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 the government 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

Whatever context good governance is used, the following major characteristic should be
present:
These characteristics are briefly described as follows:

Participation
 Participation by both men and women is a key cornerstone of good governance.
Participation could be either direct or through legitimate institutions or
representatives. It is important to point out that representative democracy does not
necessarily mean that the concern of the most vulnerable in society would not be
taken into consideration in decision making. Participation needs to be informed
and organized. This means freedom of association and expression on one hand
and an organized civil society on the other hand.

Rule of Law
 Good governance requires fair legal frameworks that are enforced impartially. It
also requires full protection of human rights, particularly those of minorities.
Impartial enforcement of laws requires an independent judiciary and an impartial
and incorruptible police force.

Transparency
 Transparency means that decisions taken and their enforcement are done in a
manner that follows rules and regulations. It means that information is freely
available and directly accessible to those who will be affected by such decisions
and their enforcement. It also means that enough information is provided and that
it is provided in easily understandable forms and media.

Responsiveness
 Good governance requires that institutions and processes try to serve the needs
all stakeholders within a reasonable timeframe.

Consensus Oriented
 Good governance requires mediation of the different interests in society to reach
a broad consensus on what is in the best interest of the whole community and how
this can be achieved. It also requires a broad and long-term perspective on what
is needed for sustainable human development and how to achieve the goals of
such development. This can only result from an understanding of the historical,
cultural and social contexts of a given society or community.

Equity & Inclusiveness

 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.

Effectiveness & Efficiency
 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.
Accountability
 Accountability is a key requirement of good governance. Not only governmental
institutions but also the private sector and civil society organizations must be
accountable to the public and to their institutional stakeholders. Who is
accountable to whom varies depending on whether decisions or actions taken are
internal or external to an organization or institution. In general, an organization or
an institution is accountable to those who will be affected by its decisions or
actions. Accountability cannot be enforced without transparency and the rule of
law.

CORPORATE GOVERNANCE: AN OVERVIEW

Corporate governance is defined as the system of rules, practices and processes by

which business corporations are directed and controlled. It basically involves balancing
the interests of a company's many stakeholders, such as shareholders, management,
customers, suppliers, financiers, government and the community.

Corporate governance is a topic that has received growing attention in the public in recent
years as policy makers and others become more aware of the contribution good corporate
governance makes to financial market stability and economic growth. Good corporate
governance is all about controlling one's business and so is relevant, and indeed vital, for
all organizations, whatever size or structure.

The corporate governance structure specifies the distrib responsibilities among different
participants in the corporation, such as the board, managers, shareholders, and other
stakeholders, 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, entrepreneurial and prudent

management that can deliver long-term success of the company. In simple terms, the
fundamental aim of corporate governance is to enhance shareholders' value and protect
the interests of other stakeholders by improving 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:

1. Fair and Equitable Treatment of Shareholders

A corporate governance structure ensures equitable and fair treatment of all shareholders
of the company. In some organizations, a group of high- net-worth individual and
institutions who have a substantial proportion of their portfolios invested in the company,
remain active through occupation of top-level positions that enable them to guard their
interest. However, all shareholders deserve equitable treatment and this equity is
safeguarded by a good governance structure in any organization.

2. Self-Assessment

Corporate governance enables firms to assess their behavior and actions before they are
scrutinized by regulatory agencies. Business establishments with a strong corporate
governance system are better able to limit exposure to regulatory risks and fines. An
active and independent board can successfully point out deficiencies or loopholes in the
company operations and help solve issues internally on a timely basis.

3. Increase Shareholders' Wealth

Another corporate governance's main objective is to protect the long- term interests of
the shareholders. Firms with strong corporate governance structure are seen to have
higher valuation attached to their shares by businessmen. This only reflects the positive
perception that good corporate governance induces potential investors to decide to invest
in a company.

4. Transparency and Full Disclosure

Good corporate governance aims at ensuring a higher degree of transparency in an
organization by encouraging full disclosure of transactions in the company accounts.

BASIC PRINCIPLES OF EFFECTIVE CORPORATE GOVERNANCE

Effective corporate governance is transparent, protects the rights of shareholders and
includes both strategic and operational risk management. It is concerned in both the long-
term earning potential as well as actual short-term earnings and holds directors
accountable for their stewardship of the business.

The basic principles of effective corporate governance are threefold as presented below:
Positive answers to the following questions indicate a firm's conformance and compliance
with the basic principles of good corporate governance:

A. Transparency and Full Disclosure

 Does the board meet the information needs of investment communities?
 Does it safeguard integrity in financial reporting? Does the board have sound
disclosure policies and practices?
 Does it make timely and balanced disclosure? > Can an outsider meaningfully
analyze the organization's actions and performance

B. Accountability
 Does the board clarify its role and that of management?
o Does it promote objective, ethical and responsible decision. making?
o Does it lay solid foundations for management oversight?
o Does the composition mix of board membership ensure an appropriate
range and mix of expertise, diversity, knowledge and added value?
o Is the organization's senior official committed to widely accepted standards
of correct and proper behavior?

C. Corporate Control
 Has the board built long-term sustainable growth in shareholders' value for the
corporation?
 Does it create an environment to take risk? Does it encourage enhanced
performance?
o Does it recognize and manage risk?
o Does it remunerate fairly and responsibly? Does it recognize the legitimate
interests of stakeholders?
 o Are conflicts of interest avoided such that the organization's best interests
prevail at all times?
ILLUSTRATIVE APPLICATION OF THE BASIC PRINCIPLES OF CORPORATE
GOVERNANCE AND BEST PRACTICE RECOMMENDATIONS
Principles of Good Corporate
Governance
1. A company should lay solid foundation
for management and oversight. It should
recognize and publish the respective roles
and responsibilities of board and
management.
2. Structure the board to add value. Have
a board of an effective composition, size
and commitment to adequately discharge
its responsibilities and duties.
3. Promote ethical and responsible
decision- making. Actively promote ethical
and responsible decision-making.
4. Safeguard integrity in financial reporting
Have a structure to independently verify
and safeguard the integrity of the
company's financial reporting.
Best Practice Recommendations
1-a. Formalize and disclose the functions
reserved to the board and those delegated
to management
2-a. A board should have independent
directors.
2-b. The roles of chairperson and chief
executive officer should not be exercise by
the same individual.
2-b. The board should establish a
nomination committee
3-a. Establish a code of conduct to guide
directors, the chief executive officer (C
equivalent), the chief financial officer
equivalent) and any other key executives
as to:
 The practices necessary to
maintain confidence in the
company's integrity; and
 The responsibility and
accountability of individuals
reporting and investigating reports
of unethical practice
3-b. Disclose the policy concerning in
company securities by dire officers and
employees.
4-a. Require the chief executive of (or
equivalent) and the chief financial officer
(or equivalent) to state in writing to the
board that the company's financial reports
present a true and fair view, in all material
respects, of the company's financial
condition and operational results and are
in accordance with relevant accounting
standards.

5. Make timely and balanced disclosure. procedures
Promote timely and balanced disclosure of compliance with IFRS.
all material matters concerning the 5-b. Listing Rule disclosure requirements
company.
6. Respect the rights of shareholders and
facilitate the effective exercise of those
rights.
7. Recognize and manage risk. Establish
a sound system of risk oversight and
management and internal control.
8. Encourage enhanced performance.
Fairly review and actively encourage
4-b. The board should establish an audit
committee.
4-c. Structure the audit committee so that
it consists of:
 Only non-executive or independent
directors;
 An independent chairperson, who
is not chairperson of the board; and
 At least three (3) members.
5-a. Establish written policies and
designed to ensure
and to ensure accountability at a senior
management level for compliance.
6-a. Design and disclose a
communications strategy to promote
effective 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.
7-a. The board or appropriate board
committee should establish policies on 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 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 respects.
8-a. Disclose the process for performance
evaluation of the board, its committees
enhanced board and management
effectiveness.
9. Remunerate fairly and responsibly.
Ensure that the level and composition of
remuneration is sufficient and reasonable
and that its relationship to corporate and
individual performance is defined.
10. Recognize the legitimate interests of
stakeholders. Recognize legal and other
obligations to all legitimate stakeholders.
and individual directors, and key
executives.
9-a. Provide disclosure in relation to the
company's remuneration policies to
enable investors to understand:
 The costs and benefits of those
policies; and
 The link between remuneration
paid to directors and key executives
and corporate performance.
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
approved by shareholders.
10-a. Establish and disclose a code of
conduct to guide compliance with legal
and other obligations to legitimate
stakeholders.
CHAPTER 2
Corporate Governance Responsibilities and Accountabilities

Introduction
Many of the characteristics of good governance described in Chapter I are relevant to both SME's
and large listed public companies. As an organization grows in size and influence, these issues
become increasingly important.

However, it is also important to recognize that good corporate governance is based on principles
underpinned by consensus and continually developing notions of good practice. There are no
absolute rules which must be adopted by all organizations. "There is no simple universal formula
for good governance". Instead emphasis is many localities, has been to encourage organizations
to give appropriate attention to the principles and adopt approaches which are tailored to the
specific needs of an organization at a given point in time.

When corporate governance is discussed, it is often spoken of in terms of a company's corporate

governance framework. The key elements within an effective governance framework, and the
issues relating to each element, are set out on the following pages and are relevant to
organizations large and small, in both the private and the public sectors. The table provides a
useful structure for any company to consider its own approach to corporate governance and the
matters which may assist it to achieve its strategic objectives.

Many of the matters listed may not be directly relevant in all situations and some may not, in
particular circumstances, be within the board's control, but it provides a useful context in which
any organization can consider its governance needs so that they might be most appropriately
addressed.

The essence of any system of good corporate governance is to allow the board and management
the freedom to drive their organization forward and to exercise that freedom within a framework
of effective accountability.

Relationship Between Shareholders/ Owners and Other Stakeholders

Governance starts with the shareholders/owners delegating responsibilities through an elected

board of directors to management and, in turn, to operating units with oversight and assistance
from internal auditors. The board of directors and its audit committee oversee management and,
in that role, are expected to protect the shareholders' rights. However, it is important to recognize
that management is part of the governance framework; management can influence who sits on
the board and the audit committee as well as other governance controls that might be put into
place.

In return for the responsibilities (and power) given to management and the board, governance
demands accountability back through the system to the shareholders. However, the
accountabilities do not extend only to the shareholders. Companies also have responsibilities to
other stakeholders. Stakeholders can be anyone who is influenced, whether directly or indirectly,
by the actions of a company. Management and the board have responsibilities to act within the
laws of society and to meet various requirements of creditors, employees and the stakeholders.

18 Chapter 2

A broad group of stakeholders has an interest in the quality of corporate governance because it
has a relationship to economic performance and the quality of financial reporting. For example,
it is likely that many employees have significant funds invested in pension plans. Those pension
plans are designed to protect the financial interests of those employees in their retirement. We
use the word society in the diagram to indicate those broad interests. In a similar fashion,
employees and creditors have a vested interest in the organization and how it is governed.
Regulators are a response to society's wishes to ensure that organizations, in their pursuit of
returns for their owners, act responsibly and operate in compliance with relevant laws.

While shareholders/owners delegate responsibilities to various parties within the corporation,

they also require accountability as to how well the resources that have been entrusted to
management and the board have been used. For example, the owners want accountability on
such things as:

• Financial performance
• Financial transparency -financial statements that are clear with full disclosure and that reflect
the underlying economics of the company.
• Stewardship, including how well the company protects and manages the resources entrusted
to it.
• Quality of internal control Composition of the board of directors and the nature of its
activities, including information on how well management incentive systems are aligned with
the shareholders' best interests.

The owners want disclosures from management that are accurate and objectively verifiable. For
instance, management has a responsibility to provide financial reports, and in some cases, reports
on internal control effectiveness. Management has always had the primary responsibility for the
accuracy and completeness of an organization's financial statements. From a financial reporting
perspective, it is management's responsibility to:

• Choose which accounting principles best portray the economic substance of company
transactions.
• Implement a system of internal control that assures completeness and accuracy in financial
reporting.
• Ensure that the financial statements contain accurate and complete disclosure.
PARTIES INVOLVED IN CORPORATE GOVERNANCE: THEIR RESPECTIVE BROAD ROLE AND
SPECIFIC RESPONSIBILITIES

Corporate governance and financial reporting reliability are receiving considerable attention from
a number of parties including regulators, standard setting bodies, the accounting profession,
lawmakers and financial statement users.

PARTY OVERVIEW OF RESPONSIBILITIES

1. Shareholders Broad role:
Provide effective oversight through election of
board members, approval of major initiatives
such as buying or selling stock, annual reports
on management compensation, from the
board.
2. Board of directors Broad Role:

The major representative of stockholders to

ensure that the organization is run according
to the organization's charter and that there is
proper 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.
• 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

2. Performance

• Ensuring the organization's long term

viability and enhancing the financial
position.
• Formulating and overseeing
implementation corporate strategy.
• Approving the plan, budget and corporate
policies.
• Agreeing key performance indicators
(KPIs)
• Monitoring/assessing assessment,
performance of the organization, the
board itself, management and major
projects.
• Overseeing the risk management
framework and monitoring business risks.
• Monitoring developments in the industry
and the operating environment.
• Oversight of the and organization,
including its control and accountability
systems.
• Approving and monitoring the progress of
major capital expenditure, capital
management and acquisitions and
divestitures.

3.Compliance/Legal Conformance

• Understanding and protecting the

organization's financial position.

• Requiring and monitoring legal and

regulatory compliance including
compliance with accounting standards,
unfair trading legislations, occupational
health and safety and environmental
standards.
 • Approving annual financial reports, annual
reports and other public documents /
sensitive reports.

• Ensuring an effective system of internal

controls exists and is operating as
expected.
3. Non-executive or Independent Broad Role:
Directors The same as the broad role of the entire board
of directors

Specific activities include among others:

• 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
agenda,
to understand that his/her 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 a
matter comes before the board, or alert
the chairman in advance to the need for
further information in relation to a
particular matter, and
• to ask appropriate questions relative to
operations.
4. Management Broad Role:

Operations and accountability. Manage the

organization effectively; provide accurate and
 timely reports to shareholders and other
stakeholders.

Specific activities include among others:

•
recommend the strategic direction and
translate the strategic plan into the
operations of the business
• manage the company's human, physical
and financial resources to achieve the
organization's objectives-run the business
• assume day to day responsibility for the
organization's conformance with relevant
laws and regulations and its compliance
framework
• develop, implement and manage the
organization's risk management and
internal control frameworks
• develop, 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
• developing financial and other reports
that meet public, stakeholder and
regulatory requirements.
5. Audit Committees of the Board of Broad Role:
Directors
Provide oversight of the internal and external
audit function and the process of preparing
the annual financial statements as well as
public reports on internal control.

Specific activities include among others:

• Selecting the external audit firm

• Approving any non-audit work performed
by the audit firm
 • Selecting and/or approving the
appointment of the Chief Audit Executive
(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 management) on specific
actions that should be taken
6. Regulators Broad Role:
a. Board of Accountancy
Set accounting and auditing standards
dictating underlying financial reporting and
auditing concepts; set the expectations of
audit quality and accounting quality.

Specific activities include among others:

• Conducting CPA Licensure Board

Examinations
• Approving accounting principles
• Approving auditing standards
• Interpreting previously issued standards
implementing quality control processes to
ensure audit quality
• Educating members on audit and
accounting requirements

Broad Role:
b. Securities and Exchange Ensure the accuracy, timeliness and fairness of
Commission public reporting of financial and other
information for public companies.

Specific activities include among others:

• Reviewing filings with the SEC

• Interacting with the Financial Reporting
Standards Council in setting accounting
standards
• Specifying independence standards
required of auditors that report on public
financial statements
 • Identify corporate frauds, investigate
causes, and suggest remedial actions
7. External Auditors Broad Role:

Perform audits of company financial

statements to ensure that the statements are
free of material misstatements including
misstatements that may be due to fraud.

Specific activities include among others:

• Audit of public company financial

statements

• Audits of nonpublic company financial

statements

• Other services such as tax or consulting

8. Internal Editors Broad Role:

Perform audits of companies for compliance

with company policies and laws, audits to
evaluate the efficiency of operations, and
periodic evaluation and tests of controls.

Specific activities include among others:

• Reporting results and analyses to

management (including operational
management) and audit committees
• Evaluating internal controls

SUMMARY OF THE KEY PRINCIPLES OF EFFECTIVE CORPORATE GOVERNANCE

In summary, the key/core governance principles related to Board and Management include:

• The board's fundamental objective should be to build long-term sustainable growth in

shareholder value for the corporation.

• Successful corporate governance depends upon successful management of the company, as

management has the primary responsibility for creating a culture of performance with
integrity and ethical behavior.
• Effective corporate governance should be integrated with the company's business strategy and
not viewed as simply a compliance obligation.

• Transparency is a critical element of effective corporate governance, and companies should

make regular efforts to ensure that they have sound disclosure policies and practices.

• Independence and objectivity are necessary attributes of board members; however, companies
must also strike the right balance in the appointment of independent and nonindependent
directors to ensure an appropriate range and mix of expertise, diversity, and knowledge on the
board.

Corporate Governance and Its Relationship to External Audit

Effective governance is important to the conduct of an audit for one very simple reason:
companies with effective corporate governance are less likely to experience fraud and are
therefore less risky to audit. For that reason, most audit firms are not willing to accept potential
audit client unless the clients demonstrate a strong commitment to effective corporate
governance. The auditor is in a much better position to provide a quality audit when governance
mechanisms, such as the board and the audit committee, adhere to and embrace fundamental
principles of effective governance.

At those types of organizations, the auditor can serve as an independent party working with other
governance parties such as management, the board, and the audit committee, to help ensure
reliable financial reporting.

However, in organizations where governance is not well developed or is heavily influenced by

management, the auditor may decide that the risk of fraud is unduly high and that audit firm is
going to have to bear too much responsibility for assuring reliable financial reporting. In essence,
ineffective corporate governance increases fraud risk to an extent that at some point the client is
not auditable from a risk-mitigation standpoint.

Fraud raises important concerns for external auditors, and they have clear professional
obligations to perform an audit that provides reasonable assurance that the financial statements
are free from material misstatement, including fraud. Various types of fraud exist, and the fraud
triangle characterizes incentives, opportunities, and rationalizations that enable fraud to exist.

While the possibility of fraud and the associated need for effective corporate governance are of
utmost importance to the external auditor, management also seeks to provide reasonable
assurance that the financial statements are free from material misstatements from either fraud
or errors.
 CHAPTER 3
SEC CODE OF CORPORATE GOVERNANCE FOR PUBLICLY LISTED
COMPANIES
("CG Code for PLCs")

Securities and Exchange Commission

SEC MC No. 19, Series of 2016 *

On November 10, 2016, the Securities and Exchange Commission approved the Code of
Corporate Governance 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 establish 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
practices". The Board of Directors is required to implement the code and make sure that
management and employees comply with the internal policies set.

While many companies have already developed their 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-listed corporations.

(Source: www.sec.gov.pk)
 CODE OF CORPORATE GOVERNANCE FOR PUBLICLY LISTED
COMPANIES

THE BOARD’S GOVERNANCE RESPONSIBILITIES

Principle 1: The company should be headed by a competent, working board to foster the
long-term success of the corporation, and to sustain its competitiveness and
profitability in a manner consistent with its corporate objectives and the long-
term best interests of its shareholders and other stakeholders.

Principle 2: The fiduciary roles, responsibilities and accountabilities of the Board as

provided under the law, the company’s articles and by-laws, and other legal
pronouncements and guidelines should be clearly made known to all directors
as well as to stockholders and other stakeholders.

Principle 3: Board committees should be set up to the extent possible to support the effective
performance of the Board’s functions, particularly with respect to audit, risk
management, related party transactions, and other key corporate governance
concerns, such as nomination and remuneration. The composition, functions and
responsibilities of all committees established should be contained in a publicly
available Committee Charter.

Principle 4: To show full commitment to the company, the directors should devote the time
and attention necessary to properly and effectively perform their duties and
responsibilities, including sufficient time to be familiar with the corporation’s
business.

Principle 5: The Board should endeavor to exercise objective and independent judgment on
all corporate affairs.

Principle 6: The best measure of the Board’s effectiveness is through an assessment process.
The Board should regularly carry out evaluations to appraise its performance as
a body, and assess whether it possesses the right mix of backgrounds and
competencies.

Principle 7: Members of the Board are duty-bound to apply high ethical standards, taking
into account the interests of all stakeholders.

DISCLOSURE AND TRANSPARENCY

Principle 8: The company should establish corporate disclosure policies and procedures that
are practical and in accordance with best practices and regulatory expectations.

2
Principle 9: The company should establish 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 and 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 FRAMEWORK

Principle 12: 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.

CULTIVATING A SYNERGIC RELATIONSHIP WITH SHAREHOLDERS

Principle 13: The company should treat all shareholders fairly and equitably, and also
recognize, protect and facilitate the exercise of their rights.

DUTIES TO STAKEHOLDERS

Principle 14: The rights of stakeholders established by law, by contractual relations and
through voluntary commitments must be respected. Where stakeholders’ rights
and/or interests are at stake, stakeholders should have the opportunity to obtain
prompt effective redress for the violation of their rights.

Principle 15: A mechanism for employee participation should be developed to create a

symbiotic environment, realize the company’s goals and participate in its
corporate governance processes.

Principle 16: The company should be socially responsible in all its dealings with the
communities where it operates. It should ensure that its interactions serve its
environment and stakeholders in a positive and progressive manner that is fully
supportive of its comprehensive and balanced development.

3
INTRODUCTION

1. 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/OECD1 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 do 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 statements of corporate governance
good practice, and are applicable to all companies.

4. The Recommendations are objective criteria that are intended to identify the specific
features of corporate governance good practice that are recommended for
companies operating according to the Code. Alternatives to a Recommendation may
be justified in particular circumstances if good governance can be achieved by other
means. When a Recommendation is not complied with, the company must disclose
and describe this non-compliance, and explain how the overall Principle is being
achieved. The alternative should be consistent 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 with 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 institutions 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 is 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 Exchange Commission (SEC).

7. Definition of Terms:

Corporate Governance – the system of stewardship and control to guide

organizations in fulfilling their long-term economic, moral, legal and social
obligations towards their stakeholders.

1
Organisation for Economic Co-operation and Development

4
 Corporate governance is a system of direction, feedback and control using
regulations, performance standards and ethical guidelines to hold the Board and
senior management accountable for ensuring ethical behavior – reconciling long-
term customer satisfaction with shareholder value – to the benefit of all
stakeholders and society.

Its purpose is to maximize the organization’s long-term success, creating sustainable

value for its shareholders, stakeholders and the nation.

Board of Directors – the governing body elected by the stockholders that exercises
the corporate powers of a corporation, conducts all its business and controls its
properties.

Management – a group of executives given the authority by the Board of Directors

to implement the policies it has laid down in the conduct of the business of the
corporation.

Independent director – a person who is independent of management and the

controlling shareholder, and is free from any business or other relationship which
could, or could reasonably be perceived to, materially interfere with his exercise of
independent judgment in carrying out his responsibilities as a director.

Executive 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 such businesses are controlled and
managed by a parent corporate entity.

Internal control – a process designed and effected by the board of directors, senior
management, and all levels of personnel to provide reasonable assurance on the
achievement of objectives through efficient and effective operations; reliable,
complete and timely financial and management information; and compliance with
applicable laws, regulations, and the organization’s policies and procedures.

Enterprise Risk Management – a 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 events that may affect the entity,
manage risks to be within its risk appetite, and provide reasonable assurance
regarding the achievement of entity objectives.2

Related Party – shall cover the company’s subsidiaries, as well as affiliates and 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 interest of the company.

2 Committee of Sponsoring Organizations of the Treadway Commission (COSO Framework)

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 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.

THE BOARD’S GOVERNANCE RESPONSIBILITIES

1. ESTABLISHING A COMPETENT BOARD

Principle

The company should be headed by a competent, working board to foster the long-term
success of the corporation, and to sustain its competitiveness and profitability in a
manner consistent with its corporate objectives and the long-term best interests of its
shareholders and other stakeholders.

Recommendation 1.1

The Board should be composed of directors with a collective working knowledge,

experience or expertise that is relevant to the company’s industry/sector. The Board
should always ensure that it has an appropriate mix of competence and expertise and
that its members remain qualified for their positions individually and collectively, to
enable it to fulfill its roles and responsibilities and respond to the needs of the
organization based on the evolving business environment and strategic direction.

Explanation

Competence can be determined from the collective knowledge, experience and expertise
of each director that is relevant to the industry/sector that the company is in. A Board
with the necessary knowledge, experience and expertise can properly perform its task of
overseeing management and governance of the corporation, formulating the
corporation’s vision, mission, strategic objectives, policies and procedures that would
guide its activities, effectively monitoring management’s performance and supervising
the proper implementation of the same. In this regard, the Board sets qualification
standards for its members to facilitate the selection of potential nominees for board
seats, and to serve as a benchmark for the evaluation of its performance.

Recommendation 1.2

The Board should be composed of a majority of non-executive directors who possess the
necessary qualifications to effectively participate and help secure objective, independent
judgment on corporate affairs and to substantiate proper checks and balances.

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Explanation

The right combination of non-executive directors (NEDs), which include independent

directors (IDs) and executive directors (EDs), ensures that no director or small group of
directors can dominate the decision-making process. Further, a board composed of a
majority of NEDs assures protection of the company’s interest over the interest of the
individual shareholders. The company determines the qualifications of the NEDs that
enable them to effectively participate in the deliberations of the Board and carry out
their roles and responsibilities.

Recommendation 1.3

The Company should provide in its Board Charter and Manual on Corporate Governance
a policy on the training of directors, including an orientation program for first-time
directors and relevant annual continuing training for all directors.

