOVERNANCE

.
The following are the basic objectives of corporate governance:
I. Fair and Equitable Treatn1e11t of Share/Jo/tiers
A corporate governance structure ensures equitable and fair treatment

of al! shareho_lde:s.of the con_1pa1_1y .. ' n some organizations, a group of
high ner-wo!1_h 111d1v1 ual. and mst1tut1ons who have a substantial
proportion of the, portfolios mvested in the c_ompany, remain active
through occupation of top-level positions that enable them to guard their
interest. However, all ::;hareholders deserve equitable treatment and this
equity is safeguarded by a good governance structure in any
organization. .
2. Self-Assessn1e11t
Corporate governance enables firms to assess their b I • d .

before they are scrutinized by re ulato e 1av1.or an ac!1ons
establishments witha strong corporate g ry agencies. Busrness
to limit
recrufatoexposure to .k dgofivernance system are better able
ry ns s an mes A t' d• d
board can successfully point out defi . .n ac rve an m ependent
company operations and help solve issue; : easll or lo pholles i the
Y on a time y basis.
_:: .!!_l1!!_1t1 ·o dl!!_11 c1i_!_lo'!.!_II to Corp11ra/L' Uoi:ema11ce 7
3. Increase Share/w/ders' lf'ca/tl,
Anoth rcorporate govcrnnncc's 111ni11 objective is to protect the long

tenn interests of the shnreholdcrs. Firms with strong corporate
governance structure arc seen to hnve higher valuation attached to their
shares by businessmen. This only rcnects the positive perception that
ood corporate governance induces potential investors to decide to
invest
111 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 a_rtehreefold as

presented below:
Transparency and Full Disclosure Accountablllty

Is the board tellingus what isgoing Is theboard taking responsibility?
on?
..
. .
Good and EffectiveGovernance I+-

f
Corporate Control
Is the board doinQ lhe ri11ht
.
thin11?
• . flrm' s con formance and
11,sitiH.' nnswers h, thl' 1 ,ll(nv1•11g qt1l'Sll•111s 1• 11c11• cn1u n · .
,·0mplt.:\lh't' "1.th th ms1. c .prin. s co r·1,,01··11..•..· governance. ,
1· I
'l c1pI 0 gom
A. T11tnspiu·t>nl')' nnd Full Disclosure

• , ·· nee.•clsof invcstment
• DQes th hoard meet the 1 11 · orma1!
•
on communities?
• Does it safuguard 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. Accountnbility
• Does tlie board clarity its role and that-of management?
► Does it promote objective,·ethical aiid responsible decision
making?
►Does it lay solid foundations for m,anagement oversight?
►Does the compositio11 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 ofcorrect and proper behavior?
C. Corporate Control
•, Has the bo rd 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 respon_sibly?
► Does it.recogniz the legitimate interests of stakeholders?
► re conflicts f interest avoided s_uch that the organization's
best mterests prevail at all times?
/nfroducfion to Corporate Governance 9
ILLUSTRATIVE APPLICATION OF THE BASIC PRINCIPLES OF

CORPORATE GOVERNANCE AND DEST PRACTICE
RECOMMENDATIONS
Principles of Good Corporate Best Practice Recommendations

Governance
1, A company should lay solid fqundationfor 1-a. Formalize and disclose the functions
management and oversight. It should reserved to the t?oard and those
recognize and publish the respective roles delegated tomanagement.
and responsibilities of board and
manaaement.
2. Structure the board to add value. Have a 2-a. A board shoul<;hl aveindependent
. board of an effective composition, size and directors.
commitment to adequately discharge its 2-b. The roles of chairperson and chief
responsibilities andduties. . executive officer should not be exercised
by the same individual.
2-b. The board should establish anomination
committee
3. Promote ethical and responsible decision- 3-a. Establish a code of conduct to guide the
, making. Actively promote ethical and directors, the chief executive officer (or·
responsible decision- aking. equivalent}, the chief financial officer (or
equivalent·}and any other key executives
as to:
• The practices necessary to
maintain confidence in the
company'sintegrity; and
• The responsibility a d
accountability of individuals for
reporting and investigating
reports of unethical practices
3-b. Disclose the policy concerning trading
in. company securities by directors,
officers anct emolovees.
10 -Chapter I
4. Safeguard integrity in financial reporting. 4.a Require the chief executive of (?r
· equivalent) and the chief finan_c,al
Have a structure to independently verify
and safeguard the integrity of the officer (or equivalent) to state tn .
company's financial reporting. writing to the board that the

company's financial reports p
esenat true and fair view, in all
matenal 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 sq that it
consists of:
• Only non-executive or
independent directors;
' •' An independent chairperson,

who is not chairperson of
the
board; and
• Atleast three (3) members.
5. Make timely and balanced disclosure. 5-a. Establish written policies and
Promote timely and balanced disclosure procedures designed to
of all material matters concerning the ensure compliance with
company. IFRS.
-
. 5-_b. Listing Rule disclosure requirements
and to ensure accountability at asenior
manaaement level for compliance.
6. Respect the rights of shareholders and 6-a. Design and disclose a communications
facilitate.the effective exercise of those strategy to promote effective
rights. communication with shareholders and
encourage effective participation at
. general meetings.
6-b. Request the external auditor to attend
the annual general meeting and be
available to answer shareholder
Questions about the audit.
/11trod11ctio11to Corporate Governance 11
7. Recognize and manage risk. Establish
7-a. The board or appropriate board
a sound system of risk oversight and committee should establish policies on
management and internal control. risk oversight and management.
2-a. The chief executive officer (or
equivalent) and the chief financial
officer (or equivalent) should state to
the board in writing that:
• The statement given in
accordance with best practice
recommendation 4-a (the
integrity 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 company's risk management
and internal compliance and
- control system is operating
.. efficiently in·all material resoects.
8. Encourage enhanced performance. Fairly 8-a. Disclose the process for performance
review and actively encourage enhanced evaluation of the board, its committees
board and management effectiveness. and indiviqual directors, and key
executives.
9. Remunerate fairly and responsibly. 9-a. Provide disclosure in relatfon to the

Ensure that the level and composition company's remuneration policies to
of remuneration is sufficient and enable investors tounderstand:
reasonable and that its relationship to • The costs and benefits of those
corporate and individual performance is policies; and
defined. • The link between remuneration
paid to directors and key
- executives and corporate
performanc.e.
- 9-b. The board should establish a
remuneration committee.
'
9-c. Clearly distinguish the structure of non-
executive director's remuneration from
that of executives.
9-d. Ensure that payment of equity-based
executive remuneration is made in
accordance with thresholds set in
plans aooroved by shareholders.
.
12 Chapter 1
10-a Establishand disclose a code of
1O. Recognize the legitimate interests of conduct to guidecomplianc_ with legal
stakeholders. Recognize legal and other
and other obligations to legitimate
obligations to all legitimate stakeholders. stakeholders.
REVIEW QUESTIONS
Questions
I. What does governance mean?
2. Explain whether the following statement is ttu.eor false.

"Governance isexercised only by the gove 1imenl of a cozmlly".
3: Explain how governance can be used in the following contexts and give
appropriate examples:
a. national governance
b. local governance
c. corporate governance
d. international governance
4. Explain briefly the eight (8) basic characteristics of good governance.
5. Transparency and accountability arc synonymous. Explain whether the

statement is correct or not.
6. Explain whether the following statement is true or false.

"Respvnsiveness usually resulfs to t1{ectfre11ess and efficiency".
7. Define C1'rporate governance.
8. \Vhat does corporate governance structure involve?
9. State the purpose of corporate governance.
I 0. Explain the basic objectives of corporate go..,emance.
11. Explain the three basic principle of effective corporate governance.

/111rod11ctio11to C'm1,oratc Govi:rmm ·c 13
ft{u/tiple Choice Questious
I. 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?
c. 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 c;orporation?
2. 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?
c. Does the· composition 111ix 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 ,
ma ing?
3. "Transparency and full disclosure" principle advocates the following

except ·
a. Sound dfsclosure policies and practices
b. Solid foundations for management oversight
c. Meeting the information needs of investment communities
d. Safeguards integrity in financial reporting
4. The ·rights of shareholders ca 1 be effectively upheld through the

followina measures except
a. By e tablishing an audit committee
b. By designing and disclosing a communications strategy to-promote
affective communication with shareholders.
c. By encouraging active participati?n at general meetings.
d. By requiring the external auditor to attend the annual general
meeting and to answer questions about the audit.
14 ('hnJlfcr f
S. T0 nf g11:1rd integrity in finnncial reporting, the business firm should do

the following except
:i. Estnblish an audit committee
b. Request the external auditor to attend the annual general meeting
c. Disclose the fu11ctions reserved to the board and those delegated to
management
d. Disclose the policy concerning trading in company securities by
directors, officers and employees.
6. To encourage enhanced performance by the board and management, it is

recommended that the following should be.adopted except
a. 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
7. The characteristic of good governance "'.here fair legal framework are
enforced impartially is . .
a. Participation
b. Rule of Law
c. Equity
d. Accountability
CORPORATE GOVERNANCE
RESPONSIBILITIES AND
ACCOUNTABILITIES
P.xpectea Leaming 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 shareholaers 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 partie_s in a corporate setting
CHAPTER2
CORPORATE GOVERNA CE RESPONSIBILITIES
AND ACCOUNTABILITIES
INTRODUCTION
Many of the characteris.tics of good governance described in Chapter_ 1 re

relevant to both SME's and large listed pubiic companies. As an 9rgan1zat1on
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 (?rganizations. "There is no simple universal formula for good governance".
Instead emphasis is many localities, has been to encourage or:ganizations 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 framewo k, and the issu,es relating to each element, are set
out on the following pages and are relevant to oi:ganizations 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 mi&ht 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:
Cor1iorr,1..: GcJ1·cma11ce lfr.1pcmsihililit's OIi(/ 1lcc"1111tohilities 17
it' 1lOSTN•S\.KHElPRl3ET\VEEN SHAREHOLDERS/ OWNER(S) AND

· ' OLDERS
T! l:io i hip between the shareholde;s / owners. management and other

s e 10 ers tn a corporation is shown below.
.
Public Corporation Stakeholders
Board of Directors Shareholders / Owners
Executive ManaQement External Auditors

Delegate Have
Shareholders / Owners
. .
'
Respon_sibilities
Accountabilitie5
I
Operational ManaQement
. Regulators I
.
Internal Auditors Society and 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 manage ent 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; managetnent can influence
who sits on the board and the audit committee as well as other governance
contcols that might be put into place.
In return for the responsibilities (and pow r) given to management and the
board, governance demands accountability back through the system to the
shareholders.
• However, the accountabilities do not extend o n. ly to the sharehol.ders.
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 la vs of society
and to meet various requirements of creditors, employees and the stakeholders.
b-:.1z:i !::TOO"' of stakeholders has
·an interest the qua f"Ity of cordporate
. ·m
· · - ,.., . . · erfonnance an t 11e
l;U" ,etrm ;:;e u :se it has a relan onsh1 p to econom ic p t av e
-...,F' :i,.of fi:-.zocra! reporrin • for example, it is likely that many empldoy e.s 1dt
--:z ,- , :; , - .. :
2
="t"V- ,-==,.-ed-.m pens.ion plans. Th ose pen.·s10 n·
.,= i..
plans arenW
.:es1
.-.-gne .th.•.o . . u . _
e
;:ett fi:12n interests of those employees in their retrreme ·.
t e use
.
ial
.dS<:..ici - i_o the di-agram to indicate t!tose br ad interests._In s1m1: ;;:.
er....,.i!o;.ees anj creditors ha\"e a vested interest rn the org mzation an
g{ :00.. Remila:rors a response to society's wishes to. ens 1brel t1iadt
P
t:r.g;- , io:is, in their pursui• t of returns for the·ir owners, a ct responsr y
• .: an
c- ,,er-.:.:e i:J co:np!iam:e with relevant laws.
'1,1:ile srcfu-eho[ders / o,.,ners delegate res nsibilitie.s to arious parties with r ,iie
ro::po:.cli.Jn, they also require accountab,lrty as to hO\\ well the resour e t mt
b:.,:e been en!ru:.,ed ro management and the board have been used. For example.
tte o,,n .s,,.,.mt accountabilrt)' on such ,hings as:
• Fir.ar.£ia! pe,formance
• Fmar.cial transparency - financial statements that are clear with full
disctosure and that reflect tJ1e under!:ing economics of the company.
• Stel ardship, including how well the compnn: protects and manages the
resources entrusted to iL
.. Q--.miily of uuemal control
• Cmr.pcs.ition of the board of directors and the nature of its activities,
incfw:ling information on ho, well management incentive systems are
aligned with the shareholders' best interests.
raeowners wanr disclosures from management that are accurate andobjectively

, erifi_-,bie. For inst2nce. management has "' respensibility to pro,•ide financial
reports, a1d in samecases. reports on internal control effecti,eness. Management
has a s nad me primary nsponsibility for the accuracy and completeness of
2-, o.ganization's iinan:ial statemeJHs. From a financial reporting perspective, it
is rr. ,., en(s responsibility to:
• CJ-,oos.e which accounrrng principles best portray the economicsubstance

of c.:,:np:m: transa-ctions.
• · fr.:;:>!emema 5:S?em of internal control that assures completeness and
a'C.:l:ra:}' in fir.an:ial reportt.'lg.
• frst:rc £ha! the fuunciaf stalements contain accurate and complete
di3Clost.re.
Corporate Gov rnance Responsibilitiesand Accountabilities 19
PARTIES INVOLVED IN CORPORATE GOVERNANCE:

THEIR RESPECTIVE BROAD ROLE AND SPECIFIC
RESPONSIBILITIES
Corp_orate governance and financial reporting reliability are receiving con 1derabl
attention from a number of parties including regulators, standard setting bodies, the
accounting profession, lawmakers and financial statement users.
Party Overview of Resoonsibilities

1. Shareholders Broad Role:
Provide effective oversight through election of board members, •
approvat of major inltialives such as buying or selling stock,
annual reports on manaaement compensation, from the board.
2. Board of Directors Broad Role:

The major representative of stockholders to ensure that the
organization isrun according to the organization'scharter and that
there isproper accountability.
Specific activities include among others:

1. Overall Operations
,,
• Establishing the organization's vision, mission,
values and ethical standards.
• Delegating an appropriate level of authority to
management.
0 • Demonstrating leadership.
• Assuming responsibility for the business
relationship with CEO including his 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 . . • · d
• Ensuring the organizalion's_l?ng term viability an
enhancing the financial pos1t1on. .
• Formulating and overseeing Implementation of
corporate strategy. ..
• Approving the plan, budget and corporate polici.es
• Agreeing key performance' indicators {KPls)
• Monitoring I assessing assessment, performance of
the organization, the board itself, management and
..
major projects.
Overseeing the risk manc,igement framework nd
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 .

'
• Urderstanding_and protecting the
organization's financial position.
• Requiring.andmonitoring 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 I sensitive reports.
I • Ensuring an effective system of internal controls
exists and is operating as expected.
3. Non-Executive or Broad Role:

I
Independent
Directors The same as the broad role of the entire board of directors
.
• to understand the organization, its business

its operating environment and its financial
position,
• to apply expertise and skills in the
organization's best interests,
• to assist management to keep
performance objectives at the top of Its
.•
Corporatt! Govr/'/la11ce Respo11sibilities and Acco1111tabilllies 21
• tounderstand that hisfller role is not to act as

auditor, nor to act as a member of the
management team, '
• to respect the collective, cabinet nature of the
board's decisions,
• to prepare for and attend board meetings,
• to seek information on a timely basis to ensure
that he/she is in a position to contribute to the
discussion when amatter comes before the
board, or alert the chairman in advance to the
need for further information in.relation to a
particular matter, and
• uestions relative lo o erations.
4. Management Broad Role:
Operations and accountability. Manage the organization

effectively; provide accurate and timely reports to shareholders
and other stakeholders. .
• recommend the strategic direction and translate the

strategic plan into the operations of the business
• manage the company's human, physical and financial
resources·toachieve the organization'sobjectives -
run the business
• assume day to day responsibility for the organization's
conformance wiJh relevant laws and regulations and its
compliance framework
• develop, implement andmanage the organization'srisk
management andinternal control frameworks
• deve'Jop, implement and update policies and procedures
• be alert to relevant trends in the industry and
the organization's operating environment
• provide information to the board
• act as conduit between the board and the organization
• developlng financial and other reports that meet public,
stakeholder and regulatory reQuirements. ·
22 Chapter 2
5. Audit Committees of the Broad Role:

.
Board of Directors
Provide oversight of the internal and external audit function and
the process ofpreparing the annual financial statements as well
as public reports on internal control.
. • 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 (Internal Auditor)
• Reviewing and approving the scope and budget of
the internal audit function
• Discussing audit findings with internal auditor
and external auditor and advising the board (and
manaQemenll on specific actions that should be taken
6. Regulators Broad Role:

a. Board of
Accountancy Setaccounting and auditing standards dictating underlying
financial reporting and audiUng concepts; set the expectations of
audit quality and ccounting quality.
• Conducting CPA Licensure Board Examinations
.
• Approving accounting principles
. • Approving audiUng standards
• lnte reting previously issued standards implementing
quah y ntrol processes to ensure audit quality
• Edu ating members on audit and accounting
requirements
•
l
I b.
_S:11rp11r'!!.(!J:_r1vernum;e H11,'fjJ!:f111bllltle,r and A_::cr,untuhill(let: 23
Socurltlo3an() Broa,1Bola:
Exchango
Commission En0urelho accuracy, timolinr;33and fairm:33ofriuhlic reporting of
financial and other inforrnationforpublir; etJmp8ni r;.
.Spqcific acl/vl//cm /nc/udoamong ofhom:

• Reviev/Jng filings with the SEC
• lnleractin(Jwilh theFinancial Reporting Standards
Council in BfJllil'ITacJ t..ounting standards
• Specifyingindependence standardsrequirf:d of auditors
that report on public financial staternr;nts
• Identify corporatefrauds, investigatecauses, and
suaaestrr:medial actions
7. External Auditors Broad Role:
Perform audits of company financial statementsto ensure that the

statements are free ofmaterial misstatementsincluding
misstatements that may be due to fraud.
• Audit of public company financial statements

• Audits of nonpublic company financial statements
• Other services such as tax or consultinq
8. Internal Auditors Broad Role:
Perform audit of companies for compliance with company policies

andlaws, audits to evaluate the efficiency of operations, and
periodic evaluation and tests of controls.
Specific activitiesinclude among others:
• Reporting results and analyses to

management (including operational
management) and audit committees ,
• Evaluatinq internal controls
24 Chopra_
REVlE'\\1 QUESTIONS
Questions
l. ..Small business enterprises donot need good governance"

Do you agree? Explain.
2. Does good governance require absolute rules that must bedopted byall
organizations? -
3. \Vhat is the essence of any system of corporate governance?
4. \Vhere does the board of directors derive its authority?
5. To whom is the board of directors accountable?
6. On what aspects do shareholders demand accountability from the board

of directors?
7. What is management's responsibility as far.as financial r porting 1s

concerned?
8. Describe thebroad role of the shareholders in a corporation.
9. Describe the broad role of the Board of Directors.
I 0. What are the specific activities of the board of directors?
1l1ultiple'Choice Questions
I. Approving annual financial reports and other public documents ·are

specific responsibilities f
a. Management
b. Board of directors
c. Shareholders
d. Employees
Corpora/e Govemance Responsibilities and Acco11ntabi/i1ies 25
2· Providing oversighl of the internal and ext!!rnal audit function, the
process of preparing the annual financial statements and public reports
on internal control are the responsibility of ·
a. Board of directors
b. Chief executive officer
c. Chief financial officer
d. 'Audit committee of the board of directors
3. Who is responsible for ensuring the accuracy, timeliness of public

reporting of financial and other information for public companies?
a. External auditors-
b. Securities and exchange commission
c. Shareholders
d. Board of Accountancy.
4. Who performs audit of compani s for compliance with company policies

and laws, audits efficiency of operations and periodic evaluation and
tests of controls?
a. External auditors ,
b. Internal auditors
C. Comm.ission on audit
d. Chief accountant
5. An independent director is expected to

a. Apply expertise and skills in the corporations best interest
b. Asset management to keep performance objectives at the top of its
agenda
c. Respect the collective, cabinet nature of the board's decision
d. Act as conduit between the board and the organization
SECURITIES AND
EXCHANGE COMMISSION-
(SEC) CODE OF CORPORATE
GOVERNANCE
<£.v,ectea£earning Outcomes
1. Understand the need for the Gode of Governance for·publicly-listed
companies.
2. Know the sixteen (16) governance responsibilities of the Board of
Directors of publicly-listed companies. .
3. Explain the meaning of "comply and.explain" approach.
4. Qescribe the threP. aspects of the Code, namely
• Principles
• Recommendations·
• Explanations
5. Know what constitutes a competent board and how can it be
established.
6. Understand the composition, functions and responsibilities of the_

board committees- that can be established such as the
• Audit Committee
• Corporate Governance Committee
• Board Risk Oversight Committee
• Related Party Transaction Committee
•
7. Know how the directors can show full commitment to the company
8. Understand how independence and objectivity of the board can be

reinforced and enhanced.
•
9. Describe how the performance and effectiveness of the board
can·be assesse_d.
CHAPTER 3
SEC CODE OF CORPORATE GOVERNANCE FOR

PUBLICLY-LISTED COMPANIES
("CG Code for PLCs")
Securities and Exc1tange Commission
SEC MC No. 19, Series of 016 *
On November 10, 2016, the Securities and Exchange Commission approved the
Code 9f Corporate Governllnce for publicly-listed companies. Its goal is to help
companies develop and sustain an ethical corporate culture and°keep abreast with
recent developments in corporate governance.
One of its salient provisions is for publicly-listed companies to establi h a code

of business conduct and submit a new manual on Corporate Governance that
would "provide standards for professional and ethical behavior as well as
articulate acceptable and unacceptable conduct and prac ices". The Board of
Directors is required to impl ment the code and make sure that management al)d
employees comply with the internal policies set.
While many companies have already developed thejr Code of Business Conduct
and Ethics, the real challenge. is in its implementation and monitoring
compliance.
The SEC Code of Corporate Governance is published in this book, not only to
acquaint readers particularly future professionals and businessmen of these rules
and regulations but also to serve as reference and guidelines to-currently existing
publicly-I isted corporations.
(Source: 111111w.sec.gov.ph)
_2_s_c_·1_".:.'P_l,_:r_3 - --------
CODE OF COllPOllATf1: GOVl HNAN<,: ft'Of<
PUJll,JCl,Y-LfST.fl.:f> COMl'ANIJ!,S
TIIE BOARD'S GOVf RNANCf; RESPONSJUff.,JTff•;S
Principle I: Thecompnny should be headed by u eompctc11t,workingbon ·cl

10 foster the long-lermiucccRllof'lhc corporation, and_ toHU/ll ,n
its compelilivcncss and profitability in a manneor nsrnt·enl
w1_lh its corporate objeclives and 1he long-lerm best ,ntcrcstr,
of 1111
Principle 2: shareholders and other swkeholders,
The fiduciary'roles, responsibilities and accounlab!lities oft' he
Board us provided under the luw, the cornpany's urt1clcH and hy
laws, und other legal pronqunccments and guidelines fihould be
clearly made known to all directors a,; well as lost?ckholdcrn
Principle 3: and other stakeholders.
Board committees should be set up lo the extent possible to
support the effective performance of the Board's functions,
particularly with respect to uudit, risk management, related
party transacti'ons, and ol)ler key corporate governance concerns,
such as nomination and remuneration. The composition,
functions and responsibiliti.es of all committees established
Principle 4:
should bc contained in a publicly available Committee
Charter.
.
To show full commitment to lhe company, the directors should
devote the time and allcnlion necessary to properly and
effect!vely_ perform t_hci _duti s and responsibilities,
Principle 5:
including sufficient tune to be famrlrnr with the corporation's
business.
Principle 6:
The Board should endeavor to exercise objective and
independentjudgmenl on all corporate affairs.
The best measure of the Board's effectiveness is through an

assess ent process.. Th_e Board should regularly carry out
cvaluatron_s to apprarsc ,ts performance .is a body, and
Principle 7:
assess whether , posscsscs the right mix of backgrounds and
compctcncres.
Members
of he
_Board arc
duty-bound
to apply
high
ct.hical
standards,
takrng 11110
account the
interests of
all
stakeholder
s.
SECCode of Corpora/e Governance 29
DISCLOSURE Al\1) TRANSPARENCY
Principle 8:
The company should establish corporate disclosure policies and
proc dures that are practical and in accordance with best
practices and regulatory expectations.
Principle 9:
The ompany should estabIish standards for the appropriate
selection of an external.auditor, and exercise effective oversight
of the same to strengthen the external auditor's independence
and enhance audit quality.
Principle10:
The company should ensure that material and reportable non
financial and sustainability issues are disclosed.
Principle 11: . The company should maintain a comprehensive aJ'!d cost
efficient communication channel for disseminating relevant
information. This channel is crucial for informed decision
making by investors, stakeholders and other
Interested users.
INTERNAL CONTROL SYSTEM AND RISK MANAGEMENT FRAl\

fEWORK
Principle 12: To ensure the integrity, transparency and proper governance in

the conduct of its affairs, the company should h?ve a strong
and effective internal control system and -enterprise risk
management framework.
CULTIVATING A SYNERGIC RELATIONSHIP WITH

SHAREHOLDERS
• • l3· Tile company should treat all shareholders fairly and equitably,
P
nnc1p1e andalso recognize, protect and f:ac1·11· tate the J
t 1e•ir
.
exerc·ise of rights.
30 Chapter 3
DUTIES TO STAKEHOLDERS
. d b I w by contractual
Principle 14: The rights of stakeholderse stabhshe y t ents must be
0
relations and through volu ta1? : ;: r interests are at
h'
respected. Where stakeholders ngh ortunity to obtain
stake, stakeholders should hav.e te. opp . . hts
prompt effective redress for the v1olat1on of their ng .
• • t· hould be deve loped to
Principle 15: A mechanism for employee part1 c1 pa ions ,
create a symb1•ot1•c envi•ronment, rea11• the company s goa1s
e
2 ·
and participate in its corporate govern nce processes.
Principle 16: The company should be socially responsible in all its dealin s
with the communities where it operates. It should e sure th t-
its interactions serve its environment and stakeholders 1 a
positi e and progressive manner that is fully supportive of its
comprehensive and balanced development.
INTRODUCTION
I . The Code of Corporate Governance is_intended to raise the corporate

governance standards of Philippine·corporations to a level at par
with its regional and global counterparts. The latest G20/OECOI
Principles of Corporate Governance and the Association_ of
Southeast Asian Nations Corporate Governance Scorecard were
used as key reference materials in the drafting of this Code.
2. The Code will adopt the "comply or explain" approach. This

approach combines voluntary compliance with mandatory
disclosure.. Companies go not have to .comply with the Code, but
they must state in- their annual corporate governance reports whether
they comply with the Code provisions, identify any areas of non
compliance, and explain the reasons for non-compliance.
3. The Code is arranged as follows: Principles, Recommendations

and Explanations. The Principles can be
considered as high-level
state_ments of corporate governance good practice, and are
applicable to all companies.
SEC Code of Corporate Governance 31
4
· :he ecommendations are objective criteria that are intended to
h enttfy the specific features of corporate governance good practice
1
at are recom ended ·for companies operating accor in to e

od . Alternatives to a Recommendation may be Justified
m
particular circumstances _ifgood governance can be achieved
by 0ther means. When a Recommendation is not complied with,
the
comp ny must disclose an describe this non-compliance, and
explain how the overall Principle is being ac.hieved. The
alternative should be consiste'nt with the overall Principle.
Descriptions and explanations should be written in·plain language
and in a clear, complete, objective and precise manner, so that
shareholders and
. other stakeholders can assess.the company's governance framework.
'
5. The Explanations strive to provide companies wi th additional
information on the recommended best practice.
This Code does not, in any way, prescribe a "one size fits all"
framework. It is designed to allow boards some flexibility in
establishing their corporate governance arrangements. Larger
. companies and financial instit1._1tions would generally be expected to
follow most of the Code's provisions. Smaller companies may
decide that the costs of some of the provisions outweigh the
benefits, or are less relevant in their case. Hence, the Principle of
Proportionality i.s considered in the application of its provisions.
6. The Code of Corporate Governance for publicly listed companies is

the first of a series of Codes that is intended to cover all types of
. corporations in the Philippines under supervision of the Securities
and Exchan e Commission (SEC).
7. Definition of Terms:
Corpo ate Governa ce - t!1 syste1 of stewardship and ontrol

to guide organization 1 . fulfilling their _long-term economic,
moral, legal and social obligations towards their stakeholde .
Corporate governance is a system of direction, fee back nd ontrol

sing regulations, performance standards and ethical gu1delmes to
old the Board and senior management accountable for ensuring
thical behavior - reconciling long-term customer satisfaction with
:hareholder value - to the benefit of all stakeho!ders and soci ty.
32 Chapter 3
Its purpose is to maximize the organization's long-term success,

creating sustainable value for its shareholders, stakeholders and the
nation.
Board of Directo - the governing body elected by _the

stockholders tl1at exercises the corporate powers of a corporation,
conducts all its business and controls its properties.
Management - a group of executives given the au_thority b_y the

Board of Directors to implement the policies it has lard down m the
conduct of the business of the corporation.
Independent director - a person who is independent f

management and the controlling shareholder, and is free from any
business or other relationship which could, or could reasonably be
perceived to, materially interfere w.ith his exercise of independent
judgment in carrying out his responsibilities as a director.
. .
Executiv director - a director who has executive responsibility of

day-to-day operations of a part or the whole of the organization.
Non-executive director - a director who has no executive

responsibility and does not perform any work related to the
operations of the corporation.
Conglomerate - a group of corporations that has diversified

business activities in varied industries, whereby the operations of
suc_h businesses are controll d and managed by a parent corporate
entity.
Internal control - a process designed and effected by the board

of di_rectors, senior management, and all levels of personnel to
providereaso able assuranc on the achievement of objectives
throug!1 efficient an_d effective operations; reliable, complete
and t_1mely fi_nanc,al and management information; and
comp(tan e, with_. applicable laws; regulations, and the
orgarnzat,on s poltc,es and procedures.
1
Organization/or Economic Co-operation and Development
. SECCode of Corporate Governance 33
Enterprise Risk Management - a process, effected by an entity's

Board of Directors, management and other personnel, applied in
strateg_ysetting and across the enterprise that is designed to
identify
ote tial events that may affect the entity, manage risks to be within
its isk appetite, and provide reasonab.le 11ssurance regarding the
achievement of entity objectives.2 •
Rel ted Party - shall cover the company's subsidiaries, as well as

affih_ates a d any party (including their subsidiaries, affiliates and
special purpose entities), that the company exerts direct or indirect
control over or that exerts direct or indirect control over the
company; the company's directors; officers; shareholders and
related interests (DOSRI), and their close family members, as well
as .corresponding persons in affiliated companies. This shall also
include such other person or juridical entity whose interest may
pose a potential conflict with the in erest of the company.
Related Party Transactions - a transfer of resources, services or

obligations between a reporting entity and a related party,
regardless of whether a price is charged. It should be interpreted
broadly to include not only transactions that are entered into with
related parties, but also outstanding transactions that are entered
into with an unrelated party that subsequently becomes a related
party.
Stakeholders - any individual, organization or society at large

who can either affect and/or be affected by the company's
strategies, policies, business decisions·and operations, in general.
This includes, among others, customers, creditors, employees,
suppliers, investors, as well as the government and community in
which it operates.
1Committee v/Sponsoring Organizations of the Treadway Commission (COSO

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S£C Code o/Corporute CJovernunce 37
co, mittee meetings and the annual board calendar, and assisting the
chair of the Board and its committees to set agendas for those
meet111gs;
b. Safekeeps and preserves the integrity of the minutes of the

meetings of the Board and its committees, as well as other official
records of the corporation;
c. eeps abreast on relevant laws, regulations, all governance

issuances, relevant industry developments and operations of the
corpMation, and advises the Board and the Chairman on all relevant
issues as they arise;
d. \Yorks fairly and objectively with the Board, Management and

stockholders and contributes to the flow of information between the
Board and management, the Board and its committees, and the
Board and its stakeholders, including shareholders;
e. Advises on the establishment of board committees and their terms

of reference;
f. Informs members of the Board, in accordance with.the by-laws, of

the agenda of their meetings at least five working days in advance,
and ensures that the members have before them accurate
information that will enable them to arrive at intelligent decisions
on matters that require their approval;
g. Attends all Board meetings, except when justifiable causes, such as

illness, death in the immediate family and serious accidents, prevent
him/her from doing so;
h. Performs require·d administrative functions;
I. Oversees the drafting of the by-laws and ensures that they conform
with regulatory requirements;.and
Performs such other duties and responsibilities as may be provided

J· by the SEC.
38 Chapter 3
Rccommcndntion 1.6
The Board should ensure that it is assisted ln its duties bya Compliance
Officer, who should have a rank of Senior Vice Presi ent. or an
equivalent position with adequate stature and authority 111 the
corporation. The Compliance Officer sbould not be_ member of the
Board of Directors and should annually attend a trammg on corporate
governance.
Explanation
• The Compliance Officer is a·member bf the company's management

team in charge of the' compliance function. Similar to the Corporate
Secretary, he/she is prjmarily liable to the corporation and its
shareholders, and not to the Chairman or President of the company.
He/she has, among others, the following duties and responsibilities:
a. Ensures proper onboarding of new directors (i.e., orientation on the

company's business, charter, articles of incorporation and by-laws,
among others);_ ·
b. Monitors, reviews, evaluates and ensures the compliance by the

corporation, its officers and directors with the relevant laws, this
Code, rules and regulations and all governance issuances of
regulatory agencies;
c. Reports the matter to the Board if violations are found and

recommends the imposition of appropriate disciplinary action;
d. Ensures the integrity and accuracy of all document.ary s u b m1· ss1·

ons to regulators;
e. Appears before the SEC when summoned in relationt

with this Code· 1·
'
0
comp 1ance
f. Collaborates with other departments to properly add •
·issues, w h" h
1c may b ·
e subJect to investigation; ress comp 1ance
1
g. Identifies possible areas of compliance issues and k

resolution of the same· wors towards the
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SliC <'odl'11/ Corp1Jra/c Go11emt111c:e_ 43
Thti n mination and election process ulso includes the review and
· I !oadr ,
. .evalua.tion of the qun11·11· cnt·1ons nil persons nom1 11atcd to 1
of 1cI
m:lu ing "hether candidates: (I) possess the knowledge, skills,
xpenence. and particularly in the case of non-executive directors,
• dependence of mind given their responsibilities to the Board and in
,ght ?f the entity's business and risk profile; (2) have a record of
mtegnty and good repute: (3) have sufficient time to carry out their
responsibilities; and (4) have the ability to promote a smooth interaction
between board members. A good practice is the use of professional
search firms or external sources when searching for candidates to the
Board. ·
In addition, the process also includes monitoring the qualifications of

the directors. The qualifications and grounds for disqualification are
contained in the company's Manual on Corporate Governance.
The following may be considered as grounds for the permanent

disqualification of a director:
a. Any person convicted by final judgment or order by a competent

judicial or administrative body of any crime that: (a) involves the
purchase or sale of securities, as defined in th Securities Regulation
Code; (b) arises out of the person's conduct as an underwriter,
broker, dealer, investment adviser, principal, distributor, mutual
fund dealer, futures commission merchant, commodity trading
advisor, or floor broker; or (c) arises out of his fiduciary
relationship with bank, quasi-bank; trust company, investment
house or as an affiliated person of any of them;
b. Any person ho, by reason of misconduct, after hearing, is

permanently enjoined by a final judgment or order. of the SEC,
Bangko Sentral ng Pilipinas (B P) or any court or administrative
body of competent jurisdiction from: (a) acting as underwriter,
broker, dealer, investment adviser, principal distributor, mutual
fund dealer, futures commission merchant, commodity trading
advisor, or floor broker; (b) acting as director or officer of a bank,
quasi-bank, trust company, investment house, or investment
company; (c) engaging in or continuing any conduct or practice in
any of the capacities mentioned in sub-paragraphs (a) a (b) above,.
or willfully violating the laws that govern securities and
banking
activities.
44 Chapter J
The disqualification should also apply if (a) such person is the

subject of an order of the SEC, BSP or any court or
administrative body denying, revoking or suspending any
registration, license or permit issued to him under the Corporation
Code,
Securities Regulation Code or any other law administered by the

SEC or BSP, or under any rule or regulati n issued by. the
Commission or BSP; (b) such person has otherwise been_
restrained to engage in any activity involving securities and
bankrng; or (c) such person is the subject of an effective order of
a self-regulatory organization suspending or expelling him from
membership, partidpation or association with a member or
participant of the
0rganization;
c. Any person convicted b) final judgment or order by a court, or

competent administrative body of an offense involving moral
turpitude, fraud, embezzlement, theft, estafa, counterfeiting,
misappropriation, forgery, bribery, false affirmation, perjury or
other fraudulent acts;
d. Any person who has been adjudged by final judgment or order of

the SEC, BSP, court, or competent administrative body to have
willfully violated, or willfully aided, abetted, counseled, induced
or procured the violation of any provision of the Corporation
Code, Securities Regulation Code or any other law, rule,
regulation or order administered by the SEC or BSP;
e. Any personjudicially declared as insolvent;
f. Any pe_rson found gu lty by final judgment or order of a foreign

court or_ equivalent_fi anc1al regulatory autl1ority of acts,
violations or
misconduct s1m,_lar to any of the acts, violations or miscondu'Ct
enumerated previously;
g. on iction by final judgment of an offense punishable

by impnson ent for mor than six years, or a
violation of the
c orp rat,on Co e committed within five years prior to the date of his
e1 ect1011 or appomtment; and
h. Other grounds as the SEC may provide
...:•.:.:W...::C:_:CoJt' of Corpora/,:Clover ,,n
- 11 (.'(> 4
Inadc i1io11, the.following may he grounds/or temporary disqualification
of a director:
a. Absence in more lhan fifty percent (50%) of all regular and

special meetings of the Board during his incumbency, or any 12-
month period during the said incumbency, unless the absence is
due to illness, death in the immediate family or serious accident.
The disqualification should apply for purposes of the succeeding
election;
b. Dismissal or termination for cause as director of any publicly-

listed company, public company, registered issuer of securities
and holder of a secondary license from the Commission.
The.disqualification should be in effect until he has cleared
himself from any involvement in the cause that gave rise to his
dismissalor termination;
c. If the beneficial equity ownership of an independent director in

the corporation or its subsidiaries and affiliates exceeds two
percent (2%) of its subscribed capital stock. The disqualification
from being elected as an independent director is lifted if the limit
is later complied with; and
d. If any of the judgments or orders cited in the·grounds for

pennanent disqualification has not yet become final. \
Recommendation 2.7
The Board should have the overall responsibility in ensuring that there
is a group-wide policy and system governing related party
transactions (RPTs) and other unusual or infrequently occurring
transactions, particularly those which pass certain thresholds of
materiality. The policy should include the appropriate review and
approval of material or siiniQcant RPTs, which guarantee fairness and
transparency of the transactions. The policy should encompass all
entities within the group, taking into account their size, structure, risk
profile and complexity of operations.
Explanation
Ensuring the integrity of related party transactions is an important

fiduciary duty of the director. It is the Board's role to initiate policies
and measures geared towards prevention of abuse and promotion of
.1.:...rrtt.·1, · '..
. .t r ble laws and regulations to
h
tmnspm ncy. and in compltnncewi a6p ,en ch measure is the required
Pl'\.'k'Ct the interest of nil shareholder:-. ne.su "ficant RPTs approved by
ratification by shareholders 0_f mat n l or,:!;' ther measures
include the Boar\'i. in accordancewithexisting .' t arm's-
length basis . at market prices, a
nsuring that transactions occur '. h of all shareholders.
and under conditions that protect the ng ts
.
The following are suggesti ons for the conten °
t f the RPT Policy:
• Definition of related parties;

• Coverage of RPT policy;
• Guidelines in ensuring arm's-length terms;
• Identification and prevention or managem.ent 0
potential or actual conflicts of interest which anse;
• Adoption of materiality threshQlds; •.
• Internal limits for individual and aggregate exposures,
• \Vhistle-blowing mechanisms, and . . ·
• Restitution of losses and qther remedies for abusive RPTs.
In addition, the compal"!y is given the discretion to set their materia!

ity threshold at a level where omission or misstatement of the
transaction could pose a significant risk to the company and influenc its
economic decision. The SEC may direct ,a company to reduce its
materiality threshold or amend excluded trans ctions if the SEC deems
that the threshold or exclusion is inappropriate considering the
company's size, risk profile, and risk manageme t systems.
Depending on the materiality threshold, approval of management, the

RPT Committee, the Board or the shareholders may be required. In
cases where the shareholders' approval is required, it is good practice
for interested shareholders to abstain and let the disinterested parties or
majority of the minority shareholders decide.
Recommendation 2.8
The Board_ should be primarily responsible for approving the selection

and as essmg the performance of the Management led by the Chief
Executive .Offic.er (CEO), and.control functions led by the·tr
respect1·ve
heads Chief Risk Officer, Cluef Compliance Officer, and Chief Audit
Executive).
SECCode of Corporate Governance 47
Explanation
It is 'the res 'b• 1

pons, 1 1· ty of the Board to appoint a competent
team at all t· .
management •mes, mon itor and assess the
performance of the
man gement team based on established performance standards that are
consistent _with the compai1y's strategic objectives, and conduct a
; gul r re iew of the company's policies with the management team. In
,e selection process, fit and proper standards are to be applied on key
personnel .and d 1e consideration is given to integrity, technical
expertise and experience m the institution's business, either current or
planned.
Recommendation 2.9
The Board should establish an effective performance management

framework that will ensure that the Management, including the Chief
Executive Officer, and personnel's performance is at par with the
standards set by the Board and Senior Management.
Explanation
Results of performance evaluation should be linked to other human

resource activities such as training.and development, remuneration, and
succession planning. These should likewise form part of the assessment
of the continuing fitness and propriety of management, including the
Chief Executive Officer, and p'ersonnel in carrying out heir respective
duties and .responsibilities.
Recommendation 2.10 .
The Board should oversee that an appropriate internal control system is

in place, including setting up a mechanism for monitoring and managing
potential conflicts of interest of Management, board members, and
·shareholders.The Board should also approve the Internal Audit Charter.
'
Explanation
In the performance of the Board's oversight responsibility, the minimum
internal control mechanisms may include overseeing the implementation
of the key control functions, such as risk management, compliance and
internal audit. and reviewing the corporation's human resource policies,
48 Chapter 3
conflict of interest situations, compensation program for employees and
m anagement succession plan.

