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Classification of Stakeholders:
Internal (directors, company secretary, management, employees, trade union)
vs. Connected (shareholders, customers, suppliers, lenders, competitors)
vs. External (auditors, regulators, government, stock exchange, small & institutional investors)
Direct (Such stakeholders having straightforward claims and are unambiguous)
vs. Indirect (Such stakeholders are voiceless e.g. individual customer of large company, environment,
wildlife, future generations)
Primary (Those required by organization to continue its existence e.g. shareholders, customers,
suppliers, government)
vs. Secondary (Not essential for organization e.g. wider community)
Narrow (Those most affected by organizations strategies e.g. shareholders, employee, customers)
vs. Wide (Those less affected by organizations strategies e.g. government, wider community)
Voluntary (Those involved with organization of their free will e.g. management, employee, customer)
vs. Involuntary (Involved due to reasons e.g. regulators, government, community)
Active (Those who participates in organizations activities e.g. management, employee, customers)
vs. Passive (Those who do not wish to participate e.g. shareholders, government, community)
Legitimate (Those who are rightful in their claims e.g. employee, shareholders, customers)
vs. Illegitimate (Those who have no legal status of their claims)
Managing Stakeholder Relation (Mendelow Matrix Model):
Segment A: Typically small shareholders and general public having lack of
power and interest to influence CG. They require minimal efforts.
Segment B: Staff, customers, suppliers and environmental pressure groups is
placed in this segment. They normally try to persuade high power group to
take actions. They must be kept informed.
Outsider System:
Dispersed and wide-spread shareholding.
Most suitable for advance and developed countries.
More robust and formal CG is required here to protect the interest of all shareholders.
Succession issues can be planned more easily and effectively.
The system promotes short-term view of investment.
D) Board of Directors:
Board Structures:
(i) Unitary Board Structure. Single tier board comprising of executive and non-executives directors where all
directors have equal responsibilities and play an active role. Especially, presence of NEDs in board is not
limited to supervising, but running of the company as well. Since all directors need to actively participate,
decision making imposes time constraints but however NEDs have better access to information they need.
(ii) Two-Tier (Dual) Board Structure. It consists of two sub-boards where lower tier is management board
and upper tier is supervisory board. There is clear and formal separation between those monitoring
(NEDs) and those being monitored (EDs). Lower tier board is responsible for day-to-day running of the
company and is led by CEO, while upper tier board, consisting of wide range of stakeholders (e.g. employee
representative, pressure groups, institutional investors etc.)is responsible to appoint, supervise and advice
management board and led by Chairman. Such type of board exists in high ethics bound country like
France, Germany.
Board Diversity:
Board should comprise of individuals belonging to different backgrounds. It could bring better governance,
effective decision making, utilization pool of expertise and enhances corporate reputation. A board could be
diversified using a range of demographic variables like race, ethnics, age, gender, education, status, religion etc.
Professionals like international experienced, lawyers, accountants, doctors or directors of private companies can
also be considered.
Board Meetings:
An agenda should be placed which consider short-term and long-term issues and every director should
have his/her input on the agenda.
Meetings should be regular and all directors should attend it and each director must commit to provide
sufficient time. (CG discourages appointment of full-time ED to more than one NED/Chairman position
in FTSE 100 companies.)
Chairman should direct meeting proceedings considering sufficient time and input from everyone.
Potential Problems for Board:
Mostly boards rely on information provided by management and therefore may not have that time or
skills to look at every detail, thus allowing management obscure problem and true state of the company.
Occasionally meetings in the board may cause unfamiliarity within board members and therefore
difficult to question the management.
Most of the times, CEOs have forceful personalities and sometimes they exercise it too much to
influence rest of the board.
Performance of CEO is judged by directors who appoints him/her
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Appointment of Directors:
The first directors are nominated by promoters of the company and retire at first AGM. However, after first
nomination, Articles of Association (AoA) governs this issue and Table A provides yearly-rotation-based
election system under which one-third of the directors retires every year (not including CEO and those offering
themselves for reelection). For large listed companies (FTSE 350), EDs should face re-election every year and
for small listed companies, EDs may face election every 3 years.