Explanation

The orientation program for first-time directors and relevant annual continuing training
for all directors aim to promote effective board performance and continuing
qualification of the directors in carrying-out their duties and responsibilities. It is
suggested that the orientation program for first-time directors, in any company, be for at
least eight hours, while the annual continuing training be for at least four hours.

All directors should be properly oriented upon joining the board. This ensures that new
members are appropriately apprised of their duties and responsibilities, before
beginning their directorships. The orientation program covers SEC-mandated topics on
corporate governance and an introduction to the company’s business, Articles of
Incorporation, and Code of Conduct. It should be able to meet the specific needs of the
company and the individual directors and aid any new director in effectively performing
his or her functions.

The annual continuing training program, on the other hand, makes certain that the
directors are continuously informed of the developments in the business and regulatory
environments, including emerging risks relevant to the company. It involves courses on
corporate governance matters relevant to the company, including audit, internal
controls, risk management, sustainability and strategy. It is encouraged that companies
assess their own training and development needs in determining the coverage of their
continuing training program.

Recommendation 1.4

The Board should have a policy on board diversity.

Explanation

Having a board diversity policy is a move to avoid groupthink and ensure that optimal
decision-making is achieved. A board diversity policy is not limited to gender diversity.
It also includes diversity in age, ethnicity, culture, skills, competence and knowledge. On
gender diversity policy, a good example is to increase the number of female directors,
including female independent directors.

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Recommendation 1.5

The Board should ensure that it is assisted in its duties by a Corporate Secretary, who
should be a separate individual from the Compliance Officer. The Corporate Secretary
should not be a member of the Board of Directors and should annually attend a training
on corporate governance.

Explanation

The Corporate Secretary is primarily responsible to the corporation and its

shareholders, and not to the Chairman or President of the Company and has, among
others, the following duties and responsibilities:

a. Assists the Board and the board committees in the conduct of their meetings,
including preparing an annual schedule of Board and committee meetings and the
annual board calendar, and assisting the chairs of the Board and its committees to
set agendas for those meetings;

b. Safe keeps 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. Keeps abreast on relevant laws, regulations, all governance issuances, relevant

industry developments and operations of the corporation, and advises the Board
and the Chairman on all relevant issues as they arise;

d. Works 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 required administrative functions;

i. Oversees the drafting of the by-laws and ensures that they conform with regulatory
requirements; and

j. Performs such other duties and responsibilities as may be provided by the SEC.

Recommendation 1.6

The Board should ensure that it is assisted in its duties by a Compliance Officer, who
should have a rank of Senior Vice President or an equivalent position with adequate
stature and authority in the corporation. The Compliance Officer should not be a

8
 member of the Board of Directors and should annually attend a training on corporate
governance.

Explanation

The Compliance Officer is a member of the company’s management team in charge of

the compliance function. Similar to the Corporate Secretary, he/she is primarily 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 documentary submissions to regulators;

e. Appears before the SEC when summoned in relation to compliance with this Code;

f. Collaborates with other departments to properly address compliance issues, which

may be subject to investigation;

g. Identifies possible areas of compliance issues and works towards the resolution of
the same;

h. Ensures the attendance of board members and key officers to relevant trainings; and

i. Performs such other duties and responsibilities as may be provided by the SEC.

2. ESTABLISHING CLEAR ROLES AND RESPONSIBILITIES OF THE BOARD

Principle

The fiduciary roles, responsibilities and accountabilities of the Board as provided under
the law, the company’s articles and by-laws, and other legal pronouncements and
guidelines should be clearly made known to all directors as well as to shareholders and
other stakeholders.

Recommendation 2.1

The Board members should act on a fully informed basis, in good faith, with due
diligence and care, and in the best interest of the company and all shareholders.

Explanation

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 There are two key elements of the fiduciary duty of board members: the duty of care and
the duty of loyalty. The duty of care requires board members to act on a fully informed
basis, in good faith, with due diligence and care. The duty of loyalty is also of central
importance; the board member should act in the interest of the company and all its
shareholders, and not those of the controlling company of the group or any other
stakeholder.

Recommendation 2.2

The Board should oversee the development of and approve the company’s business
objectives and strategy, and monitor their implementation, in order to sustain the
company’s long-term viability and strength.

Explanation

According to the OECD, the Board should review and guide corporate strategy, major
plans of action, risk management policies and procedures, annual budgets and business
plans; set performance objectives; monitor implementation and corporate performance;
and oversee major capital expenditures, acquisitions and divestitures. Sound strategic
policies and objectives translate to the company’s proper identification and
prioritization of its goals and guidance on how best to achieve them. This creates
optimal value to the corporation.

Recommendation 2.3

The Board should be headed by a competent and qualified Chairperson.

Explanation

The roles and responsibilities of the Chairman include, among others, the following:

a. Makes certain that the meeting agenda focuses on strategic matters, including the
overall risk appetite of the corporation, considering the developments in the
business and regulatory environments, key governance concerns, and contentious
issues that will significantly affect operations;

b. Guarantees that the Board receives accurate, timely, relevant, insightful, concise, and
clear information to enable it to make sound decisions;

c. Facilitates discussions on key issues by fostering an environment conducive for

constructive debate and leveraging on the skills and expertise of individual
directors;

d. Ensures that the Board sufficiently challenges and inquires on reports submitted
and representations made by Management;

e. Assures the availability of proper orientation for first-time directors and continuing
training opportunities for all directors; and

f. Makes sure that performance of the Board is evaluated at least once a year and
discussed/followed up on.

Recommendation 2.4

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 The Board should be responsible for ensuring and adopting an effective succession
planning program for directors, key officers and management to ensure growth and a
continued increase in the shareholders’ value. This should include adopting a policy on
the retirement age for directors and key officers as part of management succession and
to promote dynamism in the corporation.

Explanation

The transfer of company leadership to highly competent and qualified individuals is the
goal of succession planning. It is the Board’s responsibility to implement a process to
appoint competent, professional, honest and highly motivated management officers who
can add value to the company.

A good succession plan is linked to the documented roles and responsibilities for each
position, and should start in objectively identifying the key knowledge, skills, and
abilities required for the position. For any potential candidate identified, a professional
development plan is defined to help the individuals prepare for the job (e.g., training to
be taken and cross experience to be achieved). The process is conducted in an impartial
manner and aligned with the strategic direction of the organization.

Recommendation 2.5

The Board should align the remuneration of key officers and board members with the
long-term interests of the company. In doing so, it should formulate and adopt a policy
specifying the relationship between remuneration and performance. Further, no
director should participate in discussions or deliberations involving his own
remuneration.

Explanation

Companies are able to attract and retain the services of qualified and competent
individuals if the level of remuneration is sufficient, in line with the business and risk
strategy, objectives, values and incorporate measures to prevent conflicts of interest.
Remuneration policies promote a sound risk culture in which risk-taking behavior is
appropriate. They also encourage employees to act in the long-term interest of the
company as a whole, rather than for themselves or their business lines only. Moreover, it
is good practice for the Board to formulate and adopt a policy specifying the relationship
between remuneration and performance, which includes specific financial and non-
financial metrics to measure performance and set specific provisions for employees with
significant influence on the overall risk profile of the corporation.

Key considerations in determining proper compensation include the following: (1) the
level of remuneration is commensurate to the responsibilities of the role; (2) no director
should participate in deciding on his remuneration; and (3) remuneration pay-out
schedules should be sensitive to risk outcomes over a multi-year horizon.

For employees in control functions (e.g., risk, compliance and internal audit), their
remuneration is determined independent of any business line being overseen, and
performance measures are based principally on the achievement of their objectives so
as not to compromise their independence.

Recommendation 2.6

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 The Board should have and disclose in its Manual on Corporate Governance a formal and
transparent board nomination and election policy that should include how it accepts
nominations from minority shareholders and reviews nominated candidates. The policy
should also include an assessment of the effectiveness of the Board’s processes and
procedures in the nomination, election, or replacement of a director. In addition, its
process of identifying the quality of directors should be aligned with the strategic
direction of the company.

Explanation

It is the Board’s responsibility to develop a policy on board nomination, which is

contained in the company’s Manual on Corporate Governance. The policy should
encourage shareholders’ participation by including procedures on how the Board
accepts nominations from minority shareholders. The policy should also promote
transparency of the Board’s nomination and election process.

The nomination and election process also includes the review and evaluation of the
qualifications of all persons nominated to the Board, including whether candidates: (1)
possess the knowledge, skills, experience, and particularly in the case of non-executive
directors, independence of mind given their responsibilities to the Board and in light of
the entity’s business and risk profile; (2) have a record of integrity 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 the 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 a bank, quasi-bank, trust
company, investment house or as an affiliated person of any of them;

b. Any person who, by reason of misconduct, after hearing, is permanently enjoined by a

final judgment or order of the SEC, Bangko Sentral ng Pilipinas (BSP) 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) and (b) above, or willfully violating
the laws that govern securities and banking activities.

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,

12
 Securities Regulation Code or any other law administered by the SEC or BSP, or under
any rule or regulation issued by the Commission or BSP; (b) such person has
otherwise been restrained to engage in any activity involving securities and banking;
or (c) such person is the subject of an effective order of a self-regulatory organization
suspending or expelling him from membership, participation or association with a
member or participant of the organization;

c. Any person convicted by 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 person judicially declared as insolvent;

f. Any person found guilty by final judgment or order of a foreign court or equivalent
financial regulatory authority of acts, violations or misconduct similar to any of the
acts, violations or misconduct enumerated previously;

g. Conviction by final judgment of an offense punishable by imprisonment for more

than six years, or a violation of the Corporation Code committed within five years
prior to the date of his election or appointment; and

h. Other grounds as the SEC may provide.

In addition, the following may be grounds for temporary disqualification of a director:

a. Absence in more than 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 dismissal or 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 permanent disqualification
has not yet become final.

Recommendation 2.7

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 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 significant 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 transparency, and in compliance with applicable
laws and regulations to protect the interest of all shareholders. One such measure is the
required ratification by shareholders of material or significant RPTs approved by the
Board, in accordance with existing laws. Other measures include ensuring that
transactions occur at market prices, at arm’s-length basis and under conditions that
protect the rights of all shareholders.

The following are suggestions for the content of the RPT Policy:

• Definition of related parties;

• Coverage of RPT policy;
• Guidelines in ensuring arm’s-length terms;
• Identification and prevention or management of potential or actual
conflicts of interest which arise;
• Adoption of materiality thresholds;
• Internal limits for individual and aggregate exposures;
• Whistle-blowing mechanisms, and
• Restitution of losses and other remedies for abusive RPTs.

In addition, the company is given the discretion to set their materiality threshold at a
level where omission or misstatement of the transaction could pose a significant risk to
the company and influence its economic decision. The SEC may direct a company to
reduce its materiality threshold or amend excluded transactions if the SEC deems that
the threshold or exclusion is inappropriate considering the company’s size, risk profile,
and risk management 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 assessing the
performance of the Management led by the Chief Executive Officer (CEO), and control
functions led by their respective heads (Chief Risk Officer, Chief Compliance Officer, and
Chief Audit Executive).

Explanation

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 It is the responsibility of the Board to appoint a competent management team at all
times, monitor and assess the performance of the management team based on
established performance standards that are consistent with the company’s strategic
objectives, and conduct a regular review of the company’s policies with the management
team. In the selection process, fit and proper standards are to be applied on key
personnel and due consideration is given to integrity, technical expertise and experience
in 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 personnel in carrying out their
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, conflict of interest situations, compensation
program for employees and management 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 management policies and procedures.

Recommendation 2.12

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 The Board should have a Board Charter that formalizes and clearly states its roles,
responsibilities and accountabilities in carrying out its fiduciary duties. The Board
Charter should serve as a guide to the directors in the performance of their functions
and should be publicly available and posted on the company’s website.

Explanation

The Board Charter guides the directors on how to discharge their functions. It provides
the standards for evaluating the performance of the Board. The Board Charter also
contains the roles and responsibilities of the Chairman.

3. ESTABLISHING BOARD COMMITTEES

Principle

Board committees should be set up to the extent possible to support the effective
performance of the Board’s functions, particularly with respect to audit, risk
management, related party transactions, and other key corporate governance concerns,
such as nomination and remuneration. The composition, functions and responsibilities
of all committees established should be contained in a publicly available Committee
Charter.

Recommendation 3.1

The Board should establish board committees that focus on specific board functions to
aid in the optimal performance of its roles and responsibilities.

Explanation

Board committees such as the Audit Committee, Corporate Governance Committee,

Board Risk Oversight Committee and Related Party Transaction Committee are
necessary to support the Board in the effective performance of its functions. The
establishment of the same, or any other committees that the company deems necessary,
allows for specialization in issues and leads to a better management of the Board’s
workload. The type of board committees to be established by a company would depend
on its size, risk profile and complexity of operations. However, if the committees are not
established, the functions of these committees may be carried out by the whole board or
by any other committee.

Recommendation 3.2

The Board should establish an Audit Committee to enhance its oversight capability over
the company’s financial reporting, internal control system, internal and external audit
processes, and compliance with applicable laws and regulations. The committee should
be composed of at least three appropriately qualified non-executive directors, the
majority of whom, including the Chairman, should be independent. All of the members
of the committee must have relevant background, knowledge, skills, and/or experience

16
 in the areas of accounting, auditing and finance. The Chairman of the Audit Committee
should not be the chairman of the Board or of any other committees.

Explanation

The Audit Committee is responsible for overseeing the senior management in

establishing and maintaining an adequate, effective and efficient internal control
framework. It ensures that systems and processes are designed to provide assurance in
areas including reporting, monitoring compliance with laws, regulations and internal
policies, efficiency and effectiveness of operations, and safeguarding of assets.

The Audit Committee has the following duties and responsibilities, among others:

a. Recommends the approval the Internal Audit Charter (IA Charter), which formally
defines the role of Internal Audit and the audit plan as well as oversees the
implementation of the IA Charter;

b. Through the Internal Audit (IA) Department, monitors and evaluates the adequacy
and effectiveness of the corporation’s internal control system, integrity of financial
reporting, and security of physical and information assets. Well-designed internal
control procedures and processes that will provide a system of checks and balances
should be in place in order to (a) safeguard the company’s resources and ensure
their effective utilization, (b) prevent occurrence of fraud and other irregularities,
(c) protect the accuracy and reliability of the company’s financial data, and (d)
ensure compliance with applicable laws and regulations;

c. Oversees the Internal Audit Department, and recommends the appointment and/or
grounds for approval of an internal audit head or Chief Audit Executive (CAE). The
Audit Committee should also approve the terms and conditions for outsourcing
internal audit services;

d. Establishes and identifies the reporting line of the Internal Auditor to enable him to
properly fulfill his duties and responsibilities. For this purpose, he should directly
report to the Audit Committee;

e. Reviews and monitors Management’s responsiveness to the Internal Auditor’s

findings and recommendations;

f. Prior to the commencement of the audit, discusses with the External Auditor the
nature, scope and expenses of the audit, and ensures the proper coordination if
more than one audit firm is involved in the activity to secure proper coverage and
minimize duplication of efforts;

g. Evaluates and determines the non-audit work, if any, of the External Auditor, and
periodically reviews the non-audit fees paid to the External Auditor in relation to the
total fees paid to him and to the corporation’s overall consultancy expenses. The
committee should disallow any non-audit work that will conflict with his duties as
an External Auditor or may pose a threat to his independence3. The non-audit work,
if allowed, should be disclosed in the corporation’s Annual Report and Annual
Corporate Governance Report;

3
As defined under the Code of Ethics for Professional Accountants

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 h. Reviews and approves the Interim and Annual Financial Statements before their
submission to the Board, with particular focus on the following matters:

• Any change/s in accounting policies and practices

• Areas where a significant amount of judgment has been exercised
• Significant adjustments resulting from the audit
• Going concern assumptions
• Compliance with accounting standards
• Compliance with tax, legal and regulatory requirements

i. Reviews the disposition of the recommendations in the External Auditor’s

management letter;

j. Performs oversight functions over the corporation’s Internal and External Auditors.
It ensures the independence of Internal and External Auditors, and that both
auditors are given unrestricted access to all records, properties and personnel to
enable them to perform their respective audit functions;

k. Coordinates, monitors and facilitates compliance with laws, rules and regulations;

l. Recommends to the Board the appointment, reappointment, removal and fees of the
External Auditor, duly accredited by the Commission, who undertakes an
independent audit of the corporation, and provides an objective assurance on the
manner by which the financial statements should be prepared and presented to the
stockholders; and

m. In case the company does not have a Board Risk Oversight Committee and/or
Related Party Transactions Committee, performs the functions of said committees as
provided under Recommendations 3.4 and 3.5.

The Audit Committee meets with the Board at least 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 Board should 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 and Remuneration
Committee. It should be composed of at least three members, all of whom should be
independent directors, including the Chairman.

Explanation

The Corporate Governance Committee (CG Committee) is tasked with ensuring

compliance with and proper observance of corporate governance principles and
practices. It has the following duties and functions, among others:

a. Oversees the implementation of the corporate governance framework and

periodically reviews the said framework to ensure that it remains appropriate in
light of material changes to the corporation’s size, complexity and business strategy,
as well as its business and regulatory environments;

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 b. Oversees the periodic performance evaluation of the Board and its committees as
well as executive management, and conducts an annual self-evaluation of its
performance;

c. Ensures that the results of the Board evaluation are shared, discussed, and that
concrete action plans are developed and implemented to address the identified
areas for improvement;

d. Recommends 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 regularly, 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 business 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 Chairman 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.

Explanation

The establishment of a Board Risk Oversight Committee (BROC) is generally for

conglomerates and companies with a high risk profile.

Enterprise risk management is integral to an effective corporate governance process

and the achievement of a company's value creation objectives. Thus, the BROC has the
responsibility to assist the Board in ensuring that there is an effective and integrated
risk management process in place. With an integrated approach, the Board and top
management will be in a confident position to make well-informed decisions, having
taken into consideration risks related to significant business activities, plans and
opportunities.

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 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
management reports and assesses how the concerned units or offices are addressing
and managing these risks;

c. Evaluates the risk management plan to ensure its continued relevance,

comprehensiveness and effectiveness. The BROC revisits defined risk management
strategies, looks for emerging or changing material exposures, and stays abreast of
significant developments that seriously impact the likelihood of harm or loss;

d. Advises the Board on its risk appetite levels and risk tolerance 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 major impacts on the company;

f. Assesses the probability of each identified risk becoming a reality and estimates 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 risks, 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

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 Examples of companies that may have a separate RPT Committee are conglomerates and
universal/commercial banks in recognition of the potential magnitude of RPTs in these
kinds of corporations.

The following are the functions of the RPT Committee, among others:

a. Evaluates on an ongoing basis existing relations between and among businesses and
counterparties to ensure that all related parties are continuously identified, RPTs
are monitored, and subsequent changes in relationships with counterparties (from
non-related to related and vice versa) are captured. Related parties, RPTs and
changes in relationships should be reflected in the relevant reports to the Board and
regulators/supervisors;

b. Evaluates all material RPTs to ensure that these are not undertaken on more
favorable economic terms (e.g., price, commissions, interest rates, fees, tenor,
collateral requirement) to such related parties than similar transactions with non-
related parties under similar circumstances and that no corporate or business
resources of the company are misappropriated or misapplied, and to determine any
potential reputational risk issues that may arise as a result of or in connection with
the transactions. In evaluating RPTs, the Committee takes into account, among
others, the following:

1. The related party’s relationship to the company and interest in the transaction;
2. The material facts of the proposed RPT, including the proposed aggregate value
of such transaction;
3. The benefits to the corporation of the proposed RPT;
4. The availability of other sources of comparable products or services; and
5. An assessment of whether the proposed RPT is on terms and conditions that are
comparable to the terms generally available to an unrelated party under similar
circumstances. The company should have an effective price discovery system in
place and exercise due diligence in determining a fair price for RPTs;

c. Ensures that appropriate disclosure is made, and/or information is provided to

regulating and supervising authorities relating to the company’s RPT exposures, and
policies on conflicts of interest or potential conflicts of interest. The disclosure
should include information on the approach to managing material conflicts of
interest that are inconsistent with such policies, and conflicts that could arise as a
result of the company’s affiliation or transactions with other related parties;

d. Reports to the Board of Directors on a regular basis, the status and aggregate
exposures to each related party, as well as the total amount of exposures to all
related parties;

e. Ensures that transactions with related parties, including write-off of exposures are
subject to a periodic independent review or audit process; and

f. Oversees the implementation of the system for identifying, monitoring, measuring,

controlling, and reporting RPTs, including a periodic review of RPT policies and
procedures.

Recommendation 3.6

All established committees should be required to have Committee Charters stating in

plain terms their respective purposes, memberships, structures, operations, reporting

21
 processes, resources and other relevant information. The Charters should provide the
standards for evaluating the performance of the Committees. It should also be fully
disclosed on the company’s website.

Explanation

The Committee Charter clearly defines the roles and accountabilities of each committee
to avoid any overlapping functions, which aims at having a more effective board for the
company. This can also be used as basis for the assessment of committee performance.

4. FOSTERING COMMITMENT

Principle

To show full commitment to the company, the directors should devote the time and
attention necessary to properly and effectively perform their duties and responsibilities,
including sufficient time to be familiar with the corporation’s business.

Recommendation 4.1

The directors should attend and actively participate in all meetings of the Board,
Committees, and Shareholders in person or through tele-/videoconferencing conducted
in accordance with the rules and regulations of the Commission, except when justifiable
causes, such as, illness, death in the immediate family and serious accidents, prevent
them from doing so. In Board and Committee meetings, the director should review
meeting materials and if called for, ask the necessary questions or seek clarifications and
explanations.

Explanation

A director’s commitment to the company is evident in the amount of time he dedicates

to performing his duties and responsibilities, which includes his presence in all meetings
of the Board, Committees and Shareholders. In this way, the director is able to
effectively perform his/her duty to the company and its shareholders.

The absence of a director in more than fifty percent (50%) of all regular and special
meetings of the Board during his/her incumbency is a ground for disqualification in the
succeeding election, unless the absence 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 ensures that the members of the board are able
to effectively commit themselves to perform their roles and responsibilities, regularly

22
 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 abreast of the corporation’s
operations and to attend and actively participate during meetings, a maximum board
seat limit of five directorships is recommended.

Recommendation 4.3

A director should notify the Board where he/she is an incumbent director before
accepting a directorship in another company.

Explanation

The Board expects commitment from a director to devote sufficient time and attention
to his/her duties and responsibilities. Hence, it is important that a director notifies
his/her incumbent Board before accepting a directorship in another company. This is
for the company to be able to assess if his/her present responsibilities and commitment
to the company will be affected and if the director can still adequately provide what is
expected of him/her.

5. REINFORCING BOARD INDEPENDENCE

Principle

The board should endeavor to exercise an objective and independent judgment on all
corporate affairs.

Recommendation 5.1

The Board should have at least three independent directors, or such number as to
constitute at least one-third of the members of the Board, whichever is higher.

Explanation

The presence of independent directors in the Board is to ensure the exercise of

independent judgment on corporate affairs and proper oversight of managerial
performance, including prevention of conflict of interests and balancing of competing
demands of the corporation. There is increasing global recognition that more
independent directors in the Board lead to more objective decision-making, particularly
in conflict of interest situations. In addition, experts have recognized that there are
varying opinions on the optimal number of independent directors in the board.
However, the ideal number ranges from one-third to a substantial majority.

Recommendation 5.2

The Board should ensure that its independent directors possess the necessary
qualifications and none of the disqualifications for an independent director to hold the
position.

Explanation

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Independent directors need to possess a good general understanding of the industry
they are in. Further, it is worthy to note that independence and competence should go
hand-in-hand. It is therefore important that the non-executive directors, including
independent directors, possess 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 company unless
there has been a change in the controlling ownership of the company;

b. Is not, and has not been in the three years immediately preceding the election, a
director of the covered company; a director, officer, employee of the covered
company’s subsidiaries, associates, affiliates or related companies; or a director,
officer, employee of the covered company’s substantial shareholders and its related
companies;

c. Has not been appointed in the covered company, its subsidiaries, associates,
affiliates or related companies as Chairman “Emeritus,” “Ex-Officio”
Directors/Officers or Members of any Advisory Board, or otherwise appointed in a
capacity to assist the Board in the performance of its duties and responsibilities
within three years immediately preceding his election;

d. Is not an owner of more than two percent (2%) of the outstanding shares of the
covered company, its subsidiaries, associates, affiliates or related companies;

e. Is not a relative of a director, officer, or substantial shareholder of the covered

company or any of its related companies or of any of its substantial shareholders.
For this purpose, relatives include spouse, parent, 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. Is 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 or dealer;

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
Management and free from any business or other relationship within the three years
immediately preceding the date of his election;

i. 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;

24
 j. Is not affiliated with any non-profit organization that receives significant funding
from the covered company or any of its related companies or substantial
shareholders; and

k. Is not employed as an executive officer of another company where any of the

covered company’s executives serve as directors.

Related companies, as used in this section, refer to (a) the covered entity’s
holding/parent company; (b) its subsidiaries; and (c) subsidiaries of its holding/parent
company.

Recommendation 5.3

The Board’s independent directors should serve for a maximum cumulative term of nine
years. After which, the independent director should be perpetually barred from re-
election as such in the same company, but may continue to qualify for nomination and
election as a non-independent director. In the instance that a company wants to retain
an independent director who has served 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 term of nine years. Independent 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 of 2011.

Any term beyond nine years for an ID is subjected to particularly 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 has served for nine years. In such
instances, the Board must provide a meritorious justification for the re-election.

Recommendation 5.4

The positions of Chairman of the Board and Chief Executive Officer should be held by
separate individuals and each should have clearly defined responsibilities.