.
Recommendation 2.11
The Board should oversee that a sound enterprise risk management
(ERM) framework is in place to effectively identify, monitor, assess and
manage key business risks. The risk management framework should
guide the Board in identifying units/business lines and enterprise-level
risk exposures, as well as the effectiveness of risk management
strategies.
Explanation
Risk management policy is part and parcel of a corporation's corporate

strategy. The Board is responsible for defining the company's level of
risk tolerance and providing oversight over its risk manaoement
policies and procedures. · =-
Recommendation 2.12
The B ard should have a Board Charter that formalizes and clearlv
states_ its role_s, responsibilities and accountabilities in carrying out its
fi_duc1ary _duties. The Board Charter should serve as a guide to the
d1r ctors m the performance of their functions and should be ublicl
ava!Iable.and post d on the company's website. p y
Explanation
The _Board Charter guides the directors on how. . .

functions. It provides the standards for eval . to discharge their
the Board. The Board Charter also cot . huatmg the performance of
of the Chairman. n amst e roles and responsibilities
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I. Rl"l.'('lllmCndc: to the 0oard
,I ointment. reappointment.
1 a pI I Rccreditcd by the
c
remon1I and fees of the E:-.tenwl Aud11or,
. .
cur 't aud1't of the
Comm1 ss1 on.,,ho 1111 d ertak cs or.I inclcpcnoen h b
corporntion. and provides 1•• • ssurancc on t e manner y
an ooJectrvea d andpresented to
"hich the financial statements should be prepare
the stockholders: and
m. In case the company does not Board Risk Oversi0ht
1,ave
c' ·tte perfioroms
a
Committee and/or Related Party Transactions ommi _,e
the funct.ions of comm. ·,ttees as provided under
sar.d
Recommendations 3.4 and 3.5.
The Audit Committee meets with the Board at feast every quarter
without the presence of the CEO or other management team members,
and periodically meets with the head of the internal audit.
Recommendation 3.3
The· Boardhould establish a Corporate Governance Committee that

should be tasked to assist the Board in the performance of its corporate
governance responsibilities, including the functions that were formerly
assigned to a Nomination ancl Remuneration Committee. It should be
composed of at least three members, all of whom should be
independent directors, including the Chairman.
Explanation
The orporate G_overnanc_e Committee (CG Committee) is tasked with

ensurmg com.plia. nce wd ith and proper observance of co
rporat e
gove nance pr111c1p1es anpractices. It has the tollowing duties and
functions, among others:
a. Oversees the implementation of the corpo t

framework and periodically reviews the sa·1d rae gkovernance
ht at 1t
· remams• appropriate in light of mat {iramewor . to ensure
1 1
corporation's size, complex.ity and business's r :egyc rnnges llto t
1e
business and regulatory environments· , as we as its
. '
b. Oversees the periodic performance eval f f
°
committees as well as executive ua ion ,the Board and its
ageme man nt and d .
I ce; , on uannua self-
evaluation of its performan c cts an
SEC Code of Corporate Governance 53
•
c. E!lSures that the results of the Board evaluation are shared,
iscussed. and that concrete action plans are developed and
·'.mplemented to address the identified areas for improvement;
d. Re:ommends continuing education/training programs for directors,

assignment of tasks/projects to board committees, succession plan
for the board members and senior officers, and remuneration
packages for corporate and individual performance;
e. Adopts corporate governance policies and ensures that these are

reviewed and updated r gularly, and consistently implemented in
form and substance;
f. Proposes and plans relevant trainings for the members of the Board;
g. Determines the nomination and election process for the company's

directors and has the special duty of defining the general profile of
board members that the company may need and ensuring
appropriate knowledge, competencies and expertise that
complement the existing skills of the Board; and
h. Establishes a formal and transparent procedure to develop a policy

for determining the remuneration of directors and officers that is
consistent with the corporation's culture and strategy as well as the
busin ss environment in which it operates.
The establishment of a Corporate Governance Committee does not

preclude companies from establishing separate Remuneration or
Nomination Committees, if they deem necessary.
Recommendation 3.4
Subject to a corporation's size, risk profile' and complexity of

operations, the Board should establish a separate Board Risk Oversight
Committee (BROC) that should be responsible for the oversight of a
company's Enterprise Risk Management system to ensure its
functionality and effectiveness. The BROC should be composed of at
least three members, the majority of whom should be independent
directors including the Chairman. The Chairman should not be the
Chainna of the· Board or of any other committee. At least one member
of the committee must have relevant thorough knowledge and
experience on risk and risk management.
54 Chapter 3
Explanation
The establishment of a Board Risk Oversight Co nmi teke (BfiRIOC)

is generally for conglomerates and compan·ies with a high ns pro I e.
Enterpr.ise r.isk management 1. • .
m tegral an effective cQrpo•rate
s
tO
governance process and the a c. I11evemen t o fa va1ue creatio.n
company's.
objectives. Thus the BROC has the responsibility to as_sist the Board
rn ensuring that tl ere is an effective and integrated risk
management
process in place. With an integrated approach, the Boar.d and top
management will be in a confident position to make wcll-_rnf?rmed
decisions, having taken into consideration risks related to significant
business activities, plans and opportunities.
The BROC has the following duties and responsibilities, among others:
a. Develops a formal enterprise risk management plan which contains

the following elements: (a) common language or register of risks,
(b) well-defined risk management goals, objectives and oversight,
(c) uniform processes of assessing risks and developing strategies
to manage prioritized risks, (d) designing and implementing risk
management strategies, and (e) continuing assessments to improve
risk strategies, processes and'measures:
b. Oversees the implementation of the enterprise risk management

plan through a Management Risk Oversight Committee. The BROC
conducts regular discussions on the company's prioritized and
residual risk exposures based on regular risk managementreports
and assesses how the concerned units or offices are addressing
and managing these risks;
c. Evaluates the risk n anagcmcnt plan to ensure its continued

relcvanc , comprehensiveness and c!Tectiveness. The BROCrevisits
detin d risk management strategics, looks for emerging
orchanging material exposures, and stays abreast of significant de
I
t I1at · . . ve opments
· I y unpact the h keh hood of harm or
eri ous loss,·
d. Advises the Board on its risk appetite levels andrisktolerance
limits;
e. Reviews at least annually the company's risk appetite levels and

risk tolerance limits based on changes and developments in the
business,
the. regulatory framework, the external economic and business
environment, and when major events occur that are considered to
have ma·or ·impacts on the company;
f. Assess s the probability of each identified risk becoming a reality

and estnnates its possible significant financial impact and likelihood
of occurrence. Priority areas of concern are those risks that are the
most_likely to occur and to impact the performance and stability of
the corporation and its stakeholders·,
g. Provides oversight over Management's activities in managing

credit, market, liquidity, operational, legal and other risk
exposures of the corporation. This function includes regularly
receiving information on risk exposures and risk management
activities from Management; and
h. Reports to.the Board on a regular basis, or as deemed necessary,

the company's material risk exposures, the actions taken to reduce
the r:isks, and recommends further action or plans, as necessary.
Recommendation 3.5 .
Subject to a corporation's size, risk profile and complexity of

operations, the Board should establish a Related Party Transaction
(RPT) Committee, which should be tasked with reviewing all material
related party transactions of the company and should be composed of
at least three non-executive directors, two of whom should be
independent, including the Chairman.
Explanation
Examples of companies that may have a separate RPT Committee are

conglomerates and universal!commer ial banks in r cognition of the
potential magnitude of RPTs m these kmds of corporations.
!-6 Chap'.!:1,·1,.:...:·_I .::,_,
Thu following arc tho limclions ol'thc RP'I' Commillco. 111nong others:
n. Evaluates 011 an ongoing hnsis existing rcl111io11s between n11d

nmong busiJicsscs and counterpartics 10 ensure thnl nil rclntod
pnrl ics nrc conti1111011sly identified. RPTs nre monitored, nncl
sul>scqucnt changes in relationships with co1111turparlies (frolll
11011-rolntcd lo related and vice vcrsn) nre cnplured. Related
pnrtics, RPTs nncl chnnges in relationships should bc.rcOcctcd in
t'hc relevant reports to the Board and regulators/supervisors;
b. Evaluntes·nll rnlllerinl RPTs to ensure that these nre not

undertaken on more fovorablc economic terms (e.g., price,
commissions. interest mies. lees, tenor, collnlcrul requirement) to
such related· parties than similnr transactions with non-related
parties under similar circumstnnccs and that no corporate or
business resources of the company are misappropriated or
misapplied, and to determine any potential reputntional risk issues
thnt may nrise ns a result of or in connection with the lrnnsactions.
In evaluating RPTs. the Committee takes inl'o nccount, among
others. the following:
I. The related party's relntionship lo the company nnd interest 111

the transaction;
2. The material facts of the proposed RPT, including the
proposed aggregate value of such transaction;
3. The benefits to the corporation or the proposed RPT;
4. The availnbility or other sources of' comparable productsor
services; and
5. An assessment of whcth0r the proposed RPT is on terms and
conditions that are comparable to the terms generally available
to an unrelated part 11!1der s mih1 circumstances. The company
shoul have a_11_ cftect'.ve pncc d1scove1y system in place and
exercise clue cl1l1gence III determining a fair price forRPTs;
C.
E11s1'.res that appro riatc disclosure is made. and/or information
is provrlkd.to rcgulatmg and supervising authorities relating to the
comp, nys RP exposures, and policies on connicts of interest or
potential_ conl11c1s of interest. The disclosure should include
!nformat,on Oil he approach to managing material conflicts of
rn1cres1 hat arc 111consistcn1 with such policies, andconflicts that
('( uldans.:-asa result of the company's affiliation ortrnnsactions
wnh other related parties:
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R«om111l'nllntion 4.1 . • • f
, · ·I ar11 c1 e ·111 •all meet ings o
t
pn
rhl' di1'.'.Ch'r:- should nt1e11cl n11d nct1vcJp. person or through tele-
thl' Oo:trd. C1.)t111llittccs. and Sh rchol crs:l ,11 with the rules and
• .
.\ idcl1-:m1f1.•rt:nc111g ..:onduce, d 111 uccorc
1 I nnce
. istifinble causes, sueh as,
rel!11lntil ns ot th , .. II except w ,en Jl rious accidents, prevent
C'
l)lllllltss1. ·. . d
ill icss
--: dcnth in
. the i111111ed
B
13tc lnmily an .tste ,neetings
d id Co111m1 ee , the director
them ltum doing so. In llar_ at d f. lled for ask the r1ecessary
,;;hould review meeting mntennls nn t e ,
• · •f i · 81 id e xplnnnt1ons.
ques tions or seek clan 1 ca1 1ons ·
Explso:ition .
. is evident in the amount of
th
A director's commitment to e company 'b.lities which
time he dedicates to P7rforming h.is duties an =- on mitt es and
includes his presence m all mee.tmgs o'. the , tivel erform
Shareholders. In this way, the director is able to effec y p
his/her duty to the company and its shareholders.
The absence of a director in more than fifty per ent (5?%) of
allreg_ular and special meetings of the Board during is/her •
cumbency isa ground for disqualification in the succeedmg
election unless_ the
;bsence is due to illness, death in the immediate family, serious accident
or other unforeseen or fortuitous events.
Recommendation 4.2
The non-executive directors of the Board should concurrently serve as
directors to a maximum of five publicly listed companies to ensure that
they have sufficient time- to fully prepare for meetings, challenge
Management's proposals/views, and oversee the long-term strategy of
the company.
Explanation
Being a director necessitates a commitment to the corporation. Hence,

there is a need to set a limit on board directorships. This ensui:es that
the members of the board are able to effectively commit themselves to
perform their roles and responsibilities, regularly · update their
knowledge and enhance their skills. Since sitting on the board of too
many companies may interfere with the optimal performance of board
members, in that they may not be able to contribute enough time to
keep
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60
---
Chapter J
varyingopinion'>onthe optimal number of indcpcnd nt dir t1>rn in 1:-!.:
board.I lowcvcr, the ideal number range:; from onc--third toa .sub·;tantial
majority.
Recommendation 5.2
The Boardshould ensure that its independent direc.-tors possess the
necessary qualifications and none of the disqualifications for an
independent director to hold the position.
Explanation
Independentdirectors need to possess a good generalunderstanding of
the industry they are in. Further, it is worthy to note thatindependence
and competence should go hand-in-hand. It is therefore important that
the non-executive directors, including independent directors, pos ss the
qualifications and stature that would enable them to effectively and
objectively participate in the deliberations of the Board.
An Independent Director refers to a person who, ideally:
a. Is not, or has not been a senior officer or employee of the covered

compan unless there has been a change in the controllin
ownership of the company; -
b. Is no!, and h not been in the three years immediately precedinz the·
election, a director of the covered company,· a d'irect or, offi,-cer,
emp1.toyee thde company's subsid'iar·,,es as:-.O·{:,ate-:,
covered.
of I
panies· or a director o f f 1i cer, emp.Iovee 0r'
tahffj,Iia es odr re ate ' •
com,
e cov.ere company s substantial shareholders and 'ts ., I ed
companies; I re at
c. Has ot been appointed in the covered com an . _ . . .

ssoc1ates, affiliates or related companies as h:• itsbs1d1
1es; Ex-Officio" Directors/Officers or Mb
irman Emeritus,
Board, or otherwiseappointed ina ca ac : ers_of any Ad isory
performance of its· dut,·es and respons1b1lit
P . "'. assist· theBoardm
h· the
immediately preceding his election- ies witm threeyear5
,
.
I
S£C Code of Corporate Governance 61
d.
1
1 not an owner of more than
outstanding s ares of the'covered
two percent (2%) of the
company, its subsidiaries,
associates, affiliates or related companies;
e. Is nota re Iat1· ve of a director, offic· er, or substantial

shareholder of the covered company or any of its related
companies or of any of its
substantia shareholders. For this purpose, relatives include spouse,
p rent, child, brother, sister and the spouse of such child, brother or
sister;
f. Is not acting as a nominee or representative of any director of the

•covered company or any of its related companies;
g. s not a securities broker-dealer of listed companies and registered

issuers of securities. "Securities broker-dealer" refers to any
person holding any office of trust and responsibility in a broker-
dealer firm, which includes, among others, a director, officer,
principal stockholder, nominee of the firm to the Exchange, an
associated person or salesman, and an authorized clerk of the
broker ordealer;
h. Is not retained, either in his personal capacity or through a firm, as

a professional adviser, auditor, consultant, agent or counsel of the
covered company, any of its related companies or substantial
shareholder, or is otherwise independent of Manr,gement and free
from any business or other relationship within the three years
immediately preceding the date of his election;
Does not engage or has not engaged, whether by himself or with

other persons or through a firm of which he is a partner, director or
substantial shareholder, in any transaction with the covered
company or any of its related companies or substantial
shareholders, other than such transactions that are conducted at
arm's length and could not materially interfere with or influence
the exercise of his
independent judgment;
Is not affiliated with any non-profit organization that receives
J.
significant funding fr m the covered company or any of its related
companies or substantialshareholders; and
k. Is not employed as an executive offi er of anothedr.company where

any of the covered company's executives serve as ,rectors.
62 Chapter 3
Related companies, as used in this section, refer to (a) the o e ed

entity's holding/parent company; (b) its subsidi ries; and (c) subsidiaries
of its holding/parent company.
Recommendation 5.3
The Board's -independent directors should serve for a ma imum

cumulative term of nine years. After which, the indepen ent director
should be perpetually barred from re-election a such m th_e same
company, but may continue to qualify for nomination and elect10n a s a.
non-independent director. In the instance that a company waAts to retam
an independent director who has s rved for nine years, the Board should .
provide· meritorious justification/s and seek shareholders' approval
during the annual shareholders' meeting.
Explanation
Service in a board for a long duration may impair a director's ·ability to

act independently and objectively. Hence, the tenure of an independent
director is set to a cumulative ter_m of nine years. Independen directors
(IDs) who have served for nine years may continue as a non
independent director of the company. Reckoning of the cumulative nine-·
year term is from 2012, in connection with SEC'Memorandum Circular
No. 9, Series qf2011.
Any term beyond nine years for an ID is subjected t_oparticularly

rigorous review, taking into account the need for progressive change in
the Board to ensure an appropriate balance of skills and experience.
However, the shareholders may, in exceptional cases, choose to re-elect
an independent director who fias served for nine years.· In such
instances, the Board must provide a meritorious justification for the re
election.
Recommendation 5.4
The positions of Cl airman of the Board and Chief Executive Officer

should be held by separate individuals and each should have clearly
defined responsibilities.
Explanation
To avoi conflict or a split board and to foster·an appropriate balance of

po e_r, mcre sed. a countability .and better capacity for independent
de ision-mak'.ng, 1t 1s recommended that the positions of Chairman and
Chief Execut ve Officer (CEO) be held by different individuals. This
type of organizational structure facilitates effective decision making and
good gov ance. In addition, the division of responsibilities and
acc untabtlttte between the Chairman. and·CEO is 'clearly defined and
delineated and disclosed in the Board Charter.
Th CEO has the following roles and resp.onsibilities, among others:
a. Determines the corporation's strategic direction and formulates and

implements its strategic plan on the direction of the business;
b. Communicates and implements the corporation's vision, mission,

values and· overall strategy and promotes any organization or
stakeholder change in relation to the same;
c. Oversees. the operations of the corporation and manages human and

financial resources in accordance with the strategic plan;
d. Has a good working knowledge of the corporation's industry and

market and keeps up-to-date with its core business pi.irpose;
e. Directs, evaluates and .guides the work of the key officers of the
corporation;
f. Manages the corporation's resources prudently and ensures a proper
balance of the same;
g. Provides the Board with timely information and i_nterfaces between
the Board and the employees;
I1 uilds the corporate culture and motivates the employees of the

B
. corporation; and
Serves as the link between internal operations and external
I. stakeholders.
sponsibilities of the Chairman are provided under

The roIes and re
Recommendation 2.3.
-
H.cco11111u•111I111ion -
The Board should d\1si1 1111le n lend dircclnr 11111011µ, the i_mlcpc
nll:r)l directors ii' the Chnir11111111>f' !ho; llonl'II is not l11dorc 1 on1,
11_1chId1 ¥..'.
I
the p1_,i;itio11s \II' the Chnirn1111n1f thu llonrd rmcl C.:1110I
l •,xcc11l1vc Ofrfec,
nrc hl.'ld hy 0110 person,
Expl:luntion
In c11scs where the Chnirnrnn is noL i11clcpcndc11I und where the rol s
of Chair nnd CEO nrc co111 inocl, putting in plticc proper moc_hanrs
11s ensures independent views al1d perspoclivcs, More impo1tunlly, it
uvo1ds
tho nbusc of power 11nd 111111ority, nncl pot·c11fiul conflict of interest.
A suggestod mechunis111is the appointment of u strong «!cad
director"
amQng the independent dircclo1·s. This lead director has sufficient
nuthodty to lead lh Bonrd in cases where management has clear
conllicts of interest.
The functions of Lhc lend clireclor include, among otl)ers, the following:
a. S rves as an intermediary between the Chairman and the other
directors when nccessnry;
b. Convenes and chairs meetings of the non-executive directors; and
c. Contributes to the performance evaluation of the Chairman, as
required.
Recommendation 5.6
A direc or with a mat rial interes! in any transaction affecting the

corporation should absta111 from tak111g part in the deliberations for
the same.
Explanation
The abstentio 1 of a director_from participating in a meeting when

related parry transactions, s:I f-c(ealmgs or any transactions or matters
on which 1e/she hasa matenal 111terest are taken up ensures that
he has no
11 1flu ence over the outco me of the deliberatio,,s Tl ( ' , cl
. . . · I · I u n · amental
1e ·
principle to be observed that a director does I1ot use 1 Is pos It Ion to
Is •
.
profi t o_r ga111 some benefit or advantage for his cl/ . /h
himselfa related mterests. 11 or 11s er
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SECCodeof Corporate Governance 69
Explanation
Directors
0 ft11ave access to material inside information on the
en
codmpany. Hence, to reduce the risk. that the directors might take
a rvantan::,e o. f. tl11·s ·tn 1co. rmat1•on, 1· t 1· s cruci•al for compani•es toh ave a
P icy requmng directors to timely disclose to the company any dealin2s
1th th
e company shares. It is emphasized that the policy is on intem;I
1
isc osure to the company of anv dealinos by the director in company
sl1are -. Tl1·1s supplements the re"quiremen::,t of Rules 18 and 23 of the
Securities Regulation Code.
Recommendation 8.3
The Board should fully disclose all relevant and material information
on individual board members and key executives to evaluate their
xperience and qualifications, and assess any potential conflicts of
interest that might affect their judgment.
Explanation
A disclosure on the board members and key executives' information is

prescribed under Rule 12 Annex C of the SRC. According to best
practices and standards, proper disclosure includes directors and key
officers' qualifications, share ownership in the company, membership
of other boards, other executive positions, continuous trainings
anended and identification of independent directors.
Recommendation 8.4
The company should provide a clear disclosure of its policies and

procedure for setting Board and executive remuneration, as well as the
level and mix of the same in the Annual Corporate Governance Report.
Also, companies should disclo_sethe remune:3 ion on an individual
basis, including termination and retirement prov1s1ons.
Explanation
. losure of remuneration policies and procedure enables investors to
D 1 sc . .d d. d k
un d erstand the link between the remunerati on pat to ,rectors an · ey
management personnel and the company"s performance.
7
70 Chapter 3
The Revised Code of Corporate Governance requires only a disclosure

of all fixed and variable compensation that may be paid, directly or
indirectly, to its directors and top four management officers during the
preceding fiscal year. However, disclosure on board and executive
remuneration on an individual basis (including termination and
retirement provisions) is increasingly regarded as good practice and is
now mandated in many countries.
Recommendation 8.5
The company should disclose its policies governing Related Party

Transactions (RPTs) and other unusual or infrequently occurring
transactions in their Manual on Corporate Governance. The material or
significant RPTs reviewed and approved during the year should be
disclosed in its Annual Corporate Governance Report.
Explanation
A full, accurate and timely disclosure of the company's policy

governing RPTs and other unusual or infrequently occurring
transactions, as well as the review and approval of material a:nd
significant RPTs, is regarded as good corporate governance practice
... geared towards 'the prevention of abusive dealings and transactions and
the promotion of transparency. These policies include ensuring that
transactions .occur at market prices and under conditions that protect the
rights of aH shareholders. The said disclosure includes directors and key
executives reporting to the Board when they have RPTs that could
influence their judgment.
Recommendation 8.6
The company should.make a full, fair, accurate and timely disclosure to

the p_u?l_ic of ev_ery materi I f ct orevent that occurs, particularly on the
acqu1s1t1on or disposal of s1g111ficant assets, which could adversely affect
the viability or the interest of its shareholders and other stakeholders.
oreover, the Board of the off red company should appoint an
mdependent party to evaluate the fairness of the transaction price on the
acquisition or disposal of assets.
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72 C''.!!!L'.f_cr !._
the cxtcrnnl 1111clitor should be rccon11ncnded by the Audit Committee,

:1pp1\>ved by the Bnnrd and rntificd by the shareholders. For removal
of the external auditor, the reasons for removal or change should ?e
discl\lsed to the regulators and the public through the company
website 1111d required disclosures.
F.xplnnntion
The nppointmcnt, rcnppointment ond removal or the external audito
by the 13oarcl's npprovnl, through the Audit Committee's
recommendat.'on, and shareholders' rolificntion at shareholders'
meetings are actions regarded os good procticcs. Shareholders'
ratification clarifies or emphasizes that the external auditor is
accountable to the shareholders or to the company as a whole, rather
than to the management whom he may interact with in the conduct of
his audit.
Recommendation 9.2
The Audit Committee Charter should include the Audit Committee's

responsibility on assessing the integrity and independence of external
auditqrs and exercising effective oversight .to review and monitor the
external auditor's independence and objectivity and the effectiveness
of the audit process, taking into consideration relevant Philippine
professional and regulatory requir rnents. The Charter should also
contain the Audit Committee's responsibility on reviewing and
monitoring the external auditor's suitability·and effectiveness on an
annual basis.
'
Explanation
The Audit Committee Charter1includes a disclosure of its
responsibility on assessing the integrity and independence of the
external auditor. It establishes detailed guidelines, policies and
procedures that are ontain7d in a separa.te memorandum or
document. Nationally and
111ternat1011ally recognized best practices and standards of external
auditing guide the committee in formulating these policies and
procedures.
Moreover, establishing effective communication with the external

audito and requiri!1g them to rep rt all relevant matters help the Audit
Committee to efficiently carry out its oversight responsibilities.
I
r
SEC Code of Corporate Guver11ancc 73

Recommendation 9.3
Th company should disclose the nature of non-audit services

performed by•t extern_al auditor in the Annual Report to deal with
the potential conflt t of mterest. The Audit Committee should be
alert for any potential c nflict of interest situations, given the
guidelines or policies
on • on-audit services, which could be viewed as impairing the external
auditor's objectivity.
Explanation
The Audit Committee, in the performance of its duty, oversees the

overall relationship with the external auditor. It evaluates and
determines the nature of non-audit services, if any, of the external
auditor. Further, the Committee periodically reviews the proportion of
non-audit fees paid to the external auditor in relation to the
corporation's overall consultancy expenses. Allowing the same auditor
to perform non-audit services for the company may create a potential
conflict of interest. In order to , it'igate the risk of possible conflict
between the auditor and the company, the Audit·Committee puts in
place robust policies and procedures designed to promote auditor
independence in the long run. In formulating these policies and
procedures, the Committee is guided by nationally and internationally
recognized best practices and regulatory.requirements or.issu nces.
7-' Chu/ll••,·3
REVIE\\' QUESTIONS\ND EXERCISES
.H11ltipl1!Choice Q11£'stio11.,·
I. Audit committee activities and responsibilities include which of the

folio\\ ing?
a. Selecting the external audit firm.
b. Approving corporate strategy.
c. Reviewing management performance and determining
compensation.
d. None of the above.
2. \Vhich of the following audit committee responsibilities has the SEC

mandated?
a. Obtaining each year a report by the internal auditor that addresse the .
company's internal control procedures, any quality control or
regulatory problems, and any relationships that might threaten the
independence of the internal auditor.
b. Discussing in its meetings the company's.earnings press releases, as
well as financial information and earnings guidance provided to
analysts.
c. Reviewing with the internal auditor any audit problems or
difficulties that they have had with management.
d. All of the above.
Exercises
Exercise 1
Below is a summary of the SEC corporate governance requirements of

comp n(es. publicly-listed in the stock exchange. For each requirement,
state
d d
how 1. t mtended to help to address the risk of fraud u bl1. cI ra e
1s. inp yt
orgamzat1ons.
a. Boards need to consist of at least 3 independent directo 1/3 f h

board which is higher. _r so r o t e
b. Boards need to hold regular executive sessions of · 111
d d ·
without management present. epen ent directors
SEC Code a/Corporate Governance 15
c. Boar.ds must h·'we a / corporate governance commi•ttee composed at Ieast
3 0 f mdependent directors.
d. The corporate governance committee must have a written charter that

addresses the committee·s purpose and responsibilities, and there must
be annual performance evaluation of the committee.
e. Boards· must have an audit committee with a minimum of three
independent members.
f. The audit committee must have a written charter that addresses the
committee's purpose and responsibilities, and the committee must
produce an audit committee report; there must also be an annual
performance evaluation of the committee.
Exercise 2
Below is a summary of the SEC listing requirements for audit' committee

responsibilities of companies listed on this stock exchange. For each
requirement, state how it is intended to help to address the risk of fraud in
publicly traded organizations. ·
a. Obtaining each year a report by the external auditor that addresses the
company's internal contr.ol procedures, any quality control or
regulatory problems, and·any relationships that might thre ten the
independence of
the external auditor •
b. Discussing the company's financial statements with management and
the external auditor .
c. Discussing in its meetings the company's earnings press releases, as
well as financial information and earnings guidance provided to
analysts .
d. Discussing in its· meetings polici s with respect to risk assessment
and risk management
Meetino separately with management, internal au"ditors, and the external
e. b ,
auditor on a periodic basis . ·
f. Reviewing with the external auditor any audit problems or difficulties
that they had with management
g. Setting clear hiring policies for employees or former employ es of the
external auditors
h. Reporting regularly to the board of directors
..
SEC CODE OF CORPORATE

GOVERNANCE,CONTINUED
®q,ected Learning Outcomes

1. Understand how the ethical behavior of the board can be

strengthened.
2. Describe how the company disclosure policies and procedures
can be enhanced.
3. Appreciate how the external auditor's independence can be
strengthened and how audit quality can be enhanced.
4. Understand how a company could increase focus on non

financial and sustain.ability reporting.
5. Explain how a company can promote a comprehensive and cost

efficient access to relevant information.
6. Understand how integrity, transparency and proper governance

of a company could be ensured through effective internal control
system and enterprise risk management framework.
7. Describe briefly how a synergic relationship with shareholders

could be cultivated and promoted.
8. Explain how the rights of stakeholders could by respected and

how to institute effective redness for the violation of their
rights.
CBAPTER4
CHAPTER4 CHAPTER4
SEC CODE OF CORPORATE
GOVSRNANCE, CONTINUED SEC COD& OF SEC CODE OF CORPO1'A1'E
CORPORATE GOVER GOVERNANCE, CON1'1NU&D
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SECCode of Corporafe Governance, Confinued 79
Recommendation 12.1
TheCo_mpany should have an adequate and effective internal control

Ystem_and an enterprise risk management framework in the conduct of
its bus.mess, taking into account its size, risk profile and complexity of
operations.
Explanation
An adequate and effective internal control system and an enterprise

risk man_agement framework help sustain safe an\! sound operations
as well as implement management policies to attain corporate goals.
An effective internal control system embodies management oversight
and control culture; risk recognition aod assessment; control activities;
information and communication; monitoring activities and correcting
deficiencies. Moreover, an effective enterprise risk management
framework typically includes such activities as the identification,
sourcing, measurement, evaluation, mitigation and monitoring of risk.
Recommendation 12.2
The Company should have in place an independent internal audit

function that provides an independent and objective assurance, and
consulting services designed to add value and improve the company's
operations.
Explanation
A separate internal audit function is essential to monitor and guide the

implementation of con:ipa_ny policies. It h lps tl_1e _co pany
accomplish its objectives by bmrg ng a systemat_,c, d1sc1pl med
approach o evaluating and improving the effect1venes of the
com_pany s governance, risk m nagement nd control func 1ons. The
followmg are the functions of the mternaI aud1t, among others.
a. Provides an independent risk-based assurance service to the

Board. Audit Committee and Management, focusing on
reviewing the effectiveness of the governance and control
processes in (_I) promoting the right values and ethic , (!)
ensuring effective performance management and accountmg Ill
the organization, (3) communicating risk and control
80 Ch,1p1rr -I
information. nncl (4) . .t" "t "cs and information
t1ic n IVI 1 · , . s and
coord111111111g
amoiH! the Board. external and rntcrnnl,md1to.r
Management:
b. Performsgular and special nudil as cor tained in t t·annual
audit plnnand/or based on the company's riskassessrn '
c. Performs consulting and advisory servi:es elated to governance
and control as nppr9priate for the organ1zat1on; .
Perfom1s compliance audit of relevant laws, rul s and
d. regulations, contractual obligations and other om •t_ments,
which could have a significant impact. on the organization,
e. Reviews, audits and assesses the efficiency and effectiveness of
the internal control system of all areas of the company;
f. Evaluates operations or programs to ascertain whether results
are consistent with established objectives and goals, and
whether the operations or programs are being carried out as
planned;
g. Evaluates specific operations at the request of the Board or
Management, as appropriate; and
h. Monitors and evaluates governance processes.
. A company's internal audit activity may ue a fully resourced activity

housed within the organization or may be outsourced to qualified
independent third party service providers.
Recommendation 12.3
Subject to a company's size, risk profile and complexity of operations, it

should have a qualified Chief Audit Executive (CAE) appoint,ed by the
Board. The CAE shall oversee and be responsible for the internal audit
acti . of the organization, including that pottie,.. that is outsourced to a
third pa1ty service provider. In case of a fully outsourced internal audit
activity, a qualified independent execl;tive or seqior management
personnel should be assigned the responsibility for managing the fully
outsourced internal audit activity.
'
I SEC Code of Corporal; Governance, Continued 81

Explanation
T_he CAE, in order to achieve the necessary independence to fulfill

has/her_ responsibilities, directly reports functionally to the Audit
Committee and administratively to the CEO. The following are the
responsibilities of the CAE, among others:
a. Periodically reviews the internal audit charter and presents it

to senior· management and the Board Audit Committee for
approval;
b. Establishes a risk-based internal audit plan, including policies

and procedures, to determine the priorities of the internal
audit activity, consistent with theorganization ' s goals;

..
c. Communicates the internal audit activity's plans, resource
requirements and impact of resource limitations, as well as
significant interim changes, to senior management and the
Audit Committee for review and approval;
d. Spearheads the performance of the internal audit activity to

ensure it adds value to the organization;
e. Reports periodically to the Audit Committee on the internal

audit activity's performance relative to its plan; and
f. Presents findings and recommendations to the Audit

Committee and gives advice to senior management and the
Board on how to improve internal processes.
Recommendation 12.4
Subject to its size. risk profile and complexity of operations, the

company should have a separate risk manageme t function to identify,
assess and monitor key risk exposures.
Explanation
The risk management function involves the following activities, among

others:
a. Defining a risk management- strategy;
82 Chapter .J
b. Identifying and analyzing key risks exposure rela: lsJ)
economic environmental, social and governance
factors a;,d the achievement of the organization's strategic
objectives;
th
c. Evaluating and categorizing ea h identified risk. using e
company's predefined risk categories and parameters,
d. Establishing a risk register with clearly defined, prioritized
and residual·risks; ·
e. Developing a risk mitigation plan for the most important risks
to the company,_as defined by the risk management strategy;
f. Communicating and reporting signific!1nt risk exp sure

s includilTg business risks (i e., strategic, compliance,
operat1o,a1
financial and repl;ltational risks), control issu s and risk
mitigation plan to the Board Risk Oversight Committee; and
g. Monitoring and evaluating the effectiveness of the

organization's risk management processes.
Recommendation 12.5
In managing the company's Risk Management System, the·company

should have a Chief Risk Officer (CRO), who is the ultimate
champion of Enterprise Risk Management (ERM) and has adequate
authority, stature, resources and support to fulfill his/her
responsibiliiies, subject to a company's size, risk profile and
complexity of operations.
Explanation
The CRO has the following functions, among others:
a. Supervises the entire ERM process and spearheads the

development, implementation, maintenance and continuous
improvement of ERM processes and documentation;
b. Communicates the top risks and the status of implementation

of risk management strategies and action plans to the Board
Risk Oversight Committee;
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84 Chaprer4
Right to propose the holding of meetings and to include

- agenda items ahead of the scheduled Annual and
Special Shareholders' Meeting; . .
rd
· Right to nominate candidates to the Boa of.Directors,
J Nomination process; and
Voting procedures that would gover the Annual and
Special Shareholders' Meeting.
The right to propose the holding of meetings and ite?1s or inclusion_

in the agenda is given to all shareholders, including mmonty and
forei n shareholders. However, to prevent the abuse ofhis_right, com
an•es may require that the proposal be made by shareholders holding
a specified percentage of shares or voting rights. <;>n the other
hand, to ensure that minority shareholders are n?t effectively
prevente froi:n exercising this right, the. degree of ownership
concentration 1s considered in determining the threshold.
Further, all shareholders must be given the opportunity to nominate

candidates to the Board of Directors in accordance with the existing
laws. The proc;edures of the nomination process are expected to be
discussed clearly by the Board. The company is encouraged to fully
and promptly disclose all information regarding the experience and
background of the candidates Jo enable the shareholders to study and
conduct their own background check .as to the candidates' qualifi
ation and credibility. ·
Shareholders are also encouraged to participate when·given sufficient

information prior to voting on fundamental corporate changes such·as:
(I) amendments to .the Articles of Incorporation and By-Laws of the
company; (2) the authorization on the increa e ·in authorized capital
stock; and (3) extraordinary transactions, including the transfer of all or
of
substantially all assets that in effect result in the sale the company. In
addition, the disclosure and clear explanation of the voting procedures,
as well as r moval of excessive or unnecessary costs and other
administrative impediments, allow for· the effective exercise of the
shareholders' voting rights. Poll voting is highly encouraged as
opposed
to the show of hands. Proxy voting is also a good practice, including
the electronic distribution of proxy materials.
The· related shareholders' rights and relevant company policies should

be contained in the Manual on Corporate Governance. ·
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Re-commendntion 13.4
The Board should make available, at the option of a shareholder, an

altemative dispute mechanism to resolve intra-corpora e dispute in an
amicable and effective manner. This should be included in the
company's Manual on Corporate Governance.
Expl:rnation
It is important for the shareholders to be well-informed of the

company's processes and procedures when seeking o redress the
violation of -their rights. Putting in place proper safeguards ensures
suitable remedies for the infringement of shareholders' rights and
prevents excessive litigation. The company may also consider adopting
in its·Manual on Corporate Governance established Alternative Dispute
Resolution (ADR) procedures·.
Recommendation 13.5
The Board should establish an Investor Relations Office (IRO) to

ensure constant engagement with its share!1olders. The IRO should be
present at every shareholders' meeting.
Explanation
Setting up an avenue to_recei_ve feedback, complaints and queries from

sharehold.· ers afssuhre their active participation with reooard fo
act1·v1·t1· es
and _poI1c1es o t e. company. The IRO has a designated· investor
relatwns officer, .email add·ress and telephone nuinber• Furt.h·er, creat·ing
an In v estor R elations Program ·ensures that all d' I
informat,·on
· · · f h · regar mg t 1e
.
act1v1t1es o t e company are properly and timerl/ ·
shareholders. . -., communtcated to
,
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SEC Code of Corporate Governance, Continued 91
REVIEW QUESTIONS
Questions
I. Assu e that management had determined that its organization's audit

committee is not effective. How do the weaknesses in audit committee
affect management's evaluation of internal control over financial
reporting? Would an ineffective audit committee constitute a material
weakness in internal control over financial reporting? State the
I
rationale for your response.
2. Why is there a need for a corporation to maintain a comprehensive and

I cost-efficient communication channels to shareholders and other
investors?
, 3. What is the objective of the company in having a, strong and effective·

internal control system?
4. What is the purpose of having an independent internal audit function in

a publicly-listed corporation?
5. Give at least four (4) responsibilities of the Chief Audit Executive.
6. Enumerate the activities of the Risk Management department in a

publicly-Iisted corporation.
7. To what may the shareholders' rights relate?
8. How may participation of .employee in corporate governance be

encouraged?
9. Trlle or False. Sustainability reporting includes voluntary corporate

disclosures about sustainability initiatives. plans, and
associated
outcomes.
Io.Trlle or False. The terms 11011-fi11a11cia/ reporting. corporate social rl!

sponsibility reporling. and 1riple bouom-line reporting are each
sustainability-related terms.
92· Chapter 4
.
11. Define the.terms nonfinancia/ reporting, corporate social responsibility
reporting, and triple bottom-line reporting. How do these terms relate to
sustainability reporting?
12. What factors have driven the demand for sustainability reporting?
13. Why is there a demand·for independent assurance on sustainability

reporting?
14. In unethical for a company to provide a sustainability report, but

provide no assurance on the reliability of the information containeQ
therein?
..
UNIT II BIJSINESS ETHICS
5 Introduction to Ethics
6 Business Ethics
7 Common Unethical Practices of

Business Establishments
.
.
8 Ethical Dilemma
9 .Advocacy Against Corruption
1O Initiatives tQ Improve
Business
Ethics and Reduce Corruption
INTRODUCTION TO
ETHICS
P,x:pectecf Learning Outcomes

1. Define Ethics,
2. Enumerate.and describe the basic characteristics and values

associated with ethical behavior.
I
3. Appreciate why ethical behavior in personal, professional an.d
business dealings is.necessary.,
4. Understand t e.reasons why people act unethically,
5. Give and e)_(plain the categories of ethical principles.
6. Give and describe the ethical principles related to
a) Personal ethics
b) Professional ethics
c) Business ethics
7. Explain why profession.al ethics is important and why d f

conduct should be adopted a co e 0
CHAPTER 5
INTRODUCTION TO ETHICS
INTRODUCTION
Ell,ics _can be defined broadly as a set of moral principles or values that govern
the a tio s. and decisions of an individual or group. While personal ethics vary
from individual to individual at any point in time, most people within a society
1
are able to agree about what is considered ethical and unethical behavior. In fact,
a society passes laws that define what its citizens consider to be the more extreme
fonns .of unethical behavior.
Each of us has such a set of values, although we may or may not have considered
them explicitly. Philosophers, religious organizations, and other groups have
defined in various ways ideal sets of moral principles or values. Examples of
prescribed sets of moral,principles or values at the implementation level include
laws and regulations, church doctrine, code of business etl1ics for professional
groups such as CPAs, and codes of conduct within individual organizations.
Ethics is a topic that is receiving a great deal of attention throughout our society
today. This att ntion is an indicat on of both the importance of ethical behavior to
maintaining a civil society, and a significant number of notal:ile instances of
unethical behavior. Much of what is considered unethical in a particular society
is not specifically prohibited. So how do we know whether we are acting
ethically? Who decides what standards of conduct are appropriate? Is any type of
behavior "ethical" as long as it does not violate a law or a rule of one's
profession?
It is common for people to differ in their moral principles or values. Even if two
people agree on the· ethical principles. tha determine ethical b_eh vior, it is
unlikely that they will agree on th relative_ importance of each prmc1 le. These
. differences result from all of our life experiences. Parents, teachers, friends and
employers are known to influence our values, but so d? television, team sports,
life successes and failures, and thousands of other experiences. .
,
96 Clmptt!r 5
WITH ETHICAL
CHARACTERISTICS AND VALUES ASSOCIATED
BEHAVIOR
• haracteristics and values
The following list of ethical principles mcorporates 1t 1ec
that most people associate with ethical behavior.
Integrity . . . ,.,. t on convictions· do not

Be prmc1pled, honorable, upright, courageous anu ac h 'j h
I
be twof c.ed or unscrupulous, or adopt an end-justifies-the means P osop Y
that ignores principle. ·
Honesty
Be truthful, sincere, forthright, straightforward, frank, c ndid; do not che t,
steal. lie, deceive or act deviously.
Trustworthiness and Promise Keeping

Be worthy of trust, keep promises, full commitments, abide by the spirit as
well as the letter of an agreement; do not interpret agreements in an
unreasoriably te h,iical· or legalistic manner in order to rationalize
noncompliance or create excuses and justification for breaking commitments.
Loyalty (Fidelity) and Confidentiality

Be faith ul and oyal to amily, frien?s, employers, lient and country; do not·
use or disclose mformatron learned an confidence; 111 a professional context
safeguard the influences and conflicts of.interest. '
Fairness and Ope!mess
Be fair and. ?pen- , c.bedwi!ling to _admit error and, wher appropriate,

mdinbde
change pos1t1ons· d' an e11e1s, emonstrate a commitment to J·ust· th I
treatment of m u s, to Ierance for acceptance of d. tee , e equa
'd I d ·t y d
1v1 a an
1vers1 ; o not
o;erreach or take advantage of another's mistakes or diversities.
Caring/or Others
Be caring, kind, and compassionate; share. be giving be f . .
0
help those in need and avoid harming others. ' service to others;
..
-
/1:1_:1_,·mluctilJ11/11 F1 /11c:{?7
Re• J>C't"f fiir Others
Demon_strn_tc pcct for human dignit). prh :JC). and the right_ to sclf
d tcnnm ,1 n ol all J:k!oplc: be courteous. prompt, and decent: p r o v i_d oe
thers ' 1th the mlormation they need to m:ike informed decisions about
their own
hvcs: do not patronize, embarrass. or demean.
Responsible Citi:enship
Obey just laws; if all law unjust, openly protest it; exercise all democratic
rights and privileged responsibly by participation (voting and expressing
informed views), social consciousness, and public service: when in a
position of leadership or authority, openly respect and honor democratic
processes of decision making, avoid unnecessary secrecy or concealment of
information, and assure th&t others have all the information thev need to
make intelligent choices and exercise their rights.·
Pursuit of Excellence
Pursue excellence in all matters; 111 meeting your personal and
professional responsibilities, be diligent, reliable, industrious and
committed; perform all tasks to the best of your ability, develop and
maintain a high degree of competence, be well informed and well prepared;
do not be content with medioqrity; do not "win at any cost". ·
Accountability
Be accountable, accept responsibility for decisio.ns, for the foreseeable
consequences of actions and inactions, and for setting an example of others.
Parents, teachers, employers, many professionals and public officials have a
special obligation to lead by example, to safeguard and advance the integrity
and reputation of their families, companies, professions and the government
itself; an ethically sensitive individual avoids even the appearance of
impropriety, and takes whatever actions·are necessary to correct or prevent
inappropriate conduct of others.
\VII\' IS ETHICAL BEHAVIOR NECESSARY
Ethicnl behavior is necessary for a society to function in an orderly manner.
It caii be argued that ctl ics is the glue thnt holds a society together. Wh t
would happen i( for example we could not clepe11d oi1 the people we deal
w_,th to be honest. If parents, teachers, employees, siblings, co-wo kers and f
ien?s all consistently lied. it would be almost impossible for effective
communication to
occur.
The need for ethics in society is sufficiently important that many _comn.1only_ h ld
ethical values are incorporated into laws. For example, laws dealmg with
dnvmg while intoxicated and selling drugs concern respbnsible citizens.hip
and respect for other. Similarly, if a company sells a defec;tive produ9t, it can
be held accountable if harmed parties choose tq sue tHroughout the legal
system.
A considerable portion of the ethical values of a soci ty cannot be

ihcorporated into laws because of the judgmental nature of certain values.
Looking at the honesty principle, it is practical to have laws that deal with
cheating, stealing, lying, or deceiving others. It is far m'ore difficult to
establish meaningful laws that deal with many aspects of principles such as
integrity, loyalty and pursuit of excellence. That does not imply that these
principles are less·important for an orderly society. · ,·
Bu iness decisions influe 1ce employees, custo1:ners·,s ppliers and

competitors, while 9ompany operations affect communities, governments and
the environment. ' ·
WHY DO PEOPLE ACT UNETHICALLY?
M st people define unethical behavior as conduct th t differs from the way th

believe would have.been appropriate given the circumstances. Each of us decid:
fo o rselves what we consider unethical behavior, both for ourselves and oth
r
It 1 11 portant_ to understand what causes people·to act in a man er tht ·
decide 1s unethical. . a we
There are two primary reasons why people act unethically:
I. the person's ethical standards are different from thos f · ·

whole, or . e o society as a
A
2. the person chooses to act selfishly.
/11troductio11to Ethics 99
In many instances, both reasons exist.
1. Person's Ethical Standards differ from General Society

Ext_reme examples of people whose behavior violates almost everyone's
ethical standards are drug dealers, bank robbers, and larcenists. Most
people who commit such acts feel no remorse when they arc
apprehended, because their ethical standards differ from those of society
as a whole.
There are also many far less extreme examples when violate our ethical
values. When people cheat on their tax returns, treat other people with
hostility, lie on employment applications, or perform below their
competence level as employees, most of us regard that as unethical
behavior. If the other person has dccidc.d that this behavior is ethical and
acceptable, there is a conflict of ethical values that is unlikely to be
resolved.
2. 71te Person Chooses to Act S11lfisl,fy

A considerable portion of 1111c1hicul bcha"ior rcsuhs from selfish
behavior. The Pork Barrel Scum and the other political scanclnls resulted
· from the desire for political po\\er and "cahh: cheating on ta returns
und expense reports is motivated b) financi:il greed: performing below
one's competence nncl cheating ,,n te t urc typicnll} due to laziness. In
each case, the person 1..no\\ s that the bd1:i, ior is inappropriate. but
chooses to do it anyway because of the personal siwrili·c needed to act
ethically.
CATEGORIES OF F.TIIICAL PRINCIPLES
Principles of Personal Et/tics include attw11;: others
• Bru.ic justice. fnintl' s

• Respect for thl' right of others
• Concem fl,r the right of others
• Concern for tht• \\l.'ll-l>eing.on \\elfarc of othl-'rs
• Bc,,c, oknce. tru I\\Orthines·. h0ne:.t)
• Compliance "ith the.'ll"
100 Chapter 5
Professi nal Etltics include among otl,ers
• Integrity, impartiality, objectivity

• Professional competence
• Confidentiality •
• Professional behavior
• Avoidance of potential or apparent conflict of interest
Business EtJ,ics itt<:lude amo11g otlters
• Fair competition
• Global as well as domestic justice
• Social responsibility
• Concern for e.nvironment
The focus of this book ison Business Ethics.
The Need for Professional Ethics
To understand the importance of a Code of Ethics to professionals, one must

understand the nature of a profession asopposed to other vacation.
There is no universally accepted definition of what constitutes a profession;

yet, for generations, certain types of activities have been recognized as
professions while others have not.
Medicine, law, engineering, architecture and theology are examples of

disciplines long accorded .professional status. Public accounting is relatively
new as far as the ranking of the professions is concerned but it has achieved
widespread recogn\tion in recent decades.
All the recognized professions have several common characteristics. The most
important of these characteristics are:
(I) a responsibility to serve the public

(2) a complex body of knowledge
(3) standards of admission to the profession
(4) a need for public confidence
Introduction to Ethics 101
C a re .
lne
e gs vwieowrktoowr mt7 grity of a. professional may lead the public toa
a t iv e l a ck o.f
s a r d ·th
confidence of the puble'.entire profession. All'professionals must have public
different professions ac: nto ?e success u!· Con equently, the members of the
unison by denvmg their respective code of conduct.
Code of Good Governance for th8 Professlon In the Philippines (E.O.·No. 220, June 23, 2003)
TR he igsu lCa toodr ye BIsoaar dd sopt toe dcobv ey r tahnee,Pro.fesslonal Regulation Commission (PRC)
.and the 42 Professional perform their tasks. While h pro vir nment of good governance in which all
FIiipino professionals shall of ethics, it is generally recpgnized :; madopt and enforce its owncode
of good governanceand'code which covers the common rin . a ere a general commonality among
the various codes. This Code professionals who face critic!ethc_ipleslund·erlyi g th? codes of various
professions could be used by all
ica questions in their work.
General Principle of Professional Conduct
Pharovfeesbsoiot nh aelsthaicrealrequired not only t0 h e an e•thi'calcom.m1tme!lt, apersonal resolve toact
ethicall·y, but also between ri ht and wro renes:i aod_ eth1cal competency..Ethical aw r.eness refers.to the
ability to discern
and consier caref thg, ':"hlll catet ical competen.cy perlams to the abH1ty to engage in sound moral reasoning
u11Y e imp I ions of altemat1ve·act1ons. .
Specific Principle of Professional Conduct
1. Service to Others
Professionals are committed to a life of servic to others. They protect life, property, and publicwelfare.
To serve !hers, t ey shall be prepared for heroic sacrifice and genuine selflessness in carrying out
their professional duties even at the expense of personal gain. ·
2. Integrity and Objectivity ·
To maint n ail broaden public nfid nce,_ professiona!s shall perform their responsibilities.with the
highest sense of integrity and imbued 'with nationalism and spmtual.values. In the performance of any
professional service, they shall at alllimes, main objectivity,be free of conflicts of interest.
andrefrainfromengaging inany activity that would prejudice their abilities to carry out their duties ethically.
They shall avoid making any representation that would likely cause areasonable person
tomisunderstand or fo bedeceived.
3. Professional Competence
In providing professional services, a certain level ofcompetence is necessary,.i.e.knowledge. technical skills.
attitudes, and experience. Professionals shall, theref?re, underlake only those professional services that they
canreasonably deliver withprofessional competence. Corollary to this, it is their expressobligation to keep up
with new knowledge and techniques in their field, continually improve their skills and upgrade theirlevel
of
competence and take part in alifelong continuing educationprogram. '
4. SoUdarity and Teamwork
Each profession shallnurture and support one. organization for all i.ts members. :hougha deep spirit of
solidarity, each member should put the broader_ interest_.otfhe profession above ones personal ambition
and preference. Through teamwork within a cohesive professional orgamzat1on. eachmember sh II
effectively observe ethical practices and pursue continuing professional development as well asdeepen
onessocial and
civic responsibility.
5. Social and Clvlc Responsibility
Professionals shall always carry out their pro essional duties with due consider tion of th broader interest of
the public. They shall, therefore, serve the_1(chents/employersand the J?Ublic .with P'.°fess1onat concern and in
a manner consistent with their responsib1ht1es _to soo _tyA. s responsible F1hpinocitizens, they shall actively
contribute to the attainment of thecountry's nationaol biectives.
102 Chapter 5
6.Global Competltlvenese
Eveiy professional shaU remain open to challenges of amore dynamic inlerconnecled world. He or she shall
rise up to global standards and maintan levels of professional practices fully aUgned with gobal
best practices.
7.Equality of AllProfession, .
All professiooals shall treal their colleagues withrespect and shall strive to be fair in their dealings with one
another. No one group of professionals is superior or above others. All professionals perform an equally
important, yet distinct. service lo society. In the eyes of the PRC, all professions are equal and,
therefore,
every oneshalltreat one other professionals withrespect and fairness.
Examples of Code of Conduct and Ethics for Professionals areshown in:

Appendix A- For Professional Teachers
Appendix B - For Internal Auditors
Appendix C For Management Accountants
Examples of Code of Business Conduct and Ethics for Private Enterprises
are presented in: · · ·
Appendix D,...T:.elecommunications Company
Appendix E - Manufacturing Company
Appen ix F - Commercial Ban·k
REVIEW QUESTIONS
Que:,tions
I. Define "Ethics''.
2. What is the basic purpose of a code of ethics for a profession?
'
3. Name_ and explain the cha
r acteristics and values associated withth' I
behavior. e ica
4. Explain why_ethical behavior is necessary..