UK CGC (2010) suggests that NEDs should normally serve for 6 years. If incase, an NED serve longer than 6
years than an explanation should be provided. Higgs Report suggests that NEDs should face reelection after 9
years.
Removal of Directors:
Removal of ED is possible by a simple ordinary resolution (though this may be in breach of service contract).
However, AoA provide additional ways to remove a director.
Directors Personality & Skills:
Personality: Motivated, proactive and experienced (been there, done that)
Skills: Listening, Questioning, Negotiating, Leadership, Specialist Knowledge, General Business Knowledge
Role & Responsibilities of EDs: (DEEP.SEA.DR.SEM)
UK CGC (2010) provides key roles and responsibilities of directors which are as follows,
Providing entrepreneurial leadership of the company.
Represent company view and account to public.
Decide on a formal schedule of matters to be reserved for board decisions.
Determine the companys mission and purpose (strategic aims).
Select and appoint the CEO, Chairman and other board members.
Set the company values and standards.
Ensure that the companys management is performing its job correctly.
Establish appropriate internal controls that enable risk to be assessed and managed.
Ensure that the necessary financial and human resources are in place for the company to meets its
objectives.
Ensure that its obligations to its shareholders and other stakeholders are understood and met.
Meet regularly to discharge its duties effectively.
For listed companies;
Appoint appropriate NEDs
Establish remuneration committee
Establish nomination committee
Establish audit committee
Assess its own performance and report it annually to shareholders.
Submit themselves for reelection at regular intervals. All directors in FTSE 350 companies should face
reelection every year.
E Ensure effective two-way communication with shareholder and asks questions on behalf of
shareholders (public face) and also between EDs and NEDs
E Ensure sufficient time being allocated for controversial issues
CEO
CEO is the leader of management and at below the board level. CEO is responsible for running the business of
the company and implementing the strategies and decisions of the board and reporting to Chairman/Board.
Roles of CEO: (BRIBE)
B Business objectives and strategies development and management
R Risk management (in line with risk appetite accepted by the board) and giving ownership to
organizations control
I Investment and financing opportunities examined
B Board and committee composition recommendation
E Evaluating structure of organizational operation, performance appraisal and remuneration
suggestions
Why Chairman and CEO should not be the same person?
It is vital for good CG to separate the roles of Chairman and CEO to avoid unfettered decision-making
power in the hands of single individual.
Separation is also necessary as CEO have greater deal of influence in appointment of EDs while
Chairman over NEDs.
CEO becoming Chairman will results in interference in executive matters.
Separation of roles also brings division of responsibilities as Chairman is the leader of the board and
CEO is leader of management.
Separation of roles is also a reflection that these two positions are demanding.
E) Board Committees:
There are four types of board sub-committees;
(i) Nomination Committee (Majority NEDs, Structure & composition of board, Induction of new EDs)
The committee should comprised wholly or partially of NEDs. The nomination procedure should be
formal, rigorous and transparent. Essentially, a nomination committee has three roles as follows,
Future Role - Succession Planning. It should objectively consider, on a regular basis, the desirable size
of the board, skills, knowledge and experience possessed by the current board, the need to maintain a
balance between EDs and NEDs, succession planning and the need for diversity.
Past Role - Appraisal. Performance of the board, its committees and individual directors should be
assessed once a year. The appraisal should cover a review of the boards systems, performance
measurement, responses to problems/crisis, level of information board has, quality of information,
fulfillment of legal requirements, contribution by individual directors, assessment of level of delegation,
ability to learn lessons from experience, team-work, focus on long-term or too much involvement on
day-to-day matters etc.
Present Role - Induction. The nomination committee is also responsible for induction process. An
effective induction program should aim to:
Build an understanding of the nature of the company, its business and its markets (culture,
values, products, services, group structure, constitution, procedures, principal assets and
liabilities, contract, major competitor, regulatory constraints etc.)
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G) Reporting on CG:
Disclosures help reduce Information Asymmetry. The LSE requires the following disclosures to be made,
A narrative statement of how companies have applied the principles set out in CGC, providing any necessary
explanations and statement on compliance with CGC throughout the accounting period. In case of noncompliance, the relevant provisions need to be disclosed along with the reasons for the non-compliance.