Explanation

To avoid conflict or a split board and to foster an appropriate balance of power,

increased accountability and better capacity for independent decision-making, it is
recommended that the positions of Chairman and Chief Executive Officer (CEO) be held
by different individuals. This type of organizational structure facilitates effective
decision making and good governance. In addition, the division of responsibilities and
accountabilities between the Chairman and CEO is clearly defined and delineated and
disclosed in the Board Charter.

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 The CEO has the following roles and responsibilities, 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 purpose;

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 interfaces between the Board and
the employees;

h. Builds the corporate culture and motivates the employees of the corporation; and

i. Serves as the link between internal operations and external stakeholders.

The roles and responsibilities of the Chairman are provided under Recommendation 2.3.

Recommendation 5.5

The Board should designate a lead director among the independent directors if the
Chairman of the Board is not independent, including if the positions of the Chairman of
the Board and Chief Executive Officer are held by one person.

Explanation

In cases where the Chairman is not independent and where the roles of Chair and CEO
are combined, putting in place proper mechanisms ensures independent views and
perspectives. More importantly, it avoids the abuse of power and authority, and
potential conflict of interest. A suggested mechanism is the appointment of a strong
“lead director” among the independent directors. This lead director has sufficient
authority to lead the Board in cases where management has clear conflicts of interest.

The functions of the lead director include, among others, the following:

a. Serves as an intermediary between the Chairman and the other directors when
necessary;
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

26
 A director with a material interest in any transaction affecting the corporation should
abstain from taking part in the deliberations for the same.

Explanation

The abstention of a director from participating in a meeting when related party

transactions, self-dealings or any transactions or matters on which he/she has a
material interest are taken up ensures that he has no influence over the outcome of the
deliberations. The fundamental principle to be observed is that a director does not use
his position to profit or gain some benefit or advantage for his himself and/or his/her
related interests.

Recommendation 5.7

The non-executive directors (NEDs) should have separate periodic meetings with the
external auditor and heads of the internal audit, compliance and risk functions, without
any executive directors present to ensure that proper checks and balances are in place
within the corporation. The meetings should be chaired by the lead independent
director.

Explanation

NEDs are expected to scrutinize Management’s performance, particularly in meeting the

companies’ goals and objectives. Further, it is their role to satisfy themselves on the
integrity of the corporation’s internal control and effectiveness of the risk management
systems. This role can be better performed by the NEDs if they are provided access to
the external auditor and heads of the internal audit, compliance and risk functions, as
well as to other key officers of the company without any executive directors present.
The lead independent director should lead and preside over the meeting.

6. ASSESSING BOARD PERFORMANCE

Principle

The best measure of the Board’s effectiveness is through an assessment process. The
Board should regularly carry out evaluations to appraise its performance as a body, and
assess whether it possesses the right mix of backgrounds and competencies.

Recommendation 6.1

The Board should conduct an annual self-assessment of its performance, including the
performance of the Chairman, individual members and committees. Every three years,
the assessment should be supported by an external facilitator.

Explanation

Board assessment helps the directors to thoroughly review their performance and
understand their roles and responsibilities. The periodic review and assessment of the
Board’s performance as a body, the board committees, the individual directors, and the
Chairman show how the aforementioned should perform their responsibilities
effectively. In addition, it provides a means to assess a director’s attendance at board
and committee meetings, participation in boardroom discussions and manner of voting
on material issues. The use of an external facilitator in the assessment process increases

27
 the objectivity of the same. The external facilitator can be any independent third party
such as, but not limited to, a consulting firm, academic institution or professional
organization.

Recommendation 6.2

The Board should have in place a system that provides, at the minimum, criteria and
process to determine the performance of the Board, the individual directors, committees
and such system should allow for a feedback mechanism from the shareholders.

Explanation

Disclosure of the criteria, process and collective results of the assessment ensures
transparency and allows shareholders and stakeholders to determine if the directors are
performing their responsibilities to the company. Companies are given the discretion to
determine the assessment criteria and process, which should be based on the mandates,
functions, roles and responsibilities provided in the Board and Committee Charters. In
establishing the criteria, attention is given to the values, principles and skills required
for the company. The Corporate Governance Committee oversees the evaluation
process.

7. STRENGTHENING BOARD ETHICS

Principle

Members of the Board are duty-bound to apply high ethical standards, taking into
account the interests of all stakeholders.

Recommendation 7.1

The Board should adopt a Code of Business Conduct and Ethics, which would provide
standards for professional and ethical behavior, as well as articulate acceptable and
unacceptable conduct and practices in internal and external dealings. The Code should
be properly disseminated to the Board, senior management and employees. It should
also be disclosed and made available to the public through the company website.

Explanation

A Code of Business Conduct and Ethics formalizing ethical values is an important tool to
instill an ethical corporate culture that pervades throughout the company. The main
responsibility to create and design a Code of Conduct suitable to the needs of the
company and the culture by which it operates lies with the Board. To ensure proper
compliance with the Code, appropriate orientation and training of the Board, senior
management and employees on the same are necessary.

Recommendation 7.2

The Board should ensure the proper and efficient implementation and monitoring of
compliance with the Code of Business Conduct and Ethics and internal policies.

Explanation

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 The Board has the primary duty to make sure that the internal controls are in place to
ensure the company’s compliance with the Code of Business Conduct and Ethics and its
internal policies and procedures. Hence, it needs to ensure the implementation of said
internal controls to support, promote and guarantee compliance. This includes efficient
communication channels, which aid and encourage employees, customers, suppliers and
creditors to raise concerns on potential unethical/unlawful behavior without fear of
retribution. A company’s ethics policy can be made effective and inculcated in the
company culture through a communication and awareness campaign, continuous
training to reinforce the code, strict monitoring and implementation and setting in place
proper avenues where issues may be raised and addressed without fear of retribution.

DISCLOSURE AND TRANSPARENCY

8. ENHANCING COMPANY DISCLOSURE POLICIES AND PROCEDURES

Principle 8

The company should establish corporate disclosure policies and procedures that are
practical and in accordance with best practices and regulatory expectations.

Recommendation 8.1

The Board should establish corporate disclosure policies and procedures to ensure a
comprehensive, accurate, reliable and timely report to shareholders and other
stakeholders that gives a fair and complete picture of a company’s financial condition,
results and business operations.

Explanation

Setting up clear policies and procedures on corporate disclosure that comply with the
disclosure requirement as provided in Rule 68 of the Securities Regulation Code (SRC),
Philippine Stock Exchange Listing and Disclosure Rules, and other regulations such as
those required by the Bangko Sentral ng Pilipinas, is essential for comprehensive and
timely reporting.

Recommendation 8.2

The Company should have a policy requiring all directors and officers to disclose/report
to the company any dealings in the company’s shares within three business days.

Explanation

Directors often have access to material inside information on the company. Hence, to
reduce the risk that the directors might take advantage of this information, it is crucial
for companies to have a policy requiring directors to timely disclose to the company any
dealings with the company shares. It is emphasized that the policy is on internal

29
 disclosure to the company of any dealings by the director in company shares. This
supplements the requirement 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 experience 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
attended 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 disclose the
remuneration on an individual basis, including termination and retirement provisions.

Explanation

Disclosure of remuneration policies and procedure enables investors to understand the

link between the remuneration paid to directors and key management personnel and
the company’s performance.

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 and 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 all shareholders. The said disclosure

30
 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 public of
every material fact or event that occurs, particularly on the acquisition or disposal of
significant assets, which could adversely affect the viability or the interest of its
shareholders and other stakeholders. Moreover, the Board of the offeree company
should appoint an independent party to evaluate the fairness of the transaction price on
the acquisition or disposal of assets.

Explanation

The disclosure on the acquisition or disposal of significant assets includes, among

others, the rationale, effect on operations and approval at board meetings with
independent directors present to establish transparency and independence on the
transaction. The independent evaluation of the fairness of the transparent price ensures
the protection of the rights of shareholders.
Recommendation 8.7

The company’s corporate governance policies, programs and procedures should be

contained in its Manual on Corporate Governance, which should be submitted to the
regulators and posted on the company’s website.

Explanation

Transparency is one of the core principles of corporate governance. To ensure the better
protection of shareholders and other stakeholders’ rights, full disclosure of the
company’s corporate governance policies, programs and procedures is imperative. This
is better done if the said policies, programs and procedures are contained in one
reference document, which is the Manual on Corporate Governance. The submission of
the Manual to regulators and posting it in companies’ websites ensure easier access by
any interested party.

9. STRENGTHENING THE EXTERNAL AUDITOR’S INDEPENDENCE AND IMPROVING

AUDIT QUALITY

Principle 9

The company should establish 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.

Recommendation 9.1

The Audit Committee should have a robust process for approving and recommending
the appointment, reappointment, removal, and fees of the external auditor. The
appointment, reappointment, removal, and fees of the external auditor should be
recommended by the Audit Committee, approved by the Board and ratified by the
shareholders. For removal of the external auditor, the reasons for removal or change
should be disclosed to the regulators and the public through the company website and
required disclosures.

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Explanation

The appointment, reappointment and removal of the external auditor by the Board’s
approval, through the Audit Committee’s recommendation, and shareholders’
ratification at shareholders’ meetings are actions regarded as good practices.
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 auditors 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 requirements. 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 Charter includes a disclosure of its responsibility on assessing the
integrity and independence of the external auditor. It establishes detailed guidelines,
policies and procedures that are contained in a separate memorandum or document.
Nationally and internationally recognized best practices and standards of external
auditing guide the committee in formulating these policies and procedures.

Moreover, establishing effective communication with the external auditor and requiring
them to report all relevant matters help the Audit Committee to efficiently carry out its
oversight responsibilities.

Recommendation 9.3

The company should disclose the nature of non-audit services performed by its external
auditor in the Annual Report to deal with the potential conflict of interest. The Audit
Committee should be alert for any potential conflict of interest situations, given the
guidelines or policies on non-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 mitigate 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
issuances.

32
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 CHAPTER 4
SEC CODE OF CORPORATE GOVERNANCE, CONTINUED

10. INCREASING FOCUS ON NON-FINANCIAL AND SUSTAINABILITY

REPORTING

Principle 10
The company should ensure that the material and reportable non-financial and
sustainability issues are disclosed.

Recommendation 10.1
The Board should have a clear and focused policy on the disclosure of non-financial
information, with emphasis on the management of economic, environmental, social, and
governance (EESG) issues of its business, which underpin sustainability. Companies
should adopt a globally recognized standard/framework in reporting sustainability and
non-financial issues.

Explanation
As external pressures including resource scarcity, globalization, and access to
information continue to increase, the way corporations respond to sustainability
challenges, in addition to financial challenges, determines their long-term viability and
competitiveness. One way to respond to sustainability challenges is disclosure to all
shareholders and other stakeholders of the company's strategic (long-term goals) and
operational objectives (short-term goals), as well as the impact of a wide range of
sustainability issues.

Disclosures can be made using standards/frameworks, such as the G4 Framework by the

Global Reporting Initiative (GRI), the Integrated Reporting Framework by the
International Integrated Reporting Council (IIRC), and/or the Sustainability Accounting
Standards Board (SASB)'s Conceptual Framework.

11. PROMOTING A COMPREHENSIVE AND COST-EFFICIENT ACCESS TO

RELEVANT INFORMATION

Principle 11
The company should maintain a comprehensive and cost-efficient communication
channel for disseminating relevant information. This channel is crucial for informed
decision-making by investors, stakeholders, and other interested users.
Recommendation 11.1
The company should include media and analysts' briefings as channels of communication
to ensure the timely and accurate dissemination of public, material, and relevant
information to its shareholders and other investors.

Explanation
The manner of disseminating relevant information to its intended users is as important as
the content of the information itself. Hence, it is essential for the company to have a
strategic and well-organized channel for reporting. These communication channels can
provide timely and up-to-date information relevant to investors' decision-making, as well
as to other interested stakeholders.

INTERNAL CONTROL SYSTEM AND RISK MANAGEMENT FRAMEWORK

12. STRENGTHENING THE INTERNAL CONTROL SYSTEM AND ENTERPRISE

RISK MANAGEMENT FRAMEWORK

Principle 12
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.

Recommendation 12.1
The Company should have an adequate and effective internal control system and an
enterprise risk management framework in the conduct of its business, taking into account
its size, risk profile, and complexity of operations.

Explanation
An adequate and effective internal control system and an enterprise risk management
framework help sustain safe and 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 and 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
company policies. It helps the company accomplish its objectives by bringing a
systematic, disciplined approach to evaluating and improving the effectiveness of the
company's governance, risk management, and control functions. The following are the
functions of the internal audit, 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 (1) promoting the right values and ethics, (2)
ensuring effective performance management and accounting in the organization,
(3) communicating risk and control information, and (4) coordinating the
activities and information among the Board, external and internal auditors, and
Management;

b. Performs regular and special audit as contained in the annual audit plan and/or
based on the company's risk assessment;

c. Performs consulting and advisory services related to governance and control as

appropriate for the organization:

d. Performs compliance audit of relevant laws, rules and regulations, contractual

obligations and other commitments, 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 be 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) appointed by the Board. The CAE shall oversee
and be responsible for the internal audit activity of the organization, including that
portion that is outsourced to a third party service provider. In case of a fully outsourced
internal audit activity, a qualified independent executive or senior management personnel
should be assigned the responsibility for managing the fully outsourced internal audit
activity.

Explanation
The CAE in order to achieve the necessary independence to fulfill his/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 the
organization'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 management 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:

b. Identifying and analyzing key risks exposure relating to economic, environmental,

social and governance (EESG) factors and the achievement of the organization's
strategic objectives.

c. Evaluating and categorizing each identified risk using the company's predefined
risk categories and parameters;

d. Establishing a risk register with clearly defined, prioritized, and residual risk;

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 significant risk exposures including business risks

(ie., strategic, compliance, operational, financial, and reputational risks), control
issues 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
responsibilities, 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;

c. Collaborates with the CEO in updating and making recommendations to the

Board Risk Oversight Committee.

d. Suggests ERM policies and related guidance, as may be needed; and

e. Provides insights on the following:

• Risk management processes are performing as intended;

• Risk measures reported are continuously reviewed by risk owners for
effectiveness; and
• Established risk policies and procedures are being complied with.

There should be clear communication between the Board Risk Oversight Committee and
the CRO.

CULTIVATING A SYNERGIC RELATIONSHIP WITH SHAREHOLDERS

13. PROMOTING SHAREHOLDER RIGHTS

Principle 13
The company should treat all shareholders fairly and equitably, and also recognize,
protect and facilitate the exercise of their rights.

Recommendation 13.1
The Board should ensure that basic shareholder rights are disclosed in the Manual on
Corporate Governance and on the company's website.

Explanation
It is the responsibility of the Board to adopt a policy informing the shareholders of all
their rights. Shareholders are encouraged to exercise their rights by providing clear-cut
processes and procedures for them to follow.

Shareholders' rights relate to the following, among others:

▪ Dividend policies;
▪ Pre-emptive rights;
▪ Right to propose the holding of meetings and to include agenda items ahead of the
scheduled Annual Special Shareholders' Meeting:
 ▪ Right to nominate candidates to the Board of Directors;
▪ Nomination process; and
▪ Voting procedures that would govern the Annual and Special Shareholders'
Meeting.

The right to propose the holding of meetings and items for inclusion in the agenda is
given to all shareholders, including minority and foreign shareholders. However, to
prevent the abuse of this right, companies may require that the proposal be made by
shareholders holding a specified percentage of shares or voting rights. On the other hand,
to ensure that minority shareholders are not effectively prevented from exercising this
right, the degree of ownership concentration is 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 procedures 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 to enable the shareholders to study and conduct their own
background check as to the candidates' qualification and credibility.

Shareholders are also encouraged to participate when given sufficient information prior
to voting on fundamental corporate changes such as: (1) amendments to the Articles of
Incorporation and By-Laws of the company; (2) the authorization on the increase in
authorized capital stock; and (3) extraordinary transactions, including the transfer of all
or substantially all assets that in effect result in the sale of the company. In addition, the
disclosure and clear explanation of the voting procedures, as well as removal 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.

Recommendation 13.2
The Board should encourage active shareholder participation by sending the Notice of
Annual and Special Shareholders' Meeting with sufficient and relevant information at
least 28 days before the meeting.

Explanation
 Required information in the Notice include, among others, the date, location, meeting
agenda and its rationale and explanation, and details of issues to be deliberated on and
approved or ratified at the meeting. Sending the Notice in a timely manner allows
shareholders to plan their participation in the meetings. It is good practice to have the
Notice sent to all shareholders at least 28 days before the meeting and posted on the
company website.

Recommendation 13.3
The Board should encourage active shareholder participation by making the result of the
votes taken during the most recent Annual or Special Shareholders' Meeting publicly
available the next working day. In addition, the Minutes of the Annual and Special
Shareholders’ Meeting should be available on the company website within five business
days from the end of the meeting.

Explanation
Voting results include a breakdown of the approving and dissenting votes on the
matters raised during the Annual or Special Stockholders' Meeting. When a substantial
number of votes have been cast against a proposal made by the company, it may make
an analysis of the reasons for the same and consider having a dialogue with its
shareholders.

The Minutes of Meeting include the following matters: (1) A description of the voting
and the vote tabulation procedures used; (2) the opportunity given to shareholders to
ask questions, as well as a record of the questions and the answers received; (3) the
matters discussed and the resolutions reached;(4) a record of the voting results for each
agenda item; (5) a list of the directors, officers, and shareholders who attended the
meeting; and (6) dissenting opinion on any agenda item that is considered significant in
the discussion process.

Recommendation 13.4
The Board should make available, at the option of a shareholder, an alternative dispute
mechanism to resolve intra-corporate disputes in an amicable and effective manner. This
should be included in the company’s Manual on Corporate Governance.

Explanation
It is important for the shareholders to be well-informed of the company's processes and
procedures when seeking to 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 shareholders. The IRO should be present at every shareholders'
meeting.

Explanation
Setting up an avenue to receive feedback, complaints, and queries from shareholders
assure their active participation with regard to activities and policies of the company. The
IRO has a designated investor relations officer, email address, and telephone number.
Further, creating an Investor Relations Program ensures that all information regarding the
activities of the company are properly and timely communicated to shareholders.

DUTIES TO STAKEHOLDERS

14. RESPECTING RIGHTS OF STAKEHOLDERS AND EFFECTIVE -REDRESS FOR

VIOLATION OF STAKEHOLDER'S RIGHTS

Principle 14
The rights of stakeholders established by law, by contractual relations, and through
voluntary commitments must be respected. Where stakeholders' rights and/or interests are
at stake, stakeholders should have the opportunity to obtain prompt effective redress for
the violation of their rights.

Recommendation 14.1
The Board should identify the company's various stakeholders and promote cooperation
between them and the company in creating wealth, growth, and sustainability.

Explanation
Stakeholders in corporate governance include, but are not limited to, customers,
employees, suppliers, shareholders, investors, creditors, the community the company
operates in, society, the government, regulators, competitors, external auditors, etc. In
formulating the company's strategic and operational decisions affecting its wealth,
growth, and sustainability, due consideration is given to those who have an interest in the
company and are directly affected by its operations.

Recommendation 14.2
The Board should establish clear policies and programs to provide a mechanism on the
fair treatment and protection of stakeholders.
Explanation
In instances when stakeholders' interests are not legislated, companies' voluntary
commitments ensure the protection of the stakeholders’ rights. The company's Code of
Conduct ideally includes provisions on the company's policies and procedures on dealing
with various stakeholders. The company's stakeholders include its customers, resource
providers, creditors, and the community in which it operates. Fair, professional, and
objective dealings as well as clear, timely and regular communication with the various
stakeholders ensure their fair treatment and better protection of their rights.

Recommendation 14.3
The Board should adopt a transparent framework and process that allow stakeholders to
communicate with 1the company and to obtain redress for the violation of their rights.

Explanation
The company's stakeholders play a role in its growth and long-term viability. As such, it
is crucial for the company to maintain open and easy communication with its
stakeholders. This can be done through stakeholder engagement touchpoints in the
company, such as the Investor Relations Office, Office of the Corporate Secretary,
Customer Relations Office, and Corporate Communications Group.

15. ENCOURAGING EMPLOYEES' PARTICIPATION

Principle 15
A mechanism for employee participation should be developed to create a symbiotic
environment, realize the company's goals and participate in its corporate governance
processes.

Recommendation 15.1
The Board should establish policies, programs, and procedures that encourage employees
to actively participate in the realization of the company's goals and in its governance.

Explanation
The establishment of policies and programs covering among others, the following: (1)
health and safety welfare; (2) training and development; and (3) reward/compensation for
employees, encourages employees to perform better and motivates them to take a more
dynamic role in the corporation. Active participation is further fostered when the
company recognizes the firm-specific skills of its employees and their potential
contribution in corporate governance. The employees' viewpoint in certain key decisions
may also be considered in governance processes through work councils or employee
representation in the board.
Recommendation 15.2
The Board should set the tone and make a stand against corrupt practices by adopting an
anti-corruption policy and program in its Code of Conduct. Further, the Board should
disseminate the policy and program to employees across the organization through
trainings to embed them in the company's culture.

Explanation
The adoption of an anti-corruption policy and program endeavors to mitigate corrupt
practices such as, but not limited to, bribery, fraud, extortion, collusion, conflict of
interest, and money laundering. This encourages employees to report corrupt practices
and outlines procedures on how to combat, resist and stop these corrupt practices. Anti-
corruption programs are more effective when the Board sets the tone and leads the
company in their execution.

Recommendation 15.3
The Board should establish a suitable framework for whistleblowing that allows
employees to freely communicate their concerns about illegal or unethical practices,
without fear of retaliation and to have direct access to an independent member of the
Board or a unit created to handle whistleblowing concerns. The Board should be
conscientious in establishing the framework, as well as in supervising and ensuring its
enforcement.

Explanation
A suitable whistleblowing framework sets up the procedures and safe harbors for
complaints of employees, either personally or through their representative bodies,
concerning illegal and unethical behavior. One essential aspect of the framework is the
inclusion of safeguards to secure the confidentiality of the informer and to ensure
protection from retaliation. Further, part of the framework is granting individuals or
representative bodies confidential direct access to either an independent director or a unit
designed to deal with whistle blowing concerns. Companies may opt to establish an
ombudsman to deal with complaints and/or established confidential phone and e-mail
facilities to receive allegations.

16. ENCOURAGING SUSTAINABILITY AND SOCIAL RESPONSIBILITY

Principle 16
The company should be socially responsible in all its dealings with the communities
where it operates. It should ensure that its interactions serve its environment and
 stakeholders in a positive and progressive manner that is fully supportive of its
comprehensive and balanced development.

Recommendation 16.1
The company should recognize and place an importance on the interdependence between
business and society and promote a mutually beneficial relationship that allows the
company to grow its business, while contributing to the advancement of the society
where it operates.

Explanation
The company's value chain consists of inputs to the production process, the production
process itself and the resulting output. Sustainable development means that the company
not only complies with existing regulations, but also voluntarily employs value chain
processes that takes into consideration economic, environmental, social and governance
issues and concerns. In considering sustainability concerns. the company plays an
indispensable role alongside the government and civil society in contributing solutions to
complex global challenges like poverty, inequality, unemployment and climate change.

Updates on Corporate Governance

On February 7,2021 the Philippine Star, Business Section published a report of Iris Gonzales
entitled “Ayala Land scores High in Corporate Governance". The report goes...

"Ayala Land Inc. (ALI) made it to the list of top listed companies with high scores in corporate
governance.

ALI was again recognized for "outstanding corporate governance practices” by the Securities and
Exchange Commission (SEC) and the Institute of Corporate Directors.

"Reflecting its strong and consistent adherence to good corporate governance practices, ALI is part
of the prestigious ASEAN Asset Class PLCs that scored a minimum of 97.5 points in the scorecard.
Together with Ayala Land and Globe, Ayala Corp, and BPI were also recognized for this honor,"
the ASEAN Capital Markets Forum (AMF) said.

ALI ranked among the Top 3 publicly listed companies (PLCs) in the Philippines and Top 20 in
the ASEAN region based on the 2019 ASEAN Corporate Governance Scorecard Assessment of
AMCF, which was organized in partnership the Asian Development Bank (ADB).

"This award is very meaningful to our company, especially since good corporate governance has
always been integral to the way we do business and has been a pillar in executing our plans,” said
ALI president and CEO Bernard Vincent Dy.
With the onset of COVID-19, its importance is highlighted now more than ever as we pivoted to
adapt to this 'next normal'," Dy Said.

ACMF and ADB jointly developed the ASEAN Corporate Governance Scorecard as an assessment
based on publicly available information and benchmarked against international best practices on
corporate governance.

This is part of efforts to promote regional integration and the ASEAN region as an asset class.

This is supported by a rigorous methodology developed by corporate governance experts across

the region to assess the corporate governance standing and performance of publicly-listed
companies in the six participating ASEAN member countries namely Indonesia, Malaysia,
Philippines, Singapore, Thailand, and Vietnam.

ALI has consistently ranked among the leading companies in the scorecard through the years as it
continues to practice good corporate governance in compliance with its own corporate governance
manual, the code of corporate governance and all listing rules of the Philippine Stock Exchange,
the Philippine Dealing Exchange Corp. and the SEC.”

Philippine Inquirer, February 15, 2021

"SM companies receive 10 top awards on corporate governance"

SM Investments Corp. (SMIC) and its subsidiaries clinched 10 awards for scoring high in the
recently concluded 2019 Asean Corporate Governance Scorecard (ACGS) assessments.

For the 2019 ACGS Assessment, three award categories were recognized: Top 20 Asean Publicly
Listed Companies, Asean Asset Class Award and Top 3 Publicly Listed Companies per Country.

Under the Asean Asset Class Award, cited were SMIC, SM Prime Holdings, Inc. (SM Prime),
2GO Group, Inc., BDO Unibank, Inc., Belle Group., China Banking Corp. (China Bank) and
Premium Leisure Corp.