5. What aresome of the reasons why people act unethically?
6. Describe some the principles and or values that are related to
a. Personal etflics
b. Professional ethics
c. Business ethics
7. Explain why ethical behavior is necessary. in the
profession. practice of one's
BUSINESS ETHICS
P.x:pectecf Learning Outcomes

· 1. Explain what business ethics is

2. Discuss the purposes of business ethics
'
3. Describe 1he scope and impact of business ethics on
'
a) the economy
b) society
c) ·environment
d) business managers
4. Explain the ethical challenges in today'sworld

.
CHAPTER 6
BUSINESS ETHICS
BASlC CONCEPT OF BUSINESS ETHICS
Business ethics refers to stn11dnrds of moral co11duct, behavior a d judgm

nt n business. lt involves making the moral and right decisions while enga •
g 111
such business activities ns manufacturing and sellrng a product and_p_r v1d111ga
service to customers. Business ethics is·an area of corporate respons• •hty
here businesses are legally bound and socially·obligated to conduct business
111 an ethical manner.
.J •
Business ethics is based on the personal values and standards of each person
engaged in business.
PURPOSES OF BUSINESS ETHICS
JJ1ai11Purpose
The main pwpose of business ethics is to help business and would-be business
to derermine what business.practices are right and what are ·wrong. Hopefully,
they are going to use this knowledge to guide them 111 making the right
business decisions.
Special Purpose
There are other purposes which are corollary to the main purpose. These
purposes include the following:
I. To make businessmen realize that they cannot employ double standards

to the actions of other people and to their own actions.
2. To how businessmen that common practices which they have th◊-ught
to be right because they see other businessmen doing it, are really
wrong.
3. To serve as a standard or ideal upo·n which business conduct should
be based.
llusi11e.Ts Ethics I OS
Edxce.pt for some country's 01.gan1• zat1. ons, professi.onals wh.,c 1 1inve ,.ormuI aleu.,
1
1
an •m e mented their Code of Ethics, the business world today does not have
one t •versal _standard code of etliics. Each man hos to evaluate a situalion
accor mg_ to his own belief. Often, because there is no code of ethics to guide
them, busmessn en take ?cti?ns that 111ay be wrong. Therefore, one of the spccifie
purposes of busmess ethics 1s to assist the business world in formulating codes
of 0nduct -yerson I, company and professional - which can be used as a
guide m fomlulatmg b smess plans and strategies and in making business
decisions.
SCOPE AND IMPACT OF BUSINESS ETffiCS
usiness ethic covers all •conduct, behavior and judgment in business. This
•mcludes the_ sltghtest deviation from what is right to illegal and dishonest acts
hat are punishable by law. It i1ivolves making the right choices while engaging
m such business activities as manufacturing and selling a product or selling and
rendering a service.
Generally, actions that are not forbidden by law are ethical. In some cases,
however, what is legal (not forbidden by law) may be unethical. Business
ethics therefore covers even acts that may be legal but which are wrong
because they violate ethical principles.
Business ethics is based on the personal values and standards of each person
engaged in business. Since individual values differ, what is ethical or unethical
in making pro.fit also varies from person to person. And here lies the problem.
There is still no uniform standards of right and wrong from which all business
may base their actions.
The businessman who provides fair business competition is·the .most likely to
observe the business ethical rules of conduct, behavior and judgment. r-air
business competition means achievin succes solely by offeri g better prod • ts,
services and terms than the competitor. It 1s a form of business compet1t1on
where success is gained by the merits of'one's goods or services.
106 Chapter 6
Economic In1pact
A business J1as an economic impact on soci'ety through the wages. it p ys to its
employees, the materials that it buys from their suppliers and the prices_it char.ges
its customers. It would l ave a positive social impact on its employee if they_are
paid fair living wages and benefits. It will have a·positive effect ?n its supphe s
that they paid fairly and on time for their supplies. The effe t on its customers is
positive if the business gives them good val.ue for the pr.1 .e they pay for the
products and services.
Social Impact
The social impact of corporate governance contributes to the ethical climate ?f
society. If businesses offer bribes to secure work or other benefi!s, enga em
accounting fraud or breach regulatory and legal limitations on their operations,
the ethics of society suffer. In addition to·a deteriorating ethical environment,
such as corruption may unfairly raise the price of goods for consumers or the
quality of the product or service compromised.
Environmental I1J1pact
Environmental protection is a key area of business influence on society.
Businesses that implement good environmental policies to use energy more
efficiently, reduce waste and in general lighten their environmental footprint can
reduce their internal costs and promote a positive image of their company. The
envi'ronmental initiatives of a business leader often force competitors to take
similar action for an increased beneficia, etfect·on the environment.
Impact on B11siness Managers
The concepts and princi_ples for the thical conduct in business are relegated to
the m nagers of !he busmess enter_pnse. T us, although the manager is expected
to act m the best mte·rest 'Of the busmess, he cannot be expected to act in a
manner that iscontrary to the law or to his conscie•nce.
In particular, a manager should:
• acknowledge that his role is to serve the business enterprise and the
community;
• avoid all abuse of executive power for personal gain, advantage or

prestige;
Business Ethics I07
• eveal the fact to his superior whenever his personal business of financial
interests conffict w·ith those of the company;
• be actively concerned with the difficulties and problems of subordinates,

eat.them fairly and by example, lead them effectively, assuring to all
t e right of reasonable access and appeal to superi9rs;
• recog iz.e that his subordinates have a right to information on matter

affecting them, and make provision for its prompt communication unless
such c mmunication is likely to undermine the security and efficiency
of the business; ·
• full evaluate the likely effects o employees and the ".ommunity of the
business plans for the future before taking a final decision and
• cooperate with his c"Olleagues and not attempt to secure personal

advantage at their expense.
ETHICAL CHALLENGES IN TODAY'S WORLD
In an article, "Ethical Challeng s in Today's World" written by Ms. Mercedes 8.

Suleik published in the Business Mirror on February_ 13, 20 I8 the author
expressed her insights on "Business Ethics" where an inherent conflict between
ethics and the pursuit of profit is more pronounced.
Cited in this article is the m ssage of Pope Francis in his Ecumenical,· Evangeli
Gaudium
"Humanity is experiencing a turning point in its history as can be seen

from the advances occurring in the scienc_es and technology. We ar in
age of knowledge and information and that this has led to new and often
anonymous kinds of power. We have today an economy of exclusion and
inequality".
"In a system that idolizes increased profit. everything that stands in its
way is pushed aside. Behind this altitude lurks a rejection of ethics.
Ethics has come to be vie-wed with derision as being counterproductive.
Ethics is felt to be a threat because it condemns the manipulation and
debasement of he person and that ethics leads lo a call for a committed
response, which is outside of the categories of the marketplace."
t08 Chapter 6
She also quoted Pope Benedict XVl's Encyclical Cari/as in Verilate
"Humai1ity has a mission and the means to transform the world in Justice
and love in human relations, even in the social and economic field
A1arke1 economics must be underpinned by commitments to particular
moral goods and a certain version of the human person if ii is to serve
rather than undermine humanity's common good The economy needs
e1hics in order to function correctly - not an ethics which is people
oriented"
REVIEW QUESTIONS
Questions
I. What does business ethics mean?
2. What is the main objective of observing ethical behavior in business?
3. Name the other purpose of business ethics.
4. What is the scope of business ethics?

' .
5. Explain the economic impact of observing business ethics.
6. What is the impact of business etbics to society in general?
7. Explain ho_w business managers could act ethically.
8. Describe the inherent co 1flict between ethics and pursuit of profit.

COMMON UNETHICAL
PRACTICES OF BUSINESS
ESTABLISHMENTS
P,xpectecf Learning Outcomes

After studying the chapter, you·should be able to...
1. Tofamiliarize yourself of the common unethical practices of

business establlshmerits such as
• Misrepresentation and
• Over-Persuasion
2. Describe how direct misrepresentation is committed by business
firms such as
a) deceptive packaging
. b) misbranding or mislabeling
c) false and misleading advertising
d) adulteration
e) weight understatement
f) measurement understatement
g) quantity understatement
3. Describe how indirect misrepresentation is done by- business firms
such as
a) caveat emptor
b) deliberate withholding of information
c) passive deception
4. Describe how over-persuasion becomes un thical.

5. Describe some unethical corporate practices of the
a) board of directors
b) executive officers and lower level r:nanager
c) employees
CHAPTER 7
COMMON 'UNETHICAL PRACTICES

OF BUSINESS ESTABLISHMENTS
COMMON UNETHICAL PRACTICES OF BUSINESS

ESTABLlSHMENTS
Unethical problems in business ethics occur in ma_nyforms and types. The

most common of these unethical practices of busmess establishments are
misrepr-esentation and over-persuasion.
Misreprese11tatio11 may be classified into two types: direct misrepresentation

and indirect misrepresentation.
. Direct Misreprese11tati()11 is characterized by actively misrepresenting about

the product or customers. This includes:
Deceptive Packaging. Deceptive packaging takes many for.ms and is
of many'types. One type is the practice of placing the product in
containers of exa gerated sizes and misleading shapes to give a false
impression of its actual cbntents. An exnnwle of this type of deceptive
packaging is slack-fill packaging where containers like cartons, tin
cans and certain
plastics are filled only up to eighty-five to ninety-five percent of their
capacity.
Mishra,u/i11g or Mis/aheli11g. Misbranding. is the practice of

making folse statements on the label of a product or making its
container similar to a well-known product for the purpose of deceiving
the customer as to the quality and/or quantity of a product being sold.
False or /Jfisleadi11g Advertising. Advertising serves a useful purpose

if it conveys the· right information. It is the principal means by which
people are informed about the availability, nature and uses of old and
new products. However, advertising does not always tell the "whole
truth
Common Unethical Pract(ces of Business Establishments 11t
3nd th
dno ing but the truth" if it greatly exaggerates the virtues of
a pr ucta d tells only half of the truth or else sings praises to its
non-
exihstent virtues· lf a d ver t.1' oes not prov.ide a useful servi. ce anymore
smgd
tot customers, it can become the agent of misrepresentation.
Examples are:
a. dvertisements with pictures or statements that convey exaggerated

impression of the product's reliability or quality. · .
b. f\dvertisement that claims that the product is· the "fastest selling
brand" or the "product of the year". ·
c. Advertisements using fictitious or obsolete testimonials.
Adulteration. AduIteration is the unethical practice of debasing a pure

or genuine commodity by imitating or counterfeiting it, by adding
something_to increase its bulk or volume, or by. substituting an inferior
product for a superior one for the purpose of profit or gain. It is
unethical because an inferior product is passed off as a superior one.
This does not meet the standard for fair service, that is achieving success
by offering better service (in the form of a superior product and terms of
payment) than the competitor.
Weight understateme11t or Short weighing. In sho11 weighing, the

mechanism of the weighing scale is tampered with or something is
unobtrusively attached to it so that the scale registers more than the
actual weight. An example is a f ot pedal with a concealed string tied to
the weighing scale. The modus operandi of sellers is to use two sets of
scales one which gives the correct weight and has been sealed by the
authorities and another which· looks identical but registers more weight
than the·product. Short weighing is practiced in selling products where
prices depend on the weight such as sugar, meat, fish, vegetables. fruits,
nails, etc.
Measurement understatement or Short measurement. In short
measurement. the measuring stick or standard is shorter than the real
length or smaller in v lume than the st ndard. This unethical practice_is
found in selli1Jg situations where the price of the product depends on its
length such as selling cloth or textiles. electric cords or wires or on its
volume such as selling rice by the sa_ck.
112 Chapter 7
Qua11tity 1111derstaleme11t or Short 1111111heri11g. In this unethical pr ctice,

the seller gives the customer less than the number asked for or paid for.
Short numbering is often practiced in selling situations wh re the product
being sold is in such a shape or is packed in a manner that "":'ould make
counting the product difficult or inconvenient. For·example: a cu_stomer
who is not vigilant may receive less quantity than.what he 1s _entitled to
when buying toilet paper, bond paper, carbon paper, paper chps, thu b
tacks, matches and toothpicks which are sold by the box or package.
Indirect Misrepresentation is characterized by omitting adverse or unfavor

ble information ab9t.it the product or service. Among the most common_
pract1 es involving indirect misrepresentations are caveat emptor, deliberate
w1thhold111g of information and business ignorance. ·
Caveat emptor is a practice very COIJlmon among salesmen.

Translated, caveat emptor means "let the buyer beware". Under this
concept, the seller is not obligated to reveal any defect 'irt the product
or service he·is selling. It is responsibility or'the customer to
determine for himself the defects of the product.
Caveat emptor is indirect misrepresentation and unethical because a

seller is a witness for the goods he is selling. He testifies to.its Aature,
features, uses and qualities. As a witness, it is his obligation to "tell
the truth and nothing b.ut the truth" about his product. What makes
caveat emptor unethical is the willingness of the seller to g nerate
profit by taking advantage of the buyer's l ck of information. This is
passive deception which is also lying.
Deliberate Withholding_of Information. Following the argument that

aveat e_mP.t r is un thical, the d libe ate withholding o( significant
111form t1on m a busmess transaction, ts also unethical. No business
ran_s ction is fair whe e.on of the parties d_oes not exactly know what
he 1s g1vmg away or rece1vmg 111 return.·
.Pa siv_e ecepti n{ Direct misr presentation gives businessa bad name
while md,rect misrepresentation or passive deception is not as obvlot.fs
it nonetheless contributes to the impression that businessmen are
liarsa'nd. are _out to make_ a fast bu k. Business ignorance is passive
deception because the busmessman 1s unable to provide the customer
with the complete information that the latter needs to make a fair
decision.
Common Unethical Practices of Business £stablisl11111mts I 13
Over-Persunsio11
Persuasion is the r ' f .

andurging hir t Pbocess appealmg to the emotions of a prospective customer
and necessa uya 1 item of merchandise he needs. Persuasion is legitimate
P ersuad,·ng ,111•nt le sellmg of goods if it is done in the interest of a buyer such as
n to get a hos ·1t 11· · · · · ·
used for ti zat1on msurance policy. However, persuasion
I
P e
ti b soe benefit of selling a product without considering the interest of
le uyer is not ethic I Tl . . .
ms tances of over- mclude the
o . examples: a · 1e common
IIowing .
fi persuas ion
I. Urging a customer to satisfy a low priority need for m rchandise..

2
- Playing upon intense emotional agitation to convince a person to
buy.
3. Convin•cing a person to buy what he does not need just because he

has the capacity or money to do so.
CORPORATE ETHICS
Unethical Practic of Corporate Management
Practices of corporate management that involve ethical considerations may be

classified into two: practices of the Board of Directors and practices of executive
officers. In many cases, the practices may apply to both categories of corporate
management and the only dividing line is in the financial magnitude and
implications of a particular corporate management practice.
Some.Unethical Practices of the Board of Directors
1. Plain Graft
Some of the Board of Directors help themselves to the earnings that
·otherwise would go other stockholders. This is done by voting for
themselves and the executive officers huge per diems, .large salaries, big
bonuses that do not commensurate to the value of their services. They
can also reduce the earnings going to the other shareholders by
authorizino purchases of goods and services for the company's use at a
price high;r than norma , i consid ration of a certain percentage of the
purchase value or comm1ss1on accrumg to them.
114 Chapter 7
2. /11terlocki11g Directorship
Interlocking directorship. is often practiced by a person ho hol_ds
directorial positions in two or more corporation that do business with
each other. This practice may involve conflict of interest a d can resu t
to disloyal selling. Disloyal selling happens when this person is
compelled to decide whid1 of the two corporation's interest should be
protected or upheld. Thus, whatever decisions the per_son makes, hE>
betrays the trust reposed on him by the shareholders of either of the two
companies.
3. Insider Trading
Insider trading occurs when a broker or another person with access to

confidential information uses that information to trade ·in shares and
securities of a corporation, thus giving him an unfair advantage over the
other purchasers of these s curities.
4. Negligence of Duty
A more common failure of the members of the Board of Directors than

breach of trust is neglect of duties when they fail to attend board
meetings regularly. It is only in regular attendance that they can protect
the rights and interests of the sh'areholders and their non-attendance of
board meetings could result to betrayal of trust of the parties who
elected them to their positions.
Some Unethical Practices of Executive Officers and Lower Level Managers
To a lesser extent, executive officers may also guilty of unethical practices. All
o:
the unethical practices of the members of the Board of Directors discussed are
activi ies. t ey ar7al o apable engagi g in thou h perhaps to a lesser degree
because of certam hm1ts to their authority. Unethical practices that are more
· common to executive officers and lower level managers are:
I. Claiming a vacation trip to be a business trip. The President ora Vice

President reports his personal vacation in Europe or in the United States
as a business trip so he can get reimbursement for his expenses including
those of his family's. . . .
Common, Unethical Prqctices of Business qtablishments 115
2. . Having employees do work unrelated to the business. Executive officers

and lower managers ask company employees to do person I things for
them on company time such as having the company janitors water and
mo their lawns, having the maintenance men do house or appliance·
repairs for th rl_l, and having subordinate employees secure a license or
type letters pertaining to their other businesses.
3. Loose or ineffective_ controls·.Managers do not provide adequate

controls to remove temptation and to prevent or 'discourage employees
from enga ing in unethical proctices. A manager has the moral
obligation to provide the proper control atmosphere so that his
subordinates will not be tempted to commit dishonest acts. A manager
indirectly betrays the trust placed on him by higher executive officers if
the administrative and
· accounting controls in his office are so weak or effective that
employees are given the opportunity to misappropriate funds or engage
in petty thievery.
4. Unfair labor practices. The labor code lists the following as unfair labor
practices committed by an employer on employees or a group of·
employees who have organized themselves into a union.
a. To interfere with, restrain or coerce employees in the exercise of
their right to self-organization;
b. To require as a condition of employment that a person or an
employee shall not join a labor organization or shall withdraw
from one to Which he belongs; ·
To contract out services or functions being performed by union
C. members when such will interfere with, restrain or coerce employees
in the exercise of their rights to self organization; ·
d. Toinitiate. dominate. assist or otherwise in with the formation or
administration of any labor organization. including the giving of
financialor other support to it;
e. To discriminate with regard to wages. hours of work. and other
terms orconditions of employment in order to encourage or
discourage
membership in any labor organization.
f. To dismiss. discharge. or otherwise prejudice or discriminate.
against anemployee for having given or being about to give
testimony under
the Labor Code:
116 Chapter 7
g. To violate the duty to bargain collectively a prescribed by the Labor

Code:
h. To pay negotiation or attorneys fees to the union o its officers or
agents as part of the settlement of any issue in collective bargaining
or any other dispute:
1. To violate or refuse to compl,yvith voluntary arbitration awards or
decisions relating to·the implementation or interpretation of a
collective bar gaining agreement;
J. To violate a collective bargaining agreement.
5. Making false claim · about losses to free themselves from paying the
compensation and benefits provided by law. There are.·employers who
claim non-existent losses ro they can be exempteq from paying the
minimum wage and emergency-cost-of-living allowances required by
law.
6. Making employees sign documents showing that they are receiving fully
what they are entitled to under the law when· in fact they are only
receiving a fraction of what they are supposedio get, .
,
7. Sexual Harassment. Work, education or training-related sexual .
harassment is committed by an employer, employee, manager,
supervisor, agent of the employer, teacher, instructor, professor, coach,
trainer or any other person who, having authority, influence or moral
ascendency over another in a work or training, or education environment,
demandr, requests or ot/Jerw;se requfres sexual favor fro.m the other,
regardless of whether the demand, request or requirement for submission
is accepted or not by the object.
...
,
•
Common Unethical Practices of IJ11si11ess Estahlisl,ments 117

Some Unethical Pr·•,ctices
rnp1oyees
ofE
There are some emplo-,·ees,vI,·o are not dful of thei•r moral o bl1' gat·1ons to ti,e·ir
mm•1
emp oyers_. :hey take advantage of their position and tJ,e trust of their employees
b·v c•omm1ttm- uneth·tea pract·ices harmful to thei•r employers'. ht ese
0 I ·interest
=:
t
une btcal practices may be classified into conflict of interest and dishonesty.
I. Conflicts of Interest
A conflict of interest arises when an employee who is duty bound to

protect _and p_romote the interests of his employer violates this obligation
by getting h11nself into a situation where his decision or actuation is
influenced by what he can gain personally from it rather than what
his
employer can gain from it. Some· common examples of conflicts of
interest are:
a. An employee who holds a significant interest or shares of stock of

a competitor, supplier, customer or dealer favors this party to the
prejudice of his employer. ·
b. The employee accepts.cash, a gift or a lavish entertainment or a
loan from a suppli_erc,ustomer, competitor or contractor. In this
situation, the decision or action of the employee is influenced by
his being indebted for a favor or loan from a party with whom the
company is doing business. He, therefore, cannot act impartial_ly.
c. The employee uses or discloses confidential company
information for his or someone else's personal gain. An example
is revealing his employer's formula or menu for a well-liked food
to a competitor.
d. The employe engages in the same type of business as his
employer. He may attend to his business only after office hours
because he has somebody to mind it for him but it is still
unethical. An example is an auditor employed full-time in a
public accounting firm out maintains his own auditing office
where h works after office hours.
e. The employee uses for his own benefit a business opportunity m
which his employer has or might be expected to have an interest.
118 Chapter 7
2. Dishonesty
Business ethics is not just limited to business transactions with outside

parties. Jt also covers employee-employer relationship, especially with
respect to an employee's honesty as fie carries out his assigned duties in
the office. Examples of dishonest acts of employees are:
a. Taking office supplies home for personal use.

b. Padding an expense account through the use of fake receipts when
claiming reimbursements.
c. Taking credit for another employee's idea
119
Common Unelhical Praclices of /311si11ess Es1abli h11ienls
REVIEW QUESTIONS
Questio11s
I. What are the two most common types of unethical practices of business
establishments as far as the products r customers are concerned?
2. Give and explain briefly .at least three ways of directly

misrepresenting_ products.
3. How is indirect misrepresentation of a product undertaken?
4. What does·"caveat emptor" mean?·
5. When does over-persuasion become unethical?
6. What is "interlocking directorship" and why could .it lead to unethical

actions of a member of the board of directors?
.'
, 7. Insider trading is considere an unetliical practice. Why?
8. What are some of the unethical practices that executive officers may be
guilty of?
9; Cite some unethical practices of employees to their employers.
JO. Distinguish between direct misrepresentation indirect misrepresentation.
Multiple Cltoice Questions
I. Examples of direct misrepresentation about the product include the

following except
a. False advertising
b. Deceptive packaging
c. Mislabeling
d. Caveat emptor
120 Chapter 7
2. Examples of indirect misrepresentation about the product include the

following except
a. caveat emptor .
b. deliberate withholding adverse infonnat1on
c. business ignorance
d. false advertising
3. Examples of direct misrepresentation about the product include·the

following except
a. adulteration
b. short merging·
c. short measurement
d. over persuasion
4. Interlocking directorship can be committed by

a. rank and file employees
b. members of the board of directors
c. top executive officers
d. middle-level managers
5. The following onstitute unfair labor practices of an employer except

a. to restrain employees to form a union
b. to violate a collective bargain or agreement
c. to discriminate with regard to wages, hours of work
d. to terminate employm nt of employees found to have viofated
company poiicy or employment contract.
6. ·The following are examples of unethical practices of employers except

a. acceptance of gifrs from a customer in exchange for a favor that is
detrimental to its i1iterest of his employer
b. engagement in the same type of business as l1is employer
c. disclosure of confidential company information to s.omeone else for
personal gain.
d. Application for a loan from his employer to sett! personal liabilities.
7. The following are examples of dishonest acts of an employee toward his

employer except
a. Working ove11ime upon instruction of his supervisor.
b. Bringing home office supplies for personal use.
c. Overstating business trip expenses by submitting false receipts.
d. Doing personal errands during office hours.
'
E·rHICAL DI LEMMA
<E:(pectecf L?arning Outcomes

After studying the chapter·,you should be able.to...
1. Explain what ethical dilemma·is. ·
2. Describe the steps in resolving ethical dilemma.
3. Apply the steps in resolving ethical dilemma.

CHAPTER 8
ETHICAL DILEMMA
iNTRODUCTION
• • • • •
An etlu ca/ di lemma 1 s a s1 tuat1 on a de 1;hich a must b e
,a.cision
& '. •
person ces m . " .
. . • le of an ethH!al dilemm a
made about the app·ropr iate behav ior. A , mp1e examp f i
1s
d finding a diamond ring, which necessitates deciding whether 10 attempt to
10
the owner or to keep it.
RESOLVING ETHICAL DILEMMAS
In recent years. formal frameworks have been developed to elp people res lve
ethical dilemmas. The purpose of such a framework is in identifying the ethical
issues and deciding on an appropriate course of action using the person's own
values. The six-step approach that follows is intended to be a relatively simple
approach to resolving ethical dilemmas:
I. Obtain the relevant facts.

2. Identify the ethical issues from the facts.
3. Determine who is affected by the outcome of the dilemma and how each
person or group is affected.
4. Identify the alternatives available to the person who must resolve the
dilemma. · ·
5. Identify the likely consequences of each alternative. 6. Decide the
appropriate action.
Illustrative Case: Resolving an Ethical Dilemma
Bert Cruz has been working for 6 months as a staff assistant foralaw firm. Alvendia and Castro
£thical Dilemma 123
During lunch on the first day, Carlos says. "It will be necessary for us to work a ew e tra hours on our
isn't very profitable anyway. and we don't want to hurt our firm by going over budget.
We can accomplish this easily by coming in a half hour early, taking a short lui ch brea , and working a
Bert ecalls r:ading in the firm's policy manual that working hours and not chargmg for them on the time
Later, when discussing the issue with Martha, she says, "Carlos does this on all of his job. He is likel
Several of the other seniors staff follow the same ractice."
E-tliical Issue
The ethical issue in this situation is not difficult to identify.
• Js it ethical for Bert to work hours and not them as hours worked in this
situation?
Who is Affected and How is each Affected?

There are typically more people affected in situations iwhich ethical dilemmas occur than -would nor
involved in this situation:
How Affected
Being asked to violate firm policy. Hours of work will be affected.

Bert Pay will be affected.
Performance evaluations may be affected.
Attitude about firm may be affected.

Same as Bert.
Martha
124 Chapter8
Carlos
Success on engagement and f1irm may be
·
'" affected.
Hours of work will be affected.
Alvendia and Castro Stated firm poiicy is being-vi?late .
May result in under billing clients ,n the current
and future engagements. . .
May affect the firm's ability to realistically
budget engagements and bill clie ts.
May affect the firm's·ability to mot1vgte and
retain employees.
Staff assigned to Rayon May result in.unrealistic time budgets.
Manufacturing in the May resu.lt in unfavorable time performance
future evaluations.
, May result in pressures to continue practice
of not char:ging for hours worked.
Ot.her staff in firm · F:ollowing the prac.tice of this engagement may
motivate o hers to follow the same practice on
other engaizements.
Bert's Available Alternatives
• Refuse to work the additional hours.

• Perform in the manner requested.
• Inforn:i Carlos that he wilf•.not work the ddilional hours or w·11 f
the add·1t1ona
· I h ours to the engagement. .. 1 c 1arge
• Talk to manager or partner about Carlos request.
• Refuse to ork on the engagement.
• Quit working for the firm. •
Each of these options in ludes a potei1tial cohseque, ti
beiniz termination bv the firm. lce, le w9rst likely one
Consequences of Each Alter11ntive
In deciding the consequences of each alternattve 't · .

the short- and long-term effects. There isa flat' 11'ts esdsential to evaluate both
short term because those consequences will occur ura uickl
en ency t O h ..
emp as,ze the
term consequences may be more important. For q Y, ve when the long
consequences if Bert decides to work the add ition: : e, consider the.potential
sand not report them. In
\
Ethical Dilemma 125
the sho.rt term, he will likely get good evaluations for cooperation and perhaps
a salary 11 cr ase. In the longer term, what will be the effect of not reporting the
hours this tune when other ethical conflicts arise?
Consider the following similar ethical dilemmas Bert migi1t face in his career
as he advances: · ·
• A supervisor asks Bert to work 3 unreported hours, daily and 15

unreported hours each weekend.
• A. supervisor asks Bert to initial certain procedures as having ·been
performed when they were not. .
• Bert concludes that he cannot be promoted to manager unless he
persuades assistants to work hours that they do not record.
'
• Management inform.s Bert, who is now a partner, that either the
company gets a P400,000 legal fee or the company will change
lawyers.
• Management informs Bert that the legal fee will be increased PS0,000 if
Bert can find a lausible wa to increase robabili or wmm the case.
Appropriate Action
Only Bert can decide the appropriate option to select in the circumstances after considering his
would consider such an extreme reaction na'ive.
j •
126 Chapter 8
REVIEW QUESTIONS
Questions
I. Describe an ethical dilemma. How does a person reso ve an ethical
I
dilemma?
. . . r b professionals ?
2. Why is there a special need for ethi cal beh a vi o y ·
• d·scovers that the client's
3. After a epting an en agement,a con ul antd \hat he is not competent
industry is more technical than he realize an It nt's options?
in ceitain areas of the operation. What are the consua ·
Exercises
Exercise 1
David Lawyer sets up a small loan· company spec1·a1•iz•mg •m • to b.usineh ss

IOans
execut·ives an'd small Dav1·d does not sp.end much time m t e
comp.an·ies.
-business because he spends full time with his law practice. No employees of
David Law firm are involved in the small loan company.
Identify and discuss the ethical implications of David's act.
Exercise 2
Frank Doran, a senior audit manager for Cruz and Santos, CPAs, has
recently been informed that the firm plans to promote him to paitner within
thenext y ar or twoifhe continues to perform at the same high-quality level as
in the past. Frank excels at dealing effectively with all people, including
client personnel, professional staff, partners, and potential clients. He
hasrecently builta bigger home for entertaining and has joined the
city'smostprestigious golf and tennis club. He is excited about his future with
the firm.
Frank has recently been assigned to the audit of Machine Internationala

large wholesale company that ships goods throughout the world. It
isone'of Bright and Lorren's most prestigious clients. Durino the
audit Frank
detennines that Machine International uses a method of evenue ' ·tion
"· 11 d h Id" h I reco0e 111
called b1 an o t at 1as recently been questioned by the SEC. After
considerateresearch, Frank concludes that the method of •·
is not approp. riate for Mac. hine revenue recogn1t1on
Internat.ional.
ethical Dilemma 127
In discu.ssing the matter with the engagement partner, she conclud?s that tl e
. accounting method has been used for more than IO years' by the client and
is appropriat_e,.especially considering that the client does not tile with the C.
The partner 1s certain the firm would lose the client if.the revenue
recogn1t1on, method is found inappropriate. Frank argues th t the revemie
recognitio!1 method.was appropriate in prior years, but the new SEC
ruling makes it
appropriate in!he current year. . .
Frank recognizes the partner's responsibility to make the final decision, but
he feels strongly enough to state that he plans to 'follow the requirements
and include a statement in the working papers that he disagrees with the
partner's decision. The partner informs Frank that she is unwilling to permit
such a statement bec use of the potential legal implication;. However., she is
willing to write a letter to Frank stating that she takes full responsibility for
making the final decision if a legal dispute ever arises. She concludes by
saying, "Frank, partners must act like partners, not like loose cannons trying
to make life difficult for their partners. You have some growing up to do
before 1 would feel comfo11able with you as a partner."
Required:
Use the six-step approach lo resolve the ethical difemma.

ADVOCACY AGAINST
CORRUPTION
fEx:pectectLearning Outc mes

After studying the chapter, you should.be able to.:.
1. Understand what corruption is.·
2. Know t:iow corruption may look like.
3. Know why and how does a person become corrupt.
4. Explain the ill effects of corruption.
5. Describe the characteristics of corruption.
6. Learn and familiarize himself / herself of the impact of

corruption in the Philippines as well the efforts both of the
public and private sectors to·curp it.·
7. Know how c;:orruption may be prevented.
•
CHAPTER 9
ADVOCACY AGAINST CORRUPTION
\.VHAT IS CORRUPTION?
Corrupti ll is the abuse of private and public office for personal gain. It
includes acts of bribery, embezzlement, nep_otism, kickbacks and state.capture.
hi is often associated with and reinforced by other illegal practices such as

bid nggmg, fraud, or money laundering, extortion. . .
imply defined; corruption is receiving, asking for or giving any gratification

to induce a person to do a favour for private gain. This act covers not oniy
public corruption involving misuse of public. power by elected politician or
appointed civil servant but also private corruption' between individuals and
businesses.
A broader definition of corruption follows:
"Corruption is the misuse of entrusted power (by heritage, education, marriage,

election, appointment) for private gain. It c.overs not only the politician and the,
public ser¥ant but also tlie CEO, CFO and but other employees of a company."
. .
It involvesrong doing on the part of an authority or powerful party through ·
means that are illegitimate, immoral or incompatible with ethical standards.
Corruption often results from patronage and is associated with bribery.
A much more difficult, scientific. definition for the concept 'corruption' was
developed by Professor (emeritus) Dr. Petrus Van Duyne:
"Corruption•is an improbity or decay in the decision-making process in which a
decision-maker consents to deviate or demands deviation from the criterion
hich should rule his or her decision-making, in exchange for a reward or for the
w ·se or expectation of a reward, while th e motives influencing his or·her
p ro m , · ·f i · fh d · · "
d e c i s i o n - making cannot be part of theJ ust , 1 cat1 on o t e ec1 s 1on .
l n generaI, Corruption is a form of dishonesty. orcriminal activity undertaken by a

. • · f I · ft ·
person an organization entrusted wi th a pos1 t1 on o , au t 10n ty, o en to acqu ire
iIIicit benefit.
I JO ! '/,<_!/>ll'I' V
110\V DOES CORRUPTION LOOK LIJ<E?
'
\
i
t) .
\
,. '. I
II
,I
Corruption may take place in any of the following forms/ ways:

• A company paying a bribe to win he public contract to build the local
highway, despiie proposing a sub-standard offer.
• A politician redirecting investments to his hometown rather than to
the region most in need.
• Public official embezzling funds for school renovation to build his
private villa. •
• A private company manager recruiting an ill-suited friend fora
high level position.
• Or. local officials demanding bribes from ordinary citizens to get
access to a new water pipe..
• A salesman bribing the purchasing manager of a company to give
preference to his products. ,
At the end <ftl,e day, t'1ose'1urt most by corruption are theworld'sweakesl

and most vulnerable.
Advucaq ARal11st Corruption 131
\.VHVAND IIOW DOES A PERSONBECOMECORRUPT ,

Corruptions spread wl
• b ten t1icrc arc. opportunities when risk is m,n1mal
• • rn
comparison to cncfits obtained or when one is conf;ontcd with issues like
0 Career advancement
0 Earning of more income
D Financia' l problems caused by .illness, loss of property, etc.
Those engag ed in corru t' . •
b • . P ion 1e arn how to be d ishonest. The next corrupt
?
acti ons ecomed asier lo 0 unless one is firmly rooted on solid principles and
has·been nurture m an upright manner.
ILL EFFECTS OF CORRUPTION
Economically,
• Con·uptions add up to I 0% of the total costs of doing business in any

part of the world·and up to 25% of the cost of procurement programs in
developing countrie;;.
• Corruption leads to waste or the inefficient use of public resources.
In the Philippinef,figuresfrom 1960 to 2016 indicate that an average of
P550 billion is lost yearly to crime, corruption and tax evasion. This
amount could clearly have been used more efficiently and effectively
for poverty alleviation or education instead. ·
• Corruption corrodes public trust, undermines the rule of law, and
ultimately delegitimizes the state.
• Africa's 700 million people under 30 are seeking opportunities
with dignity and if mismatqh between aspirations and fulfilment
continues, thiscould lead to apathy, discontent and turn them to radical
extremists
and join terrorist groups.
Other significant and serious repercussion_s of corruption are:
I. If allowed to take root in society, it c n lead to a breakdown in social

order and I·ves
1
are affected when ordmary people are prevented from
. •
· ·
receiving aII the essentialservice that they are entitled to.
132 Chapter 9
.. r1k most of the public funds
Corruption may have drastic impacts . .
1 ople instead of
are used on the leisure and lifestyle of mfluei tia. pe eds of general
allotting them on hospitals, schools and other asic ne
public. ·
. . . d
2. It creates unfa ir compet1 t1 on an the cost of doing b usines s .
. s d I d
mcreas e
. . d ti omic growth an cou
Every form of corrupti on 1 s ba or econ
result to tarnished reputation of an entire country. · ·
Corruption causes businesses to flee from· the country because
businessmen find it a constant threat for their progress.
3. Corruption is cancer that spreads rapidly all over the. body.

Corruption in Australia, Caf!ada and few European countries- has
dropped extensively due to adoption of, concre!e measur s.
Nevertheless, corruption in developing and underdeveloped
countries (especially Afghanistan and Somalia) is sti.11 a critical
problem.
There is a growing worldwide concern over, corruption at the present ·time. A
consensus has now been reached that corruption is ·universal. It exists in all
countries, both developed and developing, in the p'ublit apd private sectors as
well as is non-profit and charitable organizations. Allegations and charge of
corruption now play a more central role 'in .politics thtlt at any other time.
Governments h ve fai.led careers of world renowned public figures ruined and
reputation of well-respected organizations and business firms badly tarnished on
account of it. -
Major corruption arises whenever major events. involv·ing large sums of

money, multiple parties or huge quantities of products are .at· stake.
Corruption also flourishes in situation invo.lving high
technology (e.g., purchase of a technologically far-
advanced aircr;ift) or 'in situations that are chaotic anda number of actions !s
very large such as .natural disasters, civil war and bettino in international sports
tournaments. -Major corruption thrives on a broad bas; of
small corruption payments or bribes. In the end, all corruption costs are absorbed
by the cor:isumers and the taxpayers.
Advocacy Against Corruption 133
CHARACTERISTICS OF CORRUPTION
'\lthough there is a widespread perception that corruption is prevalent, it is

difficult _to tablish how wide and deep corruption has penetrated ?ur economy
an .social hfe. This is because both partners in an exchange of power for
privileges keep their transaction secret.
a) Recipie11ts a11d pavers
Corruption is the abuse of entrusted power and elected authority for

private profit.
Worldwide complaints are heard about politicians· and 'public

officials who accept bribes and nrich themselves privately at the
expense of the common citizen. This may be at th·eexpense of the
employee and the "employer; consumer and producer; renter and
tenant; the one applying for a permit to do something, or asking
exemption from an obligation to pay or to deliver a product·or a·
service. All those cases may be
considered to be abuse of power and authority for one's own benefit:
Complainants forget that necessarily there should also be payers who
benefit from that.abuse of power and authority. The other side of the
coin shows payers assuming that their 'gift' to a politician or a public
official, may in ret_urn deliver profitable preferential treatment or
delivery.
Anyone who wants to fight corruption and safeguard integrity in
governance should not only prevent politicians and public officials
from unlawfully accepting gifts, but should also fight the 'high and
mighty' that abuse their power and authority to give privileges such as
land rights, permits, diplomas, allowances, money, against a reward.
·b) Extortion
They do not only blame politicians and public officials for willingly
accepting bribes. It is also often alleged that.those having authority
in.our society ask to be bribed'or give us t e opportunity to bribe. This
means that the question 'who is to blame', shifts from the person who
pays to the person who extorts and receives. Again on the ground of the
allegation: 'There's no escaping from it, for if you don't pay, you are
bound to fall behind'.
13.$ C•l ,..,,.,.·cr:. <.>
.
In e,etY socr etv 1 .
.
rs known. . e1ht er publr.eI) . privarel v v.hich p u b l i c -
t - ·. T h
or
- · . . . • · rec,proca11.y· . e
oflkia l i-. open to transacti ons w ith g if ts be ing
d
ma e
gift on -the part of the otl-.,cial may ht en •i m,pI ) considorin:o:: an apphcatT,ohn
wi.th pn.ort.ty. or ass1. gn.mg a s1.:holarsh1·p
•• -
or• emplovment.
•
,e
conrracr.
pote.nt1al pa)er ."11 ook f, or hi. ·'pre,· ·. h" wr•ll loohk"'
politician'public 1 I
official · of whom s everybody
for f :.
knows that - c n.ft
btn-
·boughf, that he is prepared to brea the les in ex a_nge

Therefore. the reputation that a public official or polr tcian_enJ s 1
gre.at significance. Some ,viii never be approached withof
a
J _: • ,
propo:)rnon_- the potential extortionists or bribers do know that they

(those public officials or politicians) are not open to such practices.
Equally. as regards some business enterprises, it is a known fact that
they do at keep any
cash for bribes. Thev run less risk of falling victims to e:,.."tornon.
c) Lubricant of societv
Nfany think that paying bribes is required to ensure smoother operarion
of sodety. They think that without an occasional gift (for example,
around E:hristmas and New Year), or incidentally (a gift on the occasioi:i
of a marriage or when a child is born) for instance upon entering into a
contract for the supply of a product or a service, such contracts might be
lost to them and might be assigned to others.
For entrepreneurs who want to s cure sales, those gifts are a cost item
which they account for in advance in their prices. As a consequence,
products and services cost unnecessarily more than is need d froma
commercial point of view, for as a matter of fact, these i!ifts have alreadv
been budgeted. · - -
If corruption is judged purely on the basis of business economics. macro

economically it costs money to society which should be consid;red asa
loss. From the micro-economic point of view, for the bribinc
entrepreneur, it is profitable. The payer of a bribe securesa desired
transaction which·'- if evaluated on purely commercial grounds _ strictlv
pe ing, should have been assigned to someone else. That will ha
rnd1v1dual entrepreneurs and transactions; it will harm the national
economy and the world economy.
d) An etlticn/ dilemma
Th mere fact that both the payer and the recipient of bribes want to keep
their behavior secret (and often succeed in doing so as well) shows that
such b havior is generally considered to be improper. Many consider
corruption to be an ethical problem, a behavioral problem. And refer to it
as berng 'sinful', a 'wrongdoing'. It is a problem to be solved by means
of personal 'reform'.
mpl asizing the 'sinfulness' of corruption, aims at improving especially

md1v1dual and personal behavior. Poor entrepreneurship (in a moral
sense) should then be improved on a personal basis. Our focusing on the
co ditions and the implications of corrupt behavior aims rather on the
entire structure of society and economy, and on the conditions that exist
within that structure to prevent and fight corrupt behavior and safeguard
integrity. Good ef1treP.reneurship is judged with regard to its quality in
all three aspects: People, Planet .and Profit. The qualification 'poor' is not
a sign of sinfu_lness, but a quality that signifies an adverse effect on all
thr e aspects, not only on the economics.
e) Poverty al/evintion
The explanation that refers to individual poverty reduction is especially
· given by those who have a keen eye for corruption among lower
operational staff in government service, notably lower office clerks,
police officers, customs officers, the military, teachers, admission staff in
hospitals, bus ticket collectors, car-park attendants, garbage collectors,
etc., who on an operational level often have good oppqrtunities to extract
extra income qr privileges from decisions they might take of importance
to entrepreneurs and citizens. Consequently, these have a certain value.
Investigations into the effect of the level of income enjoyed by a person,

however, provide sufficient proof that this explanation is not correct.
Low pay .does surely not automa ically imply that, _consequently, the
person conc rned is corru t. What 1s o_f much greater 1mp rtance the :or
prevention of, or fight a_gamst, corruption at a lower level rn all kmds of
hierarchies is the clearness and transparency of the rules and of the
decision-m king process, and the control exercised on the application of
the. rules? Ti!Jlely payment of salaries is an important pre-condition to
prevent corrupt behavior.
136 Chapter 9
j) Culture
Gifts are inherent to human relations and therefore present in all
cultures. You give and receive gifts on the occasion of birthdays, Sa_nta
Claus or Christmas; on the occasion of memorable events; !'n
apporntment ora departure; marriage or a retirement. •
When you receive a gift from them, it will also be open and visible to •
everyone. Corrupt payments are made in hiding, are not made known. A
gift made in public will also impose a certain obligation upon the
recipient. On a next occasion you will show your gratitude by
reciprocating the gift and you spare the.gift received with your family
and friends. In fact, in our everyday life it is not much different. You
give and receive on birthdays, on the occasion of marriages and births,
and on other festive occasions. Look at the reciprocal. state visits of
Hea.ds of government and Heads of state, exchanging gifts.
g) 'Kin_d11ess among friends'
It is essential, whether you just want to be 'thoughtfu I', or \1/hether your
gift is presented with a certain intention. Is it a sign of thougi1tfulness or
is it hiding a particular purpose, an e?(pected 'return' in the future?
Whether 'a enti n' or_ '-in!e tion', the difference is of great importance
for the relat1onsh-1p. Is 1t a friendly tum' or is it an 'investment'?
To ha e frie ds belongs to culture. However, can you 'buy' a friend? Is

real fr1endsl 1p not to_ be based on honesty and transparency? To give
·
pr esents reciprocally 1s a sign of friendship. It should. not get ma
lot· f
s
misuse o power 1c.or- pri. vate gam. s. . ·
•I
Advocacy Against Corruption 137.
THE PIDLIPPINE.SCORRUPTION REPORT*
T t Former Secretary of Finance reported in 2016 that the Philippines loses

P200 bllho fro smuggling and P400 billion from tax evasion perpetuated
through collusion_with some personaliti s in the government agencies. P2.6
trillion is lost annually m corruption globally. .
Judicial·System
Corruption risks are high in the judicial system. Bribes and irregular
payments•in return for favo,rable judicial decisions are common. The
judiciary is formally independent, but the rich and powerful have frequently
influenced proceedings in civil and criminal cases. Procedural fairness and
transparency are sever ly undermined by nepotism; favoritism, and impunity.
Companies do not
· have sufficient faith in the independence of the judiciary and they rate the
efficiency of the legal framework in settling disputes and challenging
regulations as poor. Investment disputes can take several years to resolve due
to a lack of resources, understaffing, and corruption in the court system. Low
salaries for judicial officials are said to perpetuate the problem of bribery.
.The judiciary is underfunded by the state and often depends on local sponsors
for resources and salaries, resulting in non-transparent and biased court
decisions. Foreign investors have noted.that the inefficiency and uncertainty in
the judicial system are disincentives for investment: investors regularly decline
to file disputes due to the perception of corruption among personnel and the
complex and slow litigation processes. Enforcing a contract takes much longer
than the regional average, but the costs involved are significantly lower.
In one recent case, a businessman filed an administrative complaint in the

country's Supreme Court against Makati City judg f r alle_gedly asking_ for a
PHP 15 million bribe in exchange for a favorable ruling man insurance claim.
At the time of review, no further updates on the case were available.
(Source: GAN Busi/less Anti-Corruption Portal)*