Additionally, a Directors Report should also be published which contains,
Information about directors
Responsibilities of directors (including preparation of accounts)
Attendance details
Brief details of committee workings
Relationship with auditors and shareholders
Effectiveness of internal controls
Business review (operational & financial review)
Voluntary/Additional Disclosures: (Qualitative in nature, Non-numerical)
Besides the above, the companies should make voluntary disclosures (perhaps in consultation with the
investors) as this helps provide a wider information perspective, different focus (mostly future oriented) on
information and assurance about managements commitment. Examples of voluntary disclosures includes,
chairman statement, CEO review statement, environmental policies, risk policies etc.
Reasons/Benefits of Voluntary/Additional Disclosures: (BRACoS)
Brings accountability
Reduce information asymmetry
Attracts investors
Compliance with laws and regulations
Service to range of stakeholders
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Process of Control:
Internal/control environment (how strong do the controls need to be?)
Objective setting
Event/risk identification
Risk assessment (controllable/uncontrollable)
Risk response (avoidance, reduction, transfer, acceptance)
Control activities/procedures (policies, codes etc.)
Information and communication (following up, down and across)
Monitoring (to make necessary modification and changes)
Limitations of Internal Controls: (CHOCCUP2)
C Cost of control
H Human error/fraud
O Overestimation of risks
C Collusion between employees
C Control being dependent on method of data processing
U Unforeseen circumstances
P Poor judgment
P Possibility of controls being by-passed by employee/directors
J) Risk Attitudes & Internal Environment:
Risk Appetite:
Even a Risk Averse business will tolerate risk up to a point provided that it yield an acceptable return. Risk
Seeking business may not be bothered by level of risks, but must manage such risks. Risk management is
analyzing what the key value drivers are and the risks tied up with those value drivers.
Among the other factors shaping Risk Appetite are personal views, shareholders demand, organizational
history, experience (e.g. significant losses in the past), size (e.g. large companies can afford risk management
experts and diversification), structure and lifecycle stage of the organization.
An organizations attitude towards risk will generally be influenced by the priorities of its shareholders. The
stakeholders include shareholders (who may be more interested in dividends and/or long-term capital gains).
Creditors (who may prohibit excessive risk taking), employees (who will be interested in job security and
health and safety issues), customers and suppliers, government/regulatory authorities as well as the wider
community.
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Organization should ensure job satisfaction, leading by example, peer confirmation through learning
experiences and proper infrastructure to achieve successful change.
Organizations should have clear risk policy statements and risk registers (listing and prioritizing main risks,
responsibility index and actions taken).
Risk Management Responsibilities:
The primary responsibility for determining risk management strategy and monitoring risks is that of the board.
The board also sets appropriate policies on internal controls and seeks assurance that the controls are
functioning effectively.
The CEO takes the ownership of risk management and internal control system and must monitor other directors
and senior staff.
Although limited in scope, the internal and external audit committee functions deal with risks as well.
Turnbull stresses upon the role of management in implementation of risk management system. Both managers
and staff should know their responsibilities and how to report on them.
Board Risk Management Committee:
Although the boards audit committee may serve this purpose, a large company should have separate risk
management committee of its board. UK Walker Report recommends such committees for FTSE-100 banks and
life insurance companies.
This committee will have more time, focus and powers than the audit committee to manage risk. Unlike the
backward looking focus of audit committee, the risk management committee can have forward looking focus of
determining risk appetite and monitoring appropriate limits.
Among its functions would be approving risk management strategy, reviewing reports on key risks, monitoring
overall exposure, assessing effectiveness of risk management systems and providing early warning to the board.