China Bank and SM Prime were named under Top 20 Asean Publicly Listed Companies. China
Bank was recognized among the Top 3 Publicly Listed Companies per Country.

The Asean Capital Markets Forum in partnership with the Asian Development Bank have jointly
developed the ACGS, an assessment based on publicly available information and benchmarked
against international best practices on corporate governance.
Through the years, the ACGS has been a driving force in underpinning good corporate governance
practices among publicly listed companies.
CHAPTER 5: INTRODUCTION TO ETHICS

Expected Learning Outcomes:

1. Define Ethics.
2. Enumerate and describe the basic characteristics and values associated with ethical behavior.
3. Appreciate why ethical behavior in personal, professional and business dealings is necessary,
4. Understand the reasons why people act unethically.
5. Give and explain 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 professional ethics is important and why a code of conduct should be adopted

INTRODUCTION

Ethics can be defined broadly as a set of moral principles or values that govern the actions 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 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 forms 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 ethics 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 attention is
an indication of both the importance of ethical behavior to maintaining a civil society, and a significant
number of notable 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 that determine ethical behavior, it is unlikely that they will agree on the relative
importance of each principle. These differences result from all of our life experiences. Parents, teachers,
friends and employers are known to influence our values, but so do television, team sports, life
successes and failures, and thousands of other experiences.

CHARACTERISTICS AND VALUES ASSOCIATED WITH ETHICAL BEHAVIOR

The following list of ethical principles incorporates the characteristics and values that most people
associate with ethical behavior:

1. Integrity

Be principled, honorable, upright, courageous and act on convictions; do not be twofaced or

unscrupulous, or adopt an end-justifies-the means philosophy that ignores principle.

2. Honesty

Be truthful, sincere, forthright, straightforward, frank, candid; do not cheat, steal, lie, deceive or act
deviously.

3. 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 unreasonably technical or legalistic manner in order to
rationalize noncompliance or create excuses and justification for breaking commitments.

Loyalty (Fidelity) and Confidentiality

Be faithful and loyal to family, friends, employers, client and country; do not use or disclose information
learned in confidence; in a professional context, safeguard the influences and conflicts of interest.

4. Fairness and Openness

Be fair and open-minded, be willing to admit error and, where appropriate, change positions and beliefs,
demonstrate a commitment to justice, the equal treatment of individuals, and tolerance for acceptance
of diversity; do not overreach or take advantage of another's mistakes or diversities.

5. Caring for Others

Be caring, kind, and compassionate; share, be giving, be of service to others; help those in need and
avoid harming others.

6. Respect for Others

Demonstrate respect for human dignity, privacy, and the right to self- determination of all people; be
courteous, prompt, and decent; provide others with the information they need to make informed
decisions about their own lives; do not patronize, embarrass, or demean.

7. Responsible Citizenship

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 that others have
all the information they need to make intelligent choices and exercise their rights.

8. Pursuit of Excellence

Pursue excellence in all matters; in 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 mediocrity; do
not "win at any cost".

9. Accountability

Be accountable, accept responsibility for decisions, 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.
WHY IS ETHICAL BEHAVIOR NECESSARY?

Ethical behavior is necessary for a society to function in an orderly manner. It can be argued that ethics is
the glue that holds a society together. What would happen if for example we could not depend on the
people we deal with to be honest. If parents, teachers, employees, siblings, co-workers and friends all
consistently lied, it would be almost impossible for effective communication to occur.

The need for ethics in society is sufficiently important that many commonly held ethical values are
incorporated into laws. For example, laws dealing with driving while intoxicated and selling drugs
concern responsible citizenship and respect for other. Similarly, if a company sells a defective product, it
can be held accountable if harmed parties choose to sue throughout the legal system.

A considerable portion of the ethical values of a society cannot be incorporated 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 more 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.

Business decisions influence employees, customers, suppliers and competitors, while company
operations affect communities, governments and the environment.

WHY DO PEOPLE ACT UNETHICALLY?

Most people define unethical behavior as conduct that differs from the way they believe would have
been appropriate given the circumstances. Each of us decides for ourselves what we consider unethical
behavior, both for ourselves and other. It is important to understand what causes people to act in a
manner that we decide is unethical.

There are two primary reasons why people act unethically:

1. the person's ethical standards are different from those of society as a whole, or

2. the person chooses to act selfishly.

In many instances, both reasons exist.

1. Person's Ethical Standards differ from General Society

Extreme 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 apprehended, because
their ethical standards differ from those of society remorse when they are 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 decided that this behavior is ethical and acceptable, there is a conflict of ethical values that is
unlikely to be resolved.

2. The Person Chooses to Act Selfishly

A considerable portion of unethical behavior results from selfish behavior. The Pork Barrel Scam and the
other political scandals resulted from the desire for political power and wealth; cheating on tax returns
and expense reports is motivated by financial greed; performing below one's competence and cheating
on tests are typically due to laziness. In each case, the person knows that the behavior is inappropriate,
but chooses to do it anyway because of the personal sacrifice needed to act ethically.

CATEGORIES OF ETHICAL PRINCIPLES

Principles of Personal Ethics include among others

• Basic justice, fairness

• Respect for the right of others
• Concern for the right of others
• Concern for the well-being on welfare of others
• Benevolence, trustworthiness, honesty
• Compliance with the law
Professional Ethics include among others

• Integrity, impartiality, objectivity

• Professional competence
• Confidentiality
• Professional behavior
• Avoidance of potential or apparent conflict of interest

Business Ethics include among others

• Fair competition
• Global as well as domestic justice
• Social responsibility
• Concern for environment

The focus of this book is on 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 as opposed 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 recognition in recent decades.
All the recognized professions have several common characteristics. The most important of
these characteristics are:
(1) 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
Careless work or lack of integrity of a professional may lead the public to a negative view toward
the entire profession. All professionals must have public confidence of the public to be
successful. Consequently, the members of the different professions act in unison by deriving
their respective code of conduct.

Code of Good Governance for the Profession in the Philippines (E.O. No. 220, June 23,
2003)
This Code is adopted by the Professional Regulation Commission (PRC) and the 42 Professional
Regulatory Boards to cover an environment of good governance in which all Filipino
professionals shall perform their tasks. While each profession may adopt and enforce its own
code of good governance and code of ethics, it is generally recognized that there is a general
commonality among the various codes. This Code which covers the common principles
underlying the codes of various professions could be used by all professionals who face critical
ethical questions in their work.
General Principle of Professional Conduct
Professionals are required not only to have an ethical commitment, a personal resolve to act
ethically, but also have both ethical awareness and ethical competency. Ethical awareness refers
to the ability to discern between right and wrong, while ethical competency pertains to the
ability to engage in sound moral reasoning and consider carefully the implications of alternative
actions.
Specific Principle of Professional Conduct
1. Service to Others
Professionals are committed to a life of service to others. They protect life, property, and public
welfare. To serve others, they 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 maintain and broaden public confidence, professionals shall perform their responsibilities
with the highest sense of integrity and imbued with nationalism and spiritual values. In the
performance of any professional service, they shall at all times, main objectivity, be free of
conflicts of interest, and refrain from engaging in any activity that would prejudice their abilities
to carry out their duties ethically. They shall avoid making any representation that would likely
cause a reasonable person to misunderstand or to be deceived.
3. Professional Competence
In providing professional services, a certain level of competence is necessary, i.e., knowledge,
technical skills, attitudes, and experience. Professionals shall, therefore, undertake only those
professional services that they can reasonably deliver with professional competence. Corollary
to this, it is their express obligation to keep up with new knowledge and techniques in their field,
continually improve their skills and upgrade their level of competence and take part in a lifelong
continuing education program.
4. Solidarity and Teamwork
Each profession shall nurture and support one organization for all its members. Though a deep
spirit of solidarity, each member should put the broader interest of the profession above one's
personal ambition and preference. Through teamwork within a cohesive professional
organization, each member shall effectively observe ethical practices and pursue continuing
professional development as well as deepen one's social and civic responsibility.
5. Social and Civic Responsibility
Professionals shall always carry out their professional duties with due consideration of the
broader interest of the public. They shall, therefore, serve their clients/employers and the
publics with professional concern and in a manner consistent with their responsibilities to
society. As responsible Filipino citizens, they shall actively contribute to the attainment of the
country's national objectives.
6. Global Competitiveness
Every professional shall remain open to challenges of a more dynamic interconnected world. He
or she shall rise up to global standards and maintain levels of professional practices fully aligned
with global best
practices.
7. Equality of All Professions
All professionals shall treat their colleagues with respect 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 o society. In the eyes of the PRC, all professions are equal and,
therefore, important, yet distinct, service every one shall treat one other professionals with
respect and fairness.
Examples of Code of Conduct and Ethics for Professionals are shown 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 - Telecommunications Company
Appendix E - Manufacturing Company
Appendix F - Commercial Bank
 CHAPTER 6

BUSINESS ETHICS

BASIC CONCEPT OF BUSINESS ETHICS

Business ethics refers to standards of moral conduct, behavior and judgment in business. It
involves making the moral and right decisions while engaging in such business activities as
manufacturing and selling a product and providing a service to customers. Business ethics is
an area of corporate responsibility where businesses are legally bound and socially
obligated to conduct business in an ethical manner.

Business ethics is based on the personal values and standards of each person engaged in
business. PURPOSES OF BUSINESS ETHICS

Main Purpose

The main purpose of business ethics is to help business and would-be business to

determine what business practices are right and what are wrong. Hopefully, they

are going to use this knowledge to guide them in making the right business

decisions.

Special Purpose

There are other purposes which are corollary to the main purpose. These purposes include
the following:

1. To make businessmen realize that they cannot employ double standards to the actions of
other people and to their own actions.

2. To show businessmen that common practices which they have thought to be right
because they see other businessmen doing it, are really wrong.

3. To serve as a standard or ideal upon which business conduct should be based.

Business Ethics 105

Except for some country's organizations, professionals which have formulated and
implemented their Code of Ethics, the business world today does not have one universal
standard code of ethics. Each man has to evaluate a situation according to his own belief.
Often, because there is no code of ethics to guide them, businessmen take actions that may
be wrong. Therefore, one of the specific purposes of business ethics is to assist the
business world in formulating codes of conduct-personal, company and professional-which
can be used as a guide in formulating business plans and strategies and in making business
decisions.
SCOPE AND IMPACT OF BUSINESS ETHICS

Business ethics covers all conduct, behavior and judgment in business. This includes the
slightest deviation from what is right to illegal and dishonest acts that are punishable by law.
It involves making the right choices while engaging in 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 profit 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. Fair business competition means
achieving success solely by offering better products, services and terms than the competitor.
It is a form of business competition where success is gained by the merits of one's goods or
services.

106 Chapter 6

Economic Impact

A business has an economic impact on society through the wages it pays to its employees,
the materials that it buys from their suppliers and the prices it charges its customers. It would
have a positive social impact on its employees if they are paid fair living wages and benefits.
It will have a positive effect on its suppliers that they paid fairly and on time for their supplies.
The effect on its customers is positive if the business gives them good value for the price
they pay for the products and services

Social Impact

The social impact of corporate governance contributes to the ethical climate of society. If
businesses offer bribes to secure work or other benefits, engage in 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 Impact

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 environmental initiatives of a business leader often
force competitors to take similar action for an increased beneficial effect on the environment.

Impact on Business Managers

The concepts and principles for the ethical conduct in business are relegated to the
managers of the business enterprise. Thus, although the manager is expected to act in the
best interest of the business, he cannot be expected to act in a manner that is contrary to the
law or to his conscience.

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 o prestige;
Business Ethics 107

reveal the fact to his superior whenever his personal business of financial interests conflict
with those of the company:

be actively concerned with the difficulties and problems of subordinates, treat them fairly and
by example, lead them effectively, assuring to all the right of reasonable access and appeal
to superiors;

recognize that his subordinates have a right to information on matter affecting them, and
make provision for its prompt communication unless such communication is likely to
undermine the security and efficiency of the business;

⚫fully evaluate the likely effects on employees and the community of the
business plans for the future before taking a final decision and

⚫ cooperate with his colleagues and not attempt to secure personal

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

Suleik published in the Business Mirror on February 13, 2018 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 message 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 sciences and technology. We are 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 attitude lurks a rejection of ethics. Ethics has come to be viewed with derision as
being counterproductive. Ethics is felt to be a threat because it condemns the manipulation
and debasement of the person and that ethics leads to a call for a committed response,
which is outside of the categories of the marketplace."

108 Chapter 6

She also quoted Pope Benedict XVI's Encyclical Caritas in Veritate

"Humanity has a mission and the means to transform the world in justice and love in human
relations, even in the social and economic field Market economics must be underpinned by
commitments to particular moral goods and a certain version of the human person if it is to
serve rather than undermine humanity's common good. The economy needs ethics in order
to function correctly- not an ethics which is people- oriented"

REVIEW QUESTIONS

Questions

1. 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 ethics to society in general?

7. Explain how business managers could act ethically.

8. Describe the inherent conflict between ethics and pursuit of profit.

CHAPTER 7

COMMON UNETHICAL PRACTICES OF BUSINESS ESTABLISHMENTS

Unethical problems in business ethics occur in many forms and types. The most common of
these unethical practices of business establishments are misrepresentation and
over-persuasion.

Misrepresentation may be classified into two types: direct misrepresentation and indirect
misrepresentation.

Direct Misrepresentation is characterized by actively misrepresenting about the product or

customers. This includes:

Deceptive Packaging. Deceptive packaging takes many forms and is of many types, One type is
the practice of placing the product in containers of exaggerated sizes and misleading shapes to
give a false impression of its actual contents. An example 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.

Misbranding or Mislabeling. Misbranding is the practice of making false 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 Misleading 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
and nothing but the truth" if it greatly exaggerates the virtues of a product and tells only half of
the truth or else sings praises to its non- existent virtues. If advertising does not provide a useful
service anymore to the customers, it can become the agent of misrepresentation.

Examples are:

a. Advertisements with pictures, or statements that convey exaggerated impression of the

product's reliability or quality. b. Advertisement that claims that the product is the "fastest selling
brand" or the "product of the year".

c. Advertisements using fictitious or obsolete testimonials.

Adulteration. Adulteration 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 understatement or Short weighing. In short 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 foot 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 volume than the standard. This
unethical practice is found in selling 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 sack.

Quantity understatement or Short numbering. In this unethical practice, the seller gives the
customer less than the number asked for or paid for. Short numbering is often practiced in
selling situations where the product being sold is in such a shape or is packed in a manner that
would make counting the product difficult or inconvenient. For example, a customer who is not
vigilant may receive less quantity than what he is entitled to when buying toilet paper, bond
paper, carbon paper, paper clips, thumb tacks, matches and toothpicks which are sold by the
box or package.

Indirect Misrepresentation is characterized by omitting adverse or unfavorable information about

the product or service. Among the most common practices involving indirect misrepresentations
are caveat emptor, deliberate withholding of information and business ignorance.

Caveat emptor is a practice very common among salesmen. Translated, caveat emptor means
"let the buyer beware". Under this concept, the seller is not obligated to reveal any defect in the
product or service he is selling. It is responsibility of 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 nature, features, uses and qualities. As a witness, it is his
obligation to "tell the truth and nothing but the truth" about his product. What makes caveat
emptor unethical is the willingness of the seller to generate profit by taking advantage of the
buyer's lack of information. This is passive deception which is also lying.

Deliberate Withholding of Information. Following the argument that caveat emptor is unethical,
the deliberate withholding of significant information in a business transaction, is also unethical.
No business transaction is fair where one of the parties does not exactly know what he is giving
away or receiving in return.
Passive deception. Direct misrepresentation gives business a bad name while indirect
misrepresentation or passive deception is not as obvious, it nonetheless contributes to the
impression that businessmen are liars and are out to make a fast buck. Business ignorance is
passive deception because the businessman is unable to provide the customer with the
complete information that the latter needs to make a fair decision.

Over-Persuasion

Persuasion is the process of appealing to the emotions of a prospective customer and urging
him to buy an item of merchandise he needs. Persuasion is legitimate and necessary in the
selling of goods if it is done in the interest of a buyer such as persuading him to get a
hospitalization insurance policy. However, persuasion used for the sole benefit of selling a
product without considering the interest of the buyer is not ethical. The common instances of
over-persuasion include the following examples:

1. Urging a customer to satisfy a low priority need for merchandise.

2. Playing upon intense emotional agitation to convince a person to buy.

3. Convincing a person to buy what he does not need just because he has the capacity or
money to do so.

CORPORATE ETHICS

Unethical Practices 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 authorizing purchases of goods and
services for the company's use at a price higher than normal, in consideration of a certain
percentage of the purchase value or commission accruing to them.

2. Interlocking Directorship
Interlocking directorship is often practiced by a person who holds directorial positions in two or
more corporation that do business with each other. This practice may involve conflict of interest
and can result to disloyal selling. Disloyal selling happens when this person is compelled to
decide which of the two corporation's interest should be protected or upheld. Thus, whatever
decisions the person makes, he betrays the trust reposed on him by the shareholders of either
of the two companies.

3. 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 shareholders and their non-attendance of board
meetings could result to betrayal of trust of the parties who elected them to their positions.

4. Insider Trading

Insider trading involves trading in a public company's stock by someone who has non-public
material information about that stock for any reason. Insider trading can be either illegal or legal
depending on when the insider makes the trade. It is illegal when the material information is still
non-public, and this sort of insider trading comes with harsh consequences.

Material non-public information is any information that could substantially impact on investor's
decision to buy or sell the security that has not been made available to the public.

An individual who has access to insider information would have an unfair edge over other
investors, who do not have the same access, and could potentially make larger, unfair profits
than their fellow investors.

Illegal insider trading includes tipping others when you have any sort of material non-public
information.

Legal insider trading happens when directors of the company purchase or sell shares, but they
disclose their transactions legally. The SEC has rules to protect investments from the effects of
insider trading. It does not matter how the material non-public information was received or if the
person is employed by the company. For example, suppose someone learns about non-public
material information from a family member and shares it with a friend. If the friend uses this
insider information to profit in the stock market, then all three of the people involved could be
prosecuted.

Some Unethical Practices of Executive Officers and Lower Level Managers

To a lesser extent, executive officers may also guilty of unethical practices. All the unethical
practices of the members of the Board of Directors discussed are activities they are also
capable of engaging in though perhaps to a lesser degree because of certain limits to their
authority. Unethical practices that are more

common to executive officers and lower level managers are: 1. Claiming a vacation trip to be a
business trip. The President or a 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.

2. Having employees do work unrelated to the business. Executive officers and lower managers
ask company employees to do personal things for them on company time such as having the
company janitors water and mow their lawns, having the maintenance men do house or
appliance repairs for them, 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 engaging in unethical practices. 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 laboe 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;

c. To contract out services or functions being performed by union members when such will
interfere with, restrain or coerce employees in the exercise of their rights to self organization; d.
To initiate, dominate, assist or otherwise in with the formation or administration of any labor
organization, including the giving of financial or other support to it;

e. To discriminate with regard to wages, hours of work, and other terms or conditions of
employment in order to encourage or discourage membership in any labor organization.

f. To dismiss, discharge, or otherwise prejudice or discriminate, against an employee for having

given or being about to give testimony under the Labor Code;

g. To violate the duty to bargain collectively a prescribed by the Labor Code: h. To pay
negotiation or attorneys fees to the union or its officers or agents as part of the settlement of any
issue in collective bargaining or any other dispute:
i. To violate or refuse to comply with 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 claims about losses to free themselves from paying the compensation and
benefits provided by law. There are employers who claim non-existent losses so they can be
exempted 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 wonder the low when in fact they are only receiving a fraction of what they are
supposed to 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, demands, requests or
otherwise requires sexual favor from the other, regardless of whether the demand, request or
requirement for submission is accepted or not by the object.

Some Unethical Practices of Employees

There are some employees who are not mindful of their moral obligations to their employers.
They take advantage of their position and the trust of their employees by committing unethical
practices harmful to their employers' interest these unethical practices may be classified into
conflict of interest and dishonesty.

1. Conflicts of Interest

A conflict of interest arises when an employee who is duty bound to protect and promote the
interests of his employer violates this obligation by getting himself 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 supplier,
customer, 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 impartially.
e. 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 employee 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 an auditor employed full-time in a public accounting firm but maintains
his own auditing office where he works after office hours.

e. The employee uses for his own benefit a business opportunity in which his employer has or
might be expected to have an interest.

2. Dishonesty

Business ethics is not just limited to business transactions with outside parties. It also covers
employee-employer relationship, especially with respect to an employee's honesty as he 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

 CHAPTER 8
ETHICAL DILEMMA
Expected Learning 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.

INTRODUCTION
• An ethical dilemma is a situation a person faces in which a decision must be made about
the appropriate behavior. A simple example of an ethical dilemma is finding a diamond ring,
which necessitates deciding whether to attempt to find the owner or to keep it.

RESOLVING ETHICAL DILEMMAS

• In recent years, formal frameworks have been developed to help people resolve 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:
1) 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 for a law firm, Alvendia and Castro.
Currently he is assigned to the case of Ryan Manufacturing Company under the supervision of
Carlos Reyes, an experienced senior lawyer. There are three junior legal of assistants assigned to
the case, including Bert, Carlos and more experienced assistant, Martha Sy.

During lunch on the first day. Carlos says, "It will be necessary for us to work a few extra hours on
our own time to make sure we come in on budget. This case 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 lunch break, and
working an hour or so after normal quitting time. We just won't write that time down on our time
report."
Bert recalls reading in the firm's policy manual that working hours and not charging for them on
the time report is a violation of Alvendia and Castro employment policy. He also knows that seniors
are paid bonuses, instead of overtime, whereas staffs are paid for overtime but get no bonuses.

Later, when discussing the issue with Martha, she says, "Carlos does this on all of his job. He is
likely to be our firm's next manager. The partners think he is great because his job always come in
under budget. He rewards us by giving us good engagement evaluations, especially under the
cooperative attitude category.
Several of the other seniors staff follow the same practice."

Ethical Issue
The ethical issue in this situation is not difficult to identify.
❖ Is 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 in which ethical dilemmas occur than would
normally be expected. The following are the key persons involved in this situation:

WHO: Bert
HOW AFFECTED:
a) Being asked to violate firm policy.
b) Hours of work will be affected.
c) Pay will be affected.
d) Performance evaluations may be affected.
e) Attitude about firm may be affected.

WHO: Martha
HOW AFFECTED:
a) Same as Bert.

WHO: Carlos
HOW AFFECTED:
a) Success on engagement and in firm may be affected.
b) Hours of work will be affected.

WHO: Alvienda and Castro

HOW AFFECTED:
a) Stated firm policy is being violated.
b) May result in under billing clients in the current and future engagements.
 c) May affect the firm's ability to realistically budget engagements and bill clients.
d) May affect the firm's ability to motivate and retain employees.

WHO: Staff assign to Rayon Manufacturing in the future

HOW AFFECTED:
a) May result in unrealistic time budgets.
b) May result in unfavorable time performance evaluations.
c) May result in pressures to continue practice of not charging for hours worked.

WHO: Other staff in the firm

HOW AFFECTED:
a) Following the practice of this engagement may motivate others to follow the same practice
on other engagements.

Bert's Available Alternatives

• Refuse to work the additional hours.
• Perform in the manner requested.
• Inform Carlos that he will not work the additional hours or will charge the additional hours
to the engagement.
• Talk to manager or partner about Carlos request.
• Refuse to work on the engagement.
• Quit working for the firm.

Each of these options includes a potential consequence, the worst likely one being termination by
the firm.

Consequences of Each Alternative

In deciding the consequences of each alternative, it is essential to evaluate both the short- and
long-term effects. There is a natural tendency to emphasize the short term because those
consequences will occur quickly, even when the long-term consequences may be more important.
For example, consider the potential consequences if Bert decides to work the additional hours and
not report them. In the short term, he will likely get good evaluations for cooperation and perhaps
a salary increase. In the longer term, what will be the effect of not reporting the hours this time
when other ethical conflicts arise?

Consider the following similar ethical dilemmas Bert might 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 informs 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 P50,000 if Bert can find a
plausible way to increase probability or wining the case.

Appropriate Action

Only Bert can decide the appropriate option to select in the circumstances after considering his
ethical values and the likely consequences of each option. At one extreme, Bert could decide that
the only relevant consequence is the potential impact on his career. Most of us would conclude
that Bert is an unethical person if he follows that course. At the other extreme, Bert can decide to
refuse to work for a firm that permits even one supervisor to violate firm policies. Many people
would consider such an extreme reaction naïve.
CHAPTER 9

ADVOCACY AGAINST CORRUPTION

WHAT IS CORRUPTION?
Corruption is the abuse of private and public office for personal gain. It includes acts of bribery,
embezzlement, nepotism, kickbacks and state capture.
This is often associated with and reinforced by other illegal practices such as bid rigging, fraud, or
money laundering, extortion. Simply 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 only 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 covers not only the politician and the public servant but also the
CEO, CFO and but other employees of a company." It involves wrong 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 which should rule his or
her decision-making, in exchange for a reward or for the promise or expectation of a reward, while
these motives influencing his or her decision-making cannot be part of the justification of the
decision." In general, corruption is a form of dishonesty or criminal activity undertaken by a Person an
organization entrusted with a position of authority, Often to acquire illicit benefit.

HOW DOES CORRUPTION LOOK LIKE

Corruption may take place in any of the following forms / ways:
• A company paying a bribe to win the public contract to build the local highway, despite 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 for a 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 day, those hurt most by corruption are the world's weakest and most vulnerable.

WHY AND HOW DOES A PERSON BECOME CORRUPT

corruptions spread when there are opportunities, when risk is minimal in
comparison to benefits obtained or when one is confronted with issues like
Career advancement
Earning of more income
Financial problems caused by illness, loss of property, etc.

