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    GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL Jesse Rey L. Meneses, CPA, CrFA, MBA Eugenio V. Villaceran, CPA, MBA, CTT First Edition GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL Jesse Rey L. Meneses, CPA, CrFA, MBA Eugenio V. Villaceran, CPA, MBA, CTT CONTENTS Preface .. CHAPTER 1 Introduction to Corporate Governance Learning Objectives ..... Introduction... Case Analysis: “The Fall of Enron” Definition of Terms. ‘The Need for Corporate Governance: Sarbanes-Oxley Act Definition of Corporate Governance .... Concept of “Stewardship” and “Control”... Fulfillment of Long-term Obligations... \der Theory and Stakeholder Theory . Stockhol Long-term Sustainability Goal of Governance jor. The Agency Problem... Governance and Management... Difference Between Board Independence «-. Board Setups... Guide Questions... Activity 1; Class Debate [Ure ore Activity 2: Causes of Corporate Fail 1e WorldCom Accoul Activity 3: Analyzing the Effects of th woo aanan 10 10 n 12 12 13 4 14 14 15 CHAPTER 2 Corporate Governance: What is a Well-governed Organization? Learning Objectives Introduction... At the Outset: What is a Well-governed Organization? Sarbanes-Oxley Act (SOX Law): A “Rules-based” Corporate Governance Regulation..., OECD Principles of Corporate Governance... Functions of the Board of Directors . Corporate Governance-related Provisions of the Revised Corporation Code... Revised SEC Code of Corporate Governance for Publicly-Listed Companies: A “Comply or Explain” Approach... Governance of Related Party Transactions..... Governance of Executive Compensation. Guide Questions..... Activity 1: Class Debate... Activity 2: Internet Assignment... Activity 3: Governance of Liquidity During Pandemic Times... Definition of Terms.. CHAPTER 3 Applying Ethics in Business v a 8 1g 3 - 25 26 31 32 33 34 35 36 Learning Objectives..... Introduction...... Ethics in General..... Corporate Social Responsibility Definition and Nature of Business Ethics. 39 39 40 41 42 ee Difference between Illegal Acts and Unethical Acts..... Communication of the Code of Ethical Conduct... Unethical Acts in the Various Departments of the Company... The Company's Code of Ethical Conduct... Resolution of Ethical Issues in the Field of Accounting... Guide Questions... Activity 1: To Record or Not?.. Activity 2: Is this Ethical? Activity 3: Internet Assignment: Enron’s Code of Ethics ..... Definition of Terms... CHAPTER 4 Introduction to Risk Management: “What Can Go Wrong?” 44 46 50 50 50 51 52 Learning Objectives ..... Introduction. Definition and Nature of Risk .... Types of Risk.. Definition and Nature of Risk Management... Risk Appetite ..... Steps in the Risk Management Process .. Risk Management Frameworks .... Guide Questions... Activity 1 (Group Work): Identifying Business Objective and Risks .. Activity 2 (Group Work): Risks and Management Action Plans .. Activity 3: Internet Assignment: Top Global Risks ..... Definition of Terms... 55 55 56 58 62 63 64 67 68 69 69 70 71 CHAPTER 5 Assessment of Risks and Selection of Risk Strategies ee Learning Objectives... Introduction... Components of COSO Enterprise Risk Management..... Risk Assessments... Documentation of the Risk Assessment, Risk Response, and Control Acti Monitoring and Testing of the Risk Management Process... Guide Questions..... ‘Activity 1: Assessing Risks and Selecting an Appropriate Control Activity .. Activity 2: Assessing Risks and Selecting an Appropriate Control Activity .. Activity 3: Internet Assignment Definition of Terms... CHAPTER 6 Concept of Internal Control . Learning Objectives .. ImtrodUctiOn....osccssssssecsssseescsssersssseesnseesenatesssanersanscensanscncsnnnenssanaseenunsccunecsanecqunaqenactssensst 87 Definition of Internal Control . 88 The Need for an Internal Control Framework — COSO.... a 89 Categories of internal Control Objective: Components of Internal Control... COSO Requirements for Integrated Components... “Operating Together” of Internal Control Components .... Link Between Risks and Control Activities...... Limitations of Internal Control... Guide Questions... Activity 1: Control Policies and Procedures .. Activity 2: internal Control Assessment ss. sossenn vi f ' | | ; Activity 3 (Group Work): Demonstrate How the internal Control Components Operate Together . Definition of Terms... CHAPTER 7 Internal Control in Action 105 105 Learning Objectives Introduction. Entity-level Controls . Transaction-level Controls... Hard and Soft Controls Internal Controls as to Lines of Defense... Preventive Controls ... Detective Controls. Corrective