138 Chapter 9
Police
. . 'ti the police. The national
There is a high-risk of corruption when deal111g w1 1 t institutions in the
police force is widely reg rded as ? e of e , os /
th
tion, extortion, !l,nd
country.
, Reports. of the police
I and
k military
w1·despread Companies report that they
engagmg _P
being involvedm loca rac ets are · f f fi pay for private
cannot rely on the police services. More than ha! o
security. Businesses rate the National Police's com Jtment tol
as 'poor'. Presidi::nt Duterte has accused several poltce gene(a s
fr!/
irmsI tin' corruption
be g involved
_
in the trafficki_ng of illegal drugs. ·
In one corruption case, P.olice Com1.111. ss1oner Mr. is und.er invesktigLatai mon
Som berO.'
for allegedly facilitating a PHP 50 million bri e from gambling tycoon Jae.. '
who tried to bribe immioration authorities m order to release approximate1Y
I 300 Chinese nation ls who were working in his resorts illegally. ·
' .
Public Services
Companies contend with a high corruption ris when dealing ith thepublic
services. Approximately half of business executives reported bemg asked '.or a .
bribe by someone in the government in 2017. Nearly three out of five busmess
reported expecting to give gifts in order 'to get things .done', but only one in ten
reported expecting to give gifts to get·an operating license.
Irregular payments and bribes in the public services sector sometimes occur.
Philippine officials involved in processing documents related to civil and
property registration an building permits are more likely to solicit bribes
compared to officials dealing with other types of services. Inefficient
government
bureaucracy is ranked as the most problematic factor for doing business in the
Philippines.
Civil servants often do not have the resources or abilities to fulfill their tasks-free
from corruption and red tape. Furthermore, civil servants aregenerally not
recruited ina competitive manner; appointments are based ona practice of
patronage.
Th: to!al number of p ocedures required to set-up operations, including

reg1stenng the company wrth local government and getting a construction permit,
are significantly higher than regional averages. Getting electricity takes
significantly less time than elsewhere in the region.
-
Land Administnttion
Ct m,pli\,n ri J.. in lhc land ndminbtr:llitm nrc high. I\\O 0111 of five
companie.. l\'P•-'" t':\pcct,ng h) gi,c gilt "hen ob1nininL!n con lruction
permit. Property rights an: fonnnll rccogni1cd n:1d protcctccl ' the
Philippines. but jn practice. the t:l" 1· not ::ih,11 . upheld. Ousinesscs ha,e
insufficient confidence in the
protection of pr\1pcn rights.
Corruption and arbitrariness in the application of the law are common. Multiple
agencies are responsible for land administration. "hich has led lo overlapping
procedures for land valuation and title registration: this has made the process
costly.
The court syste(n is slow to resolve land disputes. Land records are not properly
managed due to a lack of trained personnel and funds. Foreigners are not allowed
to directly own land, but they may lease land for up to 50 years with a possible
one-time extension of 25 years.
Expropriation is possible under Philippine law; the law calls for fair market
value compensation, but coming to a mutually acceptable price can be a lengthy
process in the court system. Registering property takes nine procedures in the
Philippines, which is double the regional average. However, the total
time required is less than half of the regional average.
Tax Administration
There is a high risk of corruption when dealing with the tax administration.
Around one in seven companies indicate they expect to give gifts in meetings
with tax officials. Tax regulations are among the most problematic factors for
conducting business in the Philippines. Companies indicate that they perceive
that only a fifth of businesses in their line of business pay their ta'<es
honestly. Officials at the Bureau of Internal Revenue (BIR) are believed to be
prone to corruption and known_ for embezzl ment_and extortion. A
typical example of this can be found m a recent case 111 the city of Bacolod; an
officer with the BIR was caught extorting PHP 125,000 from a local
company. Businesses rate the BIR's ommi ment to fi hting c rruption as poor.
On a more positive note, there are signs that the BIR rs pursumg more cases of
tax evasion.
Companies make twenty-eight tax payments n year. which 1s higher than the
regional average.
140 Cha1•1c:1· 9
Customs Adminislrnllon
There is a high risk or andpayments

with thein
. . 1 dealing
, •• customs
c11co1111tcrrng cor:ruptron 11
administrntion. Companies indicntc thnt 1rrcgulnr Jrrcs
and export procedures an.! very common.
t
About a quarter of companies indicate they expec1 g,ive
, gifts when obtaining
of Customs (BOC)
0 8
·
· d· a tes t hat the u r e, ,u
an import license. A busmess survey 1 1 1• re , . , ba d ' w hen it came to its
was the only agency receiving a ratmg of v ry 't burdensome import
commitment to fight!ng corruption. Compa_n, .s cine, the most problematic
procedures and corruption at the border as. berng a1 10 gTt of rocedures are
factors for importing. The fficiency a!1d lime ? ed ctab::eysi ,ni cantly higher
rated as poor. Border compliance costs I the Ph1 1pp11 e ' linegwith the
regional than the regional average, whereas .the time required rs 111
average.
The Bureau of Customs (BOC) has indicated that smuggling of goods, mong
which cigarettes, vehicles, and oil, into the Philippines h_a sl e d to the evasion
of taxes worth at least USD I billion yearly. Consistent fraud 111 the form of
under invoicing when importing-and exporting costs the state USO billions in
revenues each year. In 2016, the BOC alleged one of its employees accepted as
much as USO 4 million in bribes monthly.
Public Procuremen
There is a very high risk of corruption in tl)e public procurement sector, which is
subject to rampant corruption, irregularities, and inconsistent implementation of
legislation. Likewise, more than a fifth of businesses report they expect to give
gifts in order to win a government contract. Two in five·companies indicate that
most companies in their sector give bribes in order to win contracts. Diversion of
public funds, as well as favoritism in the decisions of-public officials, is very
common. The public sector is obliged to procure goods and services from
companies with at least 60% Ph lippine ownership. Local-level public
procurement lacks transparency, fostering a culture of eorruption through the
misuse of _the pork b rrel ysten_1; which. are un s for discretionary use by
represe t t ves forproJ7cts_111· tl err re pe t1ve districts. Philippine law allocates
resp?ns1brl1ty for mon1tonng, rnves 1gat111? and sanctioning irregularities in
public procu emen toa num_ber o different state ins itutions, leaving potential ·
misconduct, 111effic1ency and 1111pun1ty unchecked.
Natural Resources
Compa 1ies operating in the natural resources sector face a high risk of
corruption. The Philippines has shown marked improvements in its natural
res urce governance in the past few years; the country has a good enabling
environment and its regulatory quality and control of corruption are judged as
adequate. However, poor value-realization and revenue management have
caused th .co ntry's overall resource governa,ice to be ju9ged ·as
'weak'. The
Phihpp!n s has been working to achieve compliance with the Extractive
Industries Transparency Initiative (EITl) since joining in 2013. Some mining
contracts ar publicly disclosed via the EITI portal. While transparency in the
sector has unproved, poor regulation and overlapping policy responsibilities
between local and central governments have meant that small-scale minirig is still
a contentious issue. ·
Govell}ment corruption has. allowed mining companies to evade government

regulations, which has resulted in· large-scale deforestation, flattened
mountaintops and water pollution. The government responded by cracking
down on illegal mining.operations; and as of2017 Secretary of the Environment
Gina Lopez shut down 28 of the country's 41 mining companies for pplluting
the environment. However, Lopez was removed from her job by Congress in
May 2017 after mounting complaints from the pro-mining lobby.
PREVENTION OF CORRUPTION
. .
Corruptio.n in Singapore is under control. However, a clean system is not a
natural state ·of affairs. Corruption comes from weakness of human nature -
greed, temptation, the desire t amass we lth or to ob ain bu;siness through
unfair means. Even with harsh penalties, corruption cannot be eradicated
con:ipletely.
Below are some measures businesses and organizations can adopt to help prevent
corruption in. the work-place.
Clear Business Processes

H · d fi ed workflows, clear directives on financial approving authorities,
avmg e Ill ·Ocureb ment instructions canI 1eI p fl ag ·irreguI an· t1· es us·mess or
ma
and stand ard pr . .
• · These processes should be reviewed on regular basis to ensure they
orga111zat1on. ie shifting business environment.
• · o·1·
1 1gent record -k eepmg
· an d
are upd ated t to. 1 - · d · ·
.
regu Iar aud its a re also good practices to eter corrupt act1v1t1es.
142 CliaJ tcr \I
th
Policyand
Gifts onentertainment
Gifts nnd Entertninmcnt
are often offered 111 . f b isiness to
. . le itimate courseo t .
I
. •r· · t e g vi'sh or done with the
promote good relat ions. However. 1 it is fiequentd or atage• such g1. fts
and
00
deliberate intention to gain an unfair busin ess a v n dl ss' of whether

the entertainment can be tantamount · regtoa corruption,
r e .kf
corruption can be
recipient is able to fulfill the request of the giver. The_ ris nay be given and
reduced by setting a policy on when gifts and entertai men i rtners should be
accepted and wh;t records need to be kept. Your bu_smess pa
aware of your organization's .,ift and entertainment policy too.
, Declaration of Conflict of Interest

Conflict of interest occur when a person I interest or relationsl,ips is_ laced
before the business interest, and can lead to corrupt activities such a givmg or
accepting bribes. In order to safeguard the business interest, a_declaratJOn
system that is applicable to all levels of employees may be instituted_. The
company may provide a declaration form for conflict of interest for employees,
and then use the information to take the most appropriate course of action.
This could include. excluding the employeC:; from engaging in thf work or
transferring the employee toanother department or post.
Convenient Corruption Reporting System

The corruption reporting system is a key function to control corruption and
bribery risks, and can comprise a whistle-blowing policy o(feedback channel
her staff can _conveni ntly raise concerns nd feel protected from being
1dent1fied or retaliated agamst. One wa _to do thi would be by allowing
reports to be filed anonymously through a publicized email address or phone
number.
EFFORTS TO CURB CORRUPTIO THROUGH LEGISLATION

The
'b Anti-Graft
b I and Corrupt
· Practices Act criminal'izes active
· and passive .
bn ery, em ezz ement, extortion, abuse of office and confli
public sector. ct Of •interest 111
.
the
Bribery of p ublic officials and trading in influe ·

.R d T
t he AntJ- e
,
ape Act. The Act forbids tmmaI'ized . m
office-I10 Id neefi are also er·.
or material benefits in exchange for any ers r_om accepting any gifts
govern ment permit or license.
,..
Under
thRe evised Penal Code, gifts are classified as. indirect bribery. An
e_xcepti n IS made for gifts of insignificant value given as a token of fri7ndship in
lme w_ith loc11l customs. Facilitation payments are not addressed in the
law. Pn a e sector bribery is not criminalized. Under the Code, public officials
are re uired to regularly file a statement of their assets and liabilities. fn case of
any discrepancy between the official's asset declaration and the amount of
ropeli?' or. fo ancfal assets actually possessed, the official is subject to,
unmediate dismissal. Punishments for corrupt acts include imprisonment of up to
ten years, a fine, removal from office, and/or confiscation of property.
The Anti-Money Laundering Act criminalizes money laundering and organized

crime..
The Act Establishing a Code of Conduct and Ethical Standards for Public
Officials 'and Employees formu fates standards for the personal integrity and
accountability of civil servants.
The Government Procurement Reform Act requires competitive and transparent

bidding. Philippine legislation does not contain any provisions on protecting
whistleblowers who report on corruption.
The Philippines has r'atified the United Nations Convention .against Corruption.
Companies should note that the legal anti-corruption framework in the.
Philippines is complicated and poorly enforced; there is a lack of co9peration
between raw enforcement agencies, and officials are rarely prosecuted and
convicted for corruption crimes.
VIGILANCE OF CIVIL SOCIETY
Philippine civil society i$ active and is represented by a wide variety of

different organizations. Public participatio_n is high and civil society or
anization_s (CSOs) enjoy a high level of social capital. CSOs are normally not
included in formal decision-making, but they play a large role in initiating
legislation and steering debate in Congress. There are_a multitude of watchdog
organizations monitoring
implementation of policy.
The Constitution guarantees freedoms of speech and of expression, but in
practice these freedoms are not consistently upheld. The media e?vironmen_t is
Iarge Iy ·vately owned and diverse,
pn
and the state generally exercises very httle
d . I d' I
nsorship. te i t me v1 y
·1
ce The views represen n 1e
mainstream 1a are 1ea
influenced by the oligarchical owners of many of the outlets.
144 Chapter 9
The Philippines is the second most dangerous country in the world forjou
aliSts to operate in, as measured by th.enumber ofjournalist deaths. The
state is not directly responsible for the violence, which· can mostly be
blamed on local
strongmen and criminals and the weakness of the authorities.
The existence of libel and defamation laws remains a problem and are frequently
used by officials and powerful individuals t'o try to silence journalist. The media
does frequently report on high-level corruption cases. Independent observers
report that bribes and other incentives are often used by high-level officials to
motivate journalists to create one-sided reports for the official's benefit. Internet
ccess is widely a\fa lable, but there are concerns about the governm nt trying to
install some degree of censorship. The Philippine press is classified as 'partly
free'. •
REVIEW QUESTIONS
Questions
1. Explain what corruption is.
2. Give examples of how corruption can take place.
3. What are some factors that contribute to the commission of corruption?
4. ExpIail") the characteristics of corruption.

S. Describe some ill effects of corruption.
6_. Ask family, neighbors, colleagues at work, their opinion on this subject.
Do they support the opinion that it is wrong to bribe politicians and
public officials, whereas, the otner way round, they themselves bribing
these officials for their own profit would not be wrong? Would th y
denounce someone bribing an official or-politician? Why and how?
7. Ask yourself whether it is an easy way out of a personal problem to

claim that you are not corrupt but that others force you to give bribes or
expatriates buying their licenses claiming that the authorities are corrupt.
8. Did you ever refuse to pay a bribe, or would you if you had the potential
to ask for a bribe, refuse to do so? Did you feel any consequences?
9. We all know similar examples from·our own environment. Is someone

attended without standing in line? Do you get a timely answer to your
letter without waiting for that letter to reach the top of the pile of papers
in front of the handling official? Do you convince the policeman to tear
up the parking-ticket, what argument _is strong enough to convince him
that the ticket should not have been written?
Jo. Test for yourself what 'petty corruption' you observe in your own social
environment. Will the results of such an investigation enable politicians
and public officials to join the battle to prevent such corruption on the
basis of sound arguments and tofoster _safeguarding of integrity?
11. What are some of the means by which corruption could be reduced if not
totally eliminated in the Philippines?
INITIATIVES TO IMPROVE
BUSINESS ETHICS AND
REDUCE CORRUPTION
<Expectecf Leaming Outcomes

1. Explain why there is a need to improve business ethics.
2. Describe the "lntegrify Initiative Campaign".
3. Explain why a Code of Conduct is necessary.
4. Familiarize yourself with the Unified Code of Conduct for

Business as initiated by the "Integrity Initiative" organization.
5. Familiarize yourself with the "Code of Conduct for Business"

as initiated as endorsed by the Bishops-Businessmen
Conference of the Philippines.
6. Familiarize yourself with the Code of Conduct adopted by

Private Companies.
CHAPTER 10
INITIATIVES TO IMPROVE BUSINESS ETHICS.
AND R PUCE CORRUPTION
INTRODUCTION
mprow ment of business ethics ·is a common concern of everybody. It is

unperat,ve that all pa1ties involved - manufacturers, sellers, consumers,
go emment and relevant organizations must participate in improving business
ethics: Unless there is.a concerted effort ·on the part of everybody, we cannot
effectively remind businessmen and professional of their ethical responsibility
to each other, to their customers and clients.
Unethical practices are ever present. Even people who have not yet been
victims of these _practices are vaguely aware.that they exist and agree that
something must be done to rid the world of'them. Accordingly, various
approaches to improvin'g business ethics have been brought fo ward not only
in the Philippines but also in other countries.
THE INTEGRITY INITIATIVE CAMPAIGN
In 20JO, a private sector-led campaign aiming to strengthen ethical standards in

business, the Integrity Initiative was organized after the Philippines received a _
grant from Siemens. The Makati Business Club (MBC) and the European
Chamber of Commerce of the Philippines (ECCP) serve as the Integrity Initiative
Secretariat.
The Integrity Initiative is a m ltisectoral campaig.n that seek to institutionalize
integrity ·standards among v ri_ous s ctors of society- ?usmess, governn:ient,
· d. · ac deme youth, c1v1I society, church and media. Led by the private
JU ·a·tiativ'e aims to help
ct1· m.m1..Is1mg., f1 not 1iu:IyI eract1·.catmg, teh
ic1ary, .
m
ti1e 1111 . . . I b d
·se•cto h' I h f corruption in the Ph1 h pp mes, as not on y exacer ate
r, w 1c11
VICIOUS eye e O obstructed the development a compet·it·ivebus·mess
of
poverty b aISO .
ut
. t that operates on a level playmg field.
envt ronmen
I-'S Ch.11•10- I 0
.Idt ·ust in government, a more
Ultimately. the Integrity Initiative hopes _t? hui . '. will result in improved
l'quitable society and fair market conditi ns. rhi5 will evident with the
. 1 11 ployrnent generated
competiti,·eness ,rnd increased business confidence.w
llC
increase in domestic and foreign investme1_t a, nd mor e md inavibrant and
for Filipinos. Subsequently. with more F'.li inos emp oy should become
d 1K1mic Philippine economy. the alle i ti n of. povey a benchmark in
inevitability. Throuoh the initiative. the Phil1pp1nes will become t t tht
the transt'i. nnation ;rocess of any country regarded as highly corrup one a
O
fosters an ethical and progressive business environment.
To acl•ue\'e th• is goal, consultat•1ons, d '

roundtab1e 1 and public forums
·
scuss 1011
s
.
involving busine;s leader compliance officers, corporate governance experts,
academi s and practitioners from small and medium enterprises to Fortune
SOO companies. "An Integrity Compliance Handbook" containing the key oc
ments and toolkits in Integrity Initiative was published for the use of
organizatwns to promote ethical business practices.
Since 20I 0, MBC and ECCP have been joined by various organi2;ations and
industry associations in taking an active role in promoting honesty and
transparency in Philippine business. As of 20I8, a number of the organizations
and industry associati<;ms have been taking active participation in this
movement.
With the ctive participatio.n of these organizations, is hoped that the problem
of massive graft and corruption in the Philippines will b minimized if not
totally eliminated.
Appendix G shows a partial list of organizations who are actively participatino

in the"Integrity Initiative" Campaign against Corruption. · . c:,
Corporate Values
The increasing scrutiny by regu_lators, lobbyists, non-government organizations,

consumer grou s and the media have the potential to affect a business firm
mar t er eptwn and h nce value. It is therefore important that the
orga111zat1on
d·gat1· ons
s values,
· and its code k of conduct, address. the leoal d th
obl1
owe to important sta ·eholders, including for c:, a n o er
• • , examp 1 e, trad e
practices1 .aws, nva:y aws, employment laws, occupational health and·safety,
equal .opportuntty m the workplace, superannuation a nd
· ·I
env ironmenta
reguIations.
Initiatives t_o Improve Business Ethics and Reduce Corruption 149
Managing, protecting d
challe;lges fa • · a,n • •
en 1 anc111g reputation has become one of the greatest
1
the detenn. ct'-',g tod ys board. The reputation of a business is a critical factor in
be explic1•ttma ton of its value. The values and ethics of the organization need to
· Y managed.
Need for a Code of Conduct

A co de o f co n duct is a f, · • •
A d• f d orma1 expressi on of the organiza tion's values and
ethi cs. co e o con uct should;
• guide directors and senior executives as a minimum as to the practices

' '
necessary to maintain confidence in the organizatio n's integrity.
Other
me nbers of staff should also have a code of conduct relevant to them.
which may be the same as that for directors an(:! senior executives or
may be a complementary version; ·
• f!rQm te r sponsibility and accountability of i dividuals for reporting
and mvest1gatmg reports of unethical practices; and . ·
• ensure compliance with ?egal and ·other obligations to legitimate
·stakeholders.
An organization's code of conduct recognizes the important role that busihess

ethics play in the success of today's business, encouraging the .board to
actively develop an organizational culture that is established on
transparency, a countability and integrity.
One of the most significant accomplishments of•the Integrity ·tnitiative· is the

preparation of the "Unified Code of Conduct for Business". The_Code's
p.urpose is two-fold.
First it harmonizes existing ethical standards among business operating . '

'
in the Philippines. It ensures that different market players aghere to the
sanie. rules of. the game in order to· create fair market conditions
and promote transparency in doing busines . ,.
Second, the Code formally commun_icat s the signa_tories' commit.ment to

upholding high standards of. eth1csfim a tl busmess tfr nsact_1on . It
. I tes the belief that securing pro 1t at t11e expense o mtegnty 1s an
rt
a icua table and unsustainable way d . b . dI
con uct mg us mess an t1at
f
o
unaccep I ave en taken to enforce cu I t·1vate ·mtegn· ab'its w·iIt11· 11
be
and tyh
measures 1 . .
tI1e s 1. gnator·ies' respective organ1zat1ons.
150 Clwpt.-r I()
.
Initiative) THE UNIFIED CODE OF CONDUCT-NESS (Integrity
FOR BUSI
Tap 1lfn11ngeme11t
· tently demonstrating
• Our top management leads by example by cons is
the
value of conducting business with integrity. .. .
• Our officers strongly commurn.cate our organization'.s p. oshition
against bn.berv corrupt.ion and unethi.cal bus.iness practices withinf t e
company and th·e' broader public· comply with afl·tl1e requirements O
·government
regulatory bodies; and prohibit cover-ups and falsified reports that
conceal improper transactions.
• Management strongly upports integrity practices and allocates
sufficient resources for their implementation.
Huma11 Resources
• We strive to instill culture of.integrity among our employees. The

management maintains open lines of communication with employees,
particularly on matters relating to honesty, transparency and integrity in
business transactions.
• In the spirit of fairness a d due process, all employees have the right to
file and respond to complaints against practices suspected to be illegal
or unethical. . . ·
• We have appropriate tool to c_onfidentially receive, monitor and act on
internal and external complaints. '
• Emp_lo e s fil_ing complaints i_ll be protected from all types of
retaliation, while those
commensurate d.1sc1p . m unethical prattices·will be su b' t t o
. . 1involved
mary actions.
• We have instituted training· programs on bus· h'
levels of the mess et 1cs covering_ all
organization.
Sales and Marketing
• We c!early communicate rules and guidelines on . . . .

entertamment, tokens of hospitality, and contrib f /fi giving. gifts,
private organizations and their representative .u ions to rom public and
Initiatives to Improve Business Ethics and Reduce Corruplion 151
• mploye s _and all third pa1ties engaged by our company to act as our
tnten edianes, age1Hs or representatives are not permitted to offer,
r nise, or give, as well as demand or accept concessions - directly or
tn irectly - in order to obtain, retain, or secure any undue advantage in
the conduct of business.
• We ide by existing laws when tra11sacting wi h government agencies
(as stipulated under RA 6713 - Code of Conduct and Ethical Standards
for Public Officials and Employees and RA 3019 -- Anti-Graft and
Corrupt Practices Act).
Finance mu/ Accounting
• We require all our employees to ensure that all books and records they
create or are responsible for are complete and accurate.
• Our financial recor,ds conform to standard accounting principles,
comply with Sec_urities and Exchange Commission requirements on
disclosure
and transparency, and abide by anti-11101 ey laundering laws (RA 91pO)
and international conventions.
• We pay taxes in compliance with all laws.
Procure111enl
A track record of integrity and compliance with existing laws is a
• prerequisite when we vet third party consultants, suppliers,
intermediaries, and agents. Our company has transparent procurement
procedures, provides equal opportunities for all suppli rs, and prohibits,
collusion between and among our employees and suppliers.
Recognizing that_the lntegri_ty lnitiati e is sustaine through wi ely
• shared ethical practices withm the busmess community, we ent r mto
integrity pacts with our suppliers and ensure that they comply with
the
provisions of our pact.
Contractinga third party to br_ib_e or commit corrupt practices on behalf
• of the company is strictly proh1b1ted.
I2 Chapter I()
logistics
• Wecomply with laws and regulations pertaining to supply chain

management.
• We do not tolerate any breaches in existing Jaws in-exchange for
und_ue advantage and unethical concessions or favors. We pay correct
duties and taxes based on transparent assessment of goods af)d services.
• Employees are not penalized for refusing to pay bribes or facilitation
payments even if it r.esults in failure to meet deadlines or loss. of
revenue.
ln1ple111e11tation and Mo11itori11g
• We will continually to align our operations to the principles contained in

this Code periodically assess and monitor our compliance to it. We will
continue to share best practices with the business community to
strengthen ethical business processes in the Philippines.
Initiatives to Improve Business Ethics and Reduce Corruption 153
BISHOPS-BUSINESSMEN'S CONFERENCE PHILIPPINES-CODE OF

ETl]:ICS FOR THE PHILIPPINE BUSINESS *
The_ Code 0,f Ethics fo1: the Philippine Business issued by the Bishops
Busme sm_en s Co 1fer • ce Philippines is reproduced in this chapter for
reasons
of contmumg apphcab1hty, relevance and significance to entities doing
business in the Philippines.
Preamble
T!1is_ Code_ of Ethics has been formulated impelled by the belief that man
has a d1g111ty that must be respected, and that all the resource of the earth
has been created for his growth and development.
As here presented, this Code is co sidered a major step in the on-going and
changing process of understanding the growing role of business activity in the
development of man and, as much, is open to further improvement.
The Code seeks to express systematically and coherently the principles of
business practices accepted and professed by Philippine business at its best,
and seeks to apply these to current and changing needs. . .
It is the hope that this Code will serve as a-general stimulus to rene-...y and develop
or amend existing standards, and that individual entities will expand and adopt it
to the specific needs of their own organizations.
It is general Code intended to be influential rather than oercive. It is.hoped
that individual entities will consciously adopt and embrace it as a statement of
principles and, having·do 1e so, w II be unwilling to incur the sanction.of
dverse public opinion through failure to live up to the Code.
FinaJly it is Code for all people, formulat d on the premise that the modern
manag;r must be a strategist_ for l uman development, and that the business
of business is to build an enterprise oriented to the development of man.
(Source: Google Books (www.boo1Cs.google.co11Lpl1))*

I O~
C/1111'.!!!!: ..
TheConcc1>t'I
. 1. 5. iot an accidental human

Uusincss which cmbrnccs commerce and rnduSlry r. purpose is to meet
activity but an integral clement of the social order. l_ls u ai, •iently as
possible. society's human needs by providing goocfs and services se t c
following basic Those engaged in business should, therefore, recognize e
concepts: .
. fh
• All business is essentially an expression uma ° n relationships;
th0
not only
ho own and
.
with those who work in the enterprise, but also with sew . d
. . . h ply it wit h materr1a s
provide financi al resources, w ith t ose wI10 sup . . h
a n
h services with those who buy its
products or services, wit t e govern ment and w ith the w•ider
• .
publ1'c whose 1I·ves are affected by the business ac;ivity. The interest
of all those members of soci ty must e taken into account in
formulating business policy. The e interests,_ 111 themselves
legitimate, will at times conflict. While conflict and tension can be
themselves being constructive, the aim of business must always
be to reconcile opposing interests in a bal nce of justice and mutual
concern.
• The owners, management, the work force, the suppliers and
subcontractors, the customers, and government contribute to the
performance of the business enterprise, and are therefore entitled to
receive the proper worth of their contributions.
• The resources employed by a .business enterprise are financial,
technological and human. The human resources have a unique quality
and should be mployed in a manner consistent with personal dignity.
The individual should be ,given opportunity to use and develop his
faculties in his work. His contribution to the success of the enterprise
should be properly recognized and rewarded.
• usiness enterprise has a public responsibility to use all its resources
efficiently. P_rofit !n a sys em of free enterprise is recognized as
a
fundamental 1 1cent1ve, d 1s necess ry for the maintenance and
growth of the enterprise, for raising the quality or life, and for helping
meet the broader needs of society.
• Com.pet.ition. and incentifves are essential for
the maitn enance and
contmumg 1mpro ement o the quality of goods and services for
growth and for tec.h.nological pr.ogress. However, to guardaga·mts
un,r.a1• r 1r . orms of compet1t1on, a consistent standard of business
beh · t b
established and observed. avior mus e
Initiatives to Improve Business Eihics and Reduce Corrnplion 155
• In _business, as in any other institution of society. any right or
authority enJoyed b or en_trusted to business presupposes, and is
justified by, correspond111g duties, responsibilities and performance. ·
SomtPri.nciples for the Conduct ofllusiness
Those responsible_ for business policy should consider not only the interest of the
owners of the busmess, but also the interest of those affected by the activities
of the business.
Towards the Employees
Business shall recognize the unique position of employees as individuals with

a vital stake in their work and at the same time with inherent obligations to
their own families, and- provide:
• for recognition that, although rates of pay may often be determined by

union., economic and legal pressures, wages and salary policy
should.be based on the right of the employees to a fair and improving
standard of
living, irrespective of race, sex, age and creed; ·
• for fair recruitment practice that affords equal opportunity to all
qualified job-seekers;
• for job security, adequate compensation for employees. in cases of
separation ande.tirement, and opportunities for fringe benefits; ,
• for a safe and healthy atmosphere in the work environment conducive
to the physical and moral well-being and growth of the employees;
• for conditions in which human potentials and· relationships can be
developed at all levels of the work force, with a view to providing
therein
a sense of purpose and achievement; and
for participative elements so that .the k1 owled_ge, exp rience and
• creativity' of all who work in the enterprise may contribute to the
decision-making process.
156 Chapter JO
Towards /1,e C11s o111ers
Business shall, in the production of goods and services:

n to serve their purpose.
• strive after a quality that will enabIe tI1ei
efficiently and effectively;
· I
• avoid anything that would be detr unenta the health, •
safety
• d
or growth
tO
of the proper user or beneficiary of such goods and services, an .
seek to apply or make use of the d1. scov·er·ie s and inventi.on. s of science
w·ith adaptat·ions that ·im· prove tI1e·ir P .oducts or thereby
w·ill services·'
benefitting customers/ users and increasing fhetr number.
In thJs marketing arrangement, business shall:
• driver the product or service in the quality, quantity, and time agreed
upon, and at a reasonable price, and avoid the creation of artificial
shortages, price manipulation, and lrke practices;
• establish an after-sales and complaints service commensurate with
the kind of product or service supplied and the price paid;
• ensure that all mass media,·promotional, and packaging
communications be informative and true, and take into account the
precepts of morality and the sound cultural values of the community,
and manifest for human dignity.
Towards tlte Suppliers
Business shall ensure:

•
that the !erms of all c mtr cts be clearly stated and unambiguous, and
honored m f 1II unless termmated or modified by mutual consent;
•
that_ abuse of econ mic power in dealing with a smaller concern be
avoided, and that, 111 all cases, terms of payment be strictly and fully
observed . In gen eral, pay ment should always bemad· ti t the
. 'f . . e promp y a
agreed time or, 1 no specific time is agreed upon · kl , be
· t11e circumstances;
reasonable, given •
and , as qu,c y as may
• th
at no supplier be encouraged to commit his resources for apparently
long-term purposes unless there are reasonable guarantees that the
0rders, he receives from the business e terprise will not be terminated
arbitrarily.
Towards the Owners mu/ other Providers of Capital
In the interest·of the Ow ers and other Provider of Capital, business shal I:
• provide an adeq1,1ate rate of return to those contributing capital to the

enterprise and ensure the security of their investment,
• use their financial resources to provide goods and services responsibly
a d efficiently; ·
• furnish the Owners and other Providers of Capital with such
information as they may reasonably require, provided-that it does not
adversely affect the security or e ciency ofthebusiness; and
• pursue the specific objectives of the Owners and other Providers of
Capital.p_rovided these do nQt run contrary to any of the principles stated
herein.
Towards the Local a11d National Government

'
Although it is the responsibility of government to-en ct legislation and formulate
implementing policies and programs, it is the duty of business:.
• to participate in the discussion of proposed legislation and / or its'

implementation affecting sectoral, regional, nati'onal and international
interests; and
• to p_ropose sound policies in the use of human and material resqurces.

158 Chap/er /0
Towards Society i11 Gettcra/

B.usmessmen shall rec·ognize in their dec1.s1.on-111
k ' the interest of t he ge n era l
m g th t · ,
. . . . . .
pubh e and, reah z tng that they are utd 1 z mg • ortant degree e na 10n s
to an resource, shall: unp
take regular stock of thei•r response to

as·,c needs of socie.ty and kth" us
•
t11e b
ensure that these needs are taken into account ir all policy-ma mg
decisions;
• do their best to ensure that the way they deploy tl-ieir resources
benefits society in general and does not conflict with the needs and
reasonable aspirations of the communiti' s in the area where they
operate;
• pay proper regard to the envlronmental and social consequ nces of
their business activity, with special attention to the duty of renewmg
resources where possible and minimizing waste and pollution, and not
sacrific.e safety or efficiency in the interest of short-term profitability;
• as corporation citizen make such contributions as their resources will
allow, to research, development and application of indigenous
technology.; and to the financing.of social developinent projects;
• consider the human and social costs of mechanization and technology.
• esta lish a policy allowing employees, within reasonable limits, to
contribute to the public and community services during the work time.;
• establish a policy regarding conflicts of interest based on the principle
that decisions should be made in the best interest of the business
enterprise, and dedsion makers should be on their guard against
allowing personal consideration to distort their judgment; and
• not tolerate any form of illegal data-gathering or nay form of
inducement that tends to distort normal commercial judgment.
Survey of Laws Advocating Business Ethics
RA 7394
"The Consumer Act of the Philippines"
approved on April I?, 1992.
RA 3720
"The Food, Drug and
Cosmetics" approved on June
22, 1963.
RA 8293 '
I •
"The Intellectual Property Code of the Philippines"

effective January 1, 1998.
The Intellectual Property Rights Law covers

1. Copyright and Related Rights
2. Trademarks and Service Marks
3. Geographic Indications
4. Industrial Designs
5. Patents
6. Lay-out-Designs (Topographic) of
Integrated Circuits
7. Protection of Under
160 Cltapter IO
REVIEW QUESTIONS
Questions
1. Why is there a need to improve business ethics?

. : • • . M vement" led by the Makati
2. What 1s nature of the ''lnte0nty 1n1t1attve O f 1
Business Club and the European Chamber of Commerce O
t le
Philippines? ·
3. Why should business organizations adopt a Code of Conduct?
4. What are the purposes of the "Unified Code of Conduct for Business"
as prepared by the Integrity Initiative Movement?
5. The Bishops-Businessmen's Conference Philippines adopted the

·'Code of Ethics for the Philippines Business". Name at least three
rationales for its adoption.
Multiple Cltoice Questions
1. Top management's com1nitment· in the "Unified Code of Conduct for

Business" included the following, except
a. To lead by example in conducting business with integrity.
b. To communicate within the company and the general public the
company's position against bribery, corruption and unethical
business practice.
c. To institute training programs or business ethics covering all Je els
of the organization.
d. To support strat gy integrity practices and efforts and allocate
sufficient resources for their implementation.
-------...,.::.: '.! .'.l.1:1=iri·ari',E•t!y--10.!1!,J!!. .0W! IJ .
Erl,ics wit! Reduce
Corr11pt 1 0n 161
11.1·1111!.1·s
2. Among the com· · • . . .· . . .

organization" is lllltmcnts ot the 'l·111an e and Accounting Section of an
a. ;o jay taxes in compliance with all laws,
b. 0 ,ave ?'PPropriate tools to receive monitor and act on internal
and external con plaints of employees., .
c. To ommu111cate rules and 0 ouidelines or giving gifts,'entertainment
tokens. of hosp,'t a1·1ty and contri• butes to / from publi• c
o,rpri•vate organizations. ,
d. To p ohi it contracting a third party to bribe or commit corrupt
practices in behalf of the company. . .
'
3. In the ''Unified Code of Conduct for Business" the logistics department
commits to do the following, except
a. Not to penalize employees for refusing to pay bribes or facilitation
payments even if it restilts in failure to'meet deadlines o'r revenue
is lost. ·
b. Not to tolerate any breaches or violation or'existing laws
in.exchange for undue advantage and unethical concessions a
favors.
c. To pay correct duties and taxes based on transparent assessment of
goods and services.
d. To protect .employees from i·etaliation. when complaints are f!iiled
against hem.
IJNIT m INTRODIJCTION TO RISK
MANAGEMENT
· C6apter
11 Risk Management
12 Practical Insights in Red _cing

and·Managing B .sines.s Risks
RISK MANAGEMENT
ectecf Learning Outcomes

After studying the chapter, you sh uld be able to...
1. Define risk management.
2. Explain briefly the basic principles pf risk management.
3. Describe the-elements of risk management.
4. Define the relevant risk terminologies.

. .
5. Describe the potential treatments or approaches in managing
risks.
6. Explain the areas of risk managem nt.
7. Describe the steps in the risk management process.
a. Familiarize yourself with th_e SEC.requirements in dealing

with enterprise-wide risk management. .
CHAPTER ll
RISK MANAGEMENT
INTRODUCTION
l be . d 'tl,out the organization
Effective corporate governance canno ' me
·1ttn
·,s recog101• as one
nt' WI
zed
A c
mastering.the art of risk management. nd n·s•k of directors of modern
man age m
b , d
of the most important competencies nccclcd by tl e do r ·ness firms.
organization, large as well as small and mediumsi e usid because of tlie
fast The levels of risk fnccd by business firms hav , crease d rn technology
and growing sophistication of organization, globalization, moe I' ce with
legal
impact of corporate scandals. In addition therefore to comp d f .k
,an I ge O ns
requirements, top management should consider dequate
knowe
mann cmcnt.
RISK MANAGEMENT DEFINED
Risk management is the process of measuring or assessing risk a1!d _deve.lo

ing strategies to manage it. Risk management is a systematic approach m
1dent1fymg, analyzing and controlling areas or events with a potential for
causing unwanted change. Risk management is the act or practice of
controlling risk. It includes risk planning, assessing risk areas, developing
risk handling options, monitoring risks to determine how risks have changed
and documenting overall risk management program.
,
As defined in the International Organization of Standardization (ISO 3
I000), Risk Management is the identification, assessment, and prioritization·
of risks followed by coordinated and economical application of resources to
minimize monitor and control the probability and/or impact of unfortunate
events and t maximize t e realization of opportunities.
It i$ thro gh risk management that ri ks to any specific program are assessed

and systematically managed to reduce risk t an
acceptable level R'isk e
· .
tirom uncerta mty m · . k . . ., 1es,sca
eren I ns
. fi ma r et, proJ ect fai lures legal d ' t
·s,I •
manc1 a 1,·ab,· 1·,t·
co m
· k ac cidents, natural ca uses and dis asters as well as deliberate att ack fi versary
d· . . · rom
a
or events of uncertam or unpredictable root-cause. ·
Risk Management 165
BASIC PRINCIPLES OF RISK MANAGEMENT
The International Organization of Standardization (ISO) identifies the basic

principles of rlsk management.
Risk management should:
I. create value - resou.rces spent to mitigate risk" should be less than

the consequence of inaction, i.e., the benefits should exceed the costs
2. address uncertainty and assumptions
3: be an integral part of the organizationa·lprocesses and decision-making
4. be dynamic, iterative, transparent, tailorable, and responsive to change
5. create capability 9f continual improvement and enhancement
considering the best available information and human factors
6. be systematic, structured anc! continually o periodically reassessed
PROCESS OF RISK MANAGEMENT
According to th Standard ISO 3I 000 "Risk management - Principles and·

Guidelines on Implementation, "the process of risk management consists of
several steps as follows:·
· I. Establishing the Context. This will involve

a. Identification of risk in a selected qomain of interest
b. Planning the remainder of the process.
c. Mapping out the following:
1. . the social scope of risk management
II. the identity anti objectives of stakeh_old_ers
·1· , the basis upon which riskswill be evaluated, constraints.
1·1.
d. Defining· a fr mework for the activity and an agenda for
identification.
e. Developing an analysis of risks involved in the process.
f. Mitigation or Solution of risks using available technological,
human and organizational resources. ·
".•' . .11\'lll'lfl\• '111·1\111\l( • · -- -
1 .
1,,,·sk ·I(Ien11·1·"1,,1111·011c1,111 s.larl' with the
p1llc1111•111
l' IS I\
S,
. .
prn,hlc111 or w·1,11 II 1, c1, 1•1i1lys· 1s of the problem
111111Iys1 s nl the s1mrco
.
111
itscll'. <. \1111111',11 risk ido111ilicnfio11methods ore:

a. Ohjcct ivc-hnscd risk
h. Scc1111rio-b11scd risk
'-'. Tmw110111y-bnscd
risk d, Co111111on-risk
checking
c. Risk charting
3. Risk assess111c111.Once risks have been identified, their potential

severity or impact and the probability of occurrence must be asses e .
T e nsscssmcnt process is critical to make the best educated dec1s1ons
111
prioritizing the implementation of the risk.management plan.
ELEMENTS OF RISK MANAGEMENT
In practice. the process of assessing overall risks can t,e difficult, and
balancing resources to mitigate between risks with a high probability of
occurrence but tower loss versus a risk with high loss but lower probability of
occurrence can oflen be mishandled. Ideal. risk management should minimize
spending of manpower or other resources and at the same time minimizing the
negative effect of risks.
For the most part,. the performance of assessment methods should consist of the
following elements:
I. identification, characterization, and assessment of threats
2. assessment of the vulnerability of critical assets to sp cific threats
3. determination of the risk (i.e. the expected likelihood and consequences
of specific types of attacks on specific assets) •
4. identifrcation of ways to reduce those risks
5. prioritization of risk reduction measures based on a strategy
. ...
msk Mana11,e111ent 167
RELEVANT RISK TERMINOLOGIES
I. Risks Associated With Investments
Althoug. h a ·k • .
n s premi um must compensate the rnvestor for all the
singel
unce':amty associated with the investment, numerous factors may
contribute _to investment uncertainty. The factors usually considered
with respect to investments are
' • business risk
• financial risk
• I iquidity risk
• default risk
• interest rate risk
• management risk
• purchasing power risk.
.
BUSINESS RISK
Business risk refers to the uncertainty about the' rate·of return caused
by the nature of the business. The most frequently discussed causes of
business risk are uncertainty about the firm's sales and operating
expenses. Clear.ly, the firm's sales are not guarant(:ed al)d will
fluctuate as the economy fluctuates or the nature of the industry
changes. A firm's income is also related to its operating expenses. If all
operating expenses are variable, then sales volatility will be passed
directly to operating income. Most firms, however, have some fixed
operating expenses (for example,. depreciation, rent, salaries). These
fixed expenses cause the operating income to be more volatile tha sales.
Business risk is related to sales volatility as well as to the operatmg
leverage of the firm caused by.fixed operating expenses.
DEFAULT RISK
Default risk is related to the probability that some or all of the fnitial
investment wi·II not be returned. The degree of default risk is closely
related to the financial condition of the company issuing the security and
t ei security's rank in claims on assets in the event of default or
, kruptcy. for example, if a bankruptcy occurs, creditors, including
b
a n · I I. f d.
bo n dholders have a claim on assets pr ior to t ,e c aim o or mary
.
e q uity shareholders.
168 Cliopt('r I I
FINANCIAL RISK
· f f1i ancing determine financial
The firm's capital structure or sources oh :ny variability in operating
risk. If the firm is nil equity fin nced,t en equal percentage basis. If
income is·passed directly to net incoire n 8,ires fixed interest
payments tbe finn is partially financed by ebtt ! eq eferred
dividend payments,
or by preferred share that requires ti. p. leverage This leverage
then these fixed charges introduce fina;t : 1income. The introduction
causes net income to vary more than oper dg and its stockholders
to
of financial leverage causes the_ fi_rm's _l n :r ncertainty. A result of
view their income streams as havmg addition Id increase the risk
financial leverage, both investmen! g oups wou
premiums that they require for investing Ill the f i r.m .
-INTEREST RATE RISK
Because money has time, value, fluctuations in intere t rates \viii :au
e the value of an investment to flu tuate also. Although mtere t. rat
nsk 1s most commonly associated with bond price movements, nsmg
interest rates cause bond prices to decline and declining interest rates
:ause bond prices to rise. Movements in interest ra es.affect almost
IInvestment altematives.-For example, as a change 111 mterest rates
will impact the discount rate used to estimate the present value of
future cash dividends from ordinary shares. This change in the
discount rate will ll!aterially impact the analyst's,estimate of the
value of a share of ordinary share:
LIQUIDI1Y RIS
Liquidity risk is associated with the uncertainty created by the

inability to sell the investment quickly for cash. An investor
assumes that the investment can be sold at the expected price when
future consumption is planned. As the investor considers the sale of
the investment, he or she faces two uncertainties: (1) What price will
be received? {2) How long will it take to sell the asset? An example
of an illiquid asset isa house jn a market with an abundance of homes
relative to the number of potential buyers. Thi_s inves e t may not
sell for several months or evenyears. Of course, 1f the price 1s
reduced sufficiently, the real estate wilsl ell, but
the investor must make a selling price concession in order for the
transaction to occur.
Risk Management 169
In_contrast, a government Treasury bill can be sold almost immediately

with very little concession on selling price: Such an investment can be
onverted to cash almost at will and for a price·very close to the pric
the mvestor expected. ·
The liquidity risk for ordinary equity shares is more complex. Becaus
they are traded on orgai1ized and active markets, ordinary equity shares
c anb sold quickly. Some ordinary equity shares, however, have greater
liquidity risk than others due to a thin market. A thin market occurs when.
t e e arcrelatively few shares outstanding ancl investoi: trading interest
is
, (united. The thin market results in a large price spread (the differen e
between the bid price buyers are willing to pay and the ask price
sellers are willing to accept). A large spread increases the cost of
trading to the investor and thus represents liquidity risk. Investors
considering the purchase of illiquid investments - ones that have no
ready market or require price concessions -will demand a · rate of
return that compensates for the liquidity risk.
MANAGEMENT RISK
Decisions made by a firm's management and board of directors

materially affect the risk faced by investors. Areas affected by these
decisions range from product innovation and production methods
(business risk) and financing (financial risk) to acquisitions. For
example, acquisition or acquisition-defense decisions made by· the
manaoement
C,
of such firms materially affected the risk of the holders of
their companies' securities.
PURCHASING POWER RISK
Purchasing power risk is perhaP.s, more dif(tcult to recognize than the

other types of risk. It is easy to observe the decline in the price of a stock
or bond, but it is often more difficult to. recognize that the purchasing
power of the return you have earned on an investme.nt .has declined
(risen) as a result,of inflation (deflation)! It is imp_ortant to rem mber
that an investor expects to be compensated for forgoing consumption
today. If an individual is invested in peso-denominated assets such as
bonds, Treasury bills, or savings accounts d ring the period of infl tion,
the real or inflation adjusted rate of return will be less than the nommal or
stated rate of return. Thus, inflatioQ erodes the purchasing pow,er of
the peso
and increases investor risk.
170 Chapter I I
II. Risks Associated Wi(h Manufacturing, Trading And Service Concerns
. A. Market Risk
• Product Risk
o Complexity
o Obsolescence
o Research and Development
o Packaging
o Delivery of W?rranties
• Compe_titor Risk
o . Pdcing Strategy
o Market Share
o Market Strategy
B. Operations Risk
• Process Stoppage
• Health and Safety
• • After Sales Service Failure
• Environmental
• Technological Obsolescence.
• Integrity .
o Management Fraud
o Employ e Fraud
o Illegal Acts
C. Financial Risk
• Interest Rates Volatility
• Foreign Currency
• Liquidity
• Derivative
• Viability
/Usk Ma11age111e111 171
D Business Risk
• Regulatory Change
• Reputation
• Political
• Regulatory and Legal
• Shareholder Relations
• Credit Rating
• Capital Availability
• Business Interruptions
III. Risks Associated withFinancial Institutions
Financial Non-Financial
• Liauiditv Risk • Operational Risk
• Market Risk 0 Systems
0 Currency • Information
Processina
0 Equity • Technoloav
0 C0mmodity 0 Customer satisfaction
, • Credit Risk 0 Human Resources
0 Counterpartv 0 Fraud and illeaal acts
0 Tradina 0 Bankruptcy
0 Commercial • Reaulatorv Risk
• Loans 0 Capital Adeouacv
• Guarantees 0 Compliance
• Market Liauidity Risk 0 Taxation
0 Currency Rates 0 Chanaina laws and oolicies
0 Interest Rates • Environment Risk
0 Bond and Eauitv Prices 0 Politics
• Hedaed Positions Risk 0 Natural disasters
• Portfolio Exposure Risk 0 War
• Derivative Risk 0 Terrorism
• Accountina Information Risk • Integrity Risk
0 Completeness 0 Reputation
0 Accuracy • Leadershio Risk
0 Turnover
Financial Reoortina Risk
• 0 Adequacy 0 Succession
0 Comoleteness
, .. ? (°l>. r If
POTE ·rtAL Hl " TRrATf\tE "TS identified and assessed.

