Principles of Internal Controls & Corporate Governance

Business Ethics
The sum of principles and code of conduct that
businesspeople must adhere to in their dealings with
stakeholders
Unethical issues in Business
Poor labor practices e.g.
1. Nepotism
2. Tribalism
3. Overworking employees
4. Selling of substandard products.
5. Low wage rates.
Why business ethics?
1. Sensational corporate scandals.
2. Fraudulent activities
3. Doubt in business people.
4. Poor labor practices.
5. Failure of corporate.
Principles of Business Ethics
1. Trust
2. Excellence
3. Responsibility
4. Customer focus
5. Accountability
6. Focus on the people.
The Role of Ethics in Businesses
1. Protection of own reputation and interest.
2. Meet stakeholders’ expectation.
3. Prevent harm to the general public.
4. Protect organization from abuse by unethical
employees & competitors.
5. Protect the rights of their employees.
6. Attract customers thus boosting their profits
7. Reduce labor turnover thus increasing
productivity.
8. Attract skilled person ell thus reduces recruit
 cost
9. Keeps the company's share price high thus
boosting investor’s equity
Unethical issues in business.
An ethical problem is the decision made after weighing
fraudulent benefits to what he considers moral and
appropriate.
1. Conflict of interest i.e. the CEO must choose
whether to benefit himself or maximize the
shareholders wealth anger
2. Fairness and honesty.
3. Communications.
4. Business Relationships Keeping company's secrets
being responsible.
5. Plagiarism. Presenting someone else’s research
findings as your own work.
Improving Ethical behavior in Business.
 1. Develop a code of ethics.
2. Consistent leadership
3. Ethical training programs.
4. Rewards
5. Open climate
6. Controls
7. Ethical ombudsman
8. Ethics committee.
9. Hotlines
Internal controls
Policies and procedures adopted by the management
to assist in the achieving of business objectives. These
include:
1. Orderly & efficient conduct of businesses.
2. Safeguarding assets
3. The accuracy of accounting records.
4. Timely preparation of accounting information.
5. Establishing parameters to delegate power
6. Testing and reporting compliance on the
 established parameters.
7. Evaluation of operational effectiveness &
efficiency
8. Assessing reliability of financial reporting
9. Reporting compliance on the established rules and
regulations.
10. Supporting remediation efforts by examining
limits of power.

Distinction between Internal controls and internal audit

Internal controls
Are interested in validating operational and financial
processes used in the cycle with a purpose of
exposing weaknesses and identify major areas of
improvement
Internal audit
Are interested in validating data and reports at the
end of the business cycle for purposes rendering
judgment & opinion
Internal control framework
It is composed of:
1. Control Environment. Establishes the overall tone
of the organization.
2. Risk assessment. Identifies and analyzes relevant
risks and how they can be managed
3. Control activities. Policies and procedures
designed to mitigate risks and achieve internal
control objectives.
4. Information & communication.
A system that identifies, captures& communicates
upstream and downstream information/data
5. Monitoring, evaluating and reporting.
Regular monitoring occurs at all level of
 management to show effectiveness of internal
controls.
Dangers of weak internal controls
1. Business interruptions from catastrophes.
2. Erroneous management decisions.
3. Frauds, theft embezzlement of funds.
4. Statutory sanctions due to non compliance.
5. Excessive costs leading to fund deficits.
6. Misuse & loss of inventories and assets.
Benefits of internal controls
1. Clear chain of authority
2. Provides a system for identifying, analyzing and
mitigating risks.
3. In-house dissemination of reliable information.
4. Control activities proportionate to the implication
of each individual process

Indicators of a broken internal control process

 1. Inadequate management oversight and
accountability.
2. Inadequate control of activities and performance.
3. Inadequate assessment of risks.
4. Inadequate communication.
5. Ineffective and inadequate ways if monitoring
activities.
Key internal control
1. Separation of duties.
2. Documentation
3. Authorization and approval.
4. Security of assets.
5. Reconciliation and reviews.
6. Employee training.
7. Formalized policies and procedures.
Internal control players
Those who design and monitor operational efficiency of
internal controls.
1. Board of Directors
2. Executive Management
3. Internal Audit
4. Company staff
Limitations of internal controls
1. Cannot turn a poor manager to a good one.
2. Imperfect thus risks and errors are bound to occur.
3. Susceptible to management override
4. Only designed to cope up with routine
transactions.
5. Resource constraints.
Corporate Governance
Definition;
The system of checks and balances both internal and
external that ensures accountability and social
responsibility
Common failures in Governance process
1. Failure of the Board and executive management
2. Failure of internal controls
3. Failure of external controls
Failure of the Board & Executive management
 a) Ineffective boards
b)Conflicted CEO's
c) Breach of duties of care and loyalty.
d)Entrenched management.
e) Failed corporate policies.
e) Failure in corporate policies.
It entails;
1. Disregard to corporate policies.
2. Skewed compensation skills
3. Unclear strategies
4. Miss allocation of resources
5. Excessive short term focus
6. Opaque disclosure
7. Unethical behavior