Controls. Automated Controls . Specific Control Activities per Major Account... Overview of Fraud . Fraud Triangl Control Deficiencies. Internal and External Auditing.... Guide Questions .. Activity 1: Hard and Soft Controls . Activity 2: Categorizing Controls into Preventive, Detective, or Corrective. Activity 3: Fraud Triangle Elements .. Internet Assignment: ACFE’s 2020 Report to the Nations... Definition of Terms .. References .... Index .. vii PREFACE Massive corporate scandals of the 1990s and 2000s, both here and abroad, highlighted the need for corporate governance, ethics, and internal control. In addition to these business collapses are risks that continue to bombard every company across various industries. Indeed, the entire business landscape, regulatory, and operating environments have evolved ever since the Enron scandal rocked the business community and global capital markets. Premised on the above, the authors felt a compelling reason to educate people, especially our future professional accountants, with regard to the importance of governance, ethics, risk management, and internal control (GERI). Without these, it will be “game over” for any business. Needless to say, this important field of governing companies in the proper way is now part of the formal curricula of the B. S. Accountancy (BSA) program. The authors believe that acquainting BSA students about the importance of GERI at such an early stage can be used as “launching pads” for better understanding and interest in this field of study. Hence, the authors embarked to write this textbook specifically for accountancy students. In the writing process, the authors attempted to strike a balance between concepts and practical examples on how GERI can add value to the company. Care is also applied so that accountancy students will not be overwhelmed with so many codes, laws, rules, and regulations. The authors exerted efforts to tell a corporate story line in discussing GERI so as to engage the readers. This textbook is dedicated to our future professional accountants, accounting professors, our family members, and, the source of all good governance, God Almighty. Jesse Rey L. Meneses, CPA, CrFA, MBA Eugenio V. Villaceran, CPA, MBA, CTT Case Analysis: “The Fall of Enron” Figure 1. Enron’s office in Houston, Texas, USA In 2001, Enron Corporation was a éalossalienergyicompany, with an annual revenue of more than SOONMIINIOR At that time, it ranked ER in terms ofsewenue. Enron was formed in £985 through the MeérgerofHoustonmNaturaliGas and InterNorth of Nebraska, During its early years, Enron had a Simplelbusinessumodel, operating as a natural gas pipeline company centered on the delivery of specific amounts of natural gas to utilities and other customers. However, after the deregulation of the electricity market in the early 1990s, Enron’s business evolved from hard assets to more complex and speculative energy derivatives. It also began to trade natural gas commodities. These, among others, increased the risk in Enron’s operations. Meanwhile, to finance projects and its ambitious aggressive business strategies, Enron’s\debisiand its debt ratioinereased. These movements in Enron’s financial leveraee could affect the éompany'sistockiprice and,lconsequently, the stock options of corporate executives. Because of these, corporate executives began to window dress Enron's accounting records to make it appear that the company’s financial condition is sound. Enron officials at that time were ChiePEKecutive"Officer (CEO) Jeffrey Skilling, Chiet Financial Officer (CFO) Andrew Fastow, and Board Chair Kenneth Lay, One of the questionable accounting practices applied to Enron’s corporate financials was perpetrated through the use of improper transactions involving GfititieS"4(SPES). SPEs are legal entities set up to accomplish specific and very narrow However, in the case of Enron, many special purpose entities were simply created to conduct improper off-balance sheet accounting ig? [aSSiVENIOSSES and debES from the eyestofithelinvestingypublic. Gi OVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL The audit committee members who were supposed to ensUifél proper accounting treatment merely Performed a GUrSOryirevieWl of these SPE transactions. It was found out later that those members of the audit committee such as JOHRIMERGEISONN and John Wakeham (Enron’s independent directors) were receiving Sizable “PERKS! from Enron. Mendelsohn, for instance, was the president of MONANCSRSeHmcancem@enten which receives cash donations from On the accounting side, these SPE transactions involved Enron