1$0 - I000 :ibl' l-11ggc. I'- t inl l,ncc .ri ."" •hnve Tlb csc
. I c 1 techniques fa1. into
I ,
can 1
tl"Chniqucs ll manage the n s "s ouJd be •appllc·c ic
• 1
I
s
0nc-l1r nwrc -.,f1hc.c r1,11r catcg.ortl'S:
• i\, oidnncc
• Rcduction
• -haring
• Rc1en1ion
Risk A,·oidam:e
. . h Id carry
' risk· An example would
This includes performing an act1 v1ty at t to take
1 · on t1ie
b·1·1y
t . coll 1eoa1 , a I I
. not buying a property or busmess 111
be d or er no . 0
. .
that comes w ith 1t.
g n s k 11owevei,. also means losin0o out onNt11e
. 'S.
.d .
Avo1 m
potential gain that accepting (retaining) the risk ma have allo e?: ot
enteringa business to avoid the risk of loss also avoids the possibility of
earning profits.
Risk Reduction
Risk reduction or optimization involves reducing t_heseverity of the loss

or the likelihood of the loss from occurring. Optimizing risks means finding
a balance between the negative'risk and the benefit of the operation or
activity; and between risk reduction and effort applied. Outsourcing could be
an example of risk reduction ifth outsourcer can demonstrate higher
capability of managing or reducing risks.
Risk Sharing
Risk sharing means sharing with another party the burden of loss ·or the
benefit of gain, fr m a risk, and the measures to reduce a risk.
Risk Retention
Risk retention involves accepting the loss or benefit of gain from a risk when
it occurs. Self insurance falls in this category. All risks that are not
avoided are transferred o retain:d b_ydefau!t. Also, any amou1:1ts of
potential loss over the amount msured 1s retamed nsk. This is acceptable if
the chance of a very large loss is small or if the cost to in ure for greater
coverage involves a substantial amount that could hinder the goals of the
organization.
..
Risk Management 173
AREAS OF RISK
MANAGEMENT
As appl(ed tocorporate.finance, risk management is the technique for measuring,

monttonng and controlling the financial or operational risk on a firm's balance
sheet. ·
The Basel II framework breaks risks into market risk (price.risk), credit risk
and operational risk and also specifies methods for calculating capital
requirements 'for each of these components. ·
The most commonly encountered areas of risk management include
·1. Enterprise risk n:ianagement

2. Risk m nagement activit!es as applied to project management
3. Risk management for megaprojects
4. Risk management of information tec9nology
5. Risk management techniques in petroleum and natural gas
.
A simplified framework for an Enterprise-wide Risk Manag ment Process
.
follows:
Risk Menagement Sys.tern· Top Management's
Involvement
Oversight Activities
I i - ·set
J
·, -D-e fin_e_g_o_a..,.,s_a_n_d.,...object<vas:·ro\es and m"ariagerrient-po-,( ·--7
:- rasponslbillt!es. common language, aod -j establish context, set hm1ts
a. 0•1ersight structure _, t.:...:.... lerance,·etc. _ ·
Risk Managem.·e.;,nP1 --'r'?':,c--,es.-:s=::::-;:,,;:;;;;--------,

r- st7 ep 1: Assess Risks: 1+--i f Ensure thatprocess 7I
ldenU . so:.irce. :neasure , . captures e,ll_business risks J
174 Clwf"l"I' I I --- -- -·---
Risi< Munn cmcnt of Puhlicly
SEC Requirement ltclnlh l' to Enlt'l'l>risl'
1
Listed Corponltlon
SEC Code of G0vcrn1111cc Rccommcndnt1. ons?_, I I corre spon ding explanatio n

1 nnc · . •
provide the following
"The Board should oversee that a sound enle_rprise risk managdemenl (ERkM)
. I
'd /I'f 1nonitor assess an manage ey
framework is in place to effect,vely en Y, • Id guide the Board in
11
busines risks. The risk management fr mework _s ou sures as well as the
identifying units/business lines and enterpnse-/evel nsk expo ,
effectiveness of risk management strategies.
Risk management policy is part and parcel of acorporation's c rporate strategy.
The Board is responsible for defining the comp y's level of nsk tol rance
and providing oversight over its risk management poltc1es and procedures.
Principle 12 which deals with strengthening the Internal Control System and
Enterprise Risk Management Framework states that
"To ensure the integrity, transparency and proper governance in the conduct of
its affairs, the company should have a strong and·effective internal control
system and enterprise risk management framework:• ,
RISK MANAGEMENT FRAMEWORK
The Board should oversee that a sound enterprise risk management (ERM)
framework is in place to effectively identify, monitor, assess and mana$e key
business risks. The risk management framework should guide the Board in
identifying units/business lines and enterprise-level risk exposures, as well as
the effectiveness of risk management strategies.
Subject to a corporation's size, risk profit and complexity of operations, the

Board should establish a separate Board Risk Oversight Committee (BROC)
that should be responsible for the_ oversi ht f a company's Enterprise Risk
Management system to ensure its functionality and effectiveness. The BROC
· should be composed of at least three members, the majority of whom should be
independent directors, including the Chairman. The Chairman should not be
the Chairman of the Board or of any other committee. At least one member of
the
committee must have relevant thorough knowledge and experience011 risk and
risk management.
Risk Management 175
Subject to its size. risk profile and complexity of operations, the company should
havea separate risk management function to identify, assess and monitor key
risk exposures.
STEPS IN THE RISK MANAGEMENT PROCESS
To enh nce management's competence in their oversight role on risk

managementthe following steps may be followed:
I. Set up a separate risk management committee chaired by a board

member.
•
Creation of a risk management committee as board level will
demonstrate the firm's commitment to adopt an integrated
company-wide risk_management system
2. Ensure that a formal comprehensive risk management system is in place.

• This fully documen ed formal system·will provide a clear
vision of the board's desire for an effective company-wide risk
management as well as awareness of.the risks, internal and
external, that the company 'faces.
3. Assess whether the formal system possesses the necessary elements.

• The key elements that the company-wide risk management
system shouId possess are
a) goals and objectives
b) risk language identification
c) organization structure and
d) the risk management process documentation.
• The risk organizational structure should include formal

charters, levels of authorization reporting lines and job
description.
• The risk management process shall include the following steps:

a) Assessment risks: Identification; Determination of the.ir
source,
b) Development actions plans: Reduce, avoid, retain, transfer or
exploit
c) Implementation of action plans
d) Monitoring and reporting risk management performance.
e) Continuous improvem nt risk management capabilities.
,
176 Chapter / I
4. Evaluate the effectiveness of-·the vnrious steps in the assessment f the

comprehensive risks faced by the business firm.
• R•isk assessment step whr•c11 1•11c Iudes risks identification .and
determi·nati·on of the·ir sources ineasurem. re. the
an d ent' presents·
st
foundation for the rest of the procedures. This ep ts perfor ed
by respons·ible managers, fimanee officers' production
1· .e.,
managers marketing managers and human resource managers.
• This process culminates in the presentation of the risk profile or
risk map to the board of directors. I
5. Assess if management has developed and implemented th suitable risk

management strategies and evaluate heir effectiveness. ·
• The risk profile highlights all the· significan_t possible risks ·
.identified, prioritized and measured by the nsk management
system.
• Strategies are developed to m.anage and resolve these identified
risks.· These· will include the process,· people, management
feedback methodologies and systems. ·
• Strategies may include avoidance, reduction, transfer,
exploitation and·retention of risks.
6. Evaluate if management has designed and implemented risk

management capabilities.
• Directors must continu,eto monitor and assess if management

has been implementing 'designed risk management capabi Iities.
• Risk management capabilities_include processes, people,
reports, methodologies and techno_l? ies · needed. These
cO:mponents
should be complete, and al1_gned. for the risk management
structure t_o function effectively.
7. Assess management's efforts to monitor overall company risk

management performance and to improve continuously the firm's
capabi Iities.
• Risk management performance must be monitored on a

continuing basisnd _orga ization must be ready to·innovate
their approaches to be m lme with the c angi,ng lines.
\
Risk Management 177
• Monitoring is clone by nll concerned pnrtics such as senior

mnnngers, process owners and risk owners.
• An independent reviewer can also be appointed ,to validate
results.
8. See to it•that best practices as well as mistakes are shared by all. • This
involves regular communication of results and feedbacks to all
concerned. ·
• These should be an open com.munication channel to ensure

that all risk management participant particularly senior
management, are informed of risk incidents or threat of risk
incident. This will go a long way towards attaining the
company's risk management vision. '
9. Assess regularly the level of sophistication of the firm's risk

management system.
10. Hire experts when needed.
,
•Jlllll
178 Chapter I I
REVIEW QUESTIONS
Questions
1. What is''Risk Management"?
2. What is the basic approach in managing risks?
3. How does ISO 31000 defin "Risk Management"?
4. \Vhat are the basic principles of risk management?
5. Enumerate the steps in the ISO 31000 risk management process?
6. What arethe elements of the risk·management proeess?·
7. What are the key elements that the company-wide

risk.management system should possess?
Multiple Choice Questions
1. The risk that refers·to uncertainty about the rate of return caused by the
...
nature of the business is
a. Default risk c. Liquidity risk
b. Business risk d. Financial risk
2. The risk associated with the uncertainty created by the inability to turn
investment quickly for cas ·
a. Interest rate risk
b. Business risk
c. Liquidity risk
d. Default risk
3. Therisk that the real rate of-return will be lesser than the nominal or
stated rate of return due to inflation is referred to as
a. Purchasing power risk
b. Liquidity risk
c. Default risk
d. Business risk
...
Risk Management 179
4-
Operations risk is manifested in all of the following except
8· Interest rates volatility
b. Process stoppage
c. Technological obsolescence
d. Management fraud
S. Financial risks associated with Financial InstitL•tion include the

following except· ·
a. Liquidity risks
b. Credit risks
c. Market liquidity risks
d. Environment risk
6. Non-financial risks associated with Financial Institutions .include

the following except
a. Derivative risk
b., Integrity risk ·
c. Leadership risk
d. Regulatory risk
7. ISO 31000 suggests that once risks have been identified and
assessed, techniques to manage the risks should be applied. These
techniques . include the following except
a. Retention
b. Sharing
c. Reduction
d. Complete disregard
8. The technique of eliminating or reducing risk which could mean

losing out on the potential gain )s called
a. Risk sharing ·
b. Risk retention
c. • Risk avoidance
d. Risk reduction
9. involves accepti g the loss or benefit of gain from a

-----
risk when it occurs.
a. Risk avoidance
'b. Risk reduction
c. Risk 5haring
d. Risk retention
PRACTICAL GUIDELINES
IN REDUCING AN·D
M·ANAGING BUSINESS
RISKS
r. Ex:pectecf Learning Outcomes

After studying the chapter, you should be able to ...
1'. Know the basic approach in reducing enterprise-wide risks

involving
• Understanding the nature of risk
• lde)ltifying and prioritizing risks '
• Considering the acceptable level of risk
• Understanding why risks become reality
• Applying a simple risk management process
2. Understand ho_w to apply the analytical process in managing

risks in a business enterprise.
3. Understand how to apply the b.asic approach in managing

financial risk.
CHAPTER 12
PRACTICAL GUIDELINES IN REDUCING AND
MANAGING BUSINESS RISKS
Prac. tical Gui.de. li.nes in

Manag·mg and Reduc•ing Enterpri·se-w1·de R'1sk ·mherent ·m
busmes activity 1 best achieved by applying th princip_les and techniques
appropriate to the situation.
UNDERSTAND THE NATURE OF RISK
The willi lg_ness and readiness .to take personal and financial risks is a defining
charac_ter_ist1c of the entrepreneurial decision-maker. In late 90's, a study
com'.n1ss1oned by an internationally-known accounting firm found that while in
cont1 ental Europe strategies focus on avoiding and hedging risk, nglo
Amencan companies view risk as an opportunity and accept risk management as
necessary to .achieving their goals. in 2017, this relative attitude to risk among .
European and US companies remains broadly the same, the result of long
standing cultural experiences and history as well as recent ev.ents.
Successful I businessmen and decision-makers make sure that the risks resulting
from their decisions are measured, understood and as far as possible eliminated.·
They also go beyond the direct fihancial perspective and actively manage risk as
it ffects the whole organization ..
Accepting that risks exist is a starting point for the other actions needed, but the
most important is to create the right climate for risk management. People need
to understand why control systems are needed; this requires communication and
leadership skills so tha standards and exp_ectation are set and clearly
understood.
IDENTIFY AND PRIORITIZE RISKS
Identification of significant risks both wi_t in and ?utside th org nization !s

cruc·I and allows to make informed dec1s1ons. This makes 1t easier to avoid
ary surprises. Examples of significant risks might be the loss of a major
ecess
unn •h f·
tomer, 11e t cuss1gn1·r.th failure of a
key supp r or e appe8:ranceo a 1Cant
competitor.
182 Chapter 12
Consider the human factor into account. People behave· differently and
inconsistently when making decisions involving risk. They may be exuberant or
diffident, overconfident or overly concerned. They may simply overlook the
issue of risk. ·
Risk surrounds and continues to be with us. A former British prime minister once
said: "To be alive at all involves some risk." When identifying risks it helps to
define the categories into which they fall. This allows for a more structured
analysis and reduces the chances of a risk being overlooked. Some of the most
common areas of risk affecting business are shown in Table 12.1.
Table 12.1: Typical Areas of Organizational Risk
Financial Commercial Strategic Technical Operational

Accounting Loss of key Marketing, Failure of plant Product or
decisions and personnel and pricing and or equipment design failure,
practices tacit knowledge market entry including failure
decisions to maintain
suoolv
Treasury risks Failure to comply Market changes Accidental or Client failure
with legal affecting negligent actions
regulations or commercial . {such as fire,
. codes of practice decisions {due to ollution, floops)
customers
and/or .
competitorsi· ,
Fraud Contract . Political or - Breakdown in
conditions regulatory labour relations
developments
Robustness of Poor brand Resource- - Corporate
information management or building and
management handling of a
. malpractice
resource (such as sex
systems crisis allocation discrimination)
decisions
Inefficient cash Market changes - - . Political change
manaqement
Inadequate - - - -
insurance
Practical Guidelines in Reducing and Managing Business Risks 183
CONSIDER THE ACCEPTABLE LEVEL OF RISK
As e'.11"lier menti ned, the usual first step is to determine the nature and exten! of
the ris s theb smess will accept. This involves' assessing the likelihood of r_is s
becoming reahty and the effect they would have if they did. Only when this 1s
understood can measures be taken to minimize the incidence and impact of such
risks.
There is also an opportunity cost associated with risk: avoiding a risk inay mean
avoiding a potentially big opportunity. Peop_le can be too cautious an risk a e se
even though they are often at their best w.hen facing the pressur of risk dec!dmg
to take a more audacious appro_ach. Sometimes the greatest risk is to do nothing.
UNDERSTAND WHY RISKS BECOME REALITY

Once risks are identified they can be ranked according to their potential impact
and the likelihood of them occurring. This helps to highlight not only where
things might go wrong and what their impact would be, but also how, why and
where these catalysts might be triggered. The five most significant types of risk
catalyst are as follows:
• Technology. New hardware, software or system configurations can

trigger risks, as can new demands on existing information systems and
technology. In early 2010, Me ro Manila Development Authority
Chair introduced a congestion change for traffic usirig the centre of the
city; the
• . greatest threat to the scheme's success (and his tenure-as chair) was posed
by the use of new'technology. It worked and the scheme was widely
seen as a success.
• Organizational change. Risks are triggered by, for example, new

management structures or reporting lines, new strategies and commercial
agreements (including mergers, agency or distribution agreements).
• Processes. New products, markets and acquisitions all cause change and
can trigger risks. The disastrous launch of "New Coke" by Coca-Cola
was an even bigger risk than anyone at the company had realized; it
outraged Americans who felt angry that an iconic US product was being
changed.·That Coca-Cola eventually turned the situation to its advantage
shows that risk can be managed and controlled, but such success is rare.
184 Chapter 12
• People. Hiring new employees, losing key people,. poor.succession

planning. or weak people management can all create d1slocat1on, but
he main danger is behavior: everything from laziness to fraud,
exhaustion and simple human error can trigger this risk.
• Exter11nl factors. Changes to regulation and political, .economic or

social developments can all affect strategic decisions by bringing to the
surface risks that may have lain hidden. The economic disruption
caused b tl e sudden spread of t)1e SARS epidemic from China to the
rest of Asta 111 2003 highlights this risk.
APPLY A SIMPLE RISK MANAGEMENT PROCESS

. '
The stages of managing the enterprise-wide risk inherent in decisions an simple.
• First, assess and analyze the risks resulting· from a decision
by systematically identifying and quantifying them.
• Second, consider how best to avoid or mitigate them.
• Third, in parallel with the second stage, take action to manage
control and monitor the risks.
A. Risk Assessment and Analysis
It is more difficult to assess·the risks inherent in a business decision

than to identify them. Risks·that lead to frequent losses, such as an
increasing incidence of employee-related problems or difficulties
with suppliers, can often be solved using past experience. Unusual or
infrequent losses are harder to quantify. Risks with little likelihood of
occurring in the next in the next five years are not important to a
company focused on meeting shareholders' shorter-term expectations.
Thus, it is sensible to quantify the potential consequences of identified
risks and then define course,s of ction to remove or mitigate them.
Each category of risk can be mapped in terms of both likely

frequency and potential impact, with the potential consequences being
ranked on a scale ranging from ii1convenient to catastrophic (see
Figure 12.1).
Practical G11ideli11es ;11Reducing and Mm!agi11g 811si11ess Risks 185
B. Risk Management and Control
Risk should be actively managed and given a high priority across the
whole organization. Risk management procedures and techniqu s should
be ' 'ell documented, clearly communicated, regularly reviewed and
monitored. To successfully manage risks, you have to know what they
are. what factors affect them and their potential impact.
If you plot the ability to control a risk against its potential impact, as·
shown in Figure 12.J, you can decide on actions either to exercise greater
control over the risk or to mitigate its potential impact. Risks falling into
the top-right quadrant require urgent action, but those in the bottom-right
uadrant (total/significant control, major/critical impact) should not be
ignored because complacency, mistakes and a lack of control can turn the
risk into a reality.
Table 12.1: Assessing and Mapping Risk
:.: Nocontrol
!!!
a_:,
0
...
z
a:: Weak control
0u
0 ... Significant control

:::;
iii Total control
<
POTENTIAL IMPACT
Once the •inherent risks in a decision are understood, the priority is to

exercise control. All employees must be aware that unnecessary risk taking
is unacceptable. They should understand what the risks are, where they lie
and their role in controlling them. To achieve this, share information.
prepare and communicate clear guidelines, and establish control
procedures and risk measurement systems.
186 Chapter /2
Avoiding and Mitigating Risks

. k that result .only in costs: the
Start by reducing or eliminating those nss
non-trading risks. These can be thought of asd e t
th ft ed costs of risk and
tual liabilities and
might include property damage risks, legal n con r c chievedthrou.h
business interruption risks. Reducing these risks can e a fi g.
quality assurance programs environmental controlprocesses, e_n orcmg
'. • ,1·
health and safety regulat ions msta mg ccident prev.ention an. d
a
emergency equi.pment and tra11. 11.1' 1g t o use , it .and takmg security
peopIe
measures to prevent crime, sabotage, espionage, andthreats t people
and systems. Reducing a risk may also mean that the cost of msurmg
against it goes down.
Risks can be reduced or mitigated by sharing them. For example, ,_

acceptable service agreements from, vendors re essential to reducing
risk. Joint ventures, licensing.and agency agreements can also be used to
mitigate risk. To reduce the chances of things·going wrong, focus on the
quality of what people o - doing.the right things right reduces risks and
costs.
Risk management relies on accurate, timely infor.mation. Management

information systems should provide details of the likely areas of risk, and
the information needed to control the risks. This information must reach
the right people at the r.ight time so that they can in estigate and take
corrective action. ·
Create.a Positive CJimate for Managing Risk
, Recognizing the need to manage. risk is not enough. The ethos of an

organization should recognize and reward behavior that manages risk.
This requires a commitment by senior managers and the resources
(includ!n_g training) to match. Too often, control systems are seen only
as an a d1t1onal overl ead and not as something that can add value
by
ensuring the effe t1_ve use of assets, the avoidance of waste and the
success of key dec1s1ons.
Practical Guidelines in Reducing and Managing Business Ri.lks 187
Overcoming the Fear of Risk
Everyo,! accepts that taking risks is needed to keep ahead of the

competiti?n. Consequently, employees need to understand better what
the r al nsks are, to share responsibility for the risks being taken and to
see nsk a an oppo,tunity, not a threat. Understanding how organizations
man ge nsk effectively is important, but managing risk is only one
pos ible strategy. Another approach is to look for ways to use the risk to
achie e success by adding value or outstripping competitors - or both. To
do this,_ or_g nizations need to stop.taking the fun out of risk by
ontroU.mg t Ill ways that are perceived as bureaucratic and stifling. Risk
JS both desirable and necessary. It provides opportunities t_o learn and
develop and compels people to improve and effectively meet the
challenge of change. ·
C. Cont.rolling and Monitoring Enterprise-Wide Risk
The following questions when answered truthfully and positively will

assist managers in deciding how to manage the risks that confront the
business enterprise.
o Where are the greatest areas of risk relating to the most

significant strategic decisions?
0 What level of risk is acceptable for the company to bear?
0 What are the potentially disclosing events that could inflict the
greatest damage on your organization?
0
What are the risks inherent in the organization's strategic
decisions, and what is the org nization's ability to reduce their
incidence and impact on the busmess?
What is the overall level of exposure to risk? Has this been
0
assessed and is it being actively mo1 itored?
What are the costs and benefits of operating effective risk
o I
management contro s?.
What review procedures are in place to monitor risks?
0
o Are
he risks inherent in strategic decisions (such as acquiring a
t d
new business, de¥eloping a new pro ..
uct or enter i ng a new et)
adequately understood? k
mar
-- . . .◄
188 Chapter 12
o At what level in the organization nrc the risks understood n'.1d

actively mannged? Do pe0plc folly rcali;:c the potcntml
consequences ofthdractions, 1111d nrc they equipped to understand.
avoid, control or mitigate risk?
o To what extent would be compnny be exposed if key staff left'?
oIf there have .been major developments (such as a new
management structure or reporting arrangements). nre the new
res})onsibilities.understood and accepted?
o Are management information systems keeping pace with
demands? Are there persistent black spots - priority areas wh re
the system needs to be improved or overhauled'?.
o Do employees resent risk, or are they encouraged to view certain
risks as opportunities?
PRACTICAJ;., CONSIDERATIONS IN MANAGING AND REDUCING

FINANCIAL RISK .
.
Finance is the lifeblood of a business, heavily influencing strategies and
decisions at every level.
Many managers find it difficult to get to grips with financial issues and, as the
2.008 g]obal financial crisis revealed, many lost touch with basic financial
ground rules.
Profitability, cash flow, long-term shareholder v lue and risk all need to' be
considered when setting and reviewing strategy. This section provi,des practical
gu-idance about financial decisions al)d explains how to:
• improve profitability; .
• avoid pitfalls in making financial decisions;
• reduce financial risk.
• Improving Profitability '
Entrepreneurial flair and financial rigour are as m.uch about attitude as

skill. Nonetheless, certain skills will ensure that decisions are focused
on commercia·lsuccess.
...
Practical G11ideli;1es in Red'ucing and Managing Business Risks 189
A.· Variance Analysis
lnte preting the differences between actual and planned performance is

crucial. Variance analysis is used to monitor and manage the results of
p_astdecisions, assess the current situation and highlight solutions.
Comi on causes of variances include inefficiency, poor: or flawed

plannmg ( f_o re x mple, relying on. historically inaccurate
information), poor commun1cat1on, interdependence between departments
and random factors. Eve y business should use variance analysis but in
a practical and pragmatic and cost-effective way.
B. Assessment of Market Entry and Exit Barriers
How easy or difficult it is to either ente·r or leave a market is crucial in

strategic decision-making. Entry barriers include the need to compete
with · businesses that enjoy economies of scale, or established ' -
differentiated products.
Other barriers include capital requirements, access to distribution

channels, factors independent of scale (such as technology or location)
and regulatory requirements. When inarkets are difficult or costly for
competitors to enter and relatively easy and affordable to leave, firms can
achieve high, stable returns, while still'being able to leave for either
opportunities. Consider where the barriers to entry ,lie for your market
sector, how vulnerable you are to new entrants, and whether you can
strengthen and entrench your market position.
C. Break-even·Analysis
The break-even point is when sales cover costs, where neither a profit
nora loss is made. It is calculated Y.dividing the costs of the project
by the gross profit at specific dates,.making sure to allow for overhead costs.
Break-even analysis (cost-volume-profit or CVP analysis) i.s used to
decide whether to continue developing a product, alter the price,
provide or adjust a discount, or change suppliers to reduce costs. It is
also helps in managing the sales mix, cos structure and production
capacity, as well as in forecasting and budgeting.
D. Controlling Costs
T\, c0ntr0I costs:

Focusontht• bi'! ircms of e.,pendi1111·t!. Categories _costs into
. ' . · \
mai\W or pen phe ml items. Oh en. ue emphnsis is given to the
d
un
SOo of activities accounting for 20% of costs.
0
Be costtnrar,'. Casualness is the ene1ny of cost control. _While
focusing on major items of expenditure it may also be possible
to cut the-cost of peripheral items. Costs can be reduced over
the
medium to Iona term by manaoers' attitudes to cost control and
- 0
the effects of expenses on cash flow.
o /lfaintain a balance between costs and quality. Getting the best
-
Yalue means achieving a balance between the price paid and
the quality received.
o Use budgersfor dynamicfi11a11cial management. Budget early
so financial requirements are known as soon as possible.
Consider the best time-period for the budget - normally a year
but it depends on the type of business. Some larger firms have
moved to rolling budgets, getting managers to forecast the next
18 months every quarter. Budgets provide·a starting point for
cash flow forecasts and revenues. and they also play an
essential role in monitoring costs and revenues.
o Develop a positive attitude to budgeting. People need to
understand. accept and use the budget, feeling a sense of
ownership and responsibility for developing, monitoring and
controlling it. -
o Eliminate waste. For decades, leading Japanese companies
have di e ted. much of their cost-management efforts towards
waste ehmmat1on. hey acl ieve this by using techniquessuch as
process analysis. mappmg and re-engineering.
,,rat•tira/ U11ide/i11cs i11Ut1tl11ci11g and Ma11t1Rlng /)11.v/ne.v.v Rl.vk.v 191
Pmctil·nl Tcchniqul\S to Improve Profitnbility
Some prnctkal techniques to improve prolitnbilily:
• Focus decisiv11-111aki11g 011 the most JJN jitah/e areas. Concentrating on

pro uct .and services with the best margin will protect or enhance
pro.h!a.bility._ This might involve redirecting sales and advertising
act1v1ties.
• De ide.how to treat the feast pro_f,tabfe products. These often drift, with
d, ,, ,dlm profitability. Turn around a poor performer (by r,educing costs,
raismg prices, altering discounts or changing the product) or abandon
it to prevent drain on resources and reputation. The sh lf-life and
appeal of product must be considered when deciding to continue or
discontinue it.
• Make sure new products enhance overall profitability. New product
development often focuses on market need or the produ'ction process,
with insufficient regard to cost, price, sales volume and overall
profitability, which are inextricably linked.
• Manage development and production decisions. The amount spent on
research, as well as the priorities and 1,J1ethods used, affect profitability.
Too little expenditure may increase costs in the long term.
• Set the buying policy. For example, should there be a small number of
preferred suppliers or a bidding system among a wider number of
potential suppliers? Also, consider techniques for controllin_gdelivery
charges monitoring exchange rates, improving quality control, reducing
inventory and improving production lead times.
• Conside·r how to create greater value from existing customers and
products to enhance profitability. Ask: .
_ How can customer loyalty (and repeat purchasing) be enhanced?
How can the sales proposition be made n1ore competitive relative to
the opposition? · • · .
How can existing markets, sales channels, products, brand reputation
and other resources be adapted to exploit new markets and new
opportunities?
How can sales expenses be reduc.ed? . . . .
How can effectiveness of market111g act1v1t1es be 111creased?
•,.1 • how to increase profitability by managing people. Successful
• Cons1ue1• · prerequisite for prof1i tab1'I1' ty. peopIe need to be mot·ivated

is h I h .
leadersI11 ' d dand ' this implies t em 1c..a1 r ti t e1 r work,
p rewar 1 11g y or
and support e ,
192 Chapter 12
.d. lear sense of direction, and
training and developing them, provi mgc d the individual.
focusing on the needs of the team, the task an
. ti
!here are many techniques for as essmg 1 likely profitability of an
e di counted cash flows in
mvestment. One of the most used 1s to apply s ·
evaluating capital investment programs.
• Avoiding Pitfalls
Many manage.rs have financial responsibilities and their de isions· will often.
be influenced by or have an impact on other parts of the business. The
following principles will help.avoid flawed financial decision-making.
Financial expertise must he widely available
Every manager needs to understand w,hy successful financial management

increases profits people need to own their part of the financial control process,
to have the information and expertise needed to routinely make the best
financial decisions.
Consider tlte impaci of financial decisio1ts
Do not ignore or underestimate the wider impact of finance-issu s upon other

depaitments and decisions.
Avoid weak budgetary control
Budgets are an active tool to help make financial decisions·,not merel a wa

to measure performance. · y Y •
Understand tlte impact of caslt flow
Non-financia-1
'h managers often
Idb f ignore
. cash flows ai;d the t·une value of money
.
E
veryone s ou e aware o t·he importance of cash to the organ1• at1•0n. ·
Know wltere tlte risk lies
Identifying. risks and how to reduce·them is ·1 •

d cision-making. For example, managers need to rucia to successful financial
even.point is, but also how and when it will be reac :; not only where the
break-
Practical G11ideli11es i11 ReducinR and /\la11a!{i11g 811.11'1<.•,• l;f 1•;
• Reduce Financial Risk Positive Replies to the followin<1 Que<;ti,,w ·, •.·'..!!

assist Top Management to Manage Financial Risk "'
• Are he most effective and relevant performance mea.;;11r"\ "' "''.'"" '
monitor and assess the effectiveness of financi;i! ,.
• Have you analyzed key business ratios recently? How· 11se'111-1•·: "n:
perfom1ance·indicators? What are the main issues? A rP vc,.,: ,,,
•11• the right things?
111
• ls there a positive attitude to budgets and budgeting?
• Does decision-making f cus on the most profitable pr•_i;h1c! '1J1
se vices, or is it preoccupied with peripheral issues?
• \Vhat are the least profitable parts of the organizations'' 1-1 •·•· •,,•i!1 1' 1
- •
improved?
• Are market and customer decisions focused on improving profit,fr1i:·:,

Too often, attention if given to non-financial objectives;. <;··.
increasing market share, without adequately considering tl:e 1::·anv
risks and alternatives.
• How efficiently is cash managed? Do your strategic_business deci 1,

take account of cash considerations, such as the time value of rno"e-)
194 Chapter 12
REVI W QUESTIONS
Q11estio11s
1. Explain the differe1ice m attitude to risk between European and US

Companies.
2. What is the advantage of defining the categories into which risks fall?
3. Explain how the foll wing types of risk catalyst might trigger risk
a. Technology
b. Organizational charge
c. Processes
d. People
e. External factors
·' .
4. The typical areas of financial .risk includes the following except
a. Poor brand management
b. Treast:1ry risks
c. Accounting decisions and practices
d. Fraud
5. What are the stages in managing the enterprise wide risk?
6. What factors should be considered when setting and reviewing

financial strategy?
7. What are some of the financial tools that can be applied 111 making
strategic financial decision affecting profitability?
8. Enumerate and explain at least (7) practical technique to improve

profitability.
. IJNIT IV INTERNAL CONTROL:
A V-JTAL.TOOL IN
· MANAGING RISK
Chapter
13 Overview of Internal Control
.
14 Fraud and·Error
15 Errors and Irregularities in

the Transaction Cycles of
the Business Entity
. .
16 Internal Control
Affecting Assets .
17 Internal Control
Affecting Liabilities
and Equity
OVERVIEW OF
INTERNAL CONTROL
(£,:)qJected Learning Outco1nes

After studying the chapter, you·should be a le to...
1. Explain what internal control is.
2. Describe the nature and purpose of internal control.
3. Define internal control system.
4. Explain the elements of internal control1 namely,
• Contrql environment
• Entity's risk assessment process
• Information system
• Control actions
• Monitoring of controls
CHAPTER 13
OVERVIEW OF INTERNAL CONTROL
Nr\TURE AND PURPOSE OF lNTERNAL CONTROL
lmernal cvmi·o/ is the process designed and effected by those charged with
governance. n anagement and other personnel to provide reasonable assurance
about .the ach,e_vement of the entity's ol jective·s with regard to reliability of
fo anci_alreportmg, effectiveness and efficiency of operations and
compliance with ppltcable laws and regulations. It follows that internal control
is designed and implemented to address identified business risks that threaten
the achievement of any of these objectives.
Those objectives fall into three categ<?ries:
• Reliability of the entity's·financial reporting

• Effectiveness and efficiency of operations
• Compliance with app_licable laws and regulations
Whether an·.entity achieves its objectives relating to financial reporting and

compliance is determined by activities within the entity's control. However,
achieving its objectives relating to operations will depend not only on
management's decisions but also on competitor's _actions and other factors
outside the entity.
INTERNAL CONTROL SYSTEM DEFINED
Jnterllal control lystem means all the policies ancl procedures (internal
controls) adopted by the management of an. entity to assist in achievi ,g
managemen 's objective of ensuring, as far as practicable, the orderly.a 1d
efficient conduc.t of its business including adherence to management
poltc1es, the safeguarding of
assets, ti,e . prevention an_ddetection of fraud a ,d error, th.e accuracy. and
completeness of the accountmg records, and the timely preparation of reliable
financial information.
l98 ChJpt.:r 13
ELEl\fENTS OF INTERNAL CONTROL
Internal control structures vary significantly from one company to the n xt.
Factors suth as size of the business. nature of operations, the geograph,_cal
dispersion 0f its activities. and objectives of the organization affect the specific
control fe.atures of an organization. However, ce!1ain elements or features must
be present to ha,·e a satisfactory system of control in almost any large scale
org3nization.
.
'
The internal control system extends beyond these matters which relate directly to
the functions of the accounting system and consists of the following components:
a. the control environment;

b. the entity's risk assessment process;
c. the information system, including the related business processes,
relevant to financial reporting, and communication;
d. control activities;
e. monitoring of controls.
A. Control Environment
The control environment which ·means the overall a.,ttitude, awareness and
actions of directo·rs and management regarding the internal control system
and its importance in the entity. The control environment has an effect on
the effectiveness of the specific control procedures. A strong control
environment, for example, one with tight budgetary controls and an
effective internal audit function,·can significantly completnent specific
co.ntrol procedures. However, a strong environment does not, by its
lf·,ensure the effectiveness qf the internal control system. Factors reflected
in the control environment include:
• The function of the board of directors and its committees;

• .
Management's philosophy and operating style;
• The entity's organizational structure.and methods of assigning authority
and responsibility; _ ·
• Management's control system including the internal audit function,
personnel policies and proced\Jres and segregation of duties.
Ol'crl'icw uf lntemal Contrul 199
Th e.11viro1mw 11 in which internal co11trol operates has an impact 011 the

t?.flectn-enes oj the sp<'c(fic control procedures. Severn! factors comprise the
control environment. including:
l. Communication and Enforcement of Integrity a11d Ethical Values

Integrity and ethical values are essential elements of the internal control
environment. They affect the design. administration, and monitoring of
other components of internal control. An entity's ethical and behavioral
standards and the manner in which it communicates and reinforces them
determine the entity's integrity and ethical behavior. Integrity and ethical
values include management's actions to remove or reduce incentives and
temptations that might prompt personnel to engage in dishonest, illegal,
or unethical acts. They also include the communication of entity values
and behavioral standards10 personnel through policy statements, a code
of conduct, nd management's example of appropriate behavior.
2. Commitment to Competence
Competence is the knowledge and skills necessary to accomplish tasks
that define ah employee's job. Commitment to competence means that
management cpnsiders the competence levels for particular jobs in
determining the skills and knowledge required of each employee and
that it hires employees competent to perform the tasks.
\.
3. Participation by those Charged with Governance
An entity's control consciousness is influenced significantly by those
charged with governai:ice. Attributes of hose charged with governance
include independence from management, their experience and stature,
the extent of their ..involvement and scrutiny of activities, the
appropriateness of tlieif. ctions, the_ i formatiolil they re eive, the degree
to which difficult questions are raised and pursued with management,
nd their interaction with internal and external auditors. The importance
of responsibilities of those charged_ with gove_rnance is recognized in
codes of practice and other regulatu;>lls or guidance produced for the
benefit of those chargeq with governance. Other responsibilities of those
charged with, governance include oversight of the design an e ective
operation of whistle blower procedures and the process.for .rev1ewmg
the effectiveness of the entity's internal control.
!00
?erating Style
.J. ,\/,111ag,·me111'. !'/,i/osop II)' a,1<I Oi b . . k (b)
Ow·it·ds
fi•t d (other
a) usmess ris goals
,. ·
• · .
t established
Tl11- ri:fors to 111:111ageme11t's attitude
. b d et pro ' an
fin::u,,·ial reporting.{c) meeting u bT the financial statements.
\\ hich aII ha,·e impact on the reha ,ty •tri·11 g bu.siness risks its
1 O
' I , k.. and mo111 o , .
VIJ,1:1gc111ent s approac1 o ta lllg . from alternative accounting
- •1::.<'1,·ati, e or aggressive selection · vatism in developing
. . . 1 · ess and conser
pnn.:: ,ples. i ts cons c1en 1 ousn d . ti mation processing
and
,,.:.:ounting estimates, and its attitude towarfi Ill or that affect the control
the accounting function and personnel are actors , _
environment.
5. Or<:!,anizationa! Structure
' . . . .
T h e respons1 b1 h t1 es and .the var.io s·personnel with.in the
. • f
author1 t1 es o
oruanization should be established in. such a manner as to (1)asSISt: the
cn7ity in meeting its goals and objectives and (2) ens re that transactions
are processed, recorded, summari'zed and re_porte9 111 an accurate and
timely manner. Organizational structure provides the overa!I framework
for plann'ing, directing and cootrqlling operations. ·
6. Assig 1111enl of Authority anfl Responsibility

Personnel' within an organization need to have a clear understanding of
their· responsibilities and the rules and regulations that. g vern their
actions. Manageirieri.t may develop job descriptions, computer system
documentation. It may also establish policies regarding acceptable
business practice, _conflicts of interest and code of conduct.
7. fluman Resources Policies and Procedures

Pcr:1aps the most important element .of an internal accounting control .
system 1s the people who perform and execu.te the established policies
and procedures. Personnel policies should be adopted by the client to
reas_onably e1 s re th t only capable and honest persons are hired and
retained. Policies with respect to employee selection ' trainino and
supervisi?n should be adopted and implemented by ihe clien7 - The
selection of competent and honest personnel does not automatically
assu,- that e r r o rs or irre gula r'ities will not occur. Howe
. .I I d .1 ver,
adequate p rsonne . po 1c1es, coup e w1_th t e design concepts
suggested earlier in
this section,. enhance the lrkelrhood that the client's olicies and
procedures will be followed. P
Overview of Internal Control 20I
B. Entity's Risk Assessment Process
Risk _a ·sessme111 is the "identification, analysis, and management of

risks pertammg to the preparation of finaiicial statements". For example
risk assessm nt may focus on how the entity considers the possi ility of
tra1_1sactions not being. recorded or identifies and assesses significant
estimates recorded in the financial statements.
An enti_ty's risk assessment process is its process for identifying and

respondmg to business. risks and the results thereof. For financial reporting
urp ses, t!1e entity's risk assessment process includes how management
•d nt1fies risks relevant to the preparation of financial statements that are
pres nted fairly, in all material respects in accordal)ce with the entity's
applicable financial reporting framework, estimates their significance,·
assesses the likelihood of their occurrence, and· decides upon actions to
manage them.'For example, the entity's risk assessment process may
address how t e entity considers the possibility of unrecorded transactions
or identifies and ·analyzes significant estimates recorded in the financial
statements. Risks relevant to relial:ile financial reporting also relate to
specific events or transactions.
Risks relevant to financial reporting include external and internal events

and circumstances that may occur and adversely affect an entity's ability
to· initiate, record, process, .and report financial data consistent with the
assertions of management in th_efinancial statements. Qnce risks are
identified, management considers their significance, the likelihood of their
occurrence, and how they should be managed. Management may initiate
plans, programs,. or actions to address speci_fic risks or it may decide to
accept a risk because of cost or.other considerations. Risks can arise or
change due.to circumstances such as the following:
Changes in operating environment. Changes in the regulatory or

• operating environment can result in changes in competitive
pressures and significantly different risks.
• New personnel. Ne personnel may·have a different focus on
or understanding of internal control.
New or revamped information systems. Significant and rapid
• changes in information systems can change the risk relating to
internal control.·
202 Chapter 13
• Rapid rowth 'd expansion of operations can

Significant and rap• · d • t I
strain c ntrols and increase the risk of a break own in con o s._
1Vew • ·
•
Incorporating
• new technologies into
. production
change the nsk .
associated
technolo gy.
.
processes or mformat1on systems may
with internal control. ·
• New business models, products, or activities. E tering int? business
areas or transactions with which an entity has little expenence
may
introduce new risks associated with internal control.
• Corporate restructurings. Restructurings may be acco_mpanied _by
staff reductions and changes in supervision and segregation of
duties
that may change the risk associated with internal control. ·
• Expanded foreign 'operatlons. The expansion or acquisition of
foreign operations carries new and often unique risks that may
affect
internal control, for example, additional or changed risks·from
foreign currency transactions. ·
• New accounting pronouncements. Adoption of new accounting
principles or changing accounting principles may affect risks in
preparing financial statements. ·
The basic-concepts of.the entity's risk assessment process are relevant to every
entity, regardless of size, but the risk assessment process is likely to be less
formal and less structured in small entities than in larger ones. All entities
should have established financial reporting objectives, but they may be
recognized implicitly rather than explicitly in small entities. Management may
be aware of risks related to these objectives without the use .of a formal
process but through direct personal involvem nt with en.1ployees and outside
parties. '
Considerations Specific to Smaller Entities
Many small enti_ti_es are carried out_enti ely by the engagement partner (who,
may e sole practitioner). ln such s1tua 1ons, it is the engagement partner
who, hav1 g p_ersonally condu t the planning of th audit, would be
responsible for
considering the suscept1b1lity of the entity's financial statements to material
misstatement due to fraud and error.
01'ervicll'of Internal Control 203
C. I form_ation System, including the Business Processes, Rclevnnt to

Fmancial Reporting and Communication
An information system consists of infrastructure (physical and hardware

components}, software. people, procedures, and data. Infrastructure and
software will be absent. or have less sionificance. in systems that are
exclusively or primarily manual. Many info mation systems make extensive
use of IT. ·
"The Information System, lncl11di11g Related Business Processes, Relevant lo

Financial Reporting
The informa ion system relevant to financial reporting objectives. which

includes the accountmg system, consists of the procedures and records
designed and established to:
• • Initiate, record, process, and report entity transactions (as well as events
and conditions) and to maintain accountability for the related assets,
liabilities, and equity;
• Resolve incorrect processing of transactions, for example, automated
suspense files and procedures foll.owed to clear suspense items out on
a timely basis; .
• Process and account for system overrides or bypasses tocontrols;
• Transfer informatio_n from transaction processing systems to the
general ledger;
• Capture information relevant ·to financial reporting for events
and conditions other than transactions, such as
the depreciation and
amortization of assets and changes in the recoverability of accounts
receivables; and
• Ensure information required to be disclosed by the applicable
financial reporting framework is ac umulatede, corded, processed.
summarized
and appropriately reported in the financial statements.
Journal Entries
An entity's information system typi ally in ludes the1se of s andard journal

entries that are required on a recurring basis to record transactions. Examples
might be journal entries to record sales, purchases, and cash disbursements in
the
1 I d er or to record accounting estimates that are periodically made by
genera e g, receivab . I as changes
. f II "b
manageme1lt Such
, le.
111 t1e estimate o
unco ect1 le
accounts
204 Cltaptl!I'13
• des the use of non-standard
1 t ansactions or adjustments.
An entity's financial repo11ing pi·oc ss also met
journal entries to record non-recurrin_gu, nu_sua d ' tments and entries
fora
Examples of such entries include consolidatmg 8_. us estimates such as the
111
business combination or disposal or nonrecun s non-standard journal
impairment of an asset. In manual gener?I ledgerdsys er rnais and supporting
entries may be identified through iospect,on of le ger ,{ ain;ain the general
documentation. \1/h n autqmated pro edures are_ use oe:St only in electronic
ledoer and prepare financial statements, such entries may h f t
: :, "f i d th ough t e use o compu er-
fon n and may therefore be more 1dent1 1 e r
easr.ly.
assisted audit techniques.
Related Busb1ess Processes
An entity's business processes are the activities designed to:
• Dev.elop, purchase, produce, sell a1fd distribute an entity's products and

services; '
• Ensure compliance with laws and regulations; and
• Record information, inQluding accounting and financial reporting
information.
Business processes resu t in the transactions th·at are recorded, processed and
reported by the information system. Obtain_ing an understanding of the entity's
business. processes, which include how transactions are originated, assists the
auditor obtain an understanding of the entity'-sinformation ystem relevant to
financial reporting in a manner that is appropriate to th entity's circumstances.
Accordingly, an information system encompasses methods and records that:
•• Identify and record all valid transactions.