Those engaged in corruption learn how to be dishonest. The next corrupt actions become
easier to do unless one is firmly rooted on solid principles and has been nurtured in an
upright manner.

ILL EFFECTS OF CORRUPTION

Economically, Corruptions add up to 10% 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 countries.
Corruption leads to waste or the inefficient use of public resources. In the Philippines, figures
from 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 mismatch between aspirations and fulfilment
continues, this could lead to apathy, discontent and turn them to radical extremists and join
terrorist groups. Other significant and serious repercussions of corruption are: If allowed to
take root in society, 'it can lead to a breakdown in social order and lives are affected when
ordinary people are prevented from receiving all the essential service that they are entitled
to.

Corruption may have drastic impacts like most of the public funds are used on the leisure and lifestyle
of influential people instead of allotting them on hospitals, schools and other basic needs of general
public.

2. It creates unfair competition and increases the cost of doing business. Every form of corruption is
bad for economic growth and could 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, Canada and few.
European countries has dropped extensively due to adoption of concrete measures. Nevertheless,
corruption in developing and underdeveloped countries (especially Afghanistan and Somalia) is still 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 public and private sectors as well as is non-profit and charitable organizations.
Allegations and charge of corruption now play a more central role in politics that at any other time.
Governments have failed 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 involving large sums of money' multiple parties or
huge quantities of products are at stake. Corruption also flourishes in situation involving high
technology (e.g., purchase Of a technologically far-advanced aircraft) or in situations that are chaotic
and a number of actions is very large such as natural disasters, civil war and betting in international
sports tournaments. Major corruption thrives on ae broad base Of small corruption payments or
bribes. In the end, all corruption costs are absorbed by the consumers and the taxpayers.

CHARACTERISTICS OF CORRUPTION
Although* there is a widespread perception that corruption is prevalent, it is difficult to establish how
wide and deep corruption has penetrated our economy and social life. This is because both partners
in an exchange of power for privileges keep their transaction secret.

a) Recipients and papers

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 enrich
themselves privately at the expense of the common citizen. This may be at the expense 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 return 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 qccepting 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 the opportunity to bribe.
This means that the question 'who is to blame', shifts from the person who pays to the person who
extons 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'.

In every society it is known, either publicly or privately, which public official is open to transactions
with gifts being made reciprocally. The gift on the part of the official may then imply considering an
application with priority, or assigning a contract, scholarship or employment. The potential payer will
look for his "prey"; he will look for the politician/public official of whom everybody knows that he can
be 'bought', that he is prepared to break the rules in exchange for a 'gift' Therefore, the reputation
that a public official or politician enjoys, is of great significance. Some will never be approached with a
sproposition', as 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 not keep any cash for bribes. They run less risk of falling victims-to extortion. c)
Lubricant o(society. Many think that paying bribes is required to ensure smoother operation
of society. They think that without an occasional . gift (for example, around Christmas and New Year),
or incidentally (a gift on the occasion 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 secure 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 needed from a commercial point of view, for as a matter of fact, these gifts
have already been budgeted. If corruption is judged purely on the basis of business economics,
macro- economically it costs money to society which should be considered as a loss. From the micro-
economic point of view, for the bribing entrepreneur, it is profitable. The payer of a bribe secures a
desired transaction if evaluated on purely commercial grounds -- strictly speaking, should have been
assigned to someone else. That will harm individual entrepreneurs and transactions; it will harm the
national economy and the world economy.

d) An ethical dillema
The 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 behavior is generally considered to be improper.
Many consider corruption to be an ethical problem, a behavioral problem. And refer to it as being
'sinful', a 'wrongdoing'. It is a problem to be-solved by means of personal 'reform'. Emphasizing the
'sinfulness' of corruption, aims at improving especially individual and personal behavior. Poor
entrepreneurship (in a moral sense) should then be improved on a personal basis. Our focusing on
the conditions 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 entrepreneurship is judged with regard to its quality in all
three aspects: People, Planet and Profit. The qualification 'poor' is not a sign of sinfulness, but a
quality that signifies an adverse effect on all three aspects, not only on the economics.

e) Poverty alleviation
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 staffin hospitals, bus ticket
collectors, car:park attendants, garbage collectors, etc., who on an operational level often have good
opportunities to extract extra income or 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 automatically ijnply that, consequently, the person concerned is
corrupt. What is of much" greater importance for the prevention of, or fight against, corruption at a
lower level in all kinds of hierarchies, is the clearness mid transparency of the rules and of the
decision-making process, and the cr)ntrol exercised on the application of the rules? Timely payment
of salaries is an important pre-condition to prevent corrupt behavior.

f) Culture
Gifts are inherent to human relations and therefore present in all cultures. You give and receive gifts
on the occasion of birthdays, Santa Claus or Christmas; on the occasion of memorable events; an
appointment or a 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 share 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 Heads of government and Heads of state, exchanging gifts.

g) 'Kindness among friends'

It is essential, whether you just want to be 'thoughtful', or whether your gift is presented with a certain
intention. Is it a sign of thoughtfulness or is it hiding a particular purpose, an expected 'return' in the
future? Whether 'attention' or 'intention', the difference is of great importance for the relationship. Is
it a 'friendly turn' or is it an 'investment'? To have friends belongs to culture. However, can you 'buy' a
friend? Is real friendship not to be based on honesty and transparency? To give presents reciprocally
is a sign of friendship. It should not get lost in a misuse of power for private gains.

THE PHILIPPINES CORRUPTION REPORT *

The Former Secretary of Finance reported in 2016 that the Philippines loses P200 billion from
smuggling and P400 billion from tax evasion perpetuated through collusion with some personalities
in the government agencies. P2.6 trillion is lost annually in corruption globally.

Judicial System
Corruption risks are high in the judicial system. Bribes and irregular payments in return for favorable
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
severely 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-transparentl
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 judge for allegedly asking for a PHP 15 million bribe in
exchange for a favorable ruling in an insurance claim. At the time of review, no further updates on the
case were available.

Police
There is a high-risk of corruption when dealing with the police. The national police force is widely
regarded as one of the most corrupt institutions in the country. Reports ofthe police and military
engaging in corruption, extortion; and being involved in local rackets are widespread. Companies
report that they cannot rely on the police services. More than half of firms pay for private security.
Businesses rate the National Police's commitment to fighting corruption as 'poor'. President Duterte
has accused several police generals of being involved in the trafficking of illegal drugs. In one
corruption case, Police Commissioner Mr. Sombero, is under investigation for allegedly facilitating a
PHP 50 million bribe from gambling tycoon Jack Lam, who tried to bribe immigration authorities in
order to release approximately I , 300 Chinese nationals who were working in his resorts illegally.

Public Services
Companies contend with a high corruption risk when dealing with the public services. Approximately
half of business executives reported being asked for a bribe by someone in the government in 2017.
Nearly three out of five business 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 occut Philippine officials involved in processing
documents •related to civil and property registration and 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 are generally not recruited in a competitive manner; appointments
are based on a practice Of patronage. The total number of procedures required to set-up operations,
including registering the company with 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 Administration
Corruption risks in the land administration are high. Two out Of five companies report expecting to
give gifts when obtaining a construction permit. Property rights are formally recognized and
protected in the Philippines, but in practice, the law is not always upheld. Businesses have insufficient
confidence in the protection of property rights. Corruption and arbitrariness in the application of the
law are common. Multiple agencies are responsible for land administration, which has led to
overlapping procedures for land valuation and titie registration; this has made the process
costly. The court system 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 compeniation, but coming to a
mutually acceptable price can be a lengthy process in the court system. Registering property
takesmine 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 taxes honestly. Officials at the
Bureau of Internal Revenue (BIR)are believed to be prone to corruption and known for embezzlement
and' extortion. A typical example of this can be found in a recent case in the city of Bacolod; an
officer with the BIR was caught extorting PHP 125,000 from a local company. Businesses rate the BIR's
commitment to fighting corruption as poor. On a more positive note, there are signs that the BIR is
pursuing more cases of comples• make twenty-eight tax payments a year, which is higher than •the
regional average.

Customs Administration
There is a high risk of encountering corruption when dealing with the Customs administration.
Companies indicate that irregular bribes and payments in import and export procedures are very
common. About a quarter of companies indicate they expect to give gifts when obtaining an import
license. A business survey indicates that the Bureau of Customs (BOC) was the only agency receiving a
rating of 'very bad' when it came to its commitment to fighting corruption. Companies cite
burdensome import procedures and corruption at the border as being among 'the most problematic
factors for importing. The efficiency and time predictability of procedures are rated as poor. Border
compliance costs in the Philippines are significantly higher than the regional average, whereas the
time required is in line with the regional average. The Bureau of Customs (BOC) has indicated that
smuggling of goods, among which cigarettes, vehicles, and oil, into the Philippines has led to the
evasion of taxes worth at least USD I billion yearly. Consistent fraud in the form of under- invoicing
when importing and exporting costs the state USD billions in' revenues each year. In 2016, the BOC
alleged one of its employees accepted as much as USD 4 million in bribes monthly.

Public Procurement
There is a very high risk of corruption in the 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 orderto 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 Philippine
ownership. Local-level public procurement lacks transparency, fostering a culture of corruption
through the misuse of the pork barrel system; which are funds for use by representatives for projects
in their respective districts. Philippine law allocates responsibility for monitoring, investigating and
sanctioning irregularities in public procurement to a number of different state institutions, leaving
potential misconduct, inefficiency and impunity unchecked.

Natural Resources
Companies operating in the natural resources sector face a high risk of corruption. The Philippines has
shown marked improvements in its natural resource 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 managempnt have caused the country's overall
resource governance to be judged as 'weak'. The Philippines has been working to achieve compliance
with the Extractive Industries Transparency Initiative (EITI) since joining in 2013. Some mining
contracts are publicly disclosed via the EITI portal. While transparency in the sector has improved,
poor regulation and Overlapping policy responsibilities between local and central governments have
meant that small-scale mining is still a contentious issue. Government 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 of 2017 Secretary of the Environment Gina Lopez shut down 28 of the country's 41
mining companies for polluting 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
Corruption 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 to amass wealth or to
obtain business through unfair means. Even with harsh penalties, corruption cannot be eradicated
completely. Below are some measures businesses and organizations can adopt to help prevent
corruption in the work-place. Clear Business Processes Having defined workflows, clear directives on
financial approving authorities, and standard procurement instructions can help flag irregularities in a
business or organization. These processes should be reviewed on regular basis to ensure they are
updated to the shifting business environment. Diligent record-keeping and regular audits are also good
practices to deter corrupt activities.

Policy on Gifts and Entertainment

Gifts and entertainment are often offered in the legitimate course of business to promote good
relations. However, if it is too frequent or lavish, or done with the deliberate intention to gain an
unfair business advantage, such gifts and entertainment can be tantamount to corruption, regardless
of whether the recipient is able to fulfill the request of the giver. The risk of corruption can be
reduced by setting a policy on when gifts and entertainment may be given and accepted and what
records need to be kept. Your business partners should be aware of your organization's gift and
entertainment policy too.

Declaration of Conflict of Interest

Conflict of interest occur when a personal interest or relationships is placed before the business
interest, and can lead to corrupt activities such as giving or accepting bribes. In order to safeguard the
business interest, a declaration 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 courses of action. This could include excluding the
employee from engaging in the work or transferring the employee to another 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 policyor feedback channel Nwhere staff can conveniently raise concerns
and feel protected from being identified or retaliated against. One way to do this' would be by
allowing repofls to be filed anonymously through a publicized email_address or phone number.

EFFORTS To CURB CORRUPTION THROUGH LEGISLATION

The Anti-Graft and Corrupt Practices Act criminalizes active and passive bribery, embezzlement,
extortion, abuse of office and conflict of interest in the public sector. Bribery of public officials and
trading in influence are also criminalized in the Anti-Red Tape Act. The Act fOrbids office-holders
from accepting any gifts or material benefits in exchange for any government permit or license.
Under the Revised penal Code, gifts are classified as indirect bribery. An exception is made
for gifts of insignificant value given as a token of friendship in line with local customs.
Facilitation payments are not addressed in the law. Private sector bribery is not criminalized.
Under the Code, public officials are required to regularly file a statement of their assets and
liabilities. In case of any discrepancy between the official's asset declaration and the amount
of property or financial assets actually possessed, the official is subject to immediate
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 formulates 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 ratified 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 cooperation between law
enforcement agencies, and officials are rarely prosecuted and convicted for corruption
crimes.

VIGILANCE OF CIVIL SOCIETY

Philippine civil society is active and is represented by a wide variety of different organizations.
Public participation is high and civil society organizations (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 environment is largely privately owned and diverse, and the state generally exercises
very little censorship. The views represented in the mainstream media are heavily influenced
by the oligarchical owners of many of the outlets.

The Philippines is the second most dangerous country in the world for journalists to operate in, as
measured by the number of journalist 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 to try to silence journalist. Thé 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
access is widely available, but there are concerns about the government trying to install some degree
of censorship. The Philippine press is classified as “partly free”.
CURRENT ISSUES ON CORRUPTION / FRAUDULENT ACTIVITIES IN THE PHILIPPINES

"Senate Probe of SEA Games Venue Contract Pressed"

Philippine Inquirer, November 11, 2020, Melvin Gascon Sen. Risa Hontiveros on Tuesday called for a
"full-blown" investigation of the allegedly irregular deals in connection with country's hosting of the
2019 Southeast Asian (SEA) Games, especially the P9.5 billion in taxpayer money used to construct the
main sports venue inside New Clark City In a privilege speech, Hontiveros raised doubts about the
legality- of the 2018 joint venture agreement between the Bases Conversion Development Authority.
(BCDA) and a Malaysian developer, MTD Capital Berhad, for the construction of the sports venue at
the 9,450-hectare NCC She said a "fake' joint venture agreement was used to secure a "behest loan"
from a government

'White elephant'?'
She questioned why MTD did not seem•to have made any contribution to the project, except for the
actual construction work. A commission on Audit (COA) report said the sports facilities included an
aquatic center, an athletics stadium and an "athlete's village" capable of housing 1,000 people,
It said the agreed project cost to build them was P8,510 billion, "which will be contributed by the
winning PSP (private sector partner) in the form of unencumbered advances to the JV (joint
venture)." Hontiveros said the P8.5-billion funding that MTD Berhad had purportedly poured into
the project came from a P9.5-billion loan that was granted by Development Bank of the Philippines
(DBP).

Loan proposal
JMTD Berhad did not have any cash-in investment, yet they still put on an additional Pl billion into
their loan proposal," she said. Joint venture scheme Hontiveros raised suspicions that the joint venture
scheme was used to skirt the legal requirement of a public bidding and manipulate the grant of the
project to a favoured contractor. The senator suspected that the project was financed by a behest
loan, which shifts the burden of paying it to Filipino taxpayers, mainly the DBP depositors.
"What did the Filipino people derive with P9.5 billion charged from our pockets? A sports center
that was used for just about a month, and presumably until now, the government continues to
spend for its maintenance," she said. BCDA statement In a statement, the BCDA maintained that the
transactions surrounding the construction of the sports facilities were "done in aboveboard and legal
manner", with endorsement from the Asian Development Bank and the OGCC.

"Smuggled tabacco products cornered half of apprehended goods in 2020"

Philippine Inquirer, January 19, 2021, Ben O. De Vera Illicit cigarettes accounted for more than half of
the value of smuggled items that the Bureau ot Customs (BOC) confiscated last year amid prolonged
COVID-19 quarantine that slashed both supply of and demand for more expensive taxpaid tobacco. In
a statement on Monday, the Department of Finance (DOF) said that out of the P9.75 billion in
smuggled goods that the BOC apprehend in 2020, 53.5 percent in terms of value, or P5.22 billion,
worth were tobacco and cigarettes. Citing a report of Customs Commissioner Rey Leonardo B.
Guerrero to Finance Secretary Carlos G. Dominguez Ill, the DOF said that 150 out of the 792
antismuggling operations undertaken by the BOC last year yielded the smuggled cigars and tobacco
products. Illicit trade of smuggled and counterfeit cigarettes flourished amid the pandemic as supply
dwindled at the height of the longest and most stringent lockdown -in the region that stopped
domestic production and restricted movement of nonessential goods.

"New 'pastillas' raps tag alleged brains" Philippine Inquirer, November 6, 2020, Nikka G. Valenzuela
The National Bureau of Investigation on Thursday filed criminal charges against retired port
operations chief Marc Red Marifias, the alleged mastermind of the "pastillas" racket, and dozens of
former and current employees of the Bureau of Immigration (Bl) implicated in the airport extortion
Scheme. The complaint filed in the Office of the Ombudsman raised to 86 the total number of
people linked to the scam to allow the seamless entry into the country of thousands of foreigners,
mostly Chinese, who intended to work illegally in the country since 2017.

The NBI said Marihas and the others violated the Anti-Graft and Corrupt Practices Act for
"persuading, inducing or influencing" other public officials to carry out a task in violation of a
government agency's regulations or were themselves committing such as violation and also for
granting a privilege or license to unqualified people. UThe act of one is the act of all," the NBI said in
its letter to the Ombudsman that accompanied its compliant.

Travel documents
It said that based on Bl records and testimonies of witnesses, "the conspiracy" involving
immigration officers in the pastillas group has been "clearly established", adding that "they must be
charged criminally and administratively".
Marinas was identified by whistleblower and immigration officer Jeffrey Dale Ignacio as the
pastillas Uring,leader" during a Senate hearing on the multibillion-peso racket. In September, the
NBI filed graft charges against the first group of people linked to the racket - 19 immigration
officers, including Ignacio, and a Chinese tour operator.

Visa upon arrival

In this sworn statement to the NBI, Ignacio corroborated immigration officer Allison Chiongts
testimonies on the racket; which took advantage of the governmentis visa-upon-arrival policy. The
influx of Chinese nationals prompted the pastillas group to recruit more staff to man additional
counters to facilitate their entry, Ignacio said,
Chiong, the first whistleblower, presented the pastillas scam hearing in the Senate the list of names
of foreign nationals, their flights and arrival dates, their status and the officers who processed their
entry. The Bl confirmed the arrivals and noted that these foreigners already exceed their allowed
period of stay. Capirall who evaluated the first complaint, was arrested by the NBI for allegedly
extorting money from the implicated immigration officers, including Ignacio, in exchange for a
favourable decision. Dongallo said that this time, seasoned investigators and lawyers of the NBI
evaluated the case before filing charges against Marifias and the others,

"45 BI employees in 'pastillas' scam suspended"

Philippine Inquirer, October 28, 2020, Nikka Valenzuela
The Office of Ombudsman has ordered the pre-emptive suspension of 45 Bureau of Immigration
(Bl) employees who are facing allegations of involvement in 'pastillasi racket a visa-upon-arrival
scheme catering to mostly Chinese nationals who intended to work in the country. In an order
dated October 26, the Office.of the Ombudsman suspended the Bl employees for a period of six
months without pay. Ombudsman Samuel Martires signed the orden Among those suspended
were 19 Bl officials and employees charged with graft by the National Bureau of Investigation in
September.

"NBI: PhilHealth, dialysis center officials 'conspired"'

Philippine Inquirer, January 13, 2021, Marlon Ramos
Former Philippine Health Insurance Corp. (PhilHealth) president and CEO Ricardo Morales and
other senior executives of the state health insurer had "conspired" with officials of a private dialysis
center that received P33.8 million in emergency funds specifically earmarked for hospitals treating
COVID-19 patients, according to the National Bereau of Investigation.
The NBI said Morales and his subordinates also ignored policies that they themselves set for the
use of the P30-biulIion• interim reimbursement mechanism (IRM) in providing "unwarranted
benefits" to B. Braun Avitum Philippines Inc., a dialysis center. Sen. Panfilo Lacson had identified
B. Braun as a "favoured" recipient of the special financial package from PhilHealth.
These findings prompted the NBI to bring an administrative and criminal complaint alleging
corruption against Morales and more than 20 others in the Office of the Ombudsman.
'Ghost, double•claims'
The complaint was filed on Mondayt a day before an interagency body headed by the Department
of Justice (DOJ) endorsed also to the Ombudsman a report by the Presidential Anti-Crime
Commission (PACC) alleging graft against 25 PhilHealth officials in connection with a "ghost" and
"double claims" scheme that had financially strained the state insurer.
It said PhilHealth "disregarded rules in approving and releasing IRM funds." Worse, the NBI said
PhilHealth "erroneously" computed the amounts given to B. Braun and other hospitals that
requested financial aid, which PhilHealth has intended as the governments response to the
pandemic.

"43 PhilHealth Officers Quit"

Philippine Inquirer, October 9, 2020, Tina.G. Santos
The Philippine Health Insurance Corp. (PhilHealth) on Thursday said 43 senior officers heeded an
order of its newly appointed president and CEQ Dante Gierran, to resign in his bid to reorganize
the corruption-tainted state insurance company.
Of the 43, 27 tendered courtesy resignations, including 21 from the central office and six from
regional offices, PhilHealth said in a statement on Thursday night. It said 10 from the central office
and six from the regions opted to retire.
PhilHealth did not identify the officers and gave no other details. Gierran's Sept, 30 memorandum
implemented a 2019 board resolution "directing all senior officers from Salary Grade 26 and above
to tender their courtesy resignation," PhilHealth said.

"Sandiganbayan junks plea of Enrile aide"

Philippine Inquirer, January 22, 2021, Nikka G. Valenzuela
The Sandiganbayan gain junked the motion for temporary release of Jessica Lucila Reyes, the
former chief of staff of former Sen Juan Ponce Enrile, who is detained due to a plunder case
related to the pork barrel scam. Enrile and Reyes were accused before the court of receiving P172
million worth of kickbacks from Janel Lim Napoles. Napojes was the alleged mastermind of the
pork barrel scam, or the use of bogus nongovernment organizations to funnel the Priority
Development Assistance Fund of lawmakers. Enrile, now 96 was allowed in 2015 to post bail due
his advanced age and health condition.

"Credit Card Fraud Cases Surge 29%"

Philippine Inquirer, February 3, 2021, Doris Dumlao-Abadilla
CCAP reported that one type of prevalent fraud is called an account takeover. This involves
acquiring a physical card or its details along with the cardholder's one-time-password to complete
online transactions. Scammers and fraudsters normally use social engineering to deceive card-
holders into giving sensitive personal information and card details. They usually pretend to be
representatives of a bank, phone company or even from a government agency.
The growth of digital transactions have spurred the rise of phishing scams. One of the most
popular phishing scams. One of the most popular phishing techniques is sending an email that
looks like it came from the cardholder's bank. These emails have subjects ranging from a new
device log-in to a credit card upgrade and their goal is to attain the cardholder's card details and
online banking credentials.
Authentication process
CCAP also played a role in launching last year "Scam Proof', an online platform where cardholders
can discover the different forms of fraud, learn about securing their accounts and even talk about
instances where in they were scammed. Metrobank headed this initiative with support of banks
such as Philippine Savings Bank, Rizal Commercial Banking Corp., Citibank and BDO Unibank Inc.
But cardholders were reminded that they must do their share in avoiding credit card fraud. They
must never share their account details through messaging apps and social media as these could
be used by hackers and fraudsters. Writing PINs and passwords is also discouraged, as they can
fall into the wrong hands.
 CHAPTER 10
Initiatives to Improve Business Ethics & Reduce Corruption

INTRODUCTION

Improvement of business ethics is a common concern of everybody. It is imperative that all

parties involved - manufacturers, sellers, consumers, government 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 professionals 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 improving business ethics have been brought
forward not only in the Philippines but also in other countries.

THE INTEGRITY INITIATIVE CAMPAIGN

In 2010, 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 multisectoral campaign that seeks to institutionalize integrity

standards among various sectors of society - business, government, judiciary, academe, youth,
civil society, church and media. Led by the private sector, the initiative aims to help in
diminishing, if not fully eradicating, the vicious cycle of corruption in the Philippines, which has
not only exacerbated poverty but also obstructed the development of a competitive business
environment that operates on a level playing field.

Ultimately, the Integrity Initiative hopes to build trust in government, a more equitable society
and fair market conditions. This will result in improved competitiveness and increased business
confidence, which will be evident with the increase in domestic and foreign investments, and
more employment generated for Filipinos. Subsequently, with more Filipinos employed in a
vibrant and dynamic Philippine economy, the alleviation of poverty should become inevitability.
Through the initiative, the Philippines will become a benchmark in the transformation process of
any country regarded as highly corrupt to one that fosters an ethical and progressive
environment.

To achieve this goal, consultations, roundtable discussions and public forums involving business
leader compliance officers, corporate governance experts, academics and practitioners from
small and medium enterprises to Fortune 500 companies. “An Integrity Compliance Handbook”
containing the key documents and toolkits in Integrity Initiative was published for the use of
organizations to promote ethical business practices.

Since 2010, MBC and ECCP have been joined by various organizations and industry
associations in taking an active role in promoting honesty and transparency in Philippines
business. As of 2018, a number of the organizations and industry associations have been taking
active participation in this movement.

With the active participation of these organizations, is hoped that the problem of massive graft
and corruption in the Philippines will be minimized if not totally eliminated.

Appendix G shows a partial list of organizations who are actively participating in the “Integrity
Initiative" Campaign against Corruption.

CORPORATE VALUES

The increasing scrutiny by regulators, lobbyists, non-governmental organizations, consumer

groups and the media have the potential to affect a business firm market perception and hence
value. It is therefore important that the organization’s values, and its code of conduct, address
the legal and other obligations owed to important stakeholders, including, for example, trade
practices laws, privacy laws, employment loss, occupational health and safety, equal opportunity
in the workplace, superannuation, and environmental regulations.

Managing, protecting and enhancing reputation has become one of the greatest challenges
facing today’s board. The reputation of a business is a critical factor in the determination of its
value. The values and ethics of the organization need to be explicitly managed.