receiving borrowed funds that were made to look like f@V@hUES, without recording the liabilities on the company’s statement of financial position. This effectively resulted to HighNrevenues which BOIstered the GOmpany.S PFOFitiFatiO while, at the same time, showed a manageable leverage! or (ASbENEVEl. As such, |inVEStOrS and stOeklanalysts| were made to believe that ENFOR was doing well, at |6astifinianeially. The SPE loans were guaranteed with Enron stock which, at that time, was trading at over, in the New York Stock Exchange (NYSE). The start of the collapse was when EffOnS|StOEKICSIMSEIINEM. Creditors of Enron started to [Faeallithie loans due to the decline in the company’s valuation. The company found it too difficult to maintain its financial position. In August 2001, JeffreylSkilling resigned as CEO. This created a firestorm of controversies over the ability of the company to continue business operations and led to loss of EfirGn’SIreputation! The day after Skilling resigned, Enron’s Vice President for CorporatesDevelopment, SherronsWatkins, sent an anonymous letter to Kenneth Lay. In her letter, Watkins expressed her fears that Enron “fight imiplodelinja WaVeloF accounting) scandals.” Enron eventually reported a third quarter 2001 loss of $618Imillion and a one-time adjustment decreasing shareholders’ equity by a staggering SUQINIOAY The adjustment was related to transactions with partnerships run by GO) FastOW. Fastow had created those(S#RBaIaHeeISHeet partnerships for Enron and for himself. He personally earned $30, {milliontdollars in management fees from deals with those partnerships. Fastow’s conflict of interest was allowed because Enron’s Code of Ethics was not strictly implemented. Hopes of financial rescue from corporate MWhIKENIKRIBHES,” Dynergy and ChevronTexacoCorp., almost bailed out Enron from bankruptcy when they announced a tentative agreement to buy the company for SBIbiNliGA. However, Enron’s credit rating was downgraded to “juiik” status in November. Eventually, Dynergy and ChevronTexacoCorp. withdrew their purchase agreement. After the purchase withdrawal, any hope of financially resuscitating of! Enron’s stock price and the company for bankruptcy. After the Enron bankruptcy, the Sarbanes#OxleyiAct was passed with the objective investors through strengthening of corporatelgovernance, strict audit-profession and internal-controls over financial reporting. of regulation of the CHAPTER 1 Introduction to Corporate Governance 9 Questions: 1 ; 14. When did the risk in Enron’s operations and business model become difficult t) manage? i 2, Is Enron a well-governed company? Provide substantial reasons. How were investors affected by the bankruptcy of Enron? How about Enron's employees? 4, _ \s window dressing of the corporate financials proper? How does it affect the analysis of investors regarding the financial health of the company? 5, Were the independent directors of Enron really “independent”? 6. Are the management fees being received by CFO Andrew Fastow proper? 7. Howcan we prevent another scenario similar to the Enron issue? Definition of Terms \Aecountingishenanigans — accounting schemes that distort amounts and disclosures in the financial statements in order to hide financial problems and/or to paint a brighter picture of economic performance. It is synonymous with the term “window dressing’ [GEREVISFOBIEM — a situation that exists when the “agents” of the corporation use their authority for theif own benefit and not for the benefit of the “principal” or owners: The term “agents” pertains to'Corporate managers while “principal” pertains to the shareholders of the company:> ae (RUGIRESHRIRIERER — committee composed of directors tasked to perform oversight of the firiancial reporting process, selection of the external auditor and receipt of audit findings from both internaland'external auditors. SBaraloRAIReeHOHS) the governing body elected by the stockholders that exercises the carporate powers of a corporation,» conducts all its business and controls)" properties. oe gerne rs (Corporatelgovernance - system of stewardship. wnt i i a tem ardship and Controbto guide organizations " fulfilling their long-term economic, moral; tegal, and ‘oward theif stakeholders. ae Corporatelissier— a corporation that issues securities e such as to th public! stocks and bonds DDEBEFEIG a measure of nancial soundness computed as total ibis divided by*@™ hose underlying asset is pase = ae re ed on a formal exchange such as the Chicago Mercantile atasgs GOVERN, ANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL trag Eniterprise)FiskiimanageMent ~ 2 process; effected by an entity's board of directors, ‘Management, and other personnel, applied in strategy setting and across the enterprise that is designed to identify potential everitSthat may affect the entity, to manage risks to be within its isk appetite,-and to provide reasonable assurance, regarding the achievement of entity objectives. Executiverdireetor — a director who has executive responsibility of day-to-day operations of a part or the whole of the organization. iil iiamaiaial (RBSBERAERETFEEROE — 2 person who is independent of management and the controlling shareholder, and is which could reasonably be:perceived:tomaterially interfere with his/her exercise of independent judgment in carrying out his/her responsibilities'as a'director. (niternalleOntFOF - a process effected by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance. (Management - agroup o! given authority by the board of directors to implement the policies it has in the conduct of the business of the corporation. \NOneX@CUEIVENGIFeCEOR - a director who does not perform any work related to the operations of the corporation. Off-balance sheet accounting the practice of not reflecting an asset and/or a liability on the financial statements. — inter-governmental entity founded in 96D intended to stimulate economic growth through the formulation of policies for et Publicly-listed compat company whose shares of stock are traded in the stock market such the Plippine Stock Exchange Sarbanes-Oxley Act — a corporate governance regulation passed in the United States requiring the strengthening of corporate governance structures among corporate issuers, stricter regulation of the auditing profession, and assessment of internal controls over financial reporting among others. Special-purpose entity — an entity created for a narrow and specific business objective; for instance, an SPE is created simply for the purpose of obtaining finance. 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. CHAPTER rroduction to Corporate Governance 5 (SGRERSIGEHRHESHY — states that the corporation exists not only for the benefit of thes stockholders but also for the and of the other stakeholders suc as a * Stockholder theory - theory stating that the corporation exists for the benefit of the shareholders or stockholders. Short-termism —a term that eOnNOteS actions of corporate managers intended to increase White knight — a ‘ffiendly” investor that purchases a|target company at a fair price ang with the support of existii The Need for Corporate Governance: Sarbanes-Oxley Act The opening vignette highlights the need for corporate governance. It is a must. Corporate governance, in a nutshell, is the effective way of The way in which companies are directed and controlled is of interest to investors, directors, managers, regulators, auditors, and practically, to everyone. In line with the above statement, corporate officers such as CEOs, CFOs, directors, and others, must act for the long-term best interests of shareholders and other stakeholders. Without corporate governance, Figure 2. Sarbanes-Oxley Act or SOX Actas shown in the Enron scandal, it will be game over The term “corporate governance” became a household name ever since the Enron and WorldCom fiascos struck the business world. As presented in the opening vignette, the was passed in the United States right after those financial scandals, The SOX Act is primarily a corporate governance regulation. SoX seeks to strengthen the functioning of the board of directors in the oversish of managerial performance as well as enhancing board: independence. Enhancing board independence essentially on corporate boards. These independent directors, aside from being detached fro™ operational duties, must not have any business dealings with the company which cou affect the exercise of objective and independent judgment, SOX regulations also to-ensure reliable and . Investors need financial information aid in their investment decisions. SoX also instituted improvements in the oversight the a whistle-blower policies, ‘ransparent disclosures of financial and nonfinancial information among others. GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL The following key points summarizes'the importantiprovisionsiof SOX: Strengthening of external auditor's independence: The external’auditor of a corporate issuer is prohibited from performing eight non-audit services, namely: bookkeeping, information systems design and ES LAR =< een Corporate officers and directors are prohibited from fraudulently misleading or

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