• Describe on_ a ti ely basis the _transactions in sufficient detail
top·ermit proper class1ficat1on of transactions·for financial reporting.
• Me_asure the value of trans ctions in a·manner that· permits
recording their proper monetary value 111 the financial statements.
• Determine the time period in which transactions occurred to permit
recording of transactions in the proper accounting period.
• Present properly the transactions and related disclosures in the financial
statements.
Overview of Internal Control 205
Commu_ni_c ion involves providing an understanding of individual roles and

responsibtltties pertaining to internal control over financial reporting. It
includes the extent to which personnel understand how their activities in the
financial report ng information system relate to the work of others and the
means of reportm e ceptions to an appropriate higher level within the entity.
Open commun1cat1on channels help-ensure that exceptions are reported and acted
on.
Comrr unication takes such forms as policy manuals, accounting and financial
reporting manuals, and memoranda. Communication also can be made
electronically, orally, and through the actions of management.
Application to Small Entities
Information systems and related business processes relevant to financial

reporting in small entities are likely to be less formal than in larger entities but
their role is just as significant. Small entities with active management
involvement may not need extensive descriptions of accounting procedures,
sophisticated accounting records, or written policies. Communication may be less
formal and easier to achieve in a small entity than in a larger entity due to the
small entity's size and fewer levels as well.as management's greater visibility and
availability.
D. Control Activities
Control activities are the policies and procedures that help ensure that
management directives are carried out, for example, that necessary actions
are taken to address risks that threaten the achievement of the entity's
objectives. Control activities, hether w thin IT or_m nual systems, ave
. various objectives and are applied at various organ1zat1onal and functional
levels.
The major categories of control procedures are:

A. Performance Review
8. Information Processing Controls .
I) Proper authorizati n of transactions an.d activities
2) Segregation of duties
•3) Adequate documents and records
4) Safeguards over access to assets; and
5) Independent checks on performance
c. Physical controls
206 Chapter 13
A brief discussion of these control procedures follows:
I
A. Perfonnance Review
.
In a pe1forma11ce review . esusaccounting
manage_ment andaction.
kes corrective operating
Such
I data to assess perfonnance, and tt then ta

reviews include:
operating results) with
• comparing actual performance (or ft ,
budgets forecasts prior period performance, or cor_npet ors
data or t'rack.ing m'aJ. or 1. 11.1.t1a t1· ves such a.s cost-
containment. or cost-reducti·on programs to measu re the
extent to which
targets are being met.
• investigating performance indicators based o.n op rat(ng or
financial data, such as quantity or purchase price vanances
or the percentage of returns to total orders.
• reviewing functional or activity performance,. su_ch as
relating the performance of a manager responsible for a
bank's consumer 1oans with some . standard, such as
economic statistics or targets.
,
Personnel at various levels m an organization may make
performance reviews. Performance reviews may be used by
managers for the sole purpose of making operating decisions. For
example, managers may analyze performance data and base
operating decisions on them because the data are consistent wi
their expectations. This type of review improves the reliability of
the data. However, when managers follow up on unexpected
results determined by a finahcial reporting system, performance
rev1ews become a useful control over financial reporting.
B. Information Processing Controls
Information processing controls are policies and procedures

designed o require authorization of transactions and to ensure the
accuracy and completeness of transaction processing. Control
activities may be classified according to the scope of the system they
affect. General controls are control activities that prevent or detect
errors or irregularities for all accounting systems. General controls
affect all transaction cycles and apply to information processing as_a
center, hardware and systems software acquisition and maintenance,
Ovi•rl'ie,v of /ntemal Control 207
and backup and recovery procedures. Applicatio11onlrols are

controls that pertain to the processing of a specific type of
transaction. such a payroll, or sales and collections. These controls
help ensure that transactions occurred,·are authorized, and are
complet ly and accurately recorded and processed. Examples of
apphcatton controls include checking the arithmetical accuracy of
records, maintaining and ieviewing accounts and trial balances,
automated controls such as input data and numerical sequence
checks, and manual follow-up of exception reports. General IT
controls are policies and procedures that relate to many applications
and support the effective functionino of application controls by
helping to ensure the continued pro;er operation of information
systems. General IT-controls commonly include controls over-data
center and network operations; system software acquisition, change
and maintenance; access security; and application system
acquisition, development, and maintenance. These controls apply to
·mainframe, miniframe, and end-user environments. Examples of
such general IT-controls are program change controls, controls that
restrict access to programs or data, controls over the
implementation of new releases of packaged software applications,
and controls over system software that restrict access to or monitor
the use of system utilities that could change financial data or
records without leaving an audit trail.
Internal controls relating to the as:counting system are concerned

with achieving objectives such as:
• Transactions are executed in accordance with

management's general or·specific authorization.
• All transactions and other events are promptly recorded in
the correct amount, in the appropriate accounts and in the
proper accounting period so as to permit preparation of
financial statements in accordance with an identified
financial reporting framework.
• Access to assets and records is permitted only in
accordance with management's authorization.
• · Recorded assets are compared with the existing assets at
reasonable intervals and appropriate action is taken
regarding any differences.
208 ('/;1ptcr 13
Control activities related to the processing of transactions may be

grouped as follows: (1) proper authorization_, (2) design and use
of adequate documents and records, and (3) independent checks on
perfonnance.
I. Proper auihorization of tra11sactio11s and activities

As suggested earlier, authorization· for the execution f
transactions•flows from the stockholders to management and
its subordinates. Before a transaction is entered into with
another party, certain conditions must usually be met. As
part of the evaluation of.the potential transaction,
documentation will be created. The auditor uses this
documentation, to determine whether business
transactions are properly authorized. For example, the
purchase of inventory may create a purchase order; a receiving
report, and a vendor invoice. By inspecting these
documents and comparing them with company. policy, th.e
. auditor may be reasonably satisfied that a busjness
transaction was authorize_d and executed in a
·manner consistent with company policy.
2. Segregation of duties
An important element in designing an interna'I- accounting
control system that safeguards assets. and reasonably · ensures
the reliability of the accounting records is the concept of
segregation of responsibilities. No one person should be
assigned dttties that would allow that person to commit an ertor
or perpetuate fraud and to conceal the error or fraud. For
example, the sa.me person should not be responsible for
recording the cash received on account and for posting the
receipts to the accounting r cords.
3. Adequate documents.and records

The us 'of adequate do uments and records allow the company
to obtam reasonable assurance that all valid transactions have
Qeen recorded.
.
4. Access to assets
The resources of a client can be protected by the establishment
?f phys!cal barriers and· appropriate policies. For example,
mventones may be kept in a storeroom, or negotiable
Overview<?f Infernal Con/ml 209
instruments may be placed in n safe deposit box. Appropriate

company policies are adopled so that only authorized persons
have access to company resources. Safeguarding of assets is
'.nor than establishing physical baiTiers. A client should design
its internal accounting control system so that documents
authorizing the movement of assets into an organization or out of
an organization are adequately controlled.
5. Independent che h on pe,:fornwnce

The objective of a well-designed internal accounting control
system is the adoption of procedures that periodically compare
the actual asset with its recorded balance. Regardless of the
effectiveness of an internal control system, some transactions
may not be accurately recorded, and some assets may be
m•isappropriated. An important part of an internal accounting
control system is to determine the effectivene s of recording
policies nd asset access policies. This is accomplished by
periodic counts of assets by the client and comparing the counts
to the balances·in the general ledger account. Examples are the
count of inventory and the preparation of monthly bank
reconciIiation.
C. Physical Controls
Controls that encompass:
• The physical security of assets, including adequate

s.afegi1ards such as secured facilities over access to assets
and records.
• The authorization for access to computer programs and data
files.
• The periodic counting and comparison with amounts shown
on control records (for example, comparing the results of
cash, security and invento.ry counts with accounting
records).
The extent to which physical controls intended to prevent theft of

assets are relevant to the reliability of financial statement
preparation, and therefore the audit, depends on circumstances
such as when assets are highly susceptible to misappropriation.
210 Clwptlr IJ
• • · . in small entities arc
The concepts underlying con_troal ct1v1t1c_s. .b t theformality
likely to be similar to those_in l rgcr ent1 : je titics may find
"ith "hi h theyoperate vanes: rt!1er :,ort elevant because
of that ccrtam types of control act1v1t1es ar , t'.
F example managemen s
controls applied by management. ·.or d·ts les significant
retention of authority f r app ovmg c;;di canp:ovide strong
purchases, and drawdown s onmI e o fc . the need for
control over those activities, lessening or rc ovmg f f
more detailed control activities. An appropriatesegr a 1 0
duties often appears to present difficulties in small ent1t1es. vebn
companies that have onIy
employe,cs h.owever, may. e
,aecw.
able to assign their ,esponsibilities to achieve appropriate
segregat.ion or, 1. f that 1. s not pos to use management
.
·1b. f •
oversight of the incompatible act1v1t1es to achieve control
objectives.
E. Mo11itori11g of Co11trols
Monitoring, the final component of internal control, is the_ process

t_hat.an entity uses to assess the quality of internal control over t, e.
Moni onng involves assessing the design and operation of controls on a
timely basis and taking corrective action as necessary. Management
monitors controls to consider whether they are operating as intended and
to modify them as appropriate for changes in conditions. In many
entities, internal auditors evaluate the design and operation of internal
control and communicate information about strengths and weaknesses
and recommendations for improving internal control.
Some monitoring activities may include communications from external

parties. For example, customers implicitly corroborate sales data by
paying their bills or raising questions. Also, bank regulators, other
regulators, and outside auditors may communicate about the design or
effectiveness of internal control.
Monitoring activities may include using information from

communications from external parties that may indicate problems are
highlight areasin need of improvement. C.ustomers implicitly
corroborate billing data by paying their invoices or complaining about
their charges. In addition, regulators may communicate with the entity
concerning matters that affect the functioning of internal control, for
example, communications concerning examinations by bank regulatory
agencies. Also, management may consider communications
relating to internal co
t '"' • • • •
11 ro 1 ,rom external auditors in performing monitoring
activities.
Application to Small Entities
Ongoing monitor·mg act1·v1·t·1es of small entities are more likely to be

·m fiormaI an are typically performed as a part of the overall
management of the nt, 's o 'er tions. Management's close involvement in
operations often will
identify•gn,ficant varianc_es from expectations and inaccuracies in
financial· data lead mg to corrective action to the control.
REVIEW QUESTIONS AND EXERCISES
·Questions
1. What is meant by the control environment? What are the factors the
auditor must evaluate to understand it?
2. What is the relationship among the five components of internal control?
3. The separation of operational responsibility from record keeping is

meant to prevent different types of misstatements than the separation of
the custody of assets from accounting. ·Explain the difference in the
purposes of these two typ s of separation of duties.
4. For each of the following, give an example of a physical control the

client can use to protect the asset or record:
a. Petty cash
b. .Cash received by retail clerks
c. Accounts receivable records
d. Raw material inventory
e. Perishable tools
f. Manufacturing equipment
g. Marketable securities
212 Chapter /3
Exercises
Exercise 1
.
Each of the following mternal 11as taken. from a s-tandardd
contro1s b
een
. . 11 an
internal control questi onnai re for g rof risk m the payro
• , t
assessm personnel cycle. c on
I. Approvai of department l eard or foreman on time cards is required

before preparing payroll. ,
2. All prenumbered time card are accounted for before beginning data
entry for preparation of checks. · . . .
3. The payroll accounting software application will not acce·pt data 111put for
an employee number not cont 1ned in the employee master file.
4. Persons preparing the payroll do not perform other payroll. duties
(timekeeping, distribution of checks) or have access to payroll data
master files or cash.
5. The computer calculates gross anp net pay based on hours inputted
and information i·n employee master files, and payroll accounting
personnel
. double-check the mathematical nccuracy on a test bnsis.
6. All -voided and spoiled payroll checks are properly mutilated and
retained.
7. Personnel requires an investigation of an employment application from
new employees. Investigation includes checking the employee's
background, former employers, and references.
8. Written termination notices. with properly documented reasons for
termination, and approval of an appropi•iate official are required.
9. All checks not distributed to employees are returned to the treasurer for
safekeeping.
I 0. On-line abili to a d emp oyees or change pay rates to the payroll
master file 1s restricted via passwords to certain human resource
personnel.
Required:
a. For each internal control, identify a specific misstatement that 1s

likely to be prevented if the control exists and is effective.
b. For eachcontrol, list a specific misstatement that couldresult from
the absence of the control
c. F oer aclrc?ntrol, identify one audit test that the auditor could
useto uncover m1ssfatements resulting from the absence of
thecontrol.
Overvil.!11' of Internal Control 213
Exercise 2
Jhe division of the following is meant to provide the best possible controls
,or the l'vleridian Paint Company, a small wholesale store.
1
· ssemble supporting documents for general and payroll cash
disbursements.+
2· Sign general cash disbursement checks.+ .
3· Input nformation to prepare checks for signature, record checks in the
cas 1 disbursements journal, and update the appropriate master files.+
4. tvtatl checks to suppliers and deliver checks to employ es.+ ·
5. Cancel supporting documents to prev nt their reuse.+
6. Approve credit for customers included in the customer credit master
file.+
7. Input shipping and billing information to bill customers, record
invoices in the sales journal, and update the accounts receivable
master file.-!:'
•
8. Open the mail and prepare a prelisting of cash receipts.+ .
9. Enter cash receipts data to prepare the cash receipts journal and
update the accounts.receivable master file.+
I 0. Prepare daily cash deposits.+
11. Deliver daily cash deposits to the bank.+
12. Assemble the payroll time cards and input the data to prepare payroll
checks and update the payroll journal and payroll master files.+
13. Sign payroll checks.+
14. Update the"general ledger at the end of' each month and review all
accounts for unexpected balances.
15. Reconcile the accounts receivable master file with control account and
review accounts outstanding more than 90 days.· ·
16. Prepare monthly statements for customers by printing the accounts
receivable master file; then mail the statements to customers.
17. Reconcile the monthly statements from vendors with the accounts
payable master file.
18. Reconcile the bank account.
Required:
You are to divide the accounting-related uties I through 18 among Robtrt
Cruz, James Santos and Bill Reyes. All of the responsibilities marked with
a cross( +) are assumed to,take about the same amount of time and must
be
. ·d .d equally between Robert and James. Both employees are equally
d IV I e . f I • ·11·
co m petent. Bill, who is presi dent o t1e company, 1 s not w1 mg to
ti
per orm
214 Chapter 13
nn functions d signatcd by a dagger and will perform only a maximum of

t\\ o of the other functions.
ercisc3
Recently, while eating lunch with your family at a local cafeteria, you
observe a practice that is somewhat unusual. As you reach the end of t e
cafete'tia line. an adding machine operator asks how many persons arem
your party. He then totals the food purchase on the trays for all of y ur
family and writes the number of persons included in the group on th add1_ng
machine tape. He hands you the tape and asks you to pay "':'hen you _fintsh
eating. Near the end of the meal,·you decide you want a· piece of pie and
coffee so you return to the line, select your food, and again go through t e
line. The adding machine operator goes through the same procedures, but
this time he staples the second tape to the original and returns it to you.
\Vhen you leave the cafeteria, you hand the stapled adding machine tapes to
the cash register operator, who totals the two tapes, takes your money, and
puts the tapes on a spindle.
Required:
a. What internal controls has the cafeteria instituted for its operations?
b. How can the manager of the cafeteria evaluate the effectiveness of the
controls?
c. H?w do these controls differ from those used l:iy most cafeterias?
d. What are the costs and benefits of the cafeteria's system?
Exercise 4
The following are partial descriptions of internal controls for companies

engaged in the manufacturing business:
.
I. When Mr. Clark orders materials for his machine-rebuilding plant, he
sen s a duplicate _purchase or er to the re e!ving department. During the
del1v ry of maten_als, Mr. Smith, the rece1vmg clerk, records the receipt
of shipment on this purchase order. After recording, Mr. Smith sends the
purchase order to the accounting department, where it is usedto record
materials purchased and accounts payable. The materials are transported
to the storage area by forklifts. The additional purchased quantities are
recorded on storage records.
2. Every day, hundreds of employees clock in using time cards at

Generous Motors Corporation. The timekeepers collect these
cards·once a week a_nd deliver them to the computer department.
There, the data on these tune cards are entered into the computer. The
information entered int9 the computer is used 'in the preparation of the
labor cost distribution records, the payroll journal, and the payroll
checks. The treasurer Mrs. Wan, compares the payroll journal with the
payroll checks, signs the checks, and returns them to Mr. Santos, the
superior of the computer
• department. The payroll checks are distributed to the employees by Mr.
Santos.
3. The smallest branch of Super Fresh Cosmetics in lloilo City employs

Mary Santos, the branch manager, and her sales assistant, Jane Reyes.·
The branch uses as bank account in Jloilo City to pay expenses. The
account is kept in the name of "Super Fresh Cosmetics - Special
Account". To pay expenses, checks must be signed by Mary Santos or by
the treasurer of Super Fresh .Cosmetics, Juan Dy. Mary receives the
cancelled checks and bank statements. She reconciles the branch account
herself and files cancelled checks and bank statements in her records...
She also periodically prepares reports of cash disbursements and sends ,
them to the home office.
Required:
a. List the weaknesses in internal control for each of the above. To

identify the weaknesses. .
For each weakness, state the type(s) of rnisstatement(s) that is (are)
Iikely to result. Be as specific as possible. ·
c. How would you improve internal controls for each of thethree
companies?
···-· -·
nic An ;\ppn:cintil,n s )cicty operates a n1uscu111for the benefit and

Cllj0)'1llCllt of the COllllllllllity.
\Vhl..'.n the museum is open to the public, two clerks who are positioned
at the ·ntrancc collect a P50.00 admission fee from each nonmember
patron. Members of the Art Appreciation Society are permitted to enter
free of charge upon presentation of their membership cards..
At the end or each day. one of the clerks delivers the proceeds to the
treasurer. The treasurer counts the cash in the presence of the clerk and
places it in a·safe. Each Priday afternoon, the treasurer and one the
clerks deliver all cash held in the safe to the bank and receive an
authenticated deposit slip that provides the basis fo·rthe weekly entry in
the accounting records.
The Art Appreciation Society board of directors l as identified a need

to improve its internal controls over cash admission fees. The board has
determined that the cost of installing turnstiles, sales booths, or
otherwise
altering the physical layout of the museum will greatly exceed any
benefits. ·
However, the board has agreed that the sale ofadmission tickets must
be integral part of its improvement efforts.
Amparo Cruz has been asked by the board of directors of the Art
Appreciation Society to review the i'nternal control over cash
admission fees and provide suggestions for improvements.
Required:
Indicate weakness in the existing internal controls over cash admission

fees that Amparo Cruz ·should identify, and recommend one
improvement for each of th weakness indentified. Use thy following
illustrative example below:
WEAKNESS RECOMMENDATION
1. There is no basis for establishing Prenumbered admissiontickets
the documentation of the number should be issued upon payment of
of payino patrons. the admission fee.
'
FRAUD AND ERROR
P,xpectecf Learning Outconzes

_ After studying -the hapter, you sh9uld be able to...
·• 1. Explain what fraud means.
2. Explain the major types of misstatements, namely

a. Misstatements arising from misappropriation of assets
b. Misstatements arising from misappropriation of assets.and
'explain
3. Give and explain the elements of a fraud triangle.
4. Give and explain the risk factors contribute to misappropriation

of assets. ·
s. Explain who is primarily responsible for the prevention and

detection of fraud in a business enterprise. .
6. Give and explain the risk factors that contribute to

fraudulent financial reporting.
CHAPTER 14
FRAUD AND ERROR
INTRODUCTION
In the previous chapters, corporate governance has been desc_rib d as the

process bv which the owners and various of stakeholders of an orgamzatJon
exert control through requiring accountability for the resources entrusted to the
organization.
This chapter introduces fraud risk and errors and how they can be reduced if not
totally avoided by having effective internal control - a tool of good corporate
governance.
Fraud is an intentional act involving the use of deception that results in a

material misstatement of the financial statements. Two types of misstatements
are relevant to auditors' consideration of fraud: (a) misstatements arising from
misappropriation of assets, and (b) misstatements· arising from fraudulent
financial reporting.
Intent to deceive is what distinguishes fraud from errors. Auditors routinely find
financial errors in their client's books, but those errors are not intentional.
TYPES OF MISSTATEMENTS
a. Misstatements arisi11gfro11t misappropriation of assets

h. Misstatements arising from fraudulent fi11ancia/ reporti11g
Misstatements arisi11g from misappropriatio11 of assets
· Asset. mi.sap,propriatio11 occurs when a perpetrator steals Or m·isuses an

organ1zat1on s as ets. Asset misappropriations are the dominant fraud scheme
perpetrated against. small u iness and the perpetrators are usually
employees. Asset m1sappropnat1ons can be accomplisl ed1 · ·
• J d · b · 111 various ways,
meu mg em ezzlmg c?sh receipts, stealing assets, or causing the company
to pay for goods or services that were not received.
Fraud and Error 219
ssetmisappropriation commonly occurs when employees:
• ·Gain_ atcess to cash and manipulate accounts to cover up cash thefts.

• Manipulate cash disbursements through fake companies.
• Steal inventory or other assets and manipulate the finanJ;,ial records to
cover up the Fraud. ·
Misstatements arising from Fraudulent Finm,cial Reporting
The intentional maniP.ulation of reported financial results to misstate the

econo'.1'ic condition of the organization is called fraudulent financial
r po ing. The perpetrator of such a fraud generally seeks gain through the
rise in stock price and the commensurate increase in personal wealth.·
Sometimes the perpetrator does not seek direct personal gain, but instead
uses the fraudulent financial reporting to "help" the organization avoid
bankruptcy or to avoid some other negative financial outcome. Three
common ways in which fraudulent financial reporting can take place
include:
I. Manipulation, falsification, or alteration of accounting records or

supporting documents.
2. Misrepresentation or omission of events, transactions, or other
significant information.
3. Intentional misapplication of accounting principles.
THE FRAUD TRIANGLE
The Fraud Triangle characterizes incentives, opportunities and rationalizations

that enable fraud to exist.
The three elements of the fraud triangle are:
• /11ce11tive to commitfr(llu/
• Opp<>rtu11ity to commit a11d co11cea/ the fraud
• Rationalization - the mi11dset of the fraudster to justify committing
tl,e fraud.
-.
l r t.Y. nlfr,'i ar PN.·"un•,· lo Commit ,.-r,1111I
• l'c:-rs,,n:il f.t.:10r.-. such a:- sc, en: linnncinl consid\!

rntion
more lavish
• ssu f°rl'm fomi1'. frknds. or the culture to livea
lifrsr le th:rn l nc\, p rsonnl earnings nllow for
• - -
Addic1i,)11s k1 camblin g or d r u gs
The incellliH·s include the following for fraudulent financial reporting:
• r-.lanagement compensation schemes

• Othe financial pressures for either· improved earnings or an
impro\'ed balance sheet
• Debt CO\'enants
• Pending retirement or stock option expirations
• Personal wealt.htied to either financial results or survival of the
company
• Greed - for example, the backdating of stock options was
performed by individuals who already had milli.ons of pesos of
wealth through stock
Opportu11ities to Commit Fraud
One of the most fundamental and consistent findings in fraud research is

that rhere must be an opportunity for fraud to be committed. Although this
may sound obvious - that is, "everyone has an opportunity to commit
fraud" - it really conveys much more. It means not only that an opportunity
exists, but either there is a lack of controls or the complexi ies
asso'ciated •with a
transaction are such that the perpetrator assesses the risk of being ·caught as
low. Some of the oppo1tunities to commit fraud that the top management
should consider include the following: ·
• Significant related-party transactions
• A company's industry position, such as the ability to dictate ter m·s r
conditions to suppliers or customers that Jnight allow individuals to
structure fraudulent transactions
Fraud and Error 221
• Mana ement's inconsistency involving subjective judgrnents

rd
rega mg a sets or accounting estimates
• Simple transactions that are made ·complex through an unusual
\ recording process ·
• Complex or difficult to understand transactions, such as financial
derivatives or special-purpose entities .
• Ineffective monitoring of management by the board, either because
the b?ard of directors is not independent or effective, or b cause
there rs a domin'eering manager . , .
• Complex or unstable organ,izational structure

• Weak or nonexistent internal controls
,
'
Rationa/izi11g the Fraud
For asset misappropriation, personal rationalizations often revolve around

mistreatment by the company or a: sense of entitlement (such as, "the
company owes me!") by the indivi.dual perpetrating the fraud. Following are
some 9ommon rationalizations fpr'asset misapprc,priation:
• Fraud is justified to· save a family member or loved one from

fin.a ncial crisis.
-
•
.
We will lose everything (family, home, car and so on) if we don't
take tl1e money.
• No help is available from outside.

This is "borrowing", and we intend to pay the stolen m?ney back at
some point
• Something is owed by the company because others are treated better.
• We simply do. not care about the consequences of our actions or of
accepted notions of decency and trust; we are for ourselves.
For frai,dulent financial reporting, the rati.o•nalization can ra ge from "saving

the company" to personal greed, a d may rnclude the following:
• This is one-time thing to get us through the current crisis and survive
until things get better.
• Everybody cheats on the financial statements a little; we are just
playing the same game.
222 Chapter 14
• We will be in violation of all of our debt covennnts unless we find a

way to get this debt off the financial statements.
• We need a higher stock price to acquire company XYZ, or to keep our
employees through stock options, and so forth.
Risk Factors Co11trib11tory to Misappropriatiou of Assets
Misappropriation of assets involves the theft of an entity's assets and is often

perpetrated by employees in relatively small and immaterial amounts.
However, it can also involve management who are usually more able to
disguise or conceal misappropriations in ways that are difficult to detect.
Misappropriation of assets can be acc mpanied in a variety of ways including:
.
• Embezzling receipts (for example, misappropri!iting collections on

accounts receivable oi- diverting receipts in respect of written-off
accounts to personal bank accounts). ·
• Stealing physical assets or intellectual property (for example, stealing
inventory for personal use or for sale, stealing scrap for resale,
colluding with a competitor by disclosing technological data in
return for
.payment).
• Causing an entity to pay for goods and services not received (for
example, payments to fictitious vendors, kickbacks paid by vendors to
the entity's purchasing agents in return fpr inflating prices, payments
to fictitious employe_es).
• Using an entity's assets for personal use (for. example, using the
entity's assets as collateral for a personal loan or a loan to a related
party).
Misappropriation of assets is often accompanied by false or misleadi110

records or documents in order to conceal the fact that the assets are missing or
h ve been pledged without proper authorization.
A. Incentives / Pressures
I. Personal financ al obligations may create pressure on management

or e1 ployees vith access to c.ash or other assets susceptible to theft
to 1111sappropr1ate those assets.
Fraud and Error 223
2. Adverse rela
u· ps between the entity and employees wl· access
ti·onsI
lh
to cash or other assets susceptible to theft may motivate those
mpl?yees to misappropriate those assets. For example, adverse
, elat1011ships e created by the following:
mayb
(a) Known or anticipated future·employee layoffs.
(b) Recent or anticipated changes to employee compensation
or benefit plans. .·
(c) P ornotions, compensation, or other rewards inconsistent
with expectations.
B. Opportunities
I. Certain charact ristics or circumstances may increase the

susceptibility of assets to misappropriation. For example,
opportunities to misappropriate assets increase when following
situations exist:
(a) large amounts of cash on hand or processed.

·(b) inventory items that are small in size, of high value, or in
high den and.
(c) fixed assets which are small in size, marketable, or lacking
observable identification of ownership.
. .
2. Inadequate internal control· over assets may increase the
susceptibility of misappropriation of those assets. For example,
misappropriation of assets may occur because of the.following:
(a) Inadequate segregation f duties or independent checks.
(b) Inadequate oversight of senior management expenditures, .
such as travel and other reimbursements.
(c) Inadequate management oversight of employees
responsible for assets, for example, inadequate supervision
or monitoring of remote locations.
( d) Inadequate job applicant screening of employees with
access to assets.
( e) Inadequate record keeping with respect to assets.
(f) Inadequate system of uthorizat on and approval of
transactions (for example, 111 purchasing).
-- -
-
-
- --- investments.
-
. I s.1fcgunrds Over caSh·
In !dl"\lll;\IC pI\ ,i1,;J •
\!; \
i11\l.·t11\'I'). l,r l'i\c<l ;i, crs. ·1· . nsof assets.
(h) l nd. 1
.
d 11 111 Iv n:conc,•auo
l f t,mplctc an " • • d mentation of
ti) I.ad, vf
.
11111ely
d ppropriate ocu
an pie3 . , merchandise returns.
. r
trnn:-:tCl ll'll,.o r e:-.am · performing key
credit,sor
lD Lack of .
acat1ons for employees
m.rndatol,')
control functions. . information
f
(k) Inadequate
mana2ement understanding technology
o.
.- bl information
technolo!Zv. wl11ch ena es . .
- ·sappropriauon.
emplo,ees to perpetratea m1 d records.
• over automate
(I) Inadequate access contros 1 . t systems
including controls over and renew ofcompu er
e, ent logs.
C. Attitudes/ Rationalizations
J. Disre2.ard for the need for monitoring or reducing risks related to

misappropriation of assets.
2. . Disre2ard for internal control o,·er misappropriation of assets by
-
0, erridin2 existin2 controls or by failing to correct k.no,, n
internal control deficiencies.

-
3. Behavior indicating displeasure or dissatisfaction with the
entity or its treatment of the employee.
- Changes in behavior or lifestyle that may indicate assets ha,·e
been n,isappropriated.
, Tolerance of petty theft.
Risk Faaors Contrihlllory to Fraudulent Financial Reponing
Fraudulent financial reporting may be accomplishe.db) the following:
• \1anipularion. falsification (including forgery). or alterarion of

accounting records or supponing documentation from which the
financial statements are prepared.
• .\lisrepresentation in. or intentional omission from. the financial
statements of events, rransatlions or olher significant information.
• lmentional misapplication of accounting principle.s relatino 10 amounts.
classification, manner of presentation. or disclosure. :,
Fraud and Error 225
Fra d lent financial reporting involves intentional misstatements including

omisSions of amounts or disclosures in financial statements to deceive
financial state_ment.users. It can be caused by the efforts of management to
manage eammg 111 order to deceive financial statement users by
influencing their
. perceptions as to the entity's performance and· profitability. Such earnings
manage lent may start out with small actions or inappropriate adjustment of
assumptions and_ch nges in judgments by management. Pressures and
incentives may l ad these_ actions to increase to the extent that they result in
fraudulent financial reportm?. Such a s\tuation could occ r when, due to
pressures to meet market expectations or a desire to maximize compensation
based on perfori:nance, m_anagement intentionally takes positions that lead 'to
fraudulent fin c1al reportmg by materially misstating the financial statements.
In some ent1t e , • anagement may be motivated to reduce earnings by a
material amount to mm1m1ze tax or inflate earnings to secure bank financing.
Fraud, whether fraudulent financial reporting or misappropriation of assets,

involves incentive or pressure to commit fraud, a perceived opportunity to do
sb and sorµe rationalization of the act.
A. Incentive / Pressure
Incentive or pressure to commit fraudulent financial reporting may
exist wheri management is under press4re, from sources outside or
inside•the entity, to achieve an expected (and perhaps unrealistic)
earnings target or financial outcome - particularly since the
consequences to management for failing to meet financial goals can be
significant.
B. Opportunilies
A perceived opportunity to commit .fra d may exist when an
individual believes internal cohtrol can be overndden1 for. example,
because the
individual is in a position of ,trust or has knowledge of specific
weaknesses in internal control.
rauF' u d lent financial reporting boften involves

. management
ffi . I Foverride
d of
s that otherwise may appear to e oper atmg e e ct1ve y. rau can
contr oI .d. I . h h.
be committed' by management overn mg contro s using svc tee mques
as:
·ino fictitious journal entries, particularly close to the end of
Record o . · h'
• an accounting period, to mantpu1ate operatmg resu1ts or ac 1eve
other objectives.
226
Chapter 14 • · dgments used
. . tions and chang111g JU
• Inappropriately adJusung as sump · ·
to estimate account balances. .. in the financial
d I ing recogn1t1on d . h
• Omitting,. advancing or e ay . ns that have occurred urmg t e
statements of events and transact10
reporting period. · .
• · Id ffect the amounts
f1
• Concealing, or not d1sclos111g, acts that cou a • .
recorded in the financial statements. . .t
• · structured to mtsrepresen
• Engaging in complex transact1?nst 1,at are f the entity.
the financial position or financial performance O
t significant and unusua1

• Altering records and tenns related
0
transactions.
C. Rationalizations
Individuals may be abie to rationalize committing a frau ulent act.
So:e individuals possess_.an attitude, character or set of _ethtca!
value_s t.at allow them knowingly and intentionally to commit
_ad1shones act. However, even otherwise honest individuals can
commit fraud m an environment that imposes sufficient pressure on
them.
Responsibility for tlte Prevention and Detection 'of Fraud
The primary responsibility for the 'prevention· nd detection of fraud rests

with both those charged with governance· of the entity and management. It is
important that rnanage ent, with the oversight of those charged with
governance, place a strong emphasis on fraud prevention, which may reduce
opportunities for fraud to take place, and fraud deterrence, which ould persuade
individuals not to
commit fraud because of the likel_ihood of detection and punishment. This
involves a commitment to creating a culture f honesty and ethical behavior
which can be reinfor e_d by a.n active overs!g t by those charged with
governance. In exerc1smg oversight responsibility, those charged with
overnance consider the potential _for override of 'controls or other
inappropriate mfluence ov r th financial ·eportmg process, such as·efforts by
management to
m nage earnmgs 111 order_t? mfluerJce the.perceptions of analysts as to the entit
's performance and profitability. y
Fraud and Error 227

Questio11s
I. DiStinguish between the terms errors and fraud.
2. Distinguish between
ulent financial reporting and m 1• sappropn·at1· on
1c.raud
of assets. Discuss the likely difference between thes two types of
fraud on the fair presentation of financial statements: ·
3 · Define fri,.ud. , and explain the two types of misstatements that are
.relevant to auditor's coi1sideration of fraud.
4. What are the most common approaches that perpetrators use to commit
fraud lent financial reporting?
5. You are asked to be interviewed by a student newspaper regarding the

nature of accounting fraud. The reporter says, "As I understand it, asset
misappropriations are more likely to be founq are more likely to be
found in small organizations, but not in larger organizations. On the
other hand, fraudulent financia_l reporting_ is more likely to be found
in larger organizations." Hbw would you respond to the reporter's
observation?
6. The fraud triangle identifies incentives, opportunities, and

rationalizations as the three elements associated with most .frauds.
Describe how each ofthes elements is necessary for fraud to occur.
7. If one of the three elements of the frau<! triangle is not present, can
fraud still be perpetrated? Explain. ·
8. Identify factors (red flags) that would be strong, indicators of

opportunities to commit fraud.
_ Is the ability to rationali'z e t e fidraud tan_ imt o a1W1t haspect to consfidher

9 1
1
when analyzing a potentia1 1y 1rau u en st ua 10n. at are some o t e
common rationalizations used by fraud perpetrators?
Define and illustrate kiting. What controls should the client institute to
10
· prevect it? ·
:?28 ('/,apter I./
Exercises
Exercise 1
. · th1·ee factors must exist for a
The fraud trian.g.. le asserts that the followmg
person to commit fraud:
B. Pressure
·c. R tional ization
A. Opportunity
Identi.fy the fraud n.sk f ctor (!",, B or C) •m eacI1 of the following

situations:
1. The business has no camer s o security devices at its war house.

2. Managers are expected t grow business or be fired.
3. A worker sees other. employees regularly take inventory for
- personal use. .
4. No one matches the cash in the register to receipts when shifts end.
5. Officers are expected to s ow rising income or risk ?ismissal.
6. A worker feels that fellow employees are not honest.
Exercise 2
Each of the following scenarios is based on facts in an actual fraud.

Categorize each scenario as primarily indicating (I) an incel}tiv·e to
commit fraud, (2) an opportunity to commit frau , or (3) a rationalization
for committing fraud. Also state your reasoning for each scenario.
/
a. There was intense pressure to keep the corporation's stock from.

declining further. This pressure came from investors, analysts',
and. th'e CEO, whose financial well-being was significantly
dependent on
· the corporation's stock price. ·
.
b. A group of t_op-l ve· l manag ment was compensated (mostly in
the form of stock-options) well m excess of what would be
considered normal for their pqsitions in this industry.
c. Top management of the company closely ou rds internal
financial information, to the extent that even some e;ployees on a
"need-to- know basis" are denied full access. ·
Fraud and Error 229
d. Managing specific financial ratios·is very important to the ompany,

an - o_th _management and analys,ts are keenly observant of
a• iabl11ty m key ratios. Key ratios for the company changed very
little even though the ratios for the overall industry were quite
_volatile during the time period. ·. . •. ·
e. In ari effort to reduce certain accrued .expenses to meet °budget
targets, the CEO directs the general accounting department to
real_locate a division's expenses by a si•gnificant amoun't. _The gen.era!
ccounting departmeJ)t refuses to acquiesce to the reqti st, b t the
Journa) en°!' is made tlirough the corpbrate office. An accoun ant !
the ? ne al accounting department' is uncomfortable with the.journal
entries required to reallocate divfsiorial · expenses. He 'brin'gs liis
concerns·to the CFO, \.Vho assures him that everything will b_e fine
and that. the entries are necessary. The accountant considers
resigning; _.but he does not have another job lined up and is worried
.about supporting his fll:i:nily. Tb refpr ·,. e.!Jiever voices his conce ns
or
to eithertlJe. interi1al external au ffor : i,,' ..· , .
,l, ,I
·
.f.
·;,;;:',:.
Accounting .records· were eithet•nonexistent ,_ot: irr a·stitte"•of such
..disorganization that·significant":effort .was. requfred 1fo·,l0cate or
comp.tie them·. .,:; · ·
: '
Exercise 3
A competent audito·rhas done a conscientious jo of-conducting an.audit, but

because of a;clever fraud by managem·enl, a material 'fraud is incfuded in
the
financfal statemerits. the fraud, wh'icli is-·an overstatement of inventory, took
place over several years, and it covered p t h_ef a c t that the company's
financial position was· rapidly ·decfo1ing: -The fraud was accidentally
discovered in the latest audit by an unusually capable audit senior, and
the SEC wa.simmediately info r me_dS. ubsequent investigation indicated
that the
company was actµally near an ruptcy, and_the value of the stock drop e
from··P260 per share to LO _m less _th n. I montl_1. Among the losmg
stockholders were pension funds, un_fv s1ty endowment fun9s, retired
couples, and·widows. Tne individuals res·ponsible for perpetrating the
fraud were also bankrupt.
230 C/1ap1a I-I
After making an extensive investigation of the audit perform_ance in

previou_s years. the SEC was satisfied that the auditor had done a h1gh-
qualit)'.audit and had followed generally accepted auditing standards in
eve1y respe_ct. The commission concluded that it would be unreasonable
to expect auditors to
uncover this type of fraud.
Required:
State your opinion as to who should bear the loss of th·efraudulent

financial reporting. Include in your discussion a list of potential bearers
of the loss, and state why you believe they should·or should not bear the
loss.
Multiple Choice Qi1estio11s
I. What is the primary difference between fraud and errors in financial

statement repo1ting?
a. The materiality of the misstatement
b. The intent to deceive ·
c. The level of management involved
d. The type of transaction effected
2. Which of the following best represents fraudulent financial reporting?

a. The transfer agent issues 40,000 shares of the company's stock to
a friend without authorization by the board of directors.
b. The controller of the company inappropriately records January
sales in December so that year-end results will meet analysts'
expectations.
c. The in-house attorney received payments from a Ja.panese
businessman for negotiating the development of a new plant in
Batangas City.
d. The accounts receivable clerk covers up the theft of cash receipts
by writing off older receivables without authorization.
3. Which of the following creates an opportunity for fraud to be

committed in an organization?
a. Management demands.financial success.
b. Poor internal control.
c. Commitments tied to debt covenants.
d. Management is aggressive in its application of accounting rules.
Fraud and Error 231
4. Which_ of the following is a common rationalization for fraudulent

financial reporting?
a. This is one-time transaction and it will allow the company to get
through the current financial crisis but we'll never do it again.
b. We ar.e only borrowing the mone/ we will pay it back next year.
c. Executives at other companies are getting paid more than we are,
so we deserve the money.
d. The accounting rules don't make sense for our company, and they
· make our financial results look weaker than is necessary, so we have
a good reason to record revenue using a non IFRS method.
e. A,. and D.
..
ERRORS AND
IRREGULARITI S IN
THE TRANSACTION
CYCLES OF THE
BUSINESS ENTITY
ecteaLeaming Outcomes ·
Understand errors and frauds that may be committed in the

business processes, namely
a. Sales a,:id Collection Cycle
b. Acquisition and Payment Cycle
c. Payroll and Personal Cycle

CHAPTER 15
ERRORS AND IRREGULARITIES IN THE.
TRANSACTION. CYCLES OF THE
BUSINESS ENTITY
While businesses in different individuals can have striking different

chara_cteri_stics mqst have some fundamental conceptual charact ristics are
practices tn common. The'three basic business transaction cycles include ·
'
1. Sales and Collections Cycle
2. Acquisitions and Payments Cycle
3. Payroll and-Personnel Cycle
I
Management should establish co;1trols to ensure that these transactions· are

appropriately handled and recorded. However, if internal· controls are not
properly implemented, or are overridden, fraud and errors may occur. This
chapter presents the errors and fraudulent activities that .could result if there is
poor internal.control.
I. Sales a11d Collectio11s·cycle
). Errors in Recording Sales and Collections Transactions

Errors in recording sales include mechanical errors, such as using
a wrong piece or wrong quantity, recording sales in the wrong
periocl
( cutoff errors), a bookk eper's failure to understand proper
accounting for a transaction, and so on. Internal controls are
designed to prevent r detect many. of these kinds of errors.
2_ Frauds in Sales and Collections

Frauds in sales generally relate to fraudulent financial reporting. In
contrast, frauds'in cash collections relate t misappropriation of
assets, typically accomplished by clerks or management-level
employees.
234 Charter 15
I. Fra11d11/e111FinancialReporting . les typically results in
_ •1 rf1na involving sa '
Fraudulent hnanc1a repo _, returns and allowances.
derstate d s1 a e s · fl
overstal saIes or un c hi e v e high profits may m ate
l\1anagers under pressure toa ablished by senior managers, to
sales to meet target profits est f senior managers, or even
obtain bonuses, to retain the resp:ct O thods can be used to
to keep their jobs. The followmg me
increase sales fraudulently:
ating fictitious shipping
• •
• Recording fict1t1ous sa1es ere
documents, sales( invoices, and so on)
• Recording valid transactions twice .
• Recording in the current period sales t h act curred Ill
the succeeding period (improper cutoff)
• Recording operating leases as sales
, Recording deposits as sales
• Recording consignments assales . .
• .Recording sales when the chance of a return 1s likely
• Following revenue recognition practices that are not in
accordance with PFRS
• Recognizing revenue that sho ld b deferred
II. Misappropriation o{Assets: Withholding Cash Receipts

I. Skimming
This refers to the act of withholding cash receipts without
recording them. An example is when a cashier in a retail
store does not ring up a transaction and takes the cash.
Another example is when an employee who has access to
cash receipts and maintains accounts receiv.able records
can record a sale at an amount lower than the invoice
amount. When the customer pays, the employee takes the
difference between the invoice and the amount recorded as
a receivable. Detection of unrecorded cash receipts is very
difficult; however, unexplained changes in the gross profit
percentage
or sales volume may indicate that cash receipts have been
withheld. ·
Errors and /rreg111 . . III the
. Transai·tion Cycles of the Business Ent,ty
. 235
aru 1 es
2. Lapping
This technique is used to conceal the fact that cash has
been abstracted: the shortaoe in one customer's account is
covered with a subsequent p;yment made by another
customer. An employee who has access to cash receipts
and maintains acco_unts receivable can engage in lapping.
Routine testing f d ta1ls of collections compared with
validated bank deposit slips should uncover this fraud.
3. Kiting
This is.another·technique used to cover cash shortage or to
inflate cash balance. Kiting involves counting the cash
twice by using the float in the banking system. (Float is
the gap between the time the check is deposited or added
to an account and the time the check clears or is deducted
from the account it was written on). Analyzing and
verifying cash transfers during the days surrounding year-
end should reveal this type o(fraud.
II. Acquisitions a11d Payments Cycle
I. Errors in the Acquisitions and Payments Cycle

The followiQg may occur in the a quisitions and payments cycle:
• Failing to record a purchase in the proper period (cutoff
errors)
• Recording goods accepted on consignment as a purchase
• Misclassifying purchases of assets and expenses
• Failing to record a cash payment
• Recording a payment twice
• Failing to record prepaid expenses as assets
Entities normally design controls to prevent these errors from

occurring or to detect errors if they do occur. When such
controls exist, auditors test the_ control to assess their
effectiveness. If the controls are not effective, auditors should
perform substantive tests to determine that the financial
statements do not contain material
misstatements that arose because of possible errors.
236 /i,1/'fl'I' / 5
- · ·-.
:. 1-'r,111ds i11 tltr Ac,111isitio11s c111d l'c \'fll<'IIIS( '.Felt!
• Paring /(ir Fictitious f>urclmses

This involves the perpetrator acating a fictitious invoice (arid
sometimes a rccdving repott. purchnse order and so_ forth) and
processing the invoice for payment. Alternatively, the
perpetmtur can pay the invoice twice.
• R\!cefri11g Kickbacks
In this scheme. a purch.,sing agent may agree it!1 a vendor to
receive a kickback (refund payable to the purchasmg person on
goods or services acql1ired from the vendor).
This is usually done in return for the agent's ensuring that the
particular vendor receives an order from the firm. Often a
check is made payable to the purchasing agent ai1d mailed to
the agent at a location other than· his or her place of
employment. Sometimes the purchasing agent splits the
kickback with the vendor's employee for approviHg an'd
paying it. Detecting kickbacks is difficult because the buy r's
records.do not reflect their existence. However, wl1en vendors
are required to submit bids for goods or services, the likelihood
of' .kickbacks ts reduced.
, .
• Purchasing Goods for Personal Use
Goods or. services for personal use may. be purchased by
executive or purchasing agents and cl1arged to the company's
account. To execute uch a purchase, the perpetrator must' have
ac ess.to blank receiving reports and purchase approvals or
must connive with another employee. Fraud involving the
purchase of
goods for personal use is more likely to go unnoticed .when
perpetual records are not maintained.
Errors and lrregularititts in the Transaction Cycles of the Business Entity 237
Ill. Payroll and Personnel Cycle
Hist0rically, errors and irregul rities involving payroll have been

reported to occur frequently and are largely undetected. ·
I. Errors
The most errors that can occur in the payroll and personnel cycle are
a) paying employees at the wrong'rate.
b) paying employees fo·rmore hours than they worked,
c.) charging pa):'roll expense to the wrong accounts, and
d) keeping terminated erpployees 01 the payroll.
Good internal control can be established to prevent these errors

from occurring and to detect them if they do occur.
2. Frauds involving Payroll-

The major payroll-related frauds include'
a. Fictitious Employees
Adding fictitious employees to the payroll is one of the
most common defalcations. Detecting fictitious employees
on the payroll is very difficult; but auditors do sometimes
perform a surprise payoff as a deterrent to this forr:, of
defalcation. Alternatively, the auditor n:ia_y turn the check
distribution over to an official not associated with preparing
payroll, signing checks, or supervising workers. Personnel
files and the employees' completed time cards and time
tickets may a l_s ob e examined to substantiate the existence
of absent employees.
b. Excess Pqymenls to Employees

Increasing the rate above that approved or paying
employees for more hours than they workeo are the most
common ways of paying employees more than they are
entitled to receive. These practices can be substantially.
reduced by requiring personnel department officials to
authorize changes in pay rates and by monitoring total
hours worked ar d paid for.
.Analyticail procedures that' foc s on co t per unit of actual
production can also be helpful m detectmg excess
payments to employees.
238 Chapter 15
c. Failure lo Record Pa\lro/1

Companies having diffiaulty meeting profit targets or not-
for profit entities having difficulty man ging costs and
expenses might fail to record a payroll. The omission of
payroll can be difficult to hide unless a similar amount of
revenues or receipts has been omitted. Analytical procedures
can be performed to test the reasonableness of payroll cost.
d. Inappropriate Assignment of labor Costs.to Inventory

. '
A company having difficulty meeting profit targets might
assign to inventory labor cost that shou Id have been ch!
lrged to expense. Analytical procedures such as co·mparing
costs· incurred to budgeted cost and verification of
valuation·of inventory are some of the useful techniques in
detecting such fraud.
•
Errors and /1·1•og11Ja,·1·,t·es 1·11 t I,e7,ransact,•on Cycles of·th e Bus1·11ess E· nfl·ty 239

Q11estio11s
l. Define what is meant by a control and weakness in internal control. Give

two examples of each in the sales and collection cycle.
2-
Frank J?izon, a highly competent employee of Breezewater Sale·s
Coporatio_n,had been responsible for accounting-related matters for
two decades. His devotion. to the firm and his duties has always been
exceptional, and oyer the years, he had been given increased
responsibility. Both the president of Breezewate1: and the partner of an of
an independent- CPA firm in charge of the audit were shocked and
dismayed to discover that Dizon had embezzled more than PS,000,000
over a 10-year period by not recording billings in the sales journal and
subsequently diverting the cash receipts. What major factors permitted
the defalcation to the place?
Exercises
Exercise 1
The following misstatements are sometimes found in the sales and collection
cycle's account balances:
a. Cash received from collections of accounts receivable in the
subsequent period is recorded as current period receipts.
b. The allowance for uncollectible accounts is inadequate because of
the client's failure to reflect depressed economic conditions in the
allowance.
C. Several accounts receivable are in dispute as a result of claims of
,defective merchandise
d. Thepledging of acco nts receivable to the bank for a Joan is not
disclosed in the financ1a_l statements. .
e. Goods shipped and included in the current period sales were
returned in the subsequent period.
f. Several accounts receivdabl_e i1b1 t he accounts receivable master file are
notincluded in the age tri1a a a1 nce.
g Ccount receivable in the accounts receivable master file is
0 ne a . .
· included on the aged t r i_abl
alancetwice.
Chapter 15
· l r eceivable from affiliated
I1 Lono-tcnn intercst-bcan ng no c 'S .
0
· compames
•
arc• 111cI ud de ·Ill.'Cot111ts·
,ic receivable.
The trial balance total. docs not cqunl the amount in the general
I.
ledger.
Required: . • t ol that should

prevent For each misstatement, hsl 1an mterna ·conr
it.
Exercise 2
You have been asked by the board of trustees of a local' church to reviedw hits
. h ' you have prepa. re t e
account ing procedures. "As part t 1s
f . ·
o r ev iew
following comments about the collections made at weeklyservices and
record keeping for members' pledges and contributions.
a. The church's board of trustees. has delegated responsibility for

financial management .and audit of the financial records to the
finance committee. This group prepares the annual budget and
approves major cash disb rsements but is ot involved in
co.llections or record keeping. No audit has been ns1dered
necessary m recent years because the same trusted e.mployee
has kept church records and several as financial secretary for 1S
years.
,b. The c \lection at the weekly service is taken by a team of .ushers.
The head usher counts the collection .in the church office after
each
service. He thei1 places the collection and a notation of the amount in
the church safe. The next morning, the financial secretary opens
the safe and rtcounts the collection. He withholds about P1,000 to
meet cash expenditures during the coming . week and deposits
the remainder intact. To facilitate the deposit, members who
contribute by check are asked to draw their checks tocash.
c. At their request, a few members are f rnished prenumbered
predated envelopes in which to inse1t their. weekly
contributions. The head usher removes the cash from the
envelopes to be counted with the loos cash included in the
collection and discards the envelopes. No record is maintained of
issuance or return of the envelopes and the envelope system js
not encouraged. '
d. Each member is ask d to prepare a contribution pledge card
annually. The P!edge 1s regarded as a moral commitment by the
member to contribute a stated weekly amount. Based on the
amounts show on the pledge cards, the financial secretary
ftirnishes a·letter ·
Errors and Irregularities inthe Tramaction C..)icles of the Business Enlily 241
to members, upon request, toupport the tax deductibility of their

contributions. .
Required:
Identify the weakness and recommend improvements in procedures for

collections made at weekly services and record .keeping for members'
pledges and contributions.
Exercise 3
For each of the following misstatements in property, plants, and equipment

accounts, state an internal control that the client could install to prevent the
misstatement from occurring.
I. The asset lives used to depreciate equipment are le$Sthan

reas9nable, expected useful lives.
2. Capitalizable assets are routinely expensed as repairs and
maintenance, perishable tools, or suppi.ies expense.
3. Construction equipment that is abandoned ·or traded
fo·rreplacement equipment is not ry1i1oved from the accounting
records.
4. Depreciation expense for manufacturing·operations is charged to
administrative expenses.
5. Tools necessary for. the maintenanc of equipment are stolen by
company employees for their personal use.
6. Acquisitions of property are recorded at an improper amount.
7. A loan against existing equipment is not recorded in the
accounting, records. The cash receipts from the loan never reached
the company because they were used for the dow11 paymei1t on
piece of equipment now being used as an operating asset. The
equipment is also not recorded in the records.
242 Chapter 15
Exercise 4
The following types of internal controls are commonly used by
orga.nizations for property, plant and equipment:
I. A fixed asset master file is maintained with a separate record for
each fixed asset.
2. Written policies exist and are known by account ng p rsonnel. to
differentiate between capitalizable additions, freight, !nstallat1on
costs. replacements and maintenance expenditur s.
3. Acquisitions of fixed assets in excess of P20,000 are approved by
the board of directors.
4. When practical, equipment is labeled with metal tags and is
inventoried on a systematic basis.
5. Depreciation charges for individual assets are calculated for each
asset; recorded in a fixed asset master file that includes cost,
depreciation, and accumulated depreciation for each asset; and
verified periodically by an independent clerk.
Required:
State the purpose of each of the ·internal controls Just listed. Your answer
should be in the form of the type of misstatement that is likely to be reduced
because of the control.· ·
I. If preparation of a periodic scrap report is essei1tial in order to maintain

adequate control over the manufacturing process, the data for this report
should be accumulated in the_
a. accounting department. c. warehousing department.
b. Production department. d. budget department.
2. Which of the following is not n internal control weakness related to

factory equipment? .
a. Checks issued in payment of acquisitions of equipment are not
signed by the controller.
b. All acquisit ons of factory equipment art: required to be mad.e by the
• department m need of the equipment.
c. Factory equipment replacements are generally made when estimated
i:,seful lives, as indicated in depreciati_on schedules, have expired.
d. Proceeds from sales of fully depreciated equipment are credited to
other income.
Errors and lrr,, .0.1. 1/ Cl/•I·,•lt'.1' I•ll ,
II It' 7 /'(/1/.V{/C(I.OII c; y· e/cs()/·/( /,'1'/.VI·IIC.V.·\ f;·I/ tI 'ty 243
I('
3. \Vith respect lo an internal control 1\1cnsurc that will ensure

accountability for fixed nssct retirements. 111nnngcn1cnl should
implement controls that include
a. Continuous analysis of misccllnneous revenue to locate any cash
proceeds from sale of plant assets.
b. Periodic inquiry of plant executives by internal auditors as to
whether any plant assets have been retired.
c. Cot tin 1ous use of serially numbered retirement work orders.
d. Penod, observation of plant assets by the internal auditors.
4. n a company whose materials and supplies include a great number of

items, a fundamental deficiency in control requirements would be
indicated if
a. a perpetual inventory master file is not maintained for items of small
value. \
b. the storekeeping function were to be combined with production

and record keeping.
c. the cycle basis for physical inventory taking was to be used.
d. minor supply items were to be expensed when acquired.
5. For control purposes, the quantities of materials ordered may be

omitted from the copy of the ptfrchase order that is
a. forwarded to the accounting department.
b. retained in the purchasing department's files.
c. returned to the requisitioner.
d. forwarded to the receiving department.
6. Which of the following procedures would ·best detect the theft of

valuable items from an inventory that consists of hundreds of different
items selling for PIO to PIOO and a few items selling for hundreds of
pesos? · · . .
a. Maintain a perpetual 111ventory master file of only the more valuable
items with frequent periodic veri cation of the validity of the
perpetuals. .
b. Have an independent CPA firm prepare an tnternal control report on
the effectiveness of the administrativ·eand accounting controls over
inventory.
c. Have separate warehouse space for the move valuable items with
sequentially numbered tags.
d. Require an·authorized officer's signature on all requisitions for the
more valuable items.
a !Q
INTERNAL CONTROL
AFFECTING ASSETS
f£.:{pectecf Learn.1:11g Ou.tcouies

1. Describe tile internal control over tile major components of

assets of a business enterprise namely
a) Cash
b) Financial Investments
c) Receivables: Accounts and Notes and related revenue
accounts
d) lnveritories and related Cost of Goods sold
e) Property, Plant and Equipment •
2. Understand the potential misstatements (due to fraud and

errors) of the asset accounts and how weakness in internal
control increases the risks of misstatements.
CHAPTER 16
INTERNAL CONTROL AFFECTING ASSETS
INT RNAL CONTROL OVER CASH TRANSACTIONS
Most of the processes relating to cash handling are the responsibility of the
finance department, under the direction of the treasurer. These processes include
-l1a1 dli g.and depositing cash receipts; signing checks; inv sting id\e cash; and
mamtammg custody of cash, marketable sec 1rities, and other negotiable assets.
In addition, the finance department must forecast cash requirements and make
both short-ter!11 and, long-term financing a1Tangements.
Ideally, the functions of the finance department and·the accounting department

should be integrated in a mani1er that provides assurance that:
. .
1. All cash that should have been received was -in fact received, recorded
accurately and deposited promp.tly..
2. Cash disbursements have been made for authorized purposes only and
have been properly recorded.
3. Cash balances are mainfained at adequate, but not excessive, levels by
forecasting expected cash receipts and payments related to normal
operations. The need for obtaining loans for investing excess cash is
thus
·made known on a timely basis. ·
A detailed study of the business processes of the company is necessary in

developing the most efficient c ntrol pr?ced res, but there are s?me g neral
guidelines to good cash handling practices 111 all types of busmess. These
guidelines for achieving internal control over cash may be summarized as
follows:
I. Do not permit any one employee to handle_a transaction from
beginning to end.
2_ Separate cash handling from record keeping.
3. Centralize receiving of cash tothe extent practical.
'6 Clzaptl'I"16
4. Record casll receipts on a timeiy basis.