Failure of internal controls

1. Lack of technically qualified and independent
internal controls
 2. Liberal accounting policies
3. Excessive risk taking
4. Inadequate audits
Failure of external controls
1. Inadequate regulatory mechanism
2. Insufficient legal/bankruptcy regimes
3. Lack of block holder/ activist monitoring.
4. Weak/undeveloped capital markets
5. Unacceptable external audits
Inadequate regulatory mechanisms
 Inadequate tax oversight.
 Moral hazard
 Restrictive or liberal ownership rule.
 Competitive barriers
 Unclear monetary policies
 Supervisory conflicts of interest.
 Inadequate regulatory disclosures.

Corporate Governance
 Refers to the manner in which power is exercised in
corporation`s total portfolio of assets and resources
with a view to creating, maintaining and increasing
shareholder value.
Causes of Governance Failure
1. Weak boards which can be cajoled by powerful
executives
2. Lack of expertise by the executives
3. Inattentive directors who derive gains from ties
with executives
4. Ineffective internal auditors that cannot detect
and prevent problems
5. Poor external controls, regulators and auditors,
capital markets and legal frameworks to give
proper regulations

Basic Corporate Structure

Most body corporates i.e. derive their capital from
debts and equity.
The people who provide the funds enjoy certain rights
and benefit.
Some of these benefits include:
Ownership/claim on the company`s
assets.
Periodic payment of Dividends etc
Legal rights/entitlement as explained
below.
Legal rights entitled to providers of equity
They can transfer shares through the securities
exchange to other investors.
They are entitled to regular and accurate disclosures of
the company`s financial statements.
They can participate in the Annual General Meetings
(AGM) and make decisions e.g. on the selection of the
BOD, corporate reorganization and acquisitions.
The company is only liable up to the amount of equity
invested thus in the case of insolvency, the creditors/
debt providers cannot look up to shareholders for
additional capital.
The debt providers offer funds to limited liability
companies in return of periodic interest payments
along with the principal amount they lent out.
NB: Incase the company incurs losses the creditors
are given the first priority during compensation the
remainder of profits from the
sale/liquidation/realization of assets is shared out
among the equity providers.
The Agency Problem
With respect to LLCs, companies have owners known
as shareholders or stockholders. They own shares of
the company which are symbolized by stock certificates.
Public Limited Companies are those which are
registered at the Securities exchange market thus their
shares trade publicly.
Since the shareholders may be so many, they cannot
run the company, thus they approach some other
people to oversee its operations i.e. they appoint the
BoD. Thus the BoD become representatives (agents) of
shareholders (principals)
The BoD may lack the expertise to run the business
thus approach other people known as Executives
headed by the CEO/President to run the business.
When the BoD colludes with the executives to draw
undue benefits from the company, an agency problem
arises.
The Executives are given powers to make decisions
which are geared towards maximizing shareholders`
wealth. They are also charged with the responsibility of
implementing BoD decisions. The executives having
considerable control over the business may decide to
act for their own benefit and malign the BoD and
indirectly, the shareholders, an agency problem comes
up.
Since the shareholders know the BoD is bound to err,
they put up measures to reduce risks by incurring
agency costs e.g. hiring external auditors, tax assessors
and lawyers.
Forms of Ownership and Control
Total/Complete control: i.e. family owned business
Example the Brookside Dairies is owned by Kenyatta
family.
Majority control: enables the largest shareholder have
effective control of the business e.g. in amending the
corporate charter.
Legal mechanisms control. Occurs when legal
mechanisms permit effective control without majority
holder’s stake
Non-voting stock holder control/ preference
shareholder control: these have control over the
issuance of dividends. They get the first priority during
issuance of dividends but lack legal voting rights.
Voting trust control: comes about when the shares are
held by a trustee. The trustee cannot vote since he
holds the shares fro another individual.
Minority control: can only work if a large block holder
does not exist.
Management control: occurs where the management
appears to be the controller of activities.