NEED A CODE OF CONDUCT

A code of conduct is a formal expression of the organization’s values and ethics.

A code of conduct should:

● Guide directors and senior executives, as a minimum, as to the practices necessary to

maintain confidence in the organization's integrity. Other members of staff should also
have a code of conduct relevant to them which may be the same as that for directors
and senior executives or may be a complementary version;
● Promote responsibility and accountability of individuals for reporting and investigating
reports of unethical practices; and
● Ensure compliance with legal and other obligations to legitimate stakeholders.

An organization's code of conduct recognizes the important role that business ethics play in the
success of today's business, encouraging the board to actively develop an organizational
culture that is established on transparency, accountability and integrity.
One of the most significant accomplishments of the Integrity Initiative is the preparation of the
"Unified Code of Conduct for Business''. The Code's purpose is two-fold.

First, it harmonizes existing ethical standards among business operating in the

Philippines. It ensures that different market players adhere to the same rules of the
game in order to create fair market conditions and promote transparency in doing
business.

Second, the Code formally communicates the signatories' commitment to upholding high
standards of ethics in all business transactions. It articulates the belief that securing
profit at the expense of integrity is an unacceptable and unsustainable way of conducting
business and that measures have been taken to enforce and cultivate integrity habits
within the signatories' respective organizations.

THE UNIFIED CODE OF CONDUCT FOR BUSINESS (Integrity Initiative)

Top Management

● Our top management leads by example by consistently demonstrating the value

of conducting business with integrity.

● Our officers strongly communicate our organization's position against bribery,

corruption and unethical business practices within the company and the broader
public; comply with all the requirements of government regulatory bodies; and
prohibit cover-ups and falsified reports that conceal improper transactions.

● Management strongly supports integrity practices and allocates sufficient

resources for their implementation.

Human Resources

● We strive to instill culture of integrity among the 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 and due process, all employees have the right to file and
respond to complaints against practices suspected to be illegal or unethical.

● We have appropriate tools to confidentially receive, monitor, and act on internal

and external complaints.
 ● Employees filing complaints will be protected from all types of retaliation, while
those involved in unethical practices will be subject to commensurate disciplinary
actions.

● We have instituted training programs on business ethics covering all levels of the
organization.

Sales and Marketing

● We clearly communicate rules and guidelines on giving gifts, entertainment,

tokens of hospitality, and contributions to/from public and private organizations
and their representatives.

● Employees and all third parties engaged by the company to act as their
intermediaries, agents or representatives are not permitted to offer, promise, or
give, as well as demand or accept concessions - directly or indirectly - in order to
obtain, retain, or secure any undue advantage in the conduct of business.

● We abide by existing laws when transacting with 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 and Accounting

● We require all the employees to ensure that all books and records they create or
are responsible for are complete and accurate.

● Our financial records conform to standard accounting principles, comply with

Securities and Exchange Commission requirements on disclosure and
transparency, and abide by anti-money laundering laws (RA 9160) and
international conventions.

● We pay taxes in compliance with all laws.

Procurement

● A track record of integrity and compliance with existing laws is a prerequisite

when we vet third party consultants, suppliers, intermediaries, and agents. The
company has transparent procurement procedures, provides equal opportunities
for all suppliers, and prohibits, collusion between and among the employees and
suppliers.
 ● Recognizing that the Integrity Initiative is sustained through widely shared ethical
practices within the business community, we enter into integrity pacts with our
suppliers and ensure that they comply with the provisions of their pact.

● Contracting a third party to bribe or commit corrupt practices on behalf of the

company is strictly prohibited.

Logistics

● We comply with laws and regulations pertaining to supply chain management.

● We do not tolerate any breaches in existing laws in exchange for undue
advantage and unethical concessions or favors. They pay correct duties and
taxes based on transparent assessment of goods and services.

● Employees are not penalized for refusing to pay bribes or facilitation payments
even if it results in failure to meet deadlines or loss. of revenue.

Implementation and Monitoring

● We will continually to align their operations to the principles contained in this

Code to periodically assess and monitor their compliance to it. They will continue
to share best practices with the business community to strengthen ethical
business processes in the Philippines.

BISHOPS-BUSINESSMEN'S CONFERENCE PHILIPPINES - CODE OF ETHICS FOR THE

PHILIPPINE BUSINESS *

The Code of Ethics for the Philippine Business issued by the Bishops- Businessmen’s
Conference Philippine is reproduced in this Chapter for reasons of continuing applicability,
relevance, and significance to entities doing business in the Philippines.

Preamble

This Code of Ethics has been formulated impelled by the belief that man has a dignity 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 considered 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 hope that this Code will serve as a general stimulus to renew 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 a general code intended to be influential rather than coercive. It is hoped that individual
entities will consciously adopt and embrace it as a statement of principles and, having done so,
will be unwilling to incur the sanction of adverse public opinion through failure to live up to the
code.

It is a code for all people, formulated on the premise that the modern manager must be a
strategist for human development, and that the business of business is to build an enterprise
oriented to the development of man.

____________________________________________________________________________
The concepts

Business which embraces commerce and industry is not an accidental human activity but an
integral element of the social order. Its primary purpose is to meet society's human needs by
providing goods and services as efficiently as possible. Those engaged in business should,
therefore, recognize the following basic concepts:

● All business is essentially an expression of human relationships; not only with

those who work in the enterprise, but also with those who own and provide
financial resources, with those who supply it with materials and services, with
those who buy its products or services, with the government, and with the wider
public whose lives are affected by the business activity. The interest of all those
members of society must be taken into account in formulating business policy.
These interests, in 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 balance 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
employed 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.

● Business enterprise has a public responsibility to use all its resources efficiently.
Profit in a system of free enterprise is recognized as a fundamental incentive,
and is broader of the enterprise, needs of society, for raising the necessary for
the maintenance and growth of the enterprise, for raising the quality or life, and
for helping meet broader needs of society.

● Competition and incentives are essential for the maintenance and continuing
improvement of the quality of goods and services for growth and for technological
progress. However, to guard against unfair forms of competition, a consistent
standard of business behavior must be established and observed.

● In business, as in any other institution of society, any right or enjoyed by or

entrusted to business presupposes, and is justified by, corresponding duties,
responsibilities and performance.

Some Principles for the Conduct of Business

Those responsible for business policy should consider not only the interest of the owner of the
business, 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

and retirement, 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 knowledge, experience and creativity of all
who work in the enterprise may contribute to the decision-making process

Towards the Customers

Business shall, in the production of goods and services:

● strive after a quality that will enable them to serve their purpose efficiently and
effectively;

● avoid anything that would be detrimental to the health, safety or growth of the
proper user or beneficiary of such goods and services; and

● seek to apply or make use of the discoveries and inventions of science with
adaptations that will improve their products or services, thereby benefitting
customers / users and increasing their number.

In this 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 like 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 the Suppliers

Business shall ensure:

● that the terms of all contracts be clearly stated and unambiguous, and honored in
full unless terminated or modified by mutual consent;
 ● that abuse of economic power in dealing with a smaller concern be avoided, and
that, in all cases, terms of payment be strictly and fully observed. In general,
payment should always be made promptly at the agreed time or, if no specific
time is agreed upon, as quickly as may be reasonable, given the circumstances;
and

● that no supplier be encouraged to commit his resources for apparently long-term

purposes unless there are reasonable guarantees that the orders, he receives
from the business enterprise will not be terminated arbitrarily.

Towards the Owners and other Providers of Capital

In the interest of the Owners and other Providers of Capital, business shall:

● provide an adequate 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 and
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
efficiency of the business; and
● pursue the specific objectives of the Owners and other Providers of Capital
provided these do not run contrary to any of the principles stated herein.

Towards the Local and National Government

Although it is the responsibility of government to enact 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, national and international interests; and

● to propose sound policies in the use of human and material resources.

Towards Society in General

Businessmen shall recognize in their decision-making the interest of the general public and,
realizing that they are utilizing to an important degree the nation's resource, shall:

● take regular stock of their response to the basic needs of society and thus ensure
that these needs are taken into account in all policy-making decisions;
 ● do their best to ensure that the way they deploy their resources benefits society
in general and does not conflict with the needs and reasonable aspirations of the
communities in the area where they operate;

● pay proper regard to the environmental and social consequences of their

business activity, with special attention to the duty of renewing resources where
possible and minimizing waste and pollution, and not sacrifice 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 development projects;

● consider the human and social costs of mechanization and technology.

● establish 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
decision 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 13, 1992.
RA 3720 “The Food, Drug and Cosmetics” approved on June 22, 1963.
RA 8293 “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

GOVERNMENT INITIATIVES TO CURB CORRUPTION

"DU30 to DOJ: Probe all corrupt acts in Government"

Philippine Inquirer, October 28, 2020, Leila B. Salaverria

Saying official corruption had gotten worse, President Duterte announced on Tuesday that he
had directed the Department of Justice (DOJ) to launch a sweeping investigation into graft
across all government agencies and to put special focus on the Department of Public Works and
Highways (DPWH), which he earlier described as ridden with irregularities. He also ordered
Justice Secretary Menardo Guerra to prosecute and file charges against people involved in
irregularities, whether from the public or private sector.

"Graft-ridden agencies face deep budget cuts"

Philippine Inquirer, October 30, 2020, Nestor Corrales

ACT-CIS Rep. Eric Yap on Thursday said the House committee on appropriations would
separately investigate graft-ridden state agencies and it would slash or even scrap the budgets
of those that would be found dishonourable.

"We have oversight functions and as appropriations chair, we will make sure that the budget
being given to [state agencies] is properly used and not in corruption," he told reporters in an
online briefing. Yap said his committee would investigate the agencies during the two to three
weeks that the Senate would be deliberating on the P4.5-trillion proposed national budget for
2021.

Funds to other agencies

On October 28, President Duterte announced that he had directed the Department of Justice
(DOJ) to launch a sweeping investigation into graft across all government agencies and to
concentrate on the Department of Public Works and Highways (DPWH).

On October 29, Justice Secretary Menardo Guevarra said a DOJ-led task force would do the
investigation, beginning with the "usual suspects" - the DPWH, Bureau of Internal Revenue,
Bureau of Customs, Land Registration Authority, and Philippine Health Insurance Corp.
(PhilHealth).

Philippine Inquirer, Editorial, February 12, 2021

"Sporadic Victories"

Justice delayed may be justice denied, but in these two instances, the country will gladly take it.

The Sandiganbayan last week convict businesswoman Janet Lim Napoles, former Cagayan de
Oro Representative Constantino Jaraula, and several former government employees of several
counts of graft and malversation, for funneling some P28 million in lawmakers' pork barrel into
ghost projects and bogus nongovernment organizations. Yes, that's the infamous pork-barrel
scam that shook the nation some years ago but whose glacial grind through the judicial process
has all but ensured that the monumental racket is hardly remembered today.

Napoles, the alleged mastermind of the P10-billion scam, was also found guilty of plunder in
2018 in a case where her co-accused Sen. Ramon "Bong" Revilla Jr. was acquitted. The other
high- profile respondents in this case filed in 2014, former senators Juan Ponce Enrile and
Jinggoy Estrada, are out on bail and awaiting the court's decision.

Also last week, the anti-graft court ordered the forfeiture of P102 million worth of properties
amassed by retired Lt. Gen Jacinto Ligot after declaring them as "unlawfully acquired". Ligot and
four other family members were ordered to hand over condominium units, houses in California,
paid-up shares, deposits, investments, a vehicle, and several other real estate assets after they
failed to dispute evidence that the assets, acquired between 2001 and 2004, were
disproportionate to the general's lawful income in the same period. The case, filed in 2005, was
the offshoot of a lifestyle investigation of retired military officials launched by the Office of the
Ombudsman.

The guilty rulings in the two cases are rare and thus welcome - sporadic victories in the
seemingly mismatched battle against government corruption. The both cases were filed under
previous administrations also says a lot about how long and circuitous the road to justice is, and
how government zeal has limped along and even been hijacked for political ends in recent
years.
CHAPTER 11: RISK MANAGEMENT

INTRODUCTION

Effective corporate governance cannot be attained without the organization

mastering the art of risk management.And risk management is recognized as one of
the most important competencies needed by the board of directors of modern
organizations,large as well as small and medium sized business firms.

The levels of risk faced by business firms have increased because of the
fast-growing sophistication of organization, globalization, modern technology and impact
of corporate scandals. In addition therefore to compliance with legal requirements, top
management should consider adequate knowledge of risk management.

RISK MANAGEMENT DEFINED

Risk management is the process of measuring or assessing risk and developing
strategies to manage it. Risk management is a systematic approach in identifying,
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 the overall risk management program.
As defined in the International Organization of Standardization (ISO 31000), 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 to maximize the realization of
opportunities.
It is through risk management that risks to any specific program are assessed
and systematically managed to reduce risk to an acceptable level. Risks can come from
uncertainty in financial market, project failures, legal liabilities, credit risks, accidents,
natural causes and disasters as well as deliberate attack from adversary or events
adversary of uncertain or unpredictable root-cause,

BASIC PRINCIPLES OF RISK MANAGEMENT

The International Organization of Standardization (ISO) identifies the basic
principles of risk management.
Risk management should:
1. create value - resources 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 organizational processes and decision-making
4. be dynamic, iterative, transparent, tailorable, and responsive to change
5. create capability of continual improvement and enhancement considering the best
available information and human factors
6. be systematic, structured and continually or periodically reassessed

PROCESS OF RISK MANAGEMENT

According to the Standard ISO 31000 "Risk management - Principles and
Guidelines on Implementation, "the process of risk management consists of several
steps as follows:
1. Establishing the Context. This will involve:
a. Identification of risk in a selected domain of interest
b. Planning the remainder of the process.
c. Mapping out the following:
i. the social scope of risk management
ii. the identity and objectives of stakeholders
iii. the basis upon which risks will be evaluated, constraints.
d. Defining a framework 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.

2. Identification of potential risks. The risk identification can start with the analysis of the
source of the problem or with the analysis of the source of the problem or with the
analysis of the problem itself. Common risk identification methods are:
a. Objective-based risks
b. Scenario-based risks
c. Taxonomy-based risks
d. Common-risk checking
e. Risk charting

3. Risk assessment. Once risks have been identified, their potential severity of impact
and the probability of occurrence must be assessed. The assessment process is critical
to be assessed. The assessment process is to critical to best educated decisions in
prioritizing the implementation of the risk management plan

ELEMENTS OF RISK MANAGEMENT

In practice, the process of assessing overall risks can be difficult, and e
balancing resources to mitigate between risks with a high probability of occurrence but
lower loss versus a risk with high loss but lower probability of occurrence can often be
mishandled. Ideal risk management should minimize spending of manpower or other
resources and at the same time minimize the negative effect of risks.

For the most part, the performance of assessment methods should consists of the
following elements:
1. Identification, characterization, and assessment of threats
2. Assessment of the vulnerability of critical assets to specific threats
3. Determination of the risk (i.e. the expected likelihood and consequences of
specific types of attacks on specific assets)
4. Identification of ways to reduce those risks
5. Prioritization of risk reduction measures based on a strategy

RELEVANT RISK TERMINOLOGIES

I. Risks Associated With Investments
Although a single risk premium must compensate the investor for all the
uncertainty associated with the investment, numerous factors. may contribute to
investment uncertainty. The factors usually considered with respect to
investments are
● business risk
● financial risk
● liquidity 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. Clearly, the
firm's sales are not guaranteed and 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 than sales. Business
risk is related to sales volatility as well as to the operating leverage of the firm
caused by fixed operating expenses.
DEFAULT RISK
Default risk is related to the probability that some or all of the initial
investment will not be returned. The degree of default risk is closely related to the
financial condition of the company issuing the security and the security's rank in
claims on assets in the event of default or bankruptcy. For example, if a
bankruptcy occurs, creditors, including bondholders, have a claim on assets prior
to the claim of ordinary equity shareholders.

FINANCIAL RISK
The firm's capital structure or sources of financing determine financial risk.
If the firm is all equity financed, then any variability in operating income is passed
directly to net income on an equal percentage basis. If the firm is partially
financed by debt that requires fixed interest payments or by preferred share that
requires fixed preferred dividend payments, then these fixed charges introduce
financial leverage. This leverage causes net income to vary more than operating
income. The introduction of financial leverage causes the firm's lenders and its
stockholders to view their income streams as having additional uncertainty. As a
result of financial leverage, both investment groups would increase the risk
premiums that they require for investing in the firm.

INTEREST RATE RISK

Because money has time value, fluctuations in interest rates will cause the
value of an investment to fluctuate also. Although interest rate risk is most
commonly associated with bond price movements, rising interest rates cause
bond prices to decline and declining interest rates cause bond prices to rise.
Movements in interest rates affect almost all investment alternatives. For
example, as a change in interest 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 materially impact the analyst's estimate of the
value of a share of ordinary share.

LIQUIDITY RISK
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 is a house in a market with an abundance of homes
relative to the number of potential buyers. This investment may not sell for
several months or even years. Of course, if the price is reduced sufficiently, the
 real estate will sell, but the investor must make a selling price concession in
order for the transaction to occur.
In contrast, a government Treasury bill can be sold almost immediately
with very little concession on selling price. Such an investment can be converted
to cash almost at will and for a price very close to the price the investor expected.
The liquidity risk for ordinary equity shares is more complex. Because they
are traded on organized and active markets, ordinary equity shares can be sold
quickly. Some ordinary equity shares, however, have greater liquidity risk than
others due to a thin market. A thin market occurs when there are relatively few
shares outstanding and investor trading interest is limited. The thin market results
in a large price spread (the difference 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 management of such firms materially affected the risk of
the holders of their companies' securities.

PURCHASING POWER RISK

Purchasing power risk is perhaps more difficult 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 investment has declined (risen) as a result of inflation
(deflation). It is important to remember 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
during the period of inflation, the real or inflation adjusted rate of return will be
less than the nominal or stated rate of return. Thus, inflation erodes the
purchasing power of the peso and increases investor risk.

II. Risks Associated with Manufacturing, Trading And Service Concerns

A. Market Risk
● Product Risk
 ○ Complexity
○ Obsolescence
○ Research and Development
○ Packaging
○ Delivery of Warranties
● Competitor Risk
○ Pricing Strategy
○ Market Share
○ Market Strategy

B. Operation Risks
● Process Stoppage
● Health and Safety
● After Sales Service Failure
● Environmental
● Technological Obsolescence
● Integrity
○ Management Fraud
○ Employee Fraud
○ Illegal Acts

C. Financial Risk
● Interest Rate Volatility
● Foreign Currency
● Liquidity
● Derivative
● Viability

D. Business Risk
● Regulatory Change
● Reputation
● Political
● Regulatory and Legal
● Shareholder Relations
● Credit Rating
● Capital Availability
● Business Interruption

III. Risks Associated with Financial Institutions

Financial Non-Financial

● Liquidity Risks ● Operational Risk

● Market Risk ○ Systems

○ Currency ■ Information
Processing

○ Equity ■ Technology

○ Commodity ○ Customer Satisfaction

● Credit Risk ○ Human Resources

○ Counterparty ○ Fraud and illegal acts

○ Trading ○ Bankruptcy

○ Commercial ● Regulatory Risk

■ Loans ○ Capital Adequacy

■ Guarantees ○ Compliance

● Market Liquidity Risk ○ Taxation

○ Currency Rates ○ Changing laws and policies

○ Interest Rates ● Environment Risk

○ Bond and Equity Prices ○ Politics

● Hedged Positions Risks ○ Natural disasters

● Portfolio Exposure Risk ○ War

● Derivative Risk ○ Terrorism

● Accounting Information Risk ● Integrity Risk

○ Completeness ○ Reputation

○ Accuracy ● Leadership Risk

● Financial Reporting Risk ○ Turnover

○ Adequacy ○ Succession

○ Completeness
POTENTIAL RISK TREATMENTS
ISO 31000 also suggests that once risks have been identified and assessed,
techniques to manage the risks should be applied. These techniques can fall into one or
more of these four categories:
● Avoidance
● Reduction
● Sharing
● Retention

Risk Avoidance
This includes performing an activity that could carry risk. An example
would be not buying a property or business in order not to take on the legal
liability that comes with it. Avoiding risks, however, also means losing out on the
potential gain that accepting (retaining) the risk may have allowed. Not entering a
business to avoid the risk of loss also avoids the possibility of earning profits.

Risk Reduction
Risk reduction or optimization involves reducing the severity 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 if the 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, from 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 or retained by default. Also, any amount of potential loss over the
amount insured is retained risk. This is acceptable if the chance of a very large
loss is small or if the cost to insure for greater coverage involves & substantial
amounts that could hinder the goals of the organization.


AREAS OF RISK MANAGEMENT
As applied to corporate finance, risk management is the technique for measuring,
monitoring 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 management

2. Risk management activities as applied to project management 3. Risk management
for megaprojects
4. Risk management of information technology
5. Risk management techniques in petroleum and natural gas

A simplified framework for an Enterprise-wide Risk Management Process follows:

Risk Management System Top Management’s Involvement

Oversight Activities:

Define goals and objectives, roles and Set management policy. Establish
responsibilities, common language,and context, set limits and tolerance, etc.
oversight structure.

Risk Management Process:

STEP1: Asses risks: Ensure that process captures all business

Identify, source, measure risks

STEP2: Develop/Design Action Plans: Ensure that all available tools and
Reduce, avoid, retain, transfer, exploit methodologies are used

STEP3: Implement Action Plans Review effectiveness of plans, Check

capabilities

STEP4: Monitor and report risk Review and evaluate regular reports on
management performances performance

STEP5: Continuously improve risk Evaluate recommendations for

management capabilities improvement
SEC Requirement Relative to Enterprise Risk Management of Publicly-Listed
Corporation
SEC Code of Governance Recommendations 2.11 and corresponding explanation
provide the following

“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 "The
Board should oversee a sound enterprise risk management (ERM) identifying
units/business lines and enterprise-level risk exposures, as well as the
effectiveness of risk management strategies.

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 management policies 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 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.

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
Chairman 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.


 Subject to its size, risk profile and complexity of operations, the company should
have a separate risk management function to identify, assess and monitor key risk
exposures.

STEPS IN THE RISK MANAGEMENT PROCESS

To enhance management's competence in their oversight role on risk
management the following steps may be followed:
1. 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 documented 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 should
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;
a) Assessment risks: Identification; Determination of their 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 improvement risk management capabilities.
4. Evaluate the effectiveness of the various steps in the assessment of the
comprehensive risks faced by the business firm.
● Risk assessment step which includes risks identification and determination of
their sources and measurement, represents the foundation for the rest of the
procedures. This step is performed by responsible managers, i.e., finance
officers, production 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.
5. Assess if management has developed and implemented the suitable risk
management strategies and evaluate their effectiveness.
● The risk profile highlights all the significant possible risks identified, prioritized
and measured by the risk management system.
● Strategies are developed to manage 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 continue to monitor and assess if management has been
implementing designed risk management capabilities.
● Risk management capabilities include processes, people, reports, methodologies
and technologies needed. These components should be complete, and aligned
for the risk management structure to function effectively.
7. Assess management's efforts to monitor overall company risk management
performance and to continuously improve the firm's capabilities.
● Risk management performance must be monitored on a continuing basis and
organizations must be ready to innovate their approaches to be in line with the
changing lines.
● Monitoring is done by all concerned parties such as senior managers, 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 feedback to all concerned.
● These should be an open communication channel to ensure that all risk
management participants, particularly senior management, are informed of risk
incidents or threat of risk incidents. 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.
 CHAPTER 12

PRACTICAL GUIDELINES IN REDUCING AND MANAGING BUSINESS RISKS

Practical Guidelines in Managing and Reducing Enterprise-wide Risk in business activity is best
achieved by applying the principles and techniques appropriate to the situation.

THE NATURE OF RISK

The willingness and readiness to take personal and financial risks is a defining characteristic of
the entrepreneurial decision-maker. In late 90's, a study commissioned by an internationally-
known accounting firm found that while in continental Europe strategies focus on avoiding and
hedging risk, Anglo- American 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 events.

Successful 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 financial perspective and actively manage risk as it affects 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 that
standards and expectation are set and clearly understood.

IDENTIFY AND PRIORITIZE RISKS

Identification of significant risks both within and outside the organization is crucial and allows
to make informed decisions. This makes it easier to avoid unnecessary surprises. Examples of
significant risks might be the loss of a major customer, the failure of a key supplier or the
appearance of a significant competitor.
Consider the human factor into account. People behave differently and inconsistently when
making decisions involving risk. They may be exuberant o 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.

Typical Areas of Organizational Risk

Financial
 Accounting decisions and practices
 Treasury risks
 Fraud
 Robustness of information management systems
 Inefficient cash management
 Inadequate insurance
Commercial
 Loss of key personnel and tacit knowledge
 Failure to comply with legal regulations of codes of practice
 Contract conditions
 Poor brand management or handling of a crisis
 Market Changes
Strategic
 Marketing pricing and market entry decisions
 Markel changes affecting commercial decisions (due to customers and/or competitors)
 Political or regulatory developments
 Resource building and resource allocation decisions
Technical
 Failure of plant or equipment
 Accidental or negligent actions (such as fire, pollution, floods)
Operational
 Product or design failure, including failure to maintain supply
 Client failure
 Breakdown in labour relations
 Corporate malpractice (such as sex discrimination)
 Political change
CONSIDER THE ACCEPTABLE LEVEL OF RISK

As earlier mentioned, the usual first step is to determine the nature and extent of the risks the
business will accept. This involves assessing the likelihood of risks becoming reality and the
effect they would have if they did. Only when this is 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 may mean avoiding a
potentially big opportunity. People can be too cautious and risk averse even though they are
often at their best when facing the pressure of risk deciding to take a more audacious approach.
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 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, Metro Manila
Development Authority Chair introduced a congestion change for traffic using 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.