5. Encourage customers toobtain receipts and observe cash register totals.
6. Deposit cash receipts daily.
7. Make all disbursements by check or electronic funds transfer, with the
exception of small expenditures from pe cash.
8. Have monthly bank reconciliation prepared by employees . not
responsible for the issuance of checks or custody of eash. The
completed reconciliation should be reviewed promptly by an
appropriate of cial.
9. Monitor cash receipts and disbursements by comparing recorded
amounts· to forecasted amounts and investigating variances from
forecasted amounts.
Potential Misstatements -·Cash Receipts
Description of Misstatement Examples Internal ControlWeakness.or

Factors that Increase the
Risk of the Misstatement
Recording fictitious cosh receipts Froud:
• Overstoting.coshreceipts • Lock of segregation of

on the books by duties of the functions of
transferring cosh between access lo cosh ond record
honk accounts without keeping; no effective
oppropriole recording of review of honk
the transfer lo cover up on
embezzlement of cash. reconciliolions.
Failure lo record receipts from Froud:
.
,
cosh soles
• A cashier foils lo ring • Inadequate supervision of
up ond record cash soles cashiers; failure to
and
encourage customers to
embezzles the co.sh.
obtain cash receipts.
Error:
• A bookkeeper
• lnodequote controls for
reconciling cash regisier
occidenlolly omits the
recording of the tapes ond accounting
receipts from one cash records; inadequate
register for the doy. controls for reconciling
honk accounts.
-
Internal Control Ajfer::ling Assets 247
Failure to record cash from
Fraud:
collection of accounts receivable
• A cashier embezzles cash. • Lack of segregation of
payments by customers on .dutieS'between personnel
receivables, without who hove access to cash
recording the receipts in the receipts and those who
customers'.accounts. make entries into the
accounts receivable
records.
• A bookkeeper occidentally • Lack of segregation of
who·hos access to cash duties between personnel
receipts embezzles cash who hove access to cash
collected from customers receipts and those who
and writes off the make entries into the
related accounts receivable
receivables. records.
Error:
• Inadequate reconciliations
• A bookkeeper occidentally of subsidiary records of
fails to record payment accounts receivable with
on a.receivable. the general ledger control ,
account.
Early (late) recognition.of cash Fraud:
II
receipts - "cutoff problems
• Holding the cash receipts • Ineffective board of
journal open torecord next directors, audit committee,
year's cosh receipts as or internal audit function;
having occurred in this "tone at the top" not
year. conductive io ethical
conduct; undue pressure to
show improved financial
position.
Error:
• Recording cash receipts • Failure to list and deposit

based on bod information cash receipts en a timely
about dote of receipt. basis.
Potential l\lisshltements- Cnsh Disbursements
nescription of Misstatement Examples Internal ControlWeakness or
Factors that Increase the
Riskof the Misstatement
jh1mirola r rording of a Fraud:
<!rchJse t-r disbursement
• A bookkeeper prepores o • Inadequate segregation of
check to himself and duties of record keeping
records it os having been and preparing cash
issuedtoo mojor supplier. disbursements, or check
. signer does.not review and
cancel supporting
Error: documents.
'
• . A disbursement is mode to
pay on invoice for
• Ineffective control for
matching invoices with
•
. goods receiving documents
that hove not be n before disbursements ore
received. authorized.
• Disbursements for travel • Ineffective accounting
and entertainment ore coding procedures may
improperly includedwith result lrom incompetent
merchandise purchases.
. accounting personnel,
inadequate chart of
. accounts, or no controls ·
over the posting process.
Duplicate recording and payment Error:
of purchases
• A purchase is recorded • Ineffective controls for
when on invoice is received ·reviewand cancellation of
. lrom a vendor and recorded supporting documents.by
ogoin when a duplicate the check signer.
invoice is sent by the
vendor.
Unrecorded disbursements Fraud:
• In conjunction with • Ineffective control over

recorded (but deposited) record keeping for and
cash receipts, on employee access tocash.
· writes!lnd choses on
unrecorded check for the ,
identical amount.
;
/nremal Co11rrol AfJecring Assets 249
INTERNAL CONTROL OVER FINANCIAL INVESTMENTS
ThemoS t important group of financial investments consists of marketable

stocks andbonds because they are found more frequently nd usually are of
greater peso
value than the oth r kinds of investment holdings. Other types of investments
often encountered mclude commercial paper issued by corporations, mortgages
ndtrust d eds, and the cash surrender value of life· insurance policies. The
mt rnal auditors also must be concerned·with derivatives that are used to hedge
vanou nancial and operational risks or for speculation. Derivatives are
financial instruments that "derive" their value from other financial instrument.s,
underl ing assets, or indexes. For example, .a simple derivative would involve
a
o m tment by a company to purchase a coml}lodity at a certain price at some
pomt m the future. _Other derivatives are much more complex, involving, fo_r
example, relationships between fluctuations in European interest .rates and the
price of copper.
The major elements of adequate internal control over financial investments

include the following:
I. Formal i'nvestm nt policies that limit the nature if investments in

securities and other financial instruments.
2. An investment. committee of the board of directors that authorizes and
reviews financia·linvestment activitie for compliance with investment
policies.
3. Separation of duties betwee t e e cutive authorizin_gpur hases and
sales of securities and derivative instruments, the custodian of the
securities, and the person maintaini11g the·records. of investments.
4. ·complete detailed records of all securities and derivative in'struments
owned and the related provisions and terms.
,
s. Registration of securities in the name of the company. . .
6. Period.ic physical inspec ion of s:'.:u _ritiefis 01_1hhand by_ an _internal aduditor
or an official having no respons1u11 1ty or t e aut11onzat1on, custo y,
or
record keeping of investments.
7. Determination of appropriate a cco nting for complex financia,l
instruments by competent personn.e 1
2!fi(I ('ltfl/1/l'I' /()
In 11w11y com:urm,, m,11,roiwtlc111or lhc f\111cllorw or u111,1ody 1 nd record l<1Jcpi11g

Irr 11chiovcd hy tho w,c of'1111l11dopundc1111mfol<ccpi11p.11gu111', 111H.:lr11:111 11(ockholdcr,
bnnk or trnsl c11n1pn11y. Si11cc lhc i11dupc11dc11l11gc11I hmr no din,cl cnnf1t<.:I wilh tire.,
omployuc rcsplmsiblc li'nm 11111i11t11i11i111,111cco11111i11g rocordllo/' lhc invcn111w1111i11
securities, tho possibilitios of' co11cu11li11g fr1111d f111·011glr
1hl:ti11'.:11lio11 o_fl' hc 11cco1111ls 111·c µrcntly rcdncucl, II'sccrrrilic:s lll'O 1101
pl11ccd ill the c11:1lody of 1111
indcpondcnt 11gc111, Ihoy should he kc1\1in II h1111k :mlc-dcp<mil box undt.:t' I.ht.:joitll
control of' two or 111or1.: or lht.: cor11p11ny'i, of'liciah,. .!0/111 co11trol mcarni
that noithor or the lwo c11slodi1111s 11111y h11vc 11cccs:; 10 lhc !lCc11rilics except i11
llw
prcJscncc or the olhc:r. /\ lisl nf'sccuritics in the hox should be nrninlld11cd in lhc
box, and the deposit or withdrawal of'sccuriJics should be recorded 011 Lhi:i
li1Jl along with the elute and sig11111t1rcs or nll pcrnous present. '/'he safo-
dcpnsil box renl(1I should he in the nnmc orlhc company,.1101in the name of 1111
of'liccr having custody of'securities. ·
Complete detailed records orall securities and derivative instruments ownc:d

arc essential to satisfactory conlr()I,These:records frequently consist of a
subsidiary record for each security and derivative inslrumenl, with such
identifying data as the exact name, face amount or par value, certificate
number, number of slrnrci;, dnte of acquisition, n:imc of broker, cost, terms
and any intc:rest or dividend payments received. Actual interest and
dividends should be compared tc) budgeted amounts. and significant
variances should be investigatcd. The purchase and sale of investments
oncn is entrusted to a responsible financial executive, subject to frequent
review by an investment committee of'the board of directors.
Potential Mi11statcmcnts - Fin:111cial Investments
Description of Misstatement Examples Internal ControlWeakness

or Factors that Increase
,
the Risk of the
Misstatement
Misstotomenl of recorded Error:
value of inveslments • Failur,e lo record changes in • lnadequare accounting
markervalues of manual; incompetenl
invesrmenrs. accountingpersonnel.
fraud:
• Misslotemenrof the value • Ineffective boardof
of closely held inveslmenf. directors, audit commitlee,
or infernal oudil function;
norconducive lo ethical
meel earningsforgets.
◄
lntemal Control Affecting Assets 251
Unauthorized investment Fraud:
transactions
• An employee with access to • Inadequate segregation of
securities coverts them for duties of record keeping for and
personal use. custody of securities.
Incomplete recording of Error:
investments
• Failure to record derivative • o. lnodequote
agreements which ore o·ccounting manual;
embedded in other incompetent occouniing.
agreements. personnel.
.
• b. Inadequate monitoring
'byinternal auditors.
INTERNAL CONTROL OVER RECEIVABLES
Accounts receivable include not only claims against customers arising from
the sale of goods or services, but also a variety of miscellaneous claims such as
loans to officers or employees, loans to subsidiari s, claims against various
other films, claims for tax refunds and advantages to suppliers.
Sources and Nature of Notes Receivable
Notes receivable are written promises to pay certain amounts at future dates.
Typically, notes receivable is used for handling transactions of substantial
.amount; these negotiable documents are widely used. In banks and other
financial institutions, notes receivable usually constitutes the single most
important asset.
.
Internal Control of Accounts Receivable and Revenue
To understand internal control over accounts receivable and revenue, one must
consider the various components, in ludin the c?ntrol· environmen!, r_isk
assessment, monitoring, the (accountmg) tnformat1on and communicat1on
system, and control activities.
21 L'lt,1pt.·r IO
Control En\'ironmcnt '

th
Because of the risk of imentional misstatement of revenues. e control
envimnment is very importnnt to effective internal control_overr
venue.and recehnhles. Of particul:ir importance is nn independent au
1lcommitteeof the board of dir ct,.ws that monitors 1111111age111e11t's
judgments about revenue recognition principles and estimates. as well as
an effective internal audit function_.i\ lanagement should establish n 1011e at
the top of the organization that encouniges integrity nnd ethical financial
reporting. These ethical standards
should be communicated and observed throughout the organization. Also.
incentives for dishonest reporting. such as undue emphasis on meeting
unrealistic sales or earnings targets. should he diminated.
Potrntial Misstatements - Revrnuc / Receivables
Description of Misstatement Examples Internal ControlWeakness or

Factors tha1 Increase the
Riskof the Misstatement
Recording unearned revenue Fraud:
• Recording fictitious soles • Ineffective board of
without receiving o directors, audit commillee,
customerorder or shipping or internalaudit function;
the goods. undue pressure to meet
• Intentional overshipment of earnings targets."top
goods. managementoction" not
conductive to ethical
Errors: conduct
• Recordingsoles basedon • Ineffective billing process
the receipt of ordersfrom in which billing is not tied
customers rather thanthe to shipping inlormalion.
shipment ofgoods.
• lnoccurote billing and
• Ineffective controls for
recordingofsoles.
lesllnginvoices, or
ineffective input validation
theclcsandcomputer
reconciliations to ensure
the accuracy of databases.
Internal Control Affecting Assets 253
• Recording cash thot • Inadequate accounting

represents o liability (e.g., manual; incompetent
receipt of o customer's accounting personnel.
deposit) as revenue.
Early (late) recognition of revenue Fraud:
- "cutoff error" .
• Holding the soles journol • Ineffective board of
open to record next year's directors, audit committee,
sol s as having occurred or internal audit
in the current year. function; not conducive
to ethical conduct; undue
pressure to meet soles
Error: targets.
• Recording soles in
the wrong period • Ineffective cutoff
hosed on incorrect procedures in the
shipping shipping deportment.
information.
Recording revenue when Fraud:
significant uncertainties exist
• Recording s_aleswhen the • Ineffective board of
customer is likely to return directors, audit committee,
the goods. or internal audit function;
not conducive to ethical
conduct; undue pressure lo
Error: mt:et soles targets.
• Recording soles when the • A gressive attitude of
customer's poyment is management toward
contingent-uponthe financial reporting;
customer receiving incompetent chief
financing or selling the accounting officer.
goods to another party
(e.g., consignment sole's).
Recordingrevenue when Fraud:
significant services still must be • Recording franchise • Ineffective boord of
performed by seller revenue when the • directors, audit committee,
franchises are sold even or internal oudit function;
though on obligation to not conducive· to ethical
perform significant services conduct; undue pressure to
still exists. meet sales targets.
254 Chapter 16 .
,
. Error:
• Aggressive attitude of
• Amount of revenue earned management toward
on franchises is
financial reporting;
miscalculated
incompetent chief
accounting officer.
Overestimation of the amount of Fraud:
revenue earned.
• Misstating the percentage • Ineffective board of
of completion of several directors, audit committee,
projects by a construction or internal audit function;
company using the not conducive to ethical
percentage-of completion conduct; incompetent
method revenue individuals involved in the
estimation process.
. recognition.
• Overestimating the • Aggressive attitude of
percentage of completion management toward
on projects by o financial reporting;
construction company using incompetent personnel
the percentage-of- involved in the estimation
completion method of / accou ting process.
revenue recognition.
'
Internal Control over Notes Receivable
As previously stated, a basic characteristic of effective control. consists of the

subdivision of duties. As applied to notes receivable, this principle requires that:
I. The custodian of notes receivable not have access to cash or to general

accounting records.
2. The acceptance and renewal of note be authorized in writing bya
responsible official who does not have custody of the notes.
3. The write-off of defaulted notes be approved in writing by responsible
officials and effective procedures adopte.d for subsequent follow-up of
such defaulted notes.
lntcmal Control Aj]ect/nJ.: A.tvef. 255
INTE AL CONTROL OVl R INVRNTORIES AND

COS1 OF GOODS SOLi>
The interre. lation' sh''P OI'·mventon.cs and cost of goods sold make.s 1t lo. gical for
11,el h o toP.•.cs to b considered together. The controls that assure the fair
va uat1o. n ol mventones''\ t·ound •Ill t11e pmchases (or acqu• eyeIe. These
1. e 1•s1•l1on)
con.l r·o I s .me1ud.e procedures 1c or g vendors, orden·ng mereI,and'1se or
se1ectm•
mate.,1.als, mspectmg goods 1.ece1· ved , record'mg 11·11b1'I1' ty to t11e vendor, and
t1,e
autI,o•nzmg and m' C,c\SI1 d'1sbursements. In a anufactur·in bu·smess, teh
. aking m· g
a 1uat_,on of _mventories also is affected by the production (or conversion)
cycle, n which_ va ious manufacturing costs are assigned to inventories, and the
cost of uwentones ,s then transferred to the cost of goods sold.
Sources and Nature of Inventories and Cost of Goods Sold
The term ii1ventories is used in this chapter to include:
I. goods on hand ready for sale, whether the merchandise of a trading

concern or the finished go'ods of a manufacturer;
2. goods in the process of production; and··
3. good to be·consumed directly or indirectly in production, such as raw
materials, purchased parts, and supplies. ·
' .
Internal Controi over Inventories and Cost of Goods Sold
The importance of adequate internal control over inve,itories and cost of.
goods sold from the viewpoint of both management and·the auditors can
scarcely be overemphasized. ln som companies, management stresses controls
over cash and securities but pays little attention_ to control o_ er inventories..
ince many types of inventories are composed of items not particularly
susceptible to theft,
management may consider controls t? be u111'.ecessary in this area. Such thinking
ignores the fact that contr ls 7
or mventones aff ct nearly all the functions
involvedin·producing and d1spos111g of the companys products.
256 Chapter /6
Potential Misstatements - Inventory/ Cost of Goods Sold
Examples Internal Control Weakness or

Description of Misstatement
Factors that Increase the Risk of
the Misstatement
Misstatement of inventory costs Fraud:
• Intentional misstatement of • Ineffective board of
production costs assigned directors, audit committee,
to inventory. or internal audit function;
• lntenfional misstatement of "tone al the lop" not
inventory prices. conductive to ethical
meet earnings targets.
. Errors:.
.
• The assignment of.direct • Ineffective cost accounting
labor costs, direct material system; failure to update
costs, or factory o erheod standard costs on a timely
• to inventory items is basis.
inaccurate. • Ineffective input validation
• Erroneous pricing of controls on the database of
inventory. inventory costs; ineffective
s·upervisionof the
. personnel that enter the
costs on the final inventory
schedule.
Misstatement of inventory Fraud:
quantities
• Items ore stolen with no • Ineffective physical
'. ' journal entry
.. reflecting the controls over inventories.
. '
theft.
• Ineffective board of
• Inventory quantities in directors, audit committee,
locations not visited by . or internal audit function;
auditors are systematically "tone at the top" not
overstated. conducive to ethical
Errors: meet earnings targets.
' • Miscounting of inventoryby
personnel involved in • Ineffective controls or
physical inventory.1 supervision of physical
inventory.
•
•
Internal Control A.[fecting Assets 257

Early (late) recognition of Fraud:
purchases - "cutoff problems".
• Intentional recording of • · Ineffective board of
purchases in the direclors,-audit
subsequent period. committee, or internal
audit function; "tone at
the top" not conducive
to ethical conduct; undue
Error: pressure to meet
earnings targets.
• Recording purchases of the • Ineffective accounting
current period in the procedures that do not tie
subsequent period. recorded purchases to
receiving data.
INTERNAL CONTROL OVER PROPERTY, PLANT AND EQUIPMENT
The term properly, plant and equipme t includes all tangible assets with a
service .life of more than one year that are used in the operation of the business
and are not acquired for the purp,ose of resale. Three major subgroups of such
assets are generally recognized:
I. Land, such as properly used in the operation of the business, has the
significant characteristic of not being subject to depreciation.
2. Buildings, machinery, equipment and land improvements, such as fences·
and parking lots, have limited service lives and are subject to
depreciation.
3. Natural resources (wasting assets), such as oil wells, coal mines, and
tracts of timber, are subject to depletion as the natural resources are
extracted or removed.
Acquisitions and disposals of property, plant and·equipment are sually large in

dollaramount·,but concentrated in only a few transactions. I11dividual items of
plant and equipment may remain unchanged in the accounts for many years.
•
258 Chapter 16
Internal Control o,1cr Pinnt and Equipment
The amounts ·111 plant and equ·ipmen. t represents a large portion of the
·mvested
total assets of many industrial concerns. Maintenance, rearrangement ahd
deprec1·at1·on of these assets are maJ· or expenses ·111 ti1e ·111co111e state.ment. The
total expenditures for the assets and related expenses make strong mt rnal
contr?I essential to the preparation of reliable financial stateme ts. Erro_rs m
measurement of income may be material if assets are scrapped without t e•r
cost being removed from the accounts, pr if the distinction between c pita!
and
revenue expenditures is not maintained consistently. The losses h:at
mev1tably arise from uncontrolled methods of acquiring, maintaining, and ret1
111g plant and equipment are often greater than the losses from fraud in cash
handling.·
In large enterprises, the auditors may xpect to find an annual plant budget
used to forecast and control acquisitions and retirements of plant and
equipment. Many small companies also forecast expenditures for plant as ets.
Successful utilization of a plant budget presupposes the existence of reliable
and detailed accounting records for plant and equipment. A detailed
knowledge of the kinds, quantities and condition of existing equipment is an
essential basis for intelligent forecasting of the need for repJacemenfs and
additions to the plant.
Other key controls applicable to plant and equipment are. s follows:
I. A subsidiary ledger consisting of a separate record for each unit of

property. An adequate plant and equipment ledger facilitatelhe
auditor's work in analyzing additi9ns and retirements, in verifying the
depreciation provision and maintenance expenses, and in comparing
authorizatjons with actual expenditures.
2. A. system of authorization requiring.advance exe:::utive approval of
all plant and equipment acquisitions, whether by purchase tease· or
construction. Serially numbered capital work orders are a 'convenient
means of recording authorizations.
3. A reporting procedure assuring prompt disclosure and analysis· of
variances between authorized
. expenditures and actual co;ts
'
.
4. An authoritat!ve written _statement of company policy distinguishing
between capital expenditures and revenue expenditures. A dollar
m1111mu_m ordinarily will be establishe for capitalization; any
exp nd1tures of a lesser amount automat1cally classified as charges
agamst current revenue.
\
/111emrd Co11trul 1tffcctl11r, Asset 259
5. A policy requiring all purchnscs of plant nnd equipment to be hand ed

through_tl_1e purchasing department and subjected to a standard routine
for receivmg, inspection and payment.
6. Periodicl ysical inventories designed to verify the existene , location
an? condition of all property listed in the accounts and to disclose the
existence of any unrecorded units.
7. A system of retirement procedures, including serially numbered
retir me11t work orders (bottom), stating reasons for retirement and
bearing appropriate approvals.
Potential Misstatements - Investments in Property, Plant

and Equipment
Description of Examples Internal Control Weakness

Misstatement or Factors that Increase the
Risk of the Misstatement
Misstatement of acquisitions of Frau :
property, pion! ond equipment
• Expendit res for repairs • Undue pressure to meet
earnings targets.
and maintenance
expenses recorded as
property, plant·and
equipment acquisitions to
overstate income.
Error:
• Purchases of equipment ••lnndequote accounting
.
in
.
erroneously reported manual;incompetent
accounting personnel.
,mointenonceand repairs
expense account.
failure to record retirements of Error:
property, plant and equipment. • An asset that has been • Inadequate accounting
replaced is discarded policies, e.g., failure to
due use retirement work
to its lack of value, orders.
without on accounting
entry.
£rror: .
Improper reporting of unusual
transactions. • A "gain" recorded on an • lnodequote accounting
exchange of manual; incompetent
nonmonetory assets that accounting personnel.
locks commercial J
. substance.
260 Chapter 16
REVIEW QUESTION AND EXERCISES
Q11estio11s
Caslz
I. L·ist ht f1i ve pr·imary ·mvoIved 1·n the acquisition an, d payment.

e cycle.
act1·v1·t1· es
2. List at least five common fraud schemes in the acqu(sition anclpayment

cycle.
3. Describe the following types of. ash accounts: ( ) general checking

accounts, (b) casli management accounts, (c) imprest payroll a counts,
and (d) petty cash accounts.
4. List at least three common controls for petty cash.
PPE
5. Identify potential fraud schemes related to long-lived assets.
6. Consider the risks typically a sociated with tangible long-lived assets

and identify the intern.al controls over these assets that you would
expect a client to have in place.
Exercises
Cash
Exercise 1
The auditor has always received·good cooperation from a particular

client and has no .reason. to question management's integrity. The
controller has requested that the auditor inform her about which
warehouse locations that the auditor will visit during the upc,oming
inventory count. In addition, the controller has requested copies of the
auditor's observations on the physical inventory because she wants to ·
make sure tl1at a good inventory was_ taken. Should the auditor comply
with these requests? State your rationale, .including a discussion of
professional skepticism.
Internal Control Affecting Assets 261
Exercise 2
Using the following categories, define the purpose of each of the

common controls over cash listed below. You may use multiple
categories for each control. ·
Categories of Purpose of each Coinmon Control
I. To prevent theft of cash.

2. To ensure complete recording of cash.
3. To prevent modification of the recording of cash.
4. To detect inaccuracy of ending cash balance or misstatements
therein. · •
5. To ensui.-e that all items are uniquely identified and that an adequate
audit trail exists for transaction . ·
6. To serve as a deterrent for fraud.
Common Controls Over Cash
a. Segregation of duties.
b. Restrictive endorsements of customer checks.
c. Independent bank reconc1liati<?ns by employees who do ot handle cash.
d. Computerized control totals and edit tests.
e. Authorization of transactions.
f. Prenumbered cash receipts documents and turn around documents.
g. Periodic internal audits.
h. Competent, well-trained employees.
262 Chapter 16
PPE
I. Long-lived assets include which of the following?
a. Tangible assets such as equipment.
b. Intangible assets such as patents.
c. Natural resources.
2. \Vhich of the following statements is false regarding fraud risk factors

related to long-lived assets?
a. A potential fraud scheme involves not removing.sold assets from the
books.
b. Because long-lived assets are typfoally an audit area of low risk,
auditors do not need to perform brainstorming activities related to
long-lived assets. ·
c. Management might use unreasonably long depreciable lives m an
effort to reduce expenses..
d. None of the above statements is fats .•
J11ventory
3. Which of the following1is not an activity associated with the acquisition

and payment cycle?
a. Receive a customer purchase order.
b. Purchase of goods and services. ·
c. Receipt of, and acco·unting for, gods and services.
d. Approval of items for payment.
4. Which of the following is an inherent risk relating to inventory?

a. Inventory is easily transportable.
b. Inventory may become obsolete because of technological advances
even though there are no visible signs of wear.
c. Inventory is often returned by customers, so care must be taken t
separately identify returned merchandise, check it for quality and
r cord it at net realizable value.· . '
d. Afl of the above.
Internal Control Ajfeqting Assets 263
5. . Which of the following is an example of fraud in the acquisition and

payment cycle?
a. Theft of inventory by an employee.
b. Employee schemes involv'ing fictitious vendors as means to transfer
payments to themselves.
c. Executives recording fictious i;wentory or inappropriately recording
higher values for existing inventory.
6. Identify the possible inventory or cost of goods sold manipulation that

might oc ur when inventory is sold.
a. Overstate returns
b. Overcount inventory
c. Not record cost of goods sold nor reduc inventory
d. Under-record purchases
INTERNAL CONTROL
AFFECTING LIABILITIES
AND EQUITY
(£);pectecl Learning Outcomes .

1. Describe the internal control over liabilities and equity

accounts, namely·
a. Accounts Payable
b. Other Debts (Notes Payable, Bonds)
c. Equity (Share Capital, Dividends)
2. Und rstand the potential misstatements due to error or fraud

of the liability and. equity accounts and how weakness in
internal control contributes to the risks of misstatements.
,
CHAPTER 17
•
INTERNAL CONTROL AFFECTING
LIABILITIES AND EQUITY
INTERNAL CONTROL OVER ACCOUNTS PAYABLE
The tern, accounrs payable (often referred to as vouchers payable for a

,oucher sy tem) is used to desciibe short-term obligations arising from the
purchas of goods and services in the ordinary cou·rse of business. Typical
transactio s creating accounts payable include the acquisition on cre_dit of
merchandise. raw materials, plant assets and office supplies.
Other sources of accounts payable include the receipt of servic s, such as

legal and accounting services. advertising, repairs and utilities. Interest
bearing obligations should not be included in accounts payable but shown
separately as bonds. notes, mortgages. or installment contracts.
Invoices and statements from supplies usually evidence accounts payable

arising from the purchase of goods or servic·es·and most' other liabilities.
However. accn,ed liabilities (sometimes called acc1:tfed expenses) generally
accumulate over time. and management must make accounting estimates of
the vear-end liability. Such estimates are often necessary for salaries,
pensi'Cms, interest, rent, taxes and similar items.
Jn thinking about internal control over accounts payable; it is important to

recoonize that the accounts payable of one company are the accounts
rece 1able of other companies. lt follows that there is llttle danger of errors
being overlooked permanently since the client's creditors will generally
maintain complete records o_f their receivabl s a n_dwi l l nform t 1e client if
payment is not received. This feature also aids auditors m the discovery of
fraud since the perpetrator must be able to obtain and respond to the
dema lds for payment. Some c_ompanies, therefore, ay choose to min_imize
the·,r r e oc rd keepin,o,, of liabilities an d. to. rely o.n cr.editors to call attention to
any d ·11 rnak·ino
1 :::
pa,,ment.
-
This v1ewpomt 1s not an endorsement of
eIay
• t or incomplete records of accounts payable, but merely recognition
maccura e • ffi · · ·
·
that the seIf-1n
terest of creditors constitutes an e ect1ve c o n trol m accounting
.
· not present in the case of accounts receivable. .
tior payables ti1at 15
266 Chapter J 7
Discussion of internal control applicable to accounts payable may logically

be extended to the entire purchase or acquisition cycle. .
Potential Misstatements -Accounts Payable
Description of Examples Internal ControlWeakness

Misstatement or factors that Increase the
Risk of the
Misstatement
Inaccurate recording of Fraud:
a purchase
ordisbursement • A bookkeeper prepares a • Inadequate segregation
·checkto himself and of duties of record
records it as having been ke ping and preparing
issued to a major . cash
,
supplier. disbursement·s,or
, check signer does
Error: not review and
cancel supporting
• A disbursement is mode documents.
to pay on invoice for
goods that hove not • Ineffective controls for
been matching inv ices with
received. receiving documents
before disbursements ore
authorized.
Misappropriation of·porchases Fraud:
• G,oodsore ordered but • Ineffective controls for

.delivered to on matching invoices with
inappropriate address receiving documents
and stolen. before disbursements ore
authorized.
Duplica1e recording-of Error: .
purchases
• A purchase is recorded
when on invoice is
• Ineffective controls for
review and
received from a vendor cancellation of
and recorded againwhen supporting documents
late (tiarly) 1l'!CNding(If costot Fi uud:
purehas "CUil'ff probloms"
- • Pu,choso\ jou111111 • lnoffoclivoboo11I ol
"closoly ,1111ly" with diroclors, uudil
this poriod's purchosus co111111illoo, or inlornnl
11
rncordud us hovi11g uu1lit funclion; 10110 ol
ocrnrrodin subsc11uoni tholop"1101 conducivo to
poriod. othicolconduct; unduo
prossu·rnlo moot
----------- . i _:.Oll::.r:..:;ni:..:;1191!.:S:..:t;;;,.;oro_otc... ,
lNTERN.-\L CONTROL o, ER OTHER DEBTS
usin':ss corporations obtain subs1:rntinl ,rn10un1s nr their financinl rcsourccs by

ncui-rm debt a1\d issuing capital stock. The acquisition and repaymcnt or
cnpitnl is sometimes rekrred to as the .f,11011ci11g c:vcle. This transnction cycle
i,;clucles
the s quence of procedur"'s F1.,r authorizing. c:-.:1.'cuting. and rec1.,rding
trnnsnctions that lll\\)lve bank loans. nwngng."'s. bl)nds payable. and cnpital
stock as well ns the payment of interest and dividends. ·
lntenrnl Control over Dd>t
.-111thori:a1icm lf.f !he Board o. lDirec{()rs
Effective internal control 1.wcr debt begins with the authorization to incur
the debt. The bylaws of a corporation usually require that l'he board or
directors approve borrowing. The treasurer of the corporation will prepare a
report nn any proposed financing, explaining the need for funds. the estimated
effect of borrowing upon future earnings, the estimated financial position of l'he
company in comparison with others in the industry both befor"' and after the
borrowing, and alternative methods of raising the funds. Authorization by the
board of directors will include revit:w and approval of such matters as the choice
of a bank ortrustee. the type of security. registration with the SEC. agreements
with investment bankers. compliance with requirements of the state of
incorporation. and listincrof bonds on a securities exchange. Afh!r the
issuance of long-term debt the:b:,oard of directors should receive a report
stating the net amount received and its disposition as, for example. acquisition
of plant assets, addition
to working capital. or other purposes.
268 Cliopre,r -
Use vf m, l11depc11dem Ti·usf<'e
Bond issues arc alwnys for large amounts - usually many

millio_nsofpeso_s. Therefore. only relatively large companies issue bonds:
small companies obtain long-ten11 capital through 111011gage loans or other
sources. Any comp r y lar e enough to issue bonds and able to find a ready
mc1rket for thesecunt, s will almost always utilize the services of a large bank
as an independent trustee.
The trustee is charged with the protection of the creditors' inte e ts and with
monitoring the issuing company's compliance with the prov1s1ons of·the
indenture. The trustee also maintains detailed records of the names·and addresses
of the registered owners of the bonds, cancels old bond certificates and issues
new ones when bonds change ownership, follows procedures to prevent over
issuance of bond certificates, distribute interest payments, ·and distributes
principal payments when then bonds mature. Use of an independent trustee
largely solves the problem of internal control over. bonds payable. Internal
control is strengthened by the fact that the·trustee does not have access to the
issuing company's assets or accounting records and the fact that the trustee is a
large financial institution with legal responsibility for its action$.
Interest Payments on Bonds and Notes Payable
Many corporations assign the entire task of paying interest to the trustee·for
either bearer bonds or registered bonds. Hig ly effective control is then achieved,
since the company will issue a single check for the full amount of the-semiannual
interest payment on the entire bond issue.
INTERNAL CONTROL OVER OWNERS' EQUITY
The three principal elements of strong .internal control over share capital and
dividends:
I. the proper authorization of transacti,:ms by the board of di;ectors and

corporate office, ,
2. the segregation of duties in handling these transactions (preferably the
use payments), and
3. the maintenance of adequate records.
•
Internal Comro/ Affecting liabilities and Equity 269 ..
Internal Control on Equity
Co11trol of Share Capital Transacti;ns by the Board of Directors
All change in share capital·accounts should r ceive formal advance approval by

the board of directors. The board·of directors must determine the number of
shares to be issued and the ,price per share; if an installment pla ofpayment is to
be used, he b ard must prescribe the terms. If plant and equipment, services, or
any constd rat1qn other than cash is to be accepted in payment for shares, the
board of directors must establish the valuatioll' on the noncash assets received.
Transfers from retained earnings ·to the Share Capital and Paid-in Capital.
acc nts, as in.the case of stock dividends, are initiated by action of the board. In
add1t1on, St<?ck splits and changes in par or stated value of shares require
formal authorization by the board. . .
Authority for all dividend actions·rests with the dir ctors: The declaration of a
dividend_ must specify not only the amotint per.share but also the date of record
and the date of payment. ·
Independent Registrar and Stock Transfer Agent
In appraising internal control over share· capital, the first question that the
auditors consider is whether the corporation employs t e services of an
independent share registrar and a share transfer agent or handles its own capital
share transactions. Internal control is far stronger. when foe services of an
independent share registrar and a stock transfer agent are·utilized because the
banks or trust companies acting in these capacities will have the experience, the
specialized facilities, and the trained personnel to perform the work in an expert
manner. Moreover, by placing the. responsibility for handling share capital
certificates in separate and independent organizations, t_he corpor tiori achieves
to the fullest extent the internal control co cept of separation of duties. .
lotl'rrrnl ·lClnlrol o, rr lli, illc111h
fh\, n.itun.· <'f intcrn.11c\,1111\,1\),1.'1 the p:i, mcnt of dh s i11thecaseof

idc11dsn.
h·l,. i-- u.,n ·c. Jc-1,cnd, piimanl u1 \11·1\\ht:thcr the :0111pa•!Yp rforms the
· ·
lllnCtl Oll '"' ' ·Ide p:1, l\lClll ·IIM' or tilC .<,c•rv1ccs ol .independent
r
lll\ n d If ·1 · . an
lll l 1 7.C
di\ id nd-p:i ing ni;cnt·. ,,- nn independent di, idend-payi11g agent isus (!, the
COl"J)o..'rnti011 "ill pro, idc the ngcnt "ith a ce11ified copy_of the dividend
dc-cbrmion :rnd a check for the full amount of the dividend. rhe bank ortrust
comp:1n sen ing a!- stock transfer is usually appointed to distribu e thedi i end,
since it maintains the detailed records of shareholders. The agent issues dividend
check· to the individual shareholders and sends the corporation a list of the
p:1 mcnts made. The use of an independent fiscal agent is to be recori:n nded
from th stand-point of internal control, for it materially reduces the poss1blf 1ty
of fraud or error arising in connection with the distribution of dividends.
In a small corporation that does not use the services of a dividend-paying agent,
the responsibility for payment of dividends is usually lodged with the treasurer
and the secretary. After declaration of a dividend by the board of directors, the
secretary prepares a list of shareholders as of the date of record, the number of
shares held by each, and the amount of the dividend each is to receive. The total
of these individual amounts is proved by multiplying the dividend per share by
the total number of outstanding shares.
Dividend checks controlled by serial numbers are dawn payable to individual

stockholders in the amount shown on the list described above. If the shareholders
ledger is maintained on a computer master file, the dividend checks may be
prepared by the computer directly from this record. The stockholder list and
dividend checks are submitted to the treasurer for approval and signature. The
checks should be reconciled by the treasurer with the total of shares outstandino
and mailed without again coming under control of the officer who prepared them
Cash in the amount of tl_1e_ total dividend is then transferred from the general
bank account to a separate d1v1dend bank account. As the individual dividend
checks are paid from this account and returned by the bank, they should be
matched with the che k stubs or marked paid in the dividend check re·gister. A
list of outstandin checks _be _prepared month I from th open stubs or open
items in the c 1 ks register. Tl11s 11st should_agre 111 tqtal with the balance
remaining in the d1v1dend_ bank ac ount. Companies with numerous
shareholders prepare dividend checks 111 mach111e-readable form, so that the
computer may perform the reconciliation of outstanding checks.
/111a1111/ Co111rol .-lffcc1i11 l.iahilitit' rmd £,111itr 2i \
RE\llE\\' QUESTIONS ANO EXERCISES
Questions
1. \Vhat are the relevant accounts related to debt obligations?
2. \Vhat are the releYant accounts related to stockholders· equity

transactions?
3. Identify common transactions affecting stockholders' equity accounts.
4. Identify fraud risks associated with debt obligations.
5. Identify fraud risks associated with stockholders' equity accounts.
Multiple Choice Qifestio11s
I. Which of the following can be used by organizations for obtaining

financing?
a. Notes
b. Mortgages
c. Bonds
d. All of the above
2. Which of the following accounts would not typically be·included in the

audit of debt obligations?·
a. Interest income
b. Interest expense
c. Bonds payable ·
d. Notes payable
3. Inherent risks related to debt obligations primarily include which of the

following? ., ·
a. Debt is not properly authonzei:I.
b Interest expense is not properly accrued.
c: Debt covenants are not proper_l_y disclosed.
d. Debt is not appropriately class_1fik1edas shdort odrlbongbt nn._
e. All of the above are inherent ns ·s re1ate to e to 11gat1ons.
272 Chapter / 7
4. Which of the following is not an inherent risk typically associated

with the existence of dividends?
a. Dividends are recorded before being declared.
b. Dividends are not properly amortized.
c. Dividends have not been approved before being de lared.
d. Dividends are recorded in the wrong period.
5. Which of the following would an auditor typically not perform as part

of gaining an- understanding of the client's control related to debt
obligations? .
a. Review the client's documentation of controls.
b. Recalculate interest expense.
c. Inquire of management about the process· for reviewing
compliance with debt covenants.
d. Review policies related to approval required for new debt.
APPENDICES
A Code of Ethics for Professional

Teachers
B International Standards for

the Professional Practice
of Internal Auditing
C International Standards
of Ethical Co.nduct for
Practitioners of
Management Accounting
D Code of Business Conduct and

Ethics.of a Telecommunications
Company
,
.
E Code of Business .Conduct and
Ethics of a Manufa.cturing
Company ·
F Code of Business Conduct

and Ethics of a Commercial
Bank
G Partial List of Organizations

who are actively
Participating i_n the
"Integrity Initiative"
Campaign against
Corruption
Appendix ,1 Cude of £1hicsfi1r f'rofessional Teac:l'IC!rs 273
}lpperul JI.
CODE OF ETHICS FOR PROFESSIONAL TEACHERS
Pursuant to the r?vi ions of paragraph (e), Article 11, of R.A. No. 7836, otherwise
kno vn as the Phillpp1 e Teachers Professionalization Act of 1994 and paragraph (a),
section 6, P.O.:-J0- 22.>, as amended, the Board for Professional Teachers hereby
adopt the Code of Ethics for Professional Teachers.
Preamble
Teachers are duly licensed professionals who possesse dignity and reputation with
high moral valu_esas·well as technical and professional competence in the practice
of their noble pr fe sion, and they strictly adhere to, observe, and practice 'this set of
thical and moral prmc1ples, standards, and values. ·
•
Article I: Scope and Limitations
Section 1. The Philippine Constitution provides that all educational institution shall
offer quality education for all competent teachers. Commftted to its full realization,
the provision of this Code shall apply, therefore, to all teachers in schools in the
Philippines.
Section 2. This Code covers all public and private school teachers in all educational
institutions at the preschool, primary, elementary, and secondary levels whether
academic, vocational, special, technical, or non-formal. The term "teacher" shall
include industrial arts .or vocational teachers and all other persons performing
supervisory and
/or administrative functions in all school at'the aforesaid levels, whether on full time
or part-time basis.
Article II: The Teacher and the State
Section I. The schools are the nurserie·sof,the future citizens of the state; each teacher
is a trustee of the cultural and educational heritage of the·nation and is under
obligation to transmit to learners such heritage as well as to elevate national
morality. promote national prid , cultivate love of country, instil_ allegiance to the
constitution and for all
duly constituted authorities, and promote obedience to th laws of the state.
Section 2. Every teacher or school official sl all actively help .carry out the declared
policies of the state. and shall take an oath to this effect.
Section 3. In the interest of the,State and of the Filipino people as much as of his own.
e ery teacher shall be physically, mentally and morally fit.
. E shall possess and actualize a full commitment and devotion
S 1on 1
to duty.
ect 4. very teac ,er
' 274 Appendix A Code of Ethics.for Professional Teachers.
. r any political. religious,-or
Section 5. A teacher shall not engage in the pro no ion
1nd11
° rcit require collect, or
other partisan interest, and shall not, directlyr- :ect , o ny,person r entity for
receive any money or service or other valuable material ,rot .
such purposes.
. th constitutional rights
Section and Every teacher shall vote and shall exercise a o er
6. 11
responsibility.
Sect1·on7 . A er aI I not useI 1·1s pos1· t·1on or om1c1·a1 authority or influence·to coerce
teach sh
any other person to follow any political course of action.
Section 8. Every teacher shall enjoy academic freedom and sl all have privilege of
expounding the product of his researches and investigations; provided that, 1f the results
are inimical to the declared policies of the State, they shall be brought to the prope
authorities for appropriate remedial action.
Article lll: The Teacher and the Community
Section I. A teacher is a facilitator of learning and of the development of the youth;

he shall, therefore, render the best service by providing an environment conducive to
such learning and growth.
Section 2. Every teacher shall provide leadership and initiative to actively participnte
in community movements for moral, social, educational. economic and civic
benerment.
Section 3. Every teacher shall merit reasonable social recognition for which purpose
he shall·behave with honour and dignity at a,ltlimes and refrain from such
activities as gambling, smoking, drunkenness, and other excesses. much less illicit
relations.
Section 4. Every teacher shall live for and with the community nd shnll. therefore.
study and understand local customs and traditions in order to have sympathetic
attitude, therefore. refrain from disparaging the community.
Section 5. Every teacher shall help the school keep the people in the community
informed about the school's work and accomplishments as well as its needs and
problems.
Section 6. Every teacher is intellectual leader in the community, especially in the

barangay. and s all welc_ome the opportu ity to provide such leadership when needed,
to extend counseling services. as appropriate, and to actively be involved ·n tt s
affiectr.ng ht e we1,r.are ot·ht e peopI , ma e.r
e.
Section 7. Every teacher shall maintain harmonious and pleasant personal d m ·1
· ·h h •h
reIat rons w r t o t er pro,re. ss,•ona1s. wi t a n o 1c 1a
th I
government officials. and w·th
individually orcollectively. 1
e peop e,
Appendix A Code of Ethics.for Professional Teachers 275
Sectio_n 8. A teact_1er p ssesses.freedom to attend church and worships as appropriate,

but shall n_out se his positions and influence to proselyte others.
Article IV: A Teacher and the Profession
Section I. Every teacher shall actively insure that teachino is the noblest profession,
and shall manifest genuine enthusiasm and pride in teaching a; a noble calling.
Sectioi 2. Every teacher shall uphold the highest possible standards of quality
education, shall make the best preparations for the career of teaching, and shall be at
his best at all times and in the practice of his profession.
Section 3. Every teacher shall participate in the Continuing Professional Educ tion
(CPE) program of the Professional Regulation Commission, and shall pursue such other
studies as will improve his efficiency, enhance the prestige of the profession, and
strengthen his competence, virtues, and productivity in order to be nationally an
internationally competitive.
Section 4. Every teacher shall help, if duly authorized, to seek support from the
school, but shall not make improper misrepresentations through personal
advertisements and other questionable means.
Section 5. Every teacher shall use the teaching profession in a manner that makes it
dignified means for earnir.g a decent living.
Article V: The Teachers and the Profession
Section t. Teachers shall, at all times. be imbued with the spirit of professional
loyalty, mutual confidence, and faith in one another, self-sacrifice for the common
good; and full cooperation with colleagues. When the best interest of the learners,
the school, or the profession is at stake in any controversy. teachers shall support one
another.
Section 2. A teacher is not entitled to claim credit or work not of his own, and shall
give due credit for the work of o\hers which he may use.
Section 3. Before leaving his position. a teacher shall organize for whoever assumes the
position such records and other data as are necessary to carry on the work.
SeC t1. 4 A teacher shall · hold inviolate all confidential information concerning
d h. h
a
0ll
·
• d
h the school. and shall not di vulge to anyone ocuments w 1c as no
• t
ssociates an ti ti h . .
been ot1icially released. or remove records rom I es wn out perm1ss1 n.
Section s.It shall be the responsibility of e_very teacher1
. to seek corre 11ves for a_y
whamt
......ssional and unethical conduct of any associate. However, this
appear e an unpro
·rtl
11.
e is incontrover11ble evidence h con
for sue d uct.
may e to
• •
b onIy
one 1er
b d 1
276 App,mdixA - Codec?(Ethicsfvr Pl'<fessional Teachers
• •
10rities any justifiable criticism
Section 6. A teacher may submit to the p opei m t1 . ti right of the individual
against an associate, preferably in writing, without v10lating ie
concerned.· • . . r, .1 h1·ch he is qualified; provided
°
Section 7. A teacher may apply lor•a vacant pbos1t1•on f w,erit and competence.,
1
prov1.ed, d that he respects the system of selection on t 1e as1s .d d
O 11
further. ti1at all qualified candidates are given the opportunity to be consi ere·
Article VI: The Teacher and Higher Authorities in the Profession Section I.
Every teacher shall make it his duty to make an honest effort to understand and
supp rt the legitimate policies of the school and the administration regardless of
personal feelmg or
private opinion and shall faithfully carry them out.
Section 2. A teacher shall not make any false accusations or cparges
againstsuperiors, especially under anonymity. Howev.er, ifthere are valid charges, he
should present such under oath to competent authority. ·
Section 3. A teacher shall transact all official business through channels except
when special conditions warrant a different procedure, such as when special
conditions are advocated but are opposed by immediate superiors, in which case,
the· teacher shall . appeal directly to the appropriate higher authority.
Section 4. Every teacher, individually or as part of a group, has a right to seek

redress against injustice to the administratio11 and to extent po·ssible, shall raise
grievances within acceptable democratic possesses. In doing so, they shall avoid
jeopardizino the interest and the welfare of learners whose right to learn must be
respected: "'
Section_ 5. Every teacher has a right to invoke the principle·that appointments,

pro ot1ons, and trans er of teachers are made only on the basis of merit and needed
in the interest of the service.
Sect.ion 6. A teacher· whotiaccepts a position assumes a contractual obti·,o,a11·011 to 11·

ve up to h1s contract, assum111g ull knowledge of employment terms and conditions.
Article VII: School Officials, Teachers, end Other Pers IS .

officials shall at all times show professional courtesy hel ti nne ection I. All school
teachers and other personnel, such practices bei g Put dness and sympathy towards
. . d. .fi . . s an ards of effiect· h I
superv1s1on, 1g111 1ed adm1111stration, responsible leadershi . ive sc oo
• P and nhghtened directions.
..
Appendix A Code o/Elhicsfor Professional Teachers 277
Section -School.otlicials. teachers, and olher school personnel shall consider it their
cooperative responsibility to formulate policies or introduce important changes in
the system at aII IeveIs.
Section 3- School otlicials shall encourane and atte d the professional 0rowth of all
tenche1
due
:s. under them such as recommending them for promotion, givi g them
reco nition .for _n eritorious performance, and allowing them to participate in
conferences 111 tra111mg programs.
Section 4. No school officials sh II dismiss or recommend for dismissal a teacher

or other subordinates except for cause.
Section 5.. School authorities concern shall ens_ure that public school teachers are
employed 111 accordance with pertinent civil service rules, and private school teachers
are issued contracts specifying the terms and conditions of their work; provided that
they are given. if qualified. subsequent permanent tenure, in accordance with
existing laws.
Article VIII: The Teachers and Learners
Section I. A teacher has a right and duty to determine the academic marks and the
promotions of learners in the subject or grades he handles, provided that such
determination shall be in accordance with generally accepted procedures of
evaluation and measurement. In case of any complaint, teachers concerned shall
immediately take appropriate actions, observing due process.
Section 2. A teacher shall recognize that the interest and elfare of learners are of
first and foremost concern, and shall deal justifiably and impartially with each of
them.
Section 3. Under no circumstance shall a teacher be prejudiced or discrit inate against

a learner.
. 4 A teacher shall not accept favours or gifts from learners, their parents or
eS c t1 0 11 . · · 11 "f d d
ot h e r s i n their behalf in exchange for requestedoncess1 ons, espec1 a yI un eserv.e
Section 5. A teacher shall not accept. direc ly or indirectly, any remuneration from
tutorials other what is authorized for such service.
• I II base the evaluation of the learner's work only in merit
and Section 6. A teac1er
1 s 1a
quality of academic performance.
. . .
Section 7. In a s1tua11on 111
utual exercise
anractionutmost
and subsequent
professionallove developtobetwe
discreJion avoidn
where 1 11
teacher and learner, the teachers ia · ,
scanda• . nd preferential treatment of the learner.
I goss ip a
21N /'/'··11,/11· 1 t 'p,/,•, ,1 /'th,.,,,.,./'r••J,W.\/11/1111'/ioacltcrs
,','th•n S. t\ k,1\'11,·rh:1II not inllkt ,'1ll'p,11·11I p1111bl1111cn1 on nflcndin lcnrncrn rior
11111-..- d\''-h,,·th•n th11111h,•,ir·h,,1t1 1k 1111i11i-:s ns II p1111lsh1111.:111for nl:ls which nrc clearly
lh\l 111(111 Il sl.11il.,n ,,r p1hl\t'11111:trship.
,-cti,,119. ,\ t,·:\l'lwr i-hnll ensure thnt ,·111Hlilio11s conlributc to th.c mnxim 11n
,lt-h·l, pnwnt ,,r karnns :11\· 11,kq11a1c. and shttll ,·xtcnd needed nssistu11cc 111 preventmg
\lr s,11, in ll•,1111,•r's p1\1bk111s nnd dinicullics.
Arlick IX: Th,• 'l\•ndwrs 111111 Pan'nls
Sc,·ticrn I. Fvery tN1clwr shall establi$h and maintain cordial rclntions with pnrcnts,
and sh 1,1·10110111.:t himsdr10 merit their conli1knce and respect.
Section 2. L.::vt•ry 1,·ncher shall inform parents. through proper authorities, of the progress
:md ddidrncil·s of lcnrncr 11nckr him. exercising utmost ci111clour nncl tact in pointing out
the k·arn1•r's ddiri,•ncics and in seekin!! parent's cooperntion for the proper
guidance and improvcmt)nt orthe knrncrs. · ·
St'Cli(ln J. A tt:acher shall hear parent's complnints with sympathy and

understanding, nnd shnll discourng.e unfair criticism.
Article X: Thr Tcncher nnd Business
Section I. A teacher has the rigl11 to engage. directly or indirectly, in legitimate

income generation: providt>d that ii does not relate to or ndversely affoct his work as
a teacher.
Section 2. /\ tcnchcr shall maintain a good reputation with respect to the financial
matters such as in the settlement or his debts and loans in arranging satisfactorily
his private financial arn1irs.
Section 3. No teaclu;r shall act. directly or indirectly, as agent of, or be financially

interested in. any commercial venture which furnish textbooks nnd other school
commodities in the purchase and disposnl of which he can exercise official influence,
. except only when his assignment is inherently, related to such purchase and
disposal; provided they shall be in accordance with the existing regulations: provided,
further, that members of duly recognized teachers cooperntives may participate in the
distribution and sale of such commodities.
Appendix A - Code of Ethics/or Professional Teachers 279
Article XI: The Teacher as a Person
Section I. te cher is, above all, a human being endowed with life for which it is the
highest obhgahon to live with dignity at all times whether in school, in the home, or
elsewhere.
Section 2.A te che shall pla e premium upon self-discipline as the primary prin_ciple of
personal behaviour mall relationships with others and in all situations.
Sect_ion 3. A teacher shall maintain at all times a dignified personality which could
serve as a model worthy of emulation by learners, peers and all others.
Section 4. A teacher shall always recognize the Almighty God as guide of his own
destiny and of the destinies of men and nations.
Article XII-: Disciplinary Actions
Section J.• Any violation of any provision of thi code shaH be sufficient ground for the
imposition against·the errii1g teacher of the disciplin_ary action consisting of
revocation of his Certification of Regi tratio·n and License. as a Professional Teacher,
suspension from the practice of teaching profession, or reprimand or cancellation of his
temporary/special permit under causes specified in Sec. 23, Artic,le Ill or R.A. No.
7836, and under Rule 31 Article VIII, of the Rules and Regulations Implementing
'
R.A . 7836.
.
Article XI11: Effectivity
Section J. This Code shall take effect upon approval by the Professional Regulation
Commission and after sixty (60) days following its publication in the Official Gazette
or any newspaper of general circulation, which ver is earlier.
Appendi'r 8 - /11tl!l'l/atio11a!Sta111/c,rc/s Jor the Projessional l'ractice of /11/emal A11clitlng 281
.fl_ppencfiJ( <B
International Standards for the Professional Practice of Internal Auditina
Standard Definition
Attribute Standards
1000-Purpose, authority, and The purpose, authority, and responsibility
responsibility of the internal audit activity must be
formally defined in an internal audit
charter, consistent with the Mission of
internal,Audit and the mandatory
elements of the International Professional
Practices Framework (the Core Principles
for the Professional Practice of Internal
Auditing, the Code of Ethics, the
Standards, and the Definition of Internal
Auditing). The chief audit executive must
periodically review the internal audit
charter and present it to senior
management and the board for .
approval.
1100-lndependence and objectivity
Theinternal audit activity must be
independent, and internal auditors must be
objective in performing their work.
1200-Proficiency and due professional
care Engagements must be performed with
proficiency and due professional care.
1300-Quality assurance and improvement
program The chief audit executive must develop
and maintain a quality assurance and
improvement program that covers all
aspects of the internal audit activity.
Performance Standards
2000-· Managing the internal audit activity The chief audit executive must effectively
manage the internal audit activity to
ensure it adds value to the organization.
2100-Nature of work The internal audit activity must evaluate

and contribute to the improvement of the
organizatiqn's governance, risk
management, and control processes using
asystematic, disciplined, andrisk-based
, f ,. ,ctice of (ntl'rt1af AuditlnK
t,.1,r,:J//<111,r/ St,mde1rrl<Jnr th,• (
11
282 rnji'JSltlllll <
approach.Internal audit credib_ility and
value are enhanced when auditors are
proactive and their evaluatio s offer new
insights and consider future rmpacL
Internal auditors must develop and
2200-Engagement planning document a plan for each eng ge'!lent,
including the engagement's ob1ect1 es,
scope, timing, and resource alloc t,o s.,
The plan must consider the_organizations
strategies, objectives, and nsks relevant to
the engagement.
Internal auditors must identify, analyze,
2300-Performing the engagement
evaluate, and document sufficient
information to achieve the engagement's
objectives.
2400-Communicating results Internal auditors must communicate the

results of engagen:ients.
•
2500-Monitoring progress The chief audit executive must
establish and maintain a system to
monitor the disposition of results
communicated to management.
2600-Communicating the acceptance of When thechief audit executive concludes·
risks that managemen! has accepted a level of
risk that may be unacceptable to the . .
organization, thechief audit executive must
discuss the matter with senior
managemen·t.If the chief audit executive
determines that the matter has not been
resolved, thechief audit executive must
communicate the matter to the board.
Appe11dlr C- lntematio11al Standards of Ethical C'om1uc for l'ractil/011ersa/ Ma1111ge111e111Acco,mllng 283
;tppe1ufix, C
International Standards of Ethical Conduct

for Practitioners of Management Accounting
Practitioners of management accounting and financial management have an obligation to

the public, their profession, the organization they serve, and themselves, to maintain
the highest standards of ethical conduct. In recognition of this obligation, the
Institute of Management Accountants has promulgated the following standards of ethical
conduct for practitioners of management accounting.and financial management. Adherence
to these standards, both domestically and internationally, is integral to achieving the
Objectives of Management Accounting. Practitioners of management accounting
and financial management shall not commit acts contrary to these standards nor shall
they condone the commission of such acts by others with.itnheirorganizations.
Competence. Practitioners of management accounting and financial management have a

responsibility to: · . .
• Maintain an appropriate level of professional competence by ongoing
development of their knowledge and skills.
• Perform their professional duties in accordance with relevant laws,
regulations, and technical standards.
• Prepare complete and clear reports.and recommendations after appropriate
analysis of relevant and reliable information. ·
Confidentiality. Practitioners of management accounting and fin ncial management have

a responsibility to: · ·
• Refrain from disclosing confidential information acquired in the course of their
workexcept when authorized, unless legally obligated to do so.
• Inform subordinates as appropriate regarding the confidentiality of information
acquired i the course of th ir_ work and monitor their activities to assure
the maintenance of that confidentiality.
• Refrain from using or appearing to use confidential information acquired.in the
course of thei.r work for unethical or illegal advantage either personally or through
third parties.
284 ·, , s o,fManagement Accounl/ng
Appendix C- /11ternatio11a/ S1a11dards q( Ethical Co11d11ctfor Pracl lt ,one r
Integrity. Practitioners of management accounting and financial management havea

responsibility to:. . · .
• Avoid actual or apparent conflicts of interest and advise all appropnate pa ,e of
any potential conflict. • Refrain from engaging in any activity that would preJud1ce
their ability to carry out-their duties ethically. ·
• Refuse any gift, fav0r, or hospitality that would influence or would appear to
influence their actions.
• Refrain from either actively or passively subverting the attainment of the
organization's legitimate and ethical objectives. ·
• Recognize and communicate professional limitations or other constraint _that
would preclude responsibility judgment or successful performance of an act1v1ty.
• Communicate unfavorable as·well as favorable information and professional
judgments or opinions.
• Refrain from engaging in or supporting any activity that would discredit the
profession.
Objectivity. Practitioners of management accounting and financial management have a

responsibility to:
• Communicate information fairly and objectively.
• Disclose fully all relevant information that could reasonably be expected to
influence an intended user's understanding of the reports, comments, and
recommendationspresented.
Resc;>lution of Ethical Conflict. In applying the standards of ethical conduct, practitioners

of management accounting and financial management may encounter problems in
identifying unethical behavior or in resolving an ethical conflict, When faced
with significant ethical isSJ.;e , practitioners of management accounting and
financial management should follow the established policies of the organization bearing
on the resolution ,of such conflict. If these policies do not resolve the ethical conflict,
such practitioner should consider the following courses of action:
• Discuss such problems with the immediate superior except when it appears
that the superior is _involved, in wh_ich case the protil m should be presented
initially to the next higher manage:nal level. If a satisfactory resolution
cannot be achieved when the problem is initially presented, submit the issues
to the next higher managerial level.
. IJ•/ •11,ln· C l111,•mm1011nl S11111,l11nl.1 ,if f1l11ra/ <'1111d11cl.J,,,./'r,,ctllir//ll'r., ,if,\/(1111/J!<'IIICIII ,1n·r,1111tl11Y, 285
If the immediate superior is the chief executive officer, or equivalent, the acceptable revie
Clarify relevant ethical issues by confidential discussion with an objective advisor (e,g., IMA
Consult your own attorney as to legal obligations and rights concerning the ethical conflict
* Institute of Mana ement Accountants

Code<?l Business Co11d11ct and Ethics ofo Telec,m11111micati,mt Company 28
7
jlppe1uf' <D
CODE OF BUSINESS CONDUCT AND ETHICS OF A

TELECOMMUNICATIONS COMPANY
SC, INC. is dedicated to doing business in accordance with the highest standards of
ethics. The Company, its directors. officers and employees endeavor to promote a
culture of good corporate governance by observina and maintaining its core business
principles of accountability, integrity, fairness and transparency in their
relationships among
themselv s and with the Company's customer·s. suppliers. competitors. business
partners, regulators and the public. ..
This Code of Business Conduct and Ethics (the "Code") sets forth the Company's
business principles and values which shall guide and govern .all business relationships
of the Company, its directors. officers and employees, including their decisions and
actions when performing their respective duties and responsibilities..
THE FOUNDATION OF BUSINESS ETHICS: PRINCIPLES AND VALUES
In simple terms, the spirit of the Code means that all actions of ihe Company, its
directors, officers and employees·must, at all times, be consistent with the principles of .
a countability, integrity, fairness and transparency, which are definetl as follows:
A. Accountability - We shall take full re;ponsibility for all our business

decisions. actions/inactions, and conduct, and shall perform our duties and
functions with utmost responsibility, integrity, honesty, loyalty and efficiency.
We are accountable to the .Company and its stakeholders (employees, cµs
omers, shareholders and business partners) all of whom we vow toerve to
th'e be t of
our ability.
. .
B. Integrity - We shall act righteously,_morally, and legally. We shall upho_l.d th.e
simple truth 'honesty is the best policy' and endeavor to act under the highest
standards of ethics.
c. Fairness - We shall uphold the value of justice.and fair play amongst everyone
we deal with, both interoally and externally, striving always to look for a win
win situation.
D. Transparency - We shall uphold the value of t uthfulness in e erything.we do

coupled with the quality f b ing _open to scrutiny as we provide and d1sclos
accurate material infopnat1on 111 a timely manner.
288 Code of811si11ess Co11d11c1and Ethics ,!fa 7i.•lc:c:01111111111ic:at/011s Co,t1pal II
STANDARDS OF BUSINESS CONDUCT AND ETIIICS
Below are the commitments of the Company, its directors, officers oncJ employees in
their behavior and various business dealings.
A. COMPLIANCE
I. Engage in honest conduct and comply with all appti able lnw_s,
rules and regulations, including prohibitions on insider tr dmg,
both.1 letter and spirit. Demands brought on by prevailing busmess
cond1t1ons or perceived pressures are not excuses for violating any
law, rules or regulations.
2. Personally adhere to the standards and restrictions imposed by
those laws, rules and regulations.·
3. Avoid the direct or indirect commission of bribery and corruption
of representatives of government or regulators to facilitate any
transact!on or gain · any perceived or actual favor or advantage,
excluding permissible additional payments for routine
governmental actions allowed by applicable laws and regulations.
8. COMPETITION AND FAIR DEALING
I. Avoid taking unfair advantage of anyone through manipulations,

concealment, abuse of privileged information, niisrepresentation
of material facts, or any unfair dealing practice.
2. Deal fairly with the Company's customers, service providers,
suppliers, competitors and employees.
C. CONFIDENTIALITY OF INFORMATION AND PROPER USE OF

PROPERTY
I. Maintain and safeguard the confidentiality of information entrusted

by the Company, its subsidiaries, affiliate_sc,ustomers, business
partners, or such other pa11ies with whom the Company relates,
except when disclosure is authorized or legally
mandated.·Confidential information includes any non-public
information that might be of use to competitors, or harmful to the
Company, its subsidiaries, affiliates, customers. business partners,
or such other parties with whom the Company relates. if disclosed..
Follow Company policy and applicable laws regarding business records
retention. Ensure that records are not altered, concealed, destroyed
or falsified to impede. obstruct r influence any investigation by, or
proceeding before any official Company committee or body.
governmental. regulatory1or judicial body having jurisdiction.
('11 it' ofB11si11,'ss Condu,t and Ethics ,!fa l •l,·c.·,11111111111icntl1111s Company 289
3. Avl,id trading nny of the Company"s scc11ri1ics or 1hose or its

subsidinrics and nt)ilintes using pricecnsitivc informntion that is
not normallv avnilnble publicly. and obtained by rcnson of position.
or
contact within. other rdationship with the Company.
4. Use Cl,mpany prope11y nnd resources. including Company time.
supplies and sotlware. efficiently. responsibly and only for
legitimate business purposes.
5. Protect the assets of the Company from loss. damage. misuse or theft.
D. CONFLICTS OF INTEREST AND CORPORATE OPPORTUNITIES
I. Avoid any actual or apparent conflicts of interest between your

private interest, including the private interest of member of your
family, and the interes't of the Company, unless you have obtained•
prior approval by the Corporate Governance Office. Any actual
orapparent conflict of · interest. and any material transaction or
relationship that could
reasonably be expected to give rise to a conflict of interest, should
be disclosed to the Corporate Governance Office.
2. Avoid activitie and inte_rest that could significantly affect the
objective or effective performance of duties and responsibilities in the
Company. including business interests or unauthorized employment
outside the Company, the receipt from and giving of gifts to
persons or entities with whom the Company relates, as well as
insider dealing.
3. Be loyal to the Company. As such, all business decisions and
actions must be based on the best interest of the Company and
must not be motivated by personal considerations and other
relationships, which may interfere with theexerci e of independent
judgment.
4. Advance the Company's legitimate interests when .the
opportunity arises. Avoid c mpeting with the Company on a
business opportunity or acquiring an interest adverse to that of the
Company's. Refrain from taking advantage of these, for personal
gain. to compete with tlie Company. or act against the best interest
of the Company. Directors, officers and employees who intend to
make l)Se of Company property
. or services in a mnnner not solely for the henefit of the Company
should consult beforehand with the Corporate Governance Office..
5. R_efrain from direct or indirect. grant or arrangements of lonns to
any director or omcer, including loans granted or· arranoed by the
ompany's subsidiaries and affiliates, tinless such grant
oi:rrangement 1s allowed by all applicable laws and regulations.
290 Code of BusinC' SConduct a11d Ethics of a Te/ei:01111111111/cations Company
E. DISCLOSURE
I. Publicly disclose all material information (i. . anythi_ng t at co ld

potentially affect share price, as well as other 111format,on),
mclud,ng earning results. corporate strategy, related pa and off-
balance sheet transactions, as may be necessary under applicable
laws, rules and regulations.
2. To the extent relevant to your area of responsibility, comply with
the Companis disclosure controls and procedures and nternal
controls to ensure that (i) financial and non-financial information is
properly recorded, processed, summarized and reported and (ii) the
Company's public reports and documents, including the reports that
th Company files with the Philippine Securities and Exchange
Commission and such other applicable private exchanges,
government gencies or regulators, comply in all material respects
..,
.J. with the applicable laws and rules.
Each director or officer, to the extent appropriate with_in his or her
area of responsibility, should consult with other Company officers
and employees and take other appropriate steps regarding the
above mentioned disclosures with the goal of making full,
4. accurate, timely and understandable disclosure.
Be familiar with the di closure requirements applicable to the
5. Company as well as the business and financial .operations of the
Company.
. .
Do not knowingly misrepresent, o,cr ause others to misrepresent,
facts about the Company to others, whether inside or outside the
6. Company, including to the Company's. ir:idependent auditors, ·
government regulators and self-regulatory organizations. .
7. ·. Properly review and critically analyze proposed disclosure for accuracy
and completeness (or, where appropriate, delegate this task to others).
ssess the effectiveness of the discl sure controls .and procedures
and 111temal controls and take corrective actions with reoard to
0
any identified weaknesses ordeficiencies. · ·
F. RfSK MANAGEMENT
I. Restrict or minimize.undertaking of risk so as not to jeop

rdize shareholder value.
2. Fully
undert. .ak.ssess
. a n. d. .manage risks in.volv d in
a m ·
g strate gies,
acqu1s1t1ons, act1v1t1es, products, services and other business·e d f
the Company. . n eavors o
Code of Business Conduct and Ethics ofa Telecommunications Company 291
G. RELATIONS WITH SHAREHOLDERS AND INVESTORS
I. Adopt strategies, actions, decisions. and transactions based on

increasing shareholder value.
2. Adopt international best practices of good corporate governance in the
conduct of business.
3. Keep business and accounting records, which-accurately reflect the
financial position of the business.and issue financial statements to
ensure transparency. of information.
4. Ensure an independent audit.of the Company's financial statements by
external auditors selected by the Company's Audit Committe_e.
5. Communicate truthfully and regularly business. policies, achievements
and prospects.
)
IMPLEMENTATl ONAND MONITORl G OF CODE
I. Directors, officers, and employees of the Company commit to co·mply with

poth thi:: letter and spirit of this Code and the Company endeavors to obtain
the same commitment from its business partners: In this connection,
directors and office.rs should explain to employees and·business partners the
Company's principles and values set forth in this Code, and emphasize the
importance of conducting themselves in accordance with the standards set
by this Code in order to attain financial rewards for the Company and to
deter wrongdoing.
2. The Corporate Governance Office is responsible for applying the Code to
specific situations in which questions or concerns may arise, and has the
authority to interpret and decide on such issues arising from the
implementation of the Code.
3. There shall be no waiver of any of the provisions of this Code in favor of
any directors, officer or employee, except when expressly granted by the
Board of Directors, in the case of waivers for directors and officers, or by
the Corporate Governance Office in the case of waivers for employees. Any
such waiver for any director or executive officer or any material amendment
to the Code must be promptly disclosed to the shareholders of the Company.
4. Any director, officer or employee is encouraged to contact the Corpor te
Governance Office when in doubt about the best course of action in a
particular situation relating to a subject matter of the Code.
5. Any director, officer or employee who is a are of any existing or potential

violation of the Code is required to notify the Corporate Governance Office
promptly. The Corporate Governance Office shall take all action it
considers
292 Code cf811si11f!sSConduct and £r/1ic:s of a Telecom11111nicationsCompany
appropriate to investigate any violations reported to it. If viola ion ha_s

occurred, the Company shall take_ such disciplinary or preventive action as
It
deems appropriate.
6. Disciplinary actions against violators include measures s\,lch as dismiss !
and/or the filing of appropriate civil and criminal actions. F r purposes of
this Code "violators'' are defined as a) person who commit proh1b1ted act
or who fail to implement prescribed acts when there is an obvious
opportunity to do so; b) employees who knowingly abet such acts of
commission or omission _or who fail to report such acts that violate the
Code; and c) persons of authority who fail to impose the necessa1y
disciplinary measures against violat rs.
0
7. Retaliation of discrimination, whether direct or indire ct and in any form,

against any director, officer or employee who reports and in good faith,
any· violation or perceived violation of this Code shall not be tolerated.
8. All policies, systems, practice, orders and similar official corporate
issuances, whether existing or to be issued shall be revisited or revised as
soon as practicable in order to be consistent ith the letter and spirit of this
Code, pending the finalization of such amendi11ents, the provisions of this
Code shall prevail over any policies, ,systems practice, orders and similar
official corporate is uances inconsistent with this Code.
9. This Code which took effect on August 03, 2005 shall be reviewed at
least once every two (2) years or such other frequency as may be
determined by the Board of Directors' and I or the Corporate Governance
Offi e.
Code of Business Conduct and Ethics of a tvfan11/act11ring Company 293
}Ippenau:, <£,
CODE OF BUSINESS CONDUCT AND ETHICS OF A MANUFACTURING

COMPANY .
Core Purpose and Value

SMP Foods' core purpose is to nourish and nurture families worldwide. It is our
fundamental belief that everything is loaned to us by our Creator, to grow and develop
for the good of all. As such, we respect and take care of what has been entrusted to us.
It is in the spirit of "Malasakit", our core Value, which is.the deepest form of
commitment there is, that we will look after the welfare and interests of our
stakeholders.
We will delight our Customers with products and services of uncompromising
quality, gteat taste and value, easily within their reach.
We will create value and provide fair returns on our Shareholders' investments.
We will work hand-in-hand with our Suppliers and other Business Partners, helping
them grow with us, and assure them of reasonable returns.
We will work hand-in-hand with our Suppliers and other Business Partn'ers, helping
them grow with us, and assure them of reasonable r turns.
We will help improve the quality of life in Communities where we operate.
Collectively, we will give and do what is right and become proponents of good
stewardship.
Introduction and Application

SMP Foods Company. Inc. ("the Company" or "SMP Foods") and all its subsidiaries
(collectively referred to herein as the "Food Group") fully recognize that adherence
to the highest standards of business conduct is vital to its growth and success as a
le.ader in
the industry.
This Code of Ethics (the "Code") establishes the fundamental standards of conduct
and values consistent with the principles of good governance and business ethics for
observance by all Foo Group empJoyees and business partners alike. It doe not nten?
to replace or supersede any applicable legal or regulatory requirement and reads into
it existing Food Group policies. procedures and the corresponding sanctions for non
compliance therewith, as well as those that may subsequently be adopted by the Food
Group in response to prevailing business conditions. •
Policies and/or procedures may further be promulgated or revised as the need arises,
to give effect to this Code.
Thus, this Code shall henceforth be the foundation for all existing and future
nd
policiesa procedures of the Food Group, that these shall find basis in and
th
supplement e
provisions of this Code. .,,
Coc/1• of lJ11si11css Co11d11c1and £1/11. cs <f! a
' 294
Al mll/1'a• ct11ri11g Company
• .
This Code sha ll be reviewed from time to t u ne ns be deemed necessary by SMP
may Foods. ·
Mcss:lgc from the HR Division Mnnngcr
Dear Colleagues. · , C Od Of Ethics It

This manual that )'OU have in your hand contains our Companys e .d ·k
I ' k d
illustrates how a SMP Foods employee must act, t i m . an espon to. wo, r ·
r
. circumstances and to s o. ciety. It prov,'des gu.,d.mg pn·nc1· p les tliat w,·11 help
establish and sustain the integrity, honor and image that SMP Foods as a Company,
upholds. ·
.
As an employee and a business partner, we are expected to abide by these Cod s and
live it every day. It must be top of mind from the moment we wake up in the morning
and go about our business. ·
The Code of Ethics helps maintain the integrity of our name. It is said that a good name
is worth more than riches. His our desire to keep the name of SMP Foods and its
employees and partners intact with integrity and kept in good faith. Maintaining our
good name guarantees sustainability of our business because it wins the trust of
consumers - the
families worldwide whom we have promised to nourish and nurture through·our
products and serv,ices. ·
.I...
Keep this Code of Ethics close to your hearts. Discuss it freely with colleagues, be
. accountable to each other and most importantly; learn to live it every day. It is what we
are expected to be as part of the SMP Foods family. ·
We look forward to your support and to your commitment to the Code of Ethic- it is
s our way of life. ·
Rodolfo M. Abaya', _
VP and Head, Division Human Resources,
SMPfoods Company, Inc.
Expectations
• dV,:ffie believe. that what isdexpe cted in_ th_is Code is universal but cognizant of
1 erences m cuIture an c 11a11enges m interpreting and applyino the ·
• globally. b
prmc,p1es
• We recognize that the methods for, meeting these expectations m·a • d
be consi·sten't w·ith the laws, values and cultural expectations of ti Y vary or er to
m.
we.operate. · ie countries where
• The standards of conduct and values in this Code shall ouide andd fi h .
and decisions of the Food Group. b • e met e actions
• We expect all Employees to observe with zeal such values inth fi
their duties, in their relationships with fellow Employees and . e fermanc of
with shareholders, customers, suppliers, govellJment and the gen: tpu1; dealmgs
Code of Business Co11d11ct and Ethics of a Man11fact11rlng Cumpcmy 295
We expect all Business Partners to exhibit these values as a condition to their

• engagement, and for those existing al the time of effectivity hereof. and thereafter,
10 align and demonstrate compliance with the principles and standards slated in
this Code at all' times as a condition to their continued business relationship with
.the Food Group, as \veil as apply the Code to the parties with whom they
work in
providing goods and services to the Food Group.
Our Guiding Principles
Cus(omer Focus:
"Our customer is our reason for existence. "
• We strive to be the customer's preferred choice.

• We listen to our customers to intimately understand their needs.
• We develop a lasting relationship with our customers by delighting them with
products and services that anticipate and respond to their needs.
Innovativeness and.Contin'uous Learning:

"There if always a better way of doing things."
. '
• We encourage creativity and ingenuity in our processes. and systems, products and
services, continuously looking for better ways to do things, always striving to be the
first to deliver som thing better.
• We·create an enyironment that encourages teaming, not only to deliver
expectations but also t9 grow in knowledge ancj abilities.
Meritocracy and Passion for Success:
"We are responsible/or our success. What we get is commenszr ate tohow much put in.
• We constantly strive for excellence. We aspite to be the best we can be and create
value in everything we do. We are proactive and entrepreneurial, propelled _bya
sense of urgency and competitiveness, with sp·eed and precision in execution,, and
total dedication to results.
• We recognize and reward individuals and organizations·on the basis of performance
and results.
Accountability for Actions:

"With trust come great expectations. We are.accountable for our actions and decisions."
• We take full responsibility for all our actions and decisions, and discharge our
duti conscientiously, honestly and.efficiently.
• We uphold and regard as paramount the F.ood Group's interest in the undertakin of
business strategies, opportunities and endeavors, with deliberate and full evaluauon
296 Code of Business Conduct and Ethics of a Mam!facturing Company -
and management of attendant risks and the end view. of enhancing

• and maximizing
shareholder value. • . ·ng the
• We comply with and respect all applicable laws, rules a d regulations
govern, Food Group'6 businesses, i_n all jurisdictions where such 1s con
ucted.
Integrity and Mental Honesty:

"Character an1 reputation will always precede us."
• We say what we mean and mean what we say.

• We conduct business in a manner which is ethical, fair and right, and in all
reasonable circumstances. above reproach. .·
• We compete fairly and honestly. Each one of us believes in profit with honor and
is committed to good' governance and tlie highest moral standards in the
performance
of duties and responsibilities. ·
• We ensure the integrity of our records, books and accounting, and endeavor to
fully, fairly, timely and accurately report and disclose material information in
accordance
with law and regulations.
• We build and strengthen busines relationships on the basis of merit. mutual
interest, candor and fair competition, and avoid profit or gain of.competitive
advantage
tJ1rough manipulation. abuse of privileged or non-public information,
concealment. misrepresentation and other illegal or unethical practices.
• We exercise utmost discretion in accepting personal favors or gifts from
persons seeking or doing business with the Food Group, and refuse to grant
personal favors.
or decline any gift or benefit that may compromise the independence of the
Company, create a sense of obligation on its part or potentially influence its
business judgment.
• We avoid circumstances and positions that actually or potentially conflict with
the interest of the Food Group or interfere with loyalty and objectivity in
usiness dealings and relationships.
Teamwork and·Ope Communication:

"Everyone has /11:r own strength and intelligence. No one has the monopoly of
greatness We can achieve more when dothings together." ·
• We work
. . ·toward11· shared
·I aspirations. transcending boundaries alono fi • . d
organi
d z at1 ona mes w1 11 trust respect r
,or each other and u · nct1ona 1 an
an withun· ,,
t
1 y m purpose.
• We enable Employees to feel free to express opinions. voice con
suggestions to their superiors and peers.
d ffi
cems. an o er
Respect for People, Authority and Property:

"We are responsible/or everything that is entrusted to us."
• We recognize each other as individuals and commit

individual capabilities. to nurturing each other's
Code of Business Conduct and Ethics of a Manufacturing Company 297
• We commit to uplit1 the dignity of labor by encouraging each other to be the best in
their fields.
• We respect and shall pres rve the Food Group's assets and resources by ensuring
that they are used efficiently and solely for legitimate business purposes, and accord
the same to the assets and properties of others.
• We safeguard and maintain the ·confidentiality of knowledge or proprietary
information on the Food Group's products, formulations, trade secrets, business
strategies. technologies, processes and systems.
SociaI Responsibility:
"We are citizens of a bigger society. Give back _and take care ofour community."
• We strive towards good corporate citizenship and pursue pro-active volunteerism.

• We contribute positively to the promotion of social responsibility in the community
in which we live and work by supporting activities and programs geared towards
community welfare and environmental protection.
Health, Safety and E vironment
SMP Foods and its Business Partners value the health and safety of human beings and
the protection of the environment.
Worker Protection
We shall have programs in place to ensure 'the safety of our workers. Programs must
include elimination of occupational hazards in the wor piace, provision of, protective
wear and/or equipment, proper training in the handling and use of machinery and
materials, safety reminders and other measures that may be necessary to maintain
safety.
.
We shall protect workers from undue exposure to chemical. biological and physical
hazards. In case·it is necessary to deal with any hazardous material, safety information
relating to these must be provided to educate, train and safeguard workers.
Emergency Preparedness
We shall identify, assess and prepare for potential emergency situations in the
workplace and minimize their impact through prevention and readiness to implement
emergency plans and response procedures. In case such an emergency occurs, we must
immediately inform the proper authorities of the Food Group.
,
Environmental Authorizations
We shall comply with all applicable environmental regulations. All required

environmental permits, licenses, authorizations, registrations and clearances must be
obtained and their operational and reporting requirements followed.
l98 Code <?f"l311si11ess Co11d11c1mu/ Etl,ics of a Ma111!facl11ri11g Company
\Vnstennd Emissions
\\le shnll hav systems in pince to ensure the safe handling. movement. storage,
IX'cycling. r use or management of waste. air emissions and was e water discharges.
Any was_te. waste w:ller or emissions with the potential to adversely impact hum?n
or environmental health must be appropriately managed, controlled and treated prror
to release into tho enviro1lment.
H!lundous Materials
We shall have systems in place that will ensure safety in handling. storage and
releasing of hazardous materials. as well ns procedures to manage and contain
accidental spills and releases. ·
Sources
Management Systems
SMP Foods and its Business Partners adhere to effective and efficient management
systems to meet contractual obligations, facilitate continual improvement, and uphold
the image £Ind brands of the Food Group at all times.
Commitment and Accountability
We shall demonstrate commitment to the concepts described in this Code by

allocating appropriate resources to fulfill the requirements. We express accountability
by taking immediate correctiv.e action in accordance with our contractual obligations.
Business Continuity
We shall be responsible for the development and implementation of appropriate

business continuity plans for operations supporting the Food Group businesses.
Competency Development
We shall have training programs that would enable the appropr!ate level of
knowledge and skills among management ream and workers necessary 10 meet our
commitments.
Risk Assessment nnd Management
We shall have mechanisms to identify and mitigate risks in all areas of our operation
that may affect our products and services.
•
Code of B11si11iss Co11d11ct and Ethics o.f a Manufacturing Company

299
continual Improvement
we shall continually improve by setting performance objectives, executi
implement.ation pIans and tak"mg necessary correct·ive act·ions r,-or deficiencies identifiendg
by internal and/or external assessments. inspections and management reviews.
Legal and Customer Requirements
We shall identify and comply with applicable laws, rules and regulations, and
relevant customer requirements and standards, and address identified gaps in a
responsible and timely fashion.
Documentation
We shall maintain documentation necessary to denionstrate conformance with the

expectations set out in this Code, as well as compliance with applicable regulations.
Sources
Labor and Human Rights

Ethical Business Practices
SMP Foods and its Business Pa11ners conduct business with integrity and always:in an
ethical manner.
Bus_iness Integrity
. .
Any form of corruption, extortion and embezzlement shall be prohibited. We shall
not offer, pay nor accept bribes or participate in other illegal inducements in
business or govemm nt relationships. We shall_work against corruption in all.its
forms.
Fair.Competition
We shall conduct our business consistent with fair and vigorous competition and in
.compliance with applicable laws. We shall employ fair·business practices including
accurate and truthful advertising.
Trade Compliance
We shall comply with all applicable import and export controls, s nctions and.other
trade compliance laws of the Philippines and applicable laws of country(tes)
where
transaction(s) occur.
Product Quality and Food Safety
We and any party involved in the supply, manufacturing. packaging. testing, S10ra 7
an: dist bution of materials/products on behalf of the Food Group, shall uphold
comp ,anc
300 CoJ, of Busin..•ss Conduct 1111d Ethics of a Ma1111fact11ri11g Company
• . II s applicable
"1 th the Food Group qual1 1y and food safety standards. ns we a
recogn ized
. quality regulation . standards nnd practices (e.g.. Qual(ty and Food Safety
1
R g : d a: o;s
Good M:inufactunng Practices, Good Laboratory Practices. etc.) that are requir
markets "here our products are registered and distributed.
Animal \\'elfarc
Animals shall be treated humanely. Efforts shall be exerted to refine procedures
°
in rder to minimize pain. stress. and distress, which shall be scientifically valid and
acceptable to regulators. •
Accuracy of Business Records
All our financial books and records shall conform to generally accepted accounting
principles, and shall be accurate, legible, transparent, and reflect actual accounts of
events, transactions, payments and other relevant facts about the bllsiness.
Protecting Information .,
\Ve shall protect confidential and proprietary information, including personal

information collected for or from the Food Group. ·
We shall prevent information loss, misuse, theft, fraud, improper access, wrongful
disclosure or alteration, including unauthorized commul)ication and/or publication
of information acquired from oron behalf of the Food Group.
We shall make sure that any unauthorized use, disclosure or loss of the Food Group
' confidential or proprietary information is reported immediately to concerned Food
Group authorities.
Intellectual Property
We shall respect intellectual property rights. The use of Food Group trademarks
copyrights, industrial designs, patents and other intellectual property rights and th;
transfer of technology and know-how shall be done in a manner that stren thens the
equity and protects intellectual property rights of the registered owners thereof to
maximize value and drive growth and innovation of our products and services. '
Connict of Interest·
Employees and Business Partners have a·duty to,act in the best interests of the Food
Group and shall avoid any action which may involve, or may appear to involve a
conflict of interest with the Food Group.
Code of Business Conduct and Ethics of a Manufacturing Company 301
Employees. while employed by the Company, shall:
• Not seek employment or be engaged in outside business activities when such

employme_ntor activities pre ent·employees from fully performi g work,
including overtime assignments for which they are employed, U!)less otherwise agreed
by prior_ consent.
• Not act as members of boards of directors of companies with conflicts of interest or
participate in competitive business activities.
• Not have any financial or oth r business relationships with suppliers, customers
or competitors that might impair, or even appear to impair the independence of
any judgment they may need to make in the best interests of the Food Group.
Business Partners shall:
• · Avoid any interaction with any Food Group Employee or competitor that
might conflict, or appear to conflict with that Erriployee or Business Partner
acting in the best interests of the Food Group.
In the event that the personal interests of an Employee or a Business Partner
appear to conflict with the interests of the Food Group, proper disclosure by such
Employee • and/or Business Partner shall be made in order for the appropriate
authorities to resolve the conflict.
,.
Gifts, Meals, Entertainment
We shall not solicit nor accept gifts in any situation that may influence, or appear
to influence decision in relation to Business Partners.
Modest gifts, meals or entertainment may be accepted provided they are consistent with
SM Corp. policy on Solicitation and Acceptance of Gifts.
Sources
Raising Concerns
We encourage everyone to report concerns or questionable activities of Employees

and Business Partners without fear of reprisal. intimidation or harassment.
SMP Foods will not tolerate any retaliation in any form against anyol')e ,vho, in
good faith, raises a concern or reports a possible legal or ethical violation of this Code.
We wifl investigate and take corrective actions if needed.
Employees and Business Partners (including their employees and stakeholders)'

who believe that a Food Group Employee. or anyone acting on behalf of the Food Group,
has engaged in improper conduct must report t e matter promptly to SMP Foods
through its "Compliance Committee'', using the following resources:
Go online: http://www.smpf.com/pai; /concerns
Call: SMC Customer Care - 317-5555
302 Codeof Business Conduct qnd Ethics of a Manufac111ring Company
The above link sets out the procedure in reporting concerns, consistent with the other
policies and procedures implemented by the Food Group, as applicable.
The Committee will sort and direct the concerns it receives to the proper channels for
necessary action, and shall oversee their resolution.
The Head of the Compliance Committee, if not the Compliance Offi.cer of the
Company, shall coordinate at all times with the Compliance Officer, to ensure the
observance of the Code and implementation o( all relevant policies, including the
imposition of all appropriate penalties under such policies, if any, in case ofviolati9n.
. ·
The Code nor the Committee, however, shall not be used for taking up personal
grievances.
This Code shall be effective as of Aug!,ist 8, 2013.
•
ferences
Cabrera, Ma. Elenita, Cabrera, Gilbert, Auditing Theory, 2017 Edition,

Manila, Philippines
Cabrera, Ma. Elenita, Cabrera, Gilbert, Strategic Cost Management,
2019 Edition, Manila, Philippines
Whittington I Pany, Principles of Auditing and Other Assurance Services,
I 51h Edition
lntemet Websites:
Gan Business Anti-Corruption Portal (www.business-anti-corruption.com)
Catholic Bishops-Businessmen Conference Philippines (cbcpwebsite.com)
Integrity Initiative (integrityinitiative.com)
International Organization/or Standardization (www.iso.org)
Securities and Exchange Commission (www.sec.gov.ph)
•.
B_oard of Accountancy (boa.com.ph)
. .

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rporate Governance,

GILBERT ANTHONY 8. CABRERA

Philippine Copyright, 2019

Any copy of this book not bearing the

ALL RIGHTS RESERVED

Published & Printed by:

GIC ENTERPRISES & CO., INC.

Gilbert Anth·ony B. Cabrera

Cltapter t INTRODUCTION TO CORPORATE

2 CORPORATE GOVERNANCE RESPONSIBILITIES

Cllapter 6 BU.SJNESS ETHICS 103

Cllapter 7 COMMON UNETHICAL PRACTICES OF

Chapter 9 ADVOCACY AGAINST CORRUPTION

Appendix A Code of Ethics for Professional Teachers 273

Chapter INTRODUCTION TO CORPORATE

Chapter 2 CORPORATE GOVERNANCE RESPONSIBILITIES

Chapter 3 SECURITIES ANO EXCHANGE COMMISSION

Expected Learning Outcomes 26

Review Questio11s all(/ Exercises 74

Chapter 4 s c CODE OF CORPORATE GOVERNANCE,

Expected Learning Outcomes 103

Chapter 7 COMMON UNETHICAL PRACTICES OF

Review Questi<>ns 119

Chapter 9 ADVOCACY AGAINST CORRUPTION

Expected Learning Outcomes 146

UNIT III INTRODUCTION TO RISK

Chapter II RISK MANAGEMENT 163

Expected Learning Outcomes 163

Re1•iew Questions 178

Chapter PRACTICAL IN IGHTS IN REDUCING AN

Review Q11eslio11s "'"'£'1:ercises 194

UNIT IV INTERNAL CONTROL:

Chapter 13 OVERVIEW OF INTERNAL CONTROL 196

Expected Learning Outcomes 196

Nature and Purpose of Internal Control 197

Review Questio11s anti Exercises 211

Expected Learning Outcomes 217

Chapter IS ERRORS AND IRREGULARITIES IN THE

Chapter 16 INTERNAL CONTROL AFFECTING ASSETS 244

Expected Learning Outcomes 244

Review Quej•tio11s and Exercises 260

Appendix A ·Code of Ethics for Professional Teachers 273

3 Securities and Exchange

4 SEC Code of Corporate

P.x:pectecf Learn£ng Outco"':es

1. Describe what governance involves

2. Enumerate the different contexts in which governance can be

3. Name and explain the characteristics of good governance

4. Explain the meaning, purpose and objectives of corporate

5. Know and describe the principles of effective corporate

6. Understand how the principles of good corporate governance

Generally, governance refers to a process whereby elements in society wield

It comprises all the processes of governing -·whether undertaken by th·e

Governance therefore means the process of decision-making and the process by

Governance can be used in several contexts such as·corporate governance,

The focus of this book is on Corporate Governance.

CHARACTERISTICS OF GOOD GOVERNANCE

Whatever context good governance is used, the following major characteristics

Rule of Law , '!Accountallilitv

These characteristics are briefly described as follows:

Good governance ,require fair legal frameworks that are

Transparency Transparency means that decisions taken and their

Responsiveness Good governance requires that institutions and processe.s·