People - Hiring new employees, losing key people, poor succession planning, or weak people
management can all create dislocation, but the main danger is behavior: everything from
laziness to fraud, exhaustion and simple human error can trigger this risk.

External 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 by the sudden spread of the SARS epidemic from China to the rest
of Asia in 2003 highlights this risk.
APPLY A SIMPLE RISK MANAGEMENT PROCESS

The stages of managing the enterprise-wide risk inherent in decisions are 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 courses of action 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 inconvenient to catastrophic
(see Figure 12.1).

B. Risk Management and Control

Risk should be actively managed and given a high priority across the whole organization. Risk
management procedures and techniques should be well 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 12.1, 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 quadrant (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.
Once the inherent risks in a decision are understood, the priority is to exercise control All
employees must be aware that unnecessary rake 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.

Avoiding and Mitigating Risks

Start by reducing or eliminating those risks that result only in costs: the non-trading risks. These
can be thought of as the fixed costs of risk and might include property damage risks, legal and
contractual liabilities and business interruption risks. Reducing these risks can be achieved
through quality assurance programs, environmental control processes, enforcing health and
safety regulations, installing accident prevention and emergency equipment and training people
to use it, and taking security measures to prevent crime, sabotage, espionage, and threats to
people and systems. Reducing a risk may also mean that the cost of insuring against it goes
down.

Risks can be reduced or mitigated by sharing them. For example, acceptable service
agreements from vendors are 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 do - doing the right things right reduces risks and costs.

Risk management relies on accurate, timely information. 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 right time so that they can investigate and
take corrective action.
Create a Positive Climate 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 (including training) to match. Too often, control systems are seen
only as an additional overhead and not as something that can add value by ensuring the
effective use of assets, the avoidance of waste and the success of key decisions.

Overcoming the Fear of Risk

Everyone accepts that taking risks is needed to keep ahead of the competition. Consequently,
employees need to understand better what the real risks are, to share responsibility for the risks
being taken and to see risk as an opportunity, not a threat. Understanding how organizations
manage risk effectively is important, but managing risk is only one possible strategy. Another
approach is to look for ways to use the risk to achieve success by adding value or outstripping
competitors or both. To do this, organizations need to stop taking the fun out of risk by
controlling it in ways that are perceived as bureaucratic and stifling. Risk is both desirable and
necessary. It provides opportunities to learn and develop and compels people to improve and
effectively meet the challenge of change.

C. Controlling 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.

 Where are the greatest areas of risk relating to the most significant strategic decisions?

 What level of risk is acceptable for the company to bear? What are the potentially
disclosing events that could inflict the greatest damage on your organization?

 What are the risks inherent in the organization's strategic decisions, and what is the
organization's ability to reduce their incidence and impact on the business?

 What is the overall level of exposure to risk? Has this been assessed and is it being
actively monitored?

 What are the costs and benefits of operating effective risk management controls?

 What review procedures are in place to monitor risks?

 Are the risks inherent in strategic decisions (such as acquiring a new business,
developing a new product or entering a new market) adequately understood?

 At what level in the organization are the risks understood and actively managed? Do
people fully realize the potential consequences of their actions, and are they equipped to
understand, avoid, control or mitigate risk?To what extent would be company be
exposed if key staff left?
  If there have been major developments (such as a new management structure or
reporting arrangements), are the new responsibilities understood and accepted?

 Are management information systems keeping pace with demands? Are there persistent
black spots - priority areas where the system needs to be improved or overhauled?

 Do employees resent risk, or are they encouraged to view certain risks as opportunities?

PRACTICAL CONSIDERATIONS IN MANAGING AND REDUCING FINANCIAL RISK

Finance is the lifeblood of a business, heavily influencing strategies and decisions at every level.

Many find it difficult to get to grips with financial issues and, as the 2008 global financial crisis
revealed, many lost touch with basic financial ground rules.

Profitability, cash flow, long-term shareholder value and risk all need to beconsidered when
setting and reviewing strategy. This section provides practical guidance about financial
decisions and explains how to:

 improve profitability,

 avoid pitfalls in making financial decisions;

 reduce financial risk.

Improving Profitability.

Entrepreneurial flair and financial rigour are as much about attitude as skill. Nonetheless, certain
skills will ensure that decisions are focused on commercial success.

A. Variance Analysis

Interpreting the differences between actual and planned performance is crucial. Variance
analysis is used to monitor and manage the results of past decisions, assess the current
situation and highlight solutions.

Common causes of variances include inefficiency, poor or flawed planning (for example, relying
on historically inaccurate information), poor communication, interdependence between
departments and random factors. Every 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 enter 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
markets 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 other
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 nor a loss is made. It is
calculated by 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) is 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, cost structure and
production capacity, as well as in forecasting and budgeting.

D. Controlling Costs

To control costs:

 Focus on the big items of expenditure. Categories costs into major or peripheral items.
Often, undue emphasis is given to the 80% of activities accounting for 20% of costs.

 Be cost aware. Casualness is the enemy 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 long term by managers' attitudes to cost control and the
effects of expenses on cash flow.

 Maintain a balance between costs and quality. Getting the best value means achieving a
balance between the price paid and the quality received.

 Use budgets for dynamic financial 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.

 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.

 Eliminate waste. For decades, leading Japanese companies have directed much of their
cost-management efforts towards waste elimination. They achieve this by using
techniques such as process analysis, mapping and re-engineering.
 Practical Techniques to Improve Profitability

Some practical techniques to improve profitability:

 Focus decision-making on the most profitable areas. Concentrating on products and

services with the best margin will protect or enhance profitability. This might involve
redirecting sales and advertising activities.

 Decide how to treat the least profitable products. These often drift, with dwindling
profitability. Turn around a poor performer (by reducing costs, raising prices, altering
discounts or changing the product) or abandon it to prevent drain on resources and
reputation. The shelf-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 production 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 methods 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 controlling delivery charges, monitoring exchange rates,
improving quality control, reducing inventory and improving production lead times.

 Consider 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 more competitive relative to the opposition?

 How can existing markets, sales channels, products, brand reputation and other
resources be adapted to exploit new markets and newopportunities? How can
sales expenses be reduced?

 How can effectiveness of marketing activities be increased?

 Consider how to increase profitability by managing people. Successful leadership is

prerequisite for profitability.
 People need to be motivated and supported, and this implies rewarding them fairly for
their work, training and developing them, providing clear sense of direction, and focusing
on the needs of the team, the task and the individual.

There are many techniques for assessing the likely profitability of an investment. One of the
most used is to apply discounted cash flows in evaluating capital investment programs.

Avoiding Pitfalls

Many managers have financial responsibilities and their decisions 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 be widely available

Every manager needs to understand why 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 the impact of financial decisions

Do not ignore or underestimate the wider impact of finance issues upon other departments and
decisions.

Avoid weak budgetary control

Budgets are an active tool to help make financial decisions, not merely a way to

measure performance.

Understand the impact of cash flow

Non-financial managers often ignore cash flows and the time value of money. Everyone should
be aware of the importance of cash to the organization.

Know where the risk lies

Identifying risks and how to reduce them is crucial to successful financial decision-making. For
example, managers need to know not only where the break- even point is, but also how and
when it will be reached.
Reduce Financial Risk Positive Replies to the following Questions would assist Top
Management to Manage Financial Risk

 Are the most effective and relevant performance measures in place to monitor and
assess the effectiveness of financial decisions?

 Have you analyzed key business ratios recently? How useful are your performance
indicators? What are the main issues? Are you measuring the right things?

 Is there a positive attitude to budgets and budgeting?

 Does decision-making focus on the most profitable products and services, or is it

preoccupied with peripheral issues?

 What are the least profitable parts of the organizations? How will they improved?

 Are market and customer decisions focused on improving profitability?

Too often, attention if given to non-financial objectives, such as increasing market share,
without adequately considering the financial risks and alternatives.

 How efficiently is cash managed? Do your strategic business decisions take account of
cash considerations, such as the time value of money?
 CHAPTER 13
OVERVIEW OF INTERNAL CONTROL
NATURE AND PURPOSE OF INTERNAL CONTROL

Internal control is the process designed and effected by those charged with governance,
management and other personnel to provide reasonable assurance about the achievement of the
entity's objectives with regard to reliability of financial reporting, effectiveness and efficiency of
operations and compliance with applicable 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 categories:

• Reliability of the entity's financial reporting

• Effectiveness and efficiency of operations
• Compliance with applicable 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

Internal control system means all the policies and procedures (internal controls) adopted by the
management of an entity to assist in achieving management's objective of ensuring, as far as
practicable, the orderly and efficient conduct of its business, including adherence to management
policies, the safeguarding of assets, the prevention and detection of fraud and error, the accuracy
and completeness of the accounting records, and the timely preparation of reliable financial
information.

ELEMENTS/COMPONENTS OF INTERNAL CONTROL

Internal control structures vary significantly from one company to the next. Factors such as size
of the business, nature of operations, the geographical dispersion of its activities, and objectives
of the organization affect the specific control features of an organization. However, certain
elements or features must be present to have a satisfactory system of control in almost any large
scale organization.
The internal control system extends beyond these matters which relate directly to the functions of
the accounting system and consists of the following components in accordance with the COSO's
updated Internal Control Integrated Framework.
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,

Control Environment
The control environment which means the overall attitude, awareness and actions of directors
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 complement specific control procedures. However, a strong
environment does not, by itself, ensure the effectiveness of 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
procedures and segregation of duties.
The environment in which internal control operates has an impact on the effectiveness of the
specific control procedures: Several factors comprise the control environment, including:

1. Communication and Enforcement of Integrity and 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 standards to
personnel through policy statements, a code of conduct, and management's example of
appropriate behavior."

2. Commitment to Competence

Competence is the knowledge and skills necessary to accomplish tasks that define an
employee's job. Commitment to competence means that management considers 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

governance. Attributes of those charged with governance include independence from
management, their experience and stature, the extent of their involvement and scrutiny of
activities, the appropriateness of their actions, the information they receive, the degree to
which difficult questions are raised and pursued with management, and their interaction
with internal and external auditors. The importance of responsibilities of those charged
with governance is recognized in codes of practice and other regulations or guidance
produced for the benefit of those charged with governance. Other responsibilities of those
charged with governance include oversight of the design and effective operation of whistle
blower procedures and the process for reviewing the effectiveness of the entity's internal
control.

4. Management's Philosophy and Operating Style

This refers to management's attitude towards (a) business risk, (b) financial reporting, (c)
meeting budget, profit and other established goals which all have impact on the reliability
of the financial statements, Management's approach to taking and monitoring business
risks, its conservative or aggressive selection from alternative accounting principles, its
conscientiousness and conservatism in developing accounting estimates, and its attitude
toward information processing and the accounting function and personnel are factors that
affect the control environmental

5. Organizational Structure

The responsibilities and authorities of the various personnel within the organization should
be established in such a manner as to (1) assist the entity in meeting its goals and
objectives and (2) ensure that transactions are processed, recorded, summarized and
reported in an accurate and timely manner. Organizational structure provides the overall
framework for planning, directing and controlling operations..

6. Assignment of Authority and Responsibility.

Personnel within an organization need to have a clear understanding of their

responsibilities and the rules and regulations that govern their actions. Management may
develop job descriptions, computer system documentation. It may also establish policies
regarding acceptable business practice, conflicts of interest and code of conduct.

7. Human Resources Policies and Procedures

Perhaps the most important element of an internal accounting control system is the people
who perform and execute the established policies and procedures. Personnel policies
should be adopted by the client to reasonably ensure that only capable and honest
persons are hired and retained. Policies with respect to employee selection, training, and
 supervision should be adopted and implemented by the client. The selection of competent
and honest personnel does not automatically assure that errors or irregularities will not
occur. However, adequate personnel policies, coupled with the design concepts
suggested earlier in this section, enhance the likelihood that the client's policies and
procedures will be followed.

B. Entity's Risk Assessment Process

Risk assessment is the "identification, analysis, and management of risks pertaining to the
preparation of financial statements". For example risk assessment may focus on how the entity
considers the possibility of transactions not being recorded or identifies and assesses significant
estimates recorded in the financial statements.
An entity's risk assessment process is its process for identifying and responding to business risks
and the results thereof. For financial reporting purposes, the entity's risk assessment process
includes how management identifies risks relevant to the preparation of financial statements that
are presented fairly, in all material respects in accordance 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 the entity considers the possibility of unrecorded transactions or identifies and
analyzes significant estimates recorded in the financial statements. Risks relevant to reliable
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 the financial statements. Once 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
specific 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. New 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.
• Rapid growth. Significant and rapid expansion of operations can strain controls and
increase the risk of a breakdown in controls.
• New technology. Incorporating new technologies into production processes or
information systems may change the risk associated with internal control.
• New business models, products, or activities. Entering into business areas or
transactions with which an entity has little experience may introduce new risks associated
with internal control.
• Corporate restructurings. Restructurings may be accompanied by staff reductions and
changes in supervision and segregation of duties that may change the risk associated with
internal control.
 • Expanded foreign operations. 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 involvement with employees and outside parties.
Considerations Specific to Smaller Entities
Many small entities are carried out entirely by the engagement partner (who may be a sole
practitioner). In such situations, it is the engagement partner who, having personally conducted
the planning of the audit, would be responsible for considering the susceptibility of the entity's
financial statements to material misstatement due to fraud and error.

C. Information System, including the Business Processes, Relevant to Financial 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
significance, in systems that are exclusively or primarily manual. Many information systems make
extensive use of IT.
The Information System, Including Related Business Processes. Relevant to Financial Reporting
The information system relevant to financial reporting objectives, which includes the accounting
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 followed to clear suspense items out on a timely basis;
• Process and account for system overrides or bypasses to controls; Transfer information
from transaction processing systems to the general
• 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 accumulated, recorded, processed, summarized and appropriately reported
in the financial statements.
Journal Entries
An entity's information system typically includes the use of standard 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 general ledger, or to record accounting
estimates that are periodically made by management, such as changes in the estimate of
uncollectible accounts receivable.
An entity's financial reporting process also includes the use of non-standard journal entries to
record non-recurring, unusual transactions or adjustments. Examples of such entries include
consolidating adjustments and entries for a business combination or disposal or nonrecurring
estimates such as the impairment of an asset. In manual general ledger systems, non-standard
journal entries may be identified through inspection of ledgers, journals, and supporting
documentation. When automated procedures are used to maintain the general ledger and prepare
financial statements, such entries may exist only in electronic form and may therefore be more
easily identified through the use of computer- assisted audit techniques.

Related Business Processes

An entity's business processes are the activities designed to:

• Develop, purchase, produce, sell and distribute an entity's products and services:
• Ensure compliance with laws and regulations, and
• Record information, including accounting and financial reporting information.
Business processes result in the transactions that are recorded, processed and reported by the
information system. Obtaining an understanding of the entity's business processes, which include
how transactions are originated, assists the auditor obtain an understanding of the entity's
information system relevant to financial reporting in a manner that is appropriate to the entity's
circumstances.
Accordingly, an information system encompasses methods and records that:

• Identify and record all valid transactions.

• Describe on a timely basis the transactions in sufficient detail to permit proper
classification of transactions for financial reporting.
• Measure the value of transactions in a manner that permits recording their proper
monetary value in 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.
Communication involves providing an understanding of individual roles and responsibilities
pertaining to internal control over financial reporting. It includes the extent to which personnel
understand how their activities in the financial reporting information system relate to the work of
others and the means of reporting exceptions to an appropriate higher level within the entity. Open
communication channels help ensure that exceptions are reported and acted on.
Communication 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, whether within IT or manual systems,
have various objectives and are applied at various organizational and functional levels.
The major categories of control procedures are:
A. Performance Review
B. Information Processing Controls
1) Proper authorization of transactions and 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.

A brief discussion of these control procedures follows:

A. Performance Review
In a performance review management uses accounting and operating data to assess
performance, and it then takes corrective action. Such reviews include.

• comparing actual performance (or operating results) with budgets, forecasts, prior
period performance, or competitors' data or tracking major initiatives such as cost-
containment or cost-reduction programs to measure the extent to which targets
are being met.
• investigating performance indicators based on operating or financial data, such as
quantity or purchase price variances or the percentage of returns to total orders.
• reviewing functional or activity performance, such as relating the performance of a
manager responsible for a bank's consumer loans with some standard, such as
economic statistics or targets.
Personnel at various levels in 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 with their expectations. This type of review improves the reliability
of the data. However, when managers follow up on unexpected results determined by a financial
reporting system, performance reviews become a useful control over financial reporting.

B. Information Processing Controls

Information processing controls are policies and procedures designed to 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, backup, and recovery procedures. Application controls 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 completely and accurately recorded and processed. Examples of application controls
include checking the arithmetical accuracy of records, maintaining and reviewing 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 functioning of
application controls by helping to ensure the continued proper 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 accounting 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.
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 performance.
1. Proper authorization of transactions and activities

As suggested earlier, authorization for the execution of 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, the auditor may be reasonably satisfied that
a business transaction was authorized and executed in a manner consistent with
company policy.

2. Segregation of duties

An important element in designing an internal 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
duties that would allow that person to commit an error or perpetuate fraud and to
conceal the error or fraud. For example, the same person should not be
responsible for recording the cash received on account and for posting the receipts
to the accounting records.

3. Adequate documents and records the use of adequate documents and records

The use of adequate documents and records allow the company to obtain
reasonable assurance that all valid transactions have been recorded.

4. Access to assets

The resources of a client can be protected by the establishment of physical barriers

and appropriate policies. For example, inventories may be kept in storeroom, or
negotiable. instruments may be placed in a safe deposit box. Appropriate company
policies are adopted so that only authorized persons have access to company
resources. Safeguarding of assets is more than establishing physical barriers. 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 checks on performance

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 misappropriated. An
important part of an internal accounting control system is to determine the
effectiveness of recording policies and 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 reconciliation.

C. Physical Controls

Controls that encompass:

• The physical security of assets, including adequate safeguards 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 inventory 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. The
concepts underlying control activities in small entities are likely to be similar to those in
larger entities, but the formality with which they operate varies. Further, small entities may
find that certain types of control activities are not relevant because of controls applied by
management. For example, management's retention of authority for approving credit
sales, significant purchases, and drawdown's on lines of credit can provide strong control
over those activities, lessening or removing the need for more detailed control activities.
An appropriate segregation of duties often appears to present difficulties in small entities.
Even companies that have only a few employees, however, may be able to assign their
responsibilities to achieve appropriate segregation or, if that is not possible, to use
management oversight of the incompatible activities to achieve control objectives.

E. Monitoring of Controls
Monitoring, the final component of internal control, is the process that an entity uses to assess
the quality of internal control over time. Monitoring 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 areas in need of improvement. Customers 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 control from
external auditors in performing monitoring activities.

Application to Small Entities

Ongoing monitoring activities of small entities are more likely to be informal and are typically
performed as a part of the overall management of the entity's operations. Management's close
involvement in operations often will identify significant variances from expectations and
inaccuracies in financial data leading to corrective action to the control.
 CHAPTER 14
FRAUD AND ERROR

INTRODUCTION
In the previous chapters, corporate governance has been described as the process by which
the owners and various of stakeholders of an organization 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 arising front misappropriation of assets
b. Misstatements arising from fraudulent financial reporting

Misstatements arising from misappropriation of assets

Asset misappropriation occurs when a perpetrator steals or misuses an organization's assets.
Asset misappropriations are the dominant fraud scheme perpetrated against small business
and the perpetrators are usually employees. Asset misappropriations can be accomplished in
various ways, including embezzling cash receipts, stealing assets, or causing the company to
pay for goods or services that were not received.

Asset misappropriation commonly occurs when employees:

● Gain access to cash and manipulate accounts to cover up cash thefts.

● Manipulate cash disbursements through fake companies.
● Steal inventory or other assets and manipulate the financial records to cover up the
Fraud.

1
Misstatements arising from Fraudulent Financial Reporting
The intentional manipulation of reported financial results to misstate the economic condition
of the organization is called fraudulent financial reporting. 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:

1. 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:

● Incentive to commit fraud
● Opportunity to commit and conceal the fraud
● Rationalization - the mindset of the fraudster to justify committing the fraud.

Incentives or Pressures to Commit Fraud

Incentives relating to asset misappropriation include:

● Personal factors, such as severe financial considerations

● Pressure from family, friends, or the culture to live a more lavish lifestyle than one's
personal earnings allow for
● Addictions to gambling or drugs

The incentives include the following for fraudulent financial reporting:

● Management compensation schemes

● Other financial pressures for either improved earnings or an improved balance sheet
● Debt covenants

2
 ● Pending retirement or stock option expirations
● Personal wealth tied to either financial results or survival of the company
● Greed — for example, the backdating of stock options was performed by individuals
who already had millions of pesos of wealth through stock

Opportunities to Commit Fraud

One of the most fundamental and consistent findings in fraud research is that
there 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
complexities associated with a transaction are such that the perpetrator assesses the risk of
being caught as low. Some of the opportunities to commit fraud that the top management
should consider include the following:
● Significant related-party transaction
● A company's industry position, such as the ability to dictate terms or conditions to
suppliers or customers that might allow individuals to structure fraudulent
transactions.
● Management's inconsistency involving subjective judgement regarding assets 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 board of
directors is not independent or effective, or because there is a domineering manager
● Complex or unstable organizational structure
● Weak or nonexistent internal controls

Rationalizing 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 individual
perpetrating the fraud. Following are some common rationalizations for asset
misappropriation:

● Fraud is justified to save a family member or loved one from financial crisis.
● We will lose everything (family, home, car and so on) if we don't take the money.

3
 ● No help is available from outside.
● This is "borrowing", and we intend to pay the stolen money 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 fraudulent financial reporting, the rationalization can range from "saving the company"
to personal greed, and may include the following:

● This is a 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.
● We will be in violation of all of our debt covenants 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 Contributory to Misappropriation 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 accompanied in a variety of ways
including:

● Embezzling receipts (for example, misappropriating collections on accounts

receivable or 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).

4
 ● 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 for inflating prices, payments to fictitious employees).
● 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 misleading records or documents

in order to conceal the fact that the assets are missing or have been pledged without proper
authorization.

A. Incentives / Pressures
1. Personal financial obligations may create pressure on management or employees
with access to cash or other assets susceptible to theft to misappropriate those
assets.
2. Adverse relationships between the entity and employees with access to cash or
other assets susceptible to theft may motivate those employees to misappropriate
those assets. For example, adverse relationships may be created by the following:
(a) Known or anticipated future employee layoffs.
(b) Recent or anticipated changes to employee compensation or benefits plans.
(c) Promotions, compensation, or other rewards inconsistent with
expectations.
B. Opportunities
1. Certain characteristics 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 demand.
(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 of 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.

5
 (d) Inadequate job applicant screening of employees with access to assets.
(e) Inadequate record keeping with respect to assets.
(f) Inadequate system of authorization and approval of transactions (for
example, in purchasing).
(g) Inadequate physical safeguards over cash, investments, inventory, or fixed
assets.
(h) Lack of complete and timely reconciliations of assets.
(i) Lack of timely and appropriate documentation of transactions, for example,
credits for merchandise returns.
(i) Lack of mandatory vacations for employees performing key
control functions.
(k) Inadequate management understanding of information technology, which
enables information technology employees to perpetrate misappropriation.
(l) Inadequate access controls over automated records, including controls over
and review of computer systems event logs.

C. Attitudes / Rationalizations
1. Disregard for the need for monitoring or reducing risks related to
misappropriation of assets.
2. Disregard for internal control over. misappropriation of assets by overriding
existing controls or by failing to correct known internal control deficiencies.
3. Behavior indicating displeasure or dissatisfaction with the entity or its treatment
of the employee.
4. Changes in behavior or lifestyle that may indicate assets have been
misappropriated.
5. Tolerance of petty theft.

Risk Factors Contributory to Fraudulent Financial Reporting

Fraudulent financial reporting may be accomplished by the following:

● Manipulation, falsification (including forgery), or alteration of accounting records or

supporting documentation from which the financial statements are prepared.

6
 ● Misrepresentation in, or intentional omission from, the financial statements of events,
transactions or other significant information.
● Intentional misapplication of accounting principles relating to amounts, classification,
manner of presentation, or disclosure.

Fraudulent financial reporting involves intentional misstatements including omissions of

amounts or disclosures in financial statements to deceive financial statement users. It can be
caused by the efforts of management to manage earnings in order to deceive financial
statement users by influencing their perceptions as to the entity's performance and
profitability. Such earnings management may start out with small actions or inappropriate
adjustment of assumptions and changes in judgments by management. Pressures and
incentives may lead these actions to increase to the extent that they result in fraudulent
financial reporting. Such a situation could occur when, due to pressures to meet market
expectations or a desire to maximize compensation based on performance, management
intentionally takes positions that lead to fraudulent financial reporting by materially
misstating the financial statements. In some entities, management may be motivated to reduce
earnings by a material amount to minimize 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 so and some
rationalization of the act.

A. Incentive / Pressure
Incentive or pressure to commit fraudulent financial reporting may exist when
management is under pressure, 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. Opportunities
A perceived opportunity to commit fraud may exist when an individual believes
internal control can be overridden, for example, because the individual is in a position
of trust or has knowledge of specific weaknesses in internal control.

7
 Fraudulent financial reporting often involves management override of controls that
otherwise may appear to be operating effectively. Fraud can be committed by
management overriding controls using such techniques as:
● Recording fictitious journal entries, particularly close to the end of an
accounting period, to manipulate operating results or achieve other objectives.
● Inappropriately adjusting assumptions and changing judgments used to
estimate account balances.
● Omitting, advancing or delaying recognition in the financial statements of
events and transactions that have occurred during the reporting period.
● Concealing, or not disclosing, facts that could affect the amounts recorded in
the financial statements.
● Engaging in complex transactions that are structured to misrepresent the
financial position or financial performance of the entity.
● Altering records and terms related to significant and unusual transactions.

C. Rationalizations
Individuals may be able to rationalize committing a fraudulent act. Some individuals
possess an attitude, character or set of ethical values that allow them knowingly and
intentionally to commit a dishonest act. However, even otherwise honest individuals
can commit fraud in an environment that imposes sufficient pressure on them.

Material Weakness in Internal Control

A material weakness is a deficiency, or a combination of deficiencies, in internal control

over financial reporting, such that there is a reasonable possibility that a material
misstatement of the company's annual or interim financial statements will not be prevented of
detected on a timely basis. For these deficiencies, the likelihood and magnitude of potential
misstatement are such that the company cannot conclude that its internal control over
financial reporting is effective. A material weakness does not mean the control deficiency
resulted in a material, or even immaterial, misstatement in the financial statements. Rather, a
reasonable possibility is that this type of control deficiency could lead to a material
misstatement.

8
Responsibility for the Prevention and Detection of Fraud

The primary responsibility for the prevention and detection of fraud rests with both those
charged with governance of the entity and management. It is important that management,
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 could persuade individuals not to commit fraud because of the likelihood of detection
and punishment. This involves a commitment to creating a culture of honesty and ethical
behavior which can be reinforced by an active oversight by those charged with governance.
In exercising oversight responsibility, those charged with governance consider the potential
for override of controls or other inappropriate influence over the financial reporting process,
such as efforts by management to manage earnings in order to influence the perceptions of
analysts as to the entity's performance and profitability.

FRAUDULENT FINANCIAL REPORTING THROUGH EARNINGS

MANAGEMENT

Income smoothing (also known as earnings management, cooking the books, and paper
entrepreneurialism) refers to choosing accounting methods and making accounting principle
changes to produce a specified income level or trend. In particular, reducing the volatility of
income and reporting relatively gradual or continual increases in income are alleged to be
common company goals. The implicit assumption is that the investing public values a smooth
and predictable income trend. Investors perceive an erratic earnings trend as more risky than
a smooth trend.

To smooth income, firms must increase reported earnings during a downturn and decrease
reported earnings during prosperous times. Excessively high income often invites unfriendly
press coverage, government intervention and increased demands for dividends. Furthermore,
large income increases are difficult to sustain and create increased expectations.

By choosing methods that increase income, many firms seek to avoid the unfavorable
economic consequences of lowered earnings, such as reduced stock prices, higher borrowing
costs, and noncompliance with debt covenants. In spite of the evidence, however, many firms
continue to manage income to avoid earnings reductions.

9
Motivations for Earnings Management

Numbers are very important in framing people's opinions. Rarely do we question how the
numbers are computed.

Reported numbers have power to frame opinions in the corporate arena. Because reported net
income is the number that receives the most attention, it is also the number that corporate
managers might be most tempered to manipulate. This section describes four reasons for
managing reported earnings.

These aren't necessarily good reasons, however, they do reflect the forces that
are often spoken of as pushing managers to manipulate reported earnings. These four reasons
are as follows:
1. Meet internal targets
2. Meet external expectations
3. Provide income smoothing
4. Provide window dressing for an IPO or a loan

Each of these earnings management motivations will be discussed in turn in this section.

Meet Internal Targets

To meet the nearly impossible earnings targets set by the CEO of a large business entity, that
the employee sells cartridges for laser printers reportedly resorted to shipping boxes filled
with bricks to meet sales targets at the end of the quarter. Managers of other corporations
pressured by corporate earnings and revenue targets, resorted to relaxing credit standards,
reducing estimates of bad debts and finally fraudulently concealing sales returns.

Internal earnings targets represent an important means or tool in motivating managers to

increase sales efforts, control costs and use resources more efficiently. Research has
confirmed that the existence of earnings based internal bonuses contributes to the incidence
of earnings management.

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For example, research has demonstrated that managers subject to an earnings based bonus
plan are more likely to manage earnings upward if they are close to the bonus threshold and
are also more likely to manage earnings downward if reported earnings are substantially in
excess of the maximum bonus level. This latter tendency basically means that managers have
a tendency to defer some earnings "for a rainy day".

Meet External Expectations

External stakeholders, which include creditors, suppliers, customers. prospective investors,

and employees are parties who have interest in a company's financial performance.

Employee and customers want a company to do well so that it can survive for the long run
and make good on its long-term pensions and warranty obligations. Suppliers want assurance
that they will receive payment and more importantly that the purchasing company will be a
reliable purchaser for many years into the future.

For these stakeholders, reporting negative earnings and signs of financial weakness are very
bad news indeed. This scenario provides strong evidence that companies manage earnings to
avoid reporting losses and disappointing external stakeholders.

Financial analysts are considered a very important set of external financial statements users.
Financial analysts, in addition to making buy and sell recommendations about shares of a
company's stock, also generate forecastsof company earnings. Research shows that
announcing net income less than the income forecast by analysts results in a drop in stock
price. As a result, companies have an incentive to manage earnings to make sure that the
announced number is at least equal to the earnings expected by analysts. Research has
demonstrated that managers not only manage earnings to make sure they meet analysts'
forecasts but also provide overly pessimistic "guidance" to analysts to ensure that the
forecasts made are not too high to reach.

Provide Income Smoothing

Income smoothing is the practice of carefully timing the recognition of revenues and
expenses to even on the amount of reported earnings from one year to the next.

11
By making a company appear to be less volatile, income smoothing can make it easier for a
company to obtain a loan on favorable terms and easier to attract investors. By carefully
timing the recognition of gains and losses, a company can avoid reporting earnings that
bounce up and down from year to year, which is obviously apply income smoothing.

Provide Window Dressing for a Loan or Initial Public Offering (IPO) of Equity Share

In situations such as a company applying for a large loan or before the IPO of stock, it is
critical that reported earnings look good. There is therefore the tendency of managers to boost
their reported earnings using accounting assumptions that can result to artificially inflate
earnings.

EARNINGS MANAGEMENT TECHNIQUES

Earnings management generally involves a series of increasingly aggressive steps. Those

steps include reporting fictitious transactions, strategic matching of one-time gains and
losses, change in accounting methods with either full disclosure or with little or no disclosure
or applying accounting method which is in violation of Financial Accounting Standards. The
earnings management continuum (Figure 14-1) illustrates that earnings management can
range from savvy timing of transactions to outright fraud. Because of the importance and
economic significance of the catastrophic reporting failures associated with companies that
engage in more elaborate earnings management, the continuum is briefly discussed here.

12
The five items shown in Figure 14-1 also mirror the progression in earnings management
strategies followed by individual companies. These activities start small and legitimately and
really reflect nothing more than the strategic timing of transactions to smooth reported
results. In the face of operating results that fall short of targets, a company might make some
cosmetic changes in accounting estimates to meet earnings expectations but would fully
disclose these changes in accounting estimates to meet earnings expectations but would fully
disclose these changes to avoid deceiving serious financial statement users. If operating
results are far short of expectations, an increasingly desperate management might cross the
line into deceptive accounting by making accounting changes that are disclosed or by
violating Financial Reporting Standards completely. Finally, when the gap between expected
results and actual results is so great that cannot be closed by any accounting assumption, a
manager who is still fixated on making the target number must resort to out-and-out fraud by
inventing transactions and customers. The key things to remember are that the forces
encouraging managers and accountants to manage earnings are real and that if one is not
aware of those forces, it is easy to gradually slip from the left side of the earnings
management continuum to the right side.

A. Strategic Matching
Certain key transactions are completed quickly or delayed so they are recognized in
the most advantageous period.

Example: Delay in recording operating expenditures by temporarily deferring them

using asset accounts.

B. and C. Change in Methods or Estimates with Full or Little or No Disclosure

Companies frequently change accounting estimates related to bad debts. income on
pension funds, depreciation lives, to manage the amount of reported earnings.

D. Fraudulent Reporting (applying accounting method that is not in accordance

with Financial Reporting Standards)
An example of this technique is deliberate omission of impairment losses on assets
financial statements are prepared.

13
 E. Fictitious Transactions. To reflect a more favorable financial condition and
operating results, a company may record a fictitious payment of a loan by
debiting Loans Payable and crediting Revenue account.

Is Earnings Management Ethical?

Everyone agrees that the creation of fictitious transactions, at the far right side of the earnings
management continuum, is unethical. But then, the universal agreement ends with respect to
what is and what is not ethical. Hopefully, both users and preparers of financial statements
will insist on transparency in reporting in order to reduce information risk and lower the cost
of capital.

Earnings management can and does occur without any violation of the accounting rules but
most people believe that intentionally trying to deceive others is wrong, regardless of the
economic consequences.

It must be remembered that a company that has been found to have manipulated
its reported earnings can experience a huge loss of credibility. This loss of credibility harms
all of the company's relationships and drastically impairs its economic value.

The more reliable information provided by a company, the more confidence potential
investors can place in that information. High-quality information allows for better decision
making. The ability to make better decisions reduces the risk to potential investors and
creditors and thus reduces the cost of capital to a company.

And hopefully individual managers, accountants and financial statement users will be
reminded again that because of the high value of a company's reputation, ethical behavior
really is the best long-run business practice.

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 CHAPTER 15

ERRORS AND IRREGULARITIES IN THE TRANSACTION CYCLES OF THE

BUSINESS ENTITY

While businesses in different individuals can have striking different characteristics

most have some fundamental conceptual characteristics are practices in common.
The three basic business transaction cycles include:
1. Sales and Collections Cycle

2. Acquisitions and Payments Cycle

3. Payroll and Personnel Cycle

Management should establish controls 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 and Collections Cycle

1. 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 period (cut-off errors), a bookkeeper's
failure to understand proper accounting for a transaction, and so on. Internal controls
are designed to prevent or 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 to misappropriation of assets, typically accomplished by
clerks or management-level employees.

a. Fraudulent Financial Reporting

Fraudulent financial reporting involving sales typically results in overstated sales or

understated sales returns and allowances. Managers under pressure to achieve high
profits may inflate sales to meet target profits established by senior managers, to
obtain bonuses, to retain the respect of senior managers, or even to keep their jobs.
The following methods can be used to increase sales fraudulently:

- Recording fictitious sales (creating fictitious shipping documents, sales invoices,

and so on)
-Recording valid transactions twice

-Recording in the current period sales that occurred in the succeeding period
(improper cut-off)

- Recording operating leases as sales

- Recording deposits as sales

- Recording consignments as sales

- Recording sales when the chance of a return is likely

- Following revenue recognition practices that are not in accordance with PFRS

- Recognizing revenue that should be deferred

b. Misappropriation of Assets: Withholding Cash Receipts

1. 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 receivable 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.
2. Lapping

This technique is used to conceal the fact that cash has been abstracted; the
shortage in one customer's account is covered with a subsequent payment made by
another customer. An employee who has access to cash receipts and maintains
accounts receivable can engage in lapping. Routine testing of details 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 of fraud.

II. Acquisitions and Payments Cycle

1. Errors in the Acquisitions and Payments Cycle

The following may occur in the acquisitions and payments cycle:

- Failing to record a purchase in the proper period (cut-off 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 controls 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.
2. Frauds in the Acquisitions and Payments Cycle

a. Paying for Fictitious Purchases

This involves the perpetrator creating a fictitious invoice (and sometimes a receiving
report, purchase order and so forth) and processing the invoice for payment.
Alternatively, the perpetrator can pay the invoice twice.
b. Receiving Kickbacks

In this scheme, a purchasing agent may agree with a vendor to receive a kickback
(refund payable to the purchasing person on goods or services acquired 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 and 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 approving and paying it. Detecting kickbacks is difficult because the
buyer's records do not reflect their existence. However, when vendors are required
to submit bids for goods or services, the likelihood of kickbacks is reduced.

c. Purchasing Goods for Personal Use

Goods or services for personal use may be purchased by executive or purchasing
agents and charged to the company's account. To execute such a purchase, the
perpetrator must have access 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.

III. Payroll and Personnel Cycle

Historically, errors and irregularities involving payroll have been reported to occur
frequently and are largely undetected.

1. Errors

The most errors that can occur in the payroll and personnel cycle are;
a) Paying employees at the wrong rate,

b) Paying employees for more hours than they worked.

c) Charging payroll expense to the wrong accounts, and

d) Keeping terminated employees on 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 form of defalcatio n.
Alternatively, the auditor may 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 also be
examined to substantiate the existence of absent employees.

b. Excess Payments to Employees

Increasing the rate above that approved or paying employees for more hours than
they worked 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 and paid for. Analytical procedures that focus on cost per unit of
actual production can also be helpful in detecting excess payments to employees.

c. Failure to Record Payroll

Companies having difficulty meeting profit targets or not-for- profit entities having
difficulty managing 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 should have been charged to expense Analytical procedures such as
comparing costs incurred to budgeted cost and verification of valuation of inventory
are some of the useful techniques in detecting such fraud.
 CHAPTER 16
INTERNAL CONTROL AFFECTING ASSETS

INTERNAL 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 handling and
depositing cash receipts, signing checks, investing idle cash, and maintaining custody
of cash, marketable securities, and other negotiable assets. In addition, the finance
department must forecast cash requirements and make both short-term and, long-term
financing arrangements.

Ideally, the functions of the finance department and the accounting department should
be integrated in a manner that provides assurance that

1. All cash that should have been received was in fact received, recorded
accurately and deposited promptly.

2. Cash disbursements have been made for authorized purposes only and have
been properly recorded.

3. Cash balances are maintained 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 control procedures, but there are some general guidelines to good
cash handling practices in all types of business. These guidelines for achieving internal
control over cash may be summarized as follows:

1. 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 to

the extent practical.

4. Record cash receipts on a timely basis.

 5. Encourage customers to obtain 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 petty cash.

8. Have monthly bank reconciliation prepared by employees not responsible for

the issuance of checks or custody of cash. The completed reconciliation should
be reviewed promptly by an appropriate official.

9. Monitor cash receipts and disbursements by comparing recorded amounts to

forecasted amounts and investigating variances from forecasted amounts.

Potential Misstatements - Cash Receipts

Potential Misstatements - Cash Disbursements
INTERNAL CONTROL OVER FINANCIAL INVESTMENTS

The most important group of financial investments consists of marketable stocks and
bonds because they are found more frequently and usually are of greater peso value
than the other kinds of investment holdings. Other types of investments often
encountered include commercial paper issued by corporations, mortgages trust The
internal auditors also must be concerned with derivatives that are used to hedge various
financial and operational risks or for speculation. Derivatives are financial instruments
that "derive their value from other financial instruments. underlying assets, or indexes.
For example, a simple derivative would involve a commitment by a company to
purchase a commodity at a certain price at some point in the future. Other derivatives
are much more complex, involving, for 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:

In policies.

1. Formal investment policies that limit the nature if investments securities and
other financial instruments.

2. An investment committee of the board of directors that authorizes and reviews

financial investment activities for compliance with investment

3. Separation of duties between the executive authorizing purchases and sales of

securities and derivative instruments, the custodian of the securities, and the
person maintaining the records of investments

4. Complete detailed records of all securities and derivative instruments owned

and the related provisions and terms.

5. Registration of securities in the name of the company. 6. Periodic physical

inspection of securities on hand by an internal auditor or an official having no
responsibility for the authorization, custody, or record keeping of investments

7. Determination of appropriate accounting for complex financial instruments by

competent personnel.
In many concerns, segregation of the functions of custody and record keeping is
achieved by the use of an independent safekeeping agent, such as a stockholder, bank
or trust company. Since the independent agent has no direct contact with the employee
responsible from maintaining accounting records of the investments in securities, the
possibilities of concealing fraud through falsification of the accounts are greatly reduced.
If securities are not placed in the custody of an independent agent, they should be kept
in a bank safe-deposit box under the joint control of two or more of the company's
officials. Joint control means that neither of the two custodians may have access to the
securities except in the presence of the other. A list of securities in the box should be
maintained in the box, and the deposit or withdrawal of securities should be recorded on
this list along with the date and signatures of all persons present. The safe-deposit box
rental should be in the name of the company, not in the name of an officer having
custody of securities.

Complete detailed records of all securities and derivative instruments owned are
essential to satisfactory control. These records frequently consist of a subsidiary record
for each security and derivative instrument, with such identifying data as the exact
name, face amount or par value, certificate number, number of shares, date of
acquisition, name of broker, cost, terms and any interest or dividend payments received.
Actual interest and dividends should be compared to budgeted amounts, and significant
variances should be investigated. The purchase and sale of investments often is
entrusted to a responsible financial executive, subject to frequent review by an
investment committee of the board of directors.
Potential Misstatements - Financial Investments

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 subsidiaries, 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, including the control environment, risk assessment,
monitoring, the (accounting) information and communication system, and control
activities.

Control Environment

Because of the risk of intentional misstatement of revenues, the control environment is

very important to effective internal control over revenue and receivables. Of particular
importance is an independent audit committee of the board of directors that monitors
management's judgments about revenue recognition principles and estimates, as well
as an effective internal audit function. Management should establish a tone at the top of
the organization that encourages integrity and 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 be eliminated
Potential Misstatements - Revenue/Receivables
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:

1. The custodian of notes receivable not have access to cash or to general

accounting records.

2. The acceptance and renewal of notes be authorized in writing by a 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 adopted for subsequent follow-up of such defaulted
notes.

INTERNAL CONTROL OVER INVENTORIES AND COST OF GOODS SOLD

The interrelationship of inventories and cost of goods sold makes it logical for the two
topics to be considered together. The controls that assure the fair valuation of
inventories are found in the purchases (or acquisition) cycle. These controls include
procedures for selecting vendors, ordering merchandise or materials, inspecting goods
received, recording the liability to the vendor, and authorizing and making cash
disbursements. In a manufacturing business, the valuation of inventories also is affected
by the production (or conversion) cycle. in which various manufacturing costs are
assigned to inventories, and the cost of inventories is then transferred to the cost of
goods sold.

Sources and Nature of Inventories and Cost of Goods Sold

The term inventories is used in this chapter to include:

1. goods on hand ready for sale, whether the merchandise of a trading concern or the
finished goods 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 Control over Inventories and Cost of Goods Sold

The importance of adequate internal control over inventories and cost of goods sold
from the viewpoint of both management and the auditors can scarcely be
overemphasized. In some companies, management stresses controls over cash and
securities but pays little attention to control over inventories. Since many types of
inventories are composed of items not particularly susceptible to theft, management
may consider controls to be unnecessary in this area. Such thinking ignores the fact that
controls for inventories affect nearly all the functions involved in producing and
disposing of the company's products.

Potential Misstatements - Inventory / Cost of Goods Sold

INTERNAL CONTROL OVER PROPERTY, PLANT AND EQUIPMENT

The term properly, plant and equipment includes all tangible assets with service life of
more than one year that are used in the operation of the business and are not acquired
for the purpose of resale. Three major subgroups of such assets are generally
recognized:

1. 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 usually large in dollar
amount, but concentrated in only a few transactions. Individual items of plant and
equipment may remain unchanged in the accounts for many years.

Internal Control over Plant and Equipment

The amounts invested in plant and equipment represents a large portion of the total
assets of many industrial concerns. Maintenance, rearrangement and depreciation of
these assets are major expenses in the income statement. The total expenditures for
the assets and related expenses make strong internal control essential to the
preparation of reliable financial statements. Errors in measurement of income may be
material if assets are scrapped without their cost being removed from the accounts, or if
the distinction between capital and revenue expenditures is not maintained consistently.
The losses that inevitably arise from uncontrolled methods of acquiring, maintaining,
and retiring plant and equipment are often greater than the losses from fraud in cash
handling.

In large enterprises, the auditors may expect 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 assets. 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 replacements
and additions to the plant.

Other key controls applicable to plant and equipment are as follows:

1. A subsidiary ledger consisting of a separate record for each unit of property.

An adequate plant and equipment ledger facilitate the auditor's work in analyzing
additions and retirements, in verifying the depreciation provision and
maintenance expenses, and in comparing authorizations with actual
expenditures.

2. A system of authorization requiring advance executive approval of all plant and

equipment acquisitions, whether by purchase, lease 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 costs.

4. An authoritative written statement of company policy distinguishing between

capital expenditures and revenue expenditures. A dollar minimum ordinarily will
be established for capitalization; any expenditures of a lesser amount
automatically classified as charges against current revenue,

5. A policy requiring all purchases of plant and equipment to be handled through

the purchasing department and subjected to a standard routine for receiving,
inspection and payment.

6. Periodic physical inventories designed to verify the existence, location and

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 retirement

work orders (bottom), stating reasons for retirement and bearing appropriate
approvals.
Potential Misstatements - Investments in Property, Plant, and Equipment
 CHAPTER 17
INTERNAL CONTROL
AFFECTING LIABILITIES
AND EQUITY

INTERNAL CONTROL OVER ACCOUNTS PAYABLE

• The term accounts payable (often referred to as vouchers payable for a voucher system)
is used to describe short-term obligations arising from the purchase of goods and services
in the ordinary course of business.
• Typical transactions creating accounts payable include the acquisition on credit of
merchandise, raw materials, plant assets and office supplies.
• Other sources of accounts payable include the receipt of services, 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 services and most other liabilities. However, accrued liabilities
(sometimes called accrued expenses) generally accumulate over time, and management
must make accounting estimates of the year-end liability. Such estimates are often
necessary for salaries, pensions, interest, rent, taxes and similar items.
• In thinking about internal control over accounts payable, it is important to recognize that
the accounts payable of one company are the accounts receivable of other companies. 'It
follows that there is little danger of errors being overlooked permanently since the client's
creditors will generally maintain complete records of their receivables and will inform the
client if payment is not received. This feature also aids auditors in the discovery of fraud,
since the perpetrator must be able to obtain and respond to the demands for payment.
• Some companies, therefore, may choose to minimize their record keeping of liabilities and
to rely on creditors to call attention to any delay in making payment. This viewpoint is not
an endorsement of inaccurate or incomplete records of accounts payable, but merely
recognition that the self-interest of creditors constitutes an effective control in accounting
for payables that is not present in the case of accounts receivable.

INTERNAL CONTROL OVER OTHER DEBTS

Business corporations obtain substantial amounts of their financial resources by incurring debt
and issuing capital stock. The acquisition and repayment of capital is sometimes referred to as
the financing cycle, This transaction cycle includes the sequence of procedures for authorizing,
executing, and recording transactions that involve bank loans, mortgages, bonds payable, and
capital stock as well as the payment of interest and dividends.
Internal Control over Debt

Authorization by the Board of Directors

Effective internal control over debt begins with the authorization to incur the debt. The bylaws of
a corporation usually require that the board of directors approve borrowing. The treasurer of the
corporation will prepare a report on any proposed financing, explaining the need for funds, the
estimated effect of borrowing upon future earnings, the estimated financial position of the
company in comparison with others in the industry both before and after the borrowing, and
alternative methods of raising funds. Authorization by the board of directors will include review
and approval of such matters as the choice of a bank or trustee, the type of security, registration
with the SEC, agreements with investment bankers, compliance with requirements of the state of
incorporation, and listing bonds on a securities exchange. After the issuance of long-term debt,
the board 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.

Use of an Independent Trustee

Bond issues are always for large amounts, usually many millions of pesos. Therefore, only
relatively large companies issue bonds: small companies obtain long-term capital through
mortgage loans or other sources. Any company large enough to issue bonds and able to find a
ready market for the securities will almost always utilize the services of a large bank as an
independent trustee. The trustee is charged with the protection of the creditors' interests and with
monitoring the issuing company's compliance with the provisions 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 actions.

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. Highly 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:
l. the proper authorization of transactions by the board of directors and corporate office,
2. the segregation of duties in handling these transactions (preferably the use" payments), and
3. the maintenance of adequate records.
Internal Control on Equity
Control of Share capital Transactions by the Board of Directors

All changes in share capital accounts should receive 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 plan of payment is to be used, the board must prescribe the terms. If
plant and equipment, services, or any consideration other than cash is to be accepted in payment
for shares, the board of directors must establish the valuation on the noncash assets received.
Transfers from retained earnings to the Share Capital and Paid-in Capital accounts, as in the case
of stock dividends, are initiated by action of the board. In addition, stock splits and changes in par
or stated value of shares require formal authorization by the board. Authority for all dividend
actions rests with the directors. The declaration of a dividend must specify not only the amount
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 the services of an independent share registrar and a share
transfer agent or handles its own capital share transactions. Internal control is far stronger when
the . 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, the corporation achieves to the fullest extent the internal control concept of
separation of duties.

Internal Control over Dividends

The nature of internal control over the payment of dividends. as in the case of stock issuance,
depends primarily upon shelter the company performs the function of dividend payment itself or
utilizes the services of an independent dividend-paying agent. If an independent dividend-paying
agent is used, the corporation will provide the agent with a certified copy of the dividend
declaration and a check for the full amount of the dividend. The bank or trust company serving as
stock transfer is usually appointed to distribute the dividend. since it maintains the detailed records
of shareholders. The agent issues dividend checks to the individual shareholders and sends the
corporation a list of the payments made. The use of an independent fiscal agent is to be
recommended from the standpoint of internal control, for it materially reduces the possibility 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 held by each, and the amount of the dividend each is to
receive\c. 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 down 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 outstanding and mailed
without again coming under control of the officer who prepared them.

Cash in the amount of the total dividend is then transferred from the general bank account to a
separate dividend bank account. As the individual dividend checks are paid from this account and
returned by the bank, they should be matched with the check stubs or marked paid in the dividend
check register. A list of outstanding checks is prepared monthly from the open stubs or open items
in the checks register. This list should agree in total the balance remaining in the dividend bank
account. Companies with numerous shareholders prepare dividend checks in machine-readable
form, so that the computer may perform the reconciliation of outstanding checks.