Role of Risk Committee: (SEEM-R)
S Strategies and policies
E Early warning indicator
E Effectiveness of risk management system
M Monitoring risk exposure
R Reviewing report on key risks
Risk Management Specialists: (PRICE-DEED)
A specialist risk manager could be hired to provide following functions;
P Providing overall leadership, vision and direction for ERM
R Reporting to CEO on progress and recommendations
I Implementing set of risk indicators and reports
C Championing ERM competence and awareness throughout organization
E Establishing integrated ERM framework
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De Developing policies
E Establishing common ERM language
D Dealing with insurance companies
Objective Setting:
Internal control is all about achieving objectives by managing risks. Granger identifies 3 types of objectives:
Mission (general objective, open-ended)
Corporate objective (concerned with whole firm, quantifiable)
Unit objective (at divisional, business units and subsidiary levels)
Competitors
Dependence upon inputs
R&D capacity
Stage in product/organization lifecycle
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Reputation Risk (Image of company suffers due to anything that went wrong. For e.g. production of poor
quality products, product recalls, adverse publicity, unethical advertising, poor CG, poor ethics etc.)
Market Risk (Risks which derive from the sector in which the business is operating and loss due to an adverse
move in the market e.g. fall in value of assets, lack of resources, customer dissatisfaction etc.)
Legal or Litigation Risk (This risk arises from the possibility of legal action being taken against an
organization. For e.g. penalties, suits filed from customers, suppliers, competitors etc.)
Political Risk (This risk depends largely to the extent of political stability in the countries in which companies
operates and the attitude of governments towards protectionism.)
Regulatory Risk (Risk that regulatory bodies will affect the way an organization has to operate.)
Compliance Risk (It is the risk of losses, possibly fines resulting from non-compliance with laws or regulation.)
Health & Safety Risk (These are inherent risks arising from particular industry in which an organization
operates like oil rigs, factories, coal mines etc. For e.g. injury, loss of life, compensation for defaults etc.)
Fraud Risk (This risk arise from intentional and willful acts. For e.g. ghost employees/suppliers, data
falsification, hacking, alteration in programs, theft of information)
Knowledge Management Risk (This risk arises from unauthorized use of knowledge resources. For e.g. misuse
of intellectual property)
Entrepreneurial Risk (This is the necessary risk which is associated with every new business or product
venture or opportunity in the new or existing market. For e.g. major investment failing to deliver)
L) Risk Assessment & Response to Risks:
Risk Assessment:
While not always easy, organization must assess and respond to risks dynamically.
Risk assessment determines mitigation or management strategies. Underestimation of risks or exaggeration can
both result in additional costs and inefficient resource allocation (Stop and Go Errors!).
It is important therefore, not only to assess all relevant risks but also the severity and frequency of risks.
Risks quotient may change due to organizations own strategic decisions or those by the competitors, suppliers,
customers etc. Other factors influencing risk include technology and general social, economic and political
factors etc.
Objective Approach to Risk Assessment: Accounting Ratios
Debt Ratio (Total Debt / Total Assets) x 100 [50% is the benchmark]
Gearing Ratio (Interest Bearing Debt / Shareholders Equity Interest Bearing Debt) x 100 [50% is the
benchmark)
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Interest Cover (PBIT / Interest Charges) [Interest cover of 3 times or below is worryingly low]
Cash Flow Ratio (Net Cash Inflow / Total Debts)
Current Ratio (Current Assets / Current Liabilities) [Ideally excess of 1]
Quick Ratio (Current Assets less Inventories / Current Liabilities) [Ideally at least 1]
Risk Interrelation:
Risks may be inter-related (correlation or covariance). In case of positive correlation, risks will increase or
decrease together (product fault risk and reputation risk). In case of negative correlation, one risk will increase
as the other decreases (expenditure on controls reduces most risks but increases financial risks.)
Subjective Approach to Risk Assessment: (Likelihood/Consequences Matrix)
Including Risk Response Strategies (Accept, Reduce, Transfer, Avoid)
Consequences (Impacts/Hazards)
Low
ACCEPT
REDUCE
Likelihood (Risk Probability)
Low
High
TRANSFER
AVOID
High
Even when risk has to be accepted, judgment will be involved in deciding what level of risk is as low as
reasonably practicable (ALARP Principle).
A dynamic environment requires constant risk assessment and flexibility in approach.
Transfer: Risk may be transferred through insurance, hold harmless agreements and limitation of liability.
Avoidance: Organization needs to consider if it is really desirable?
Reduction: Policies need to be in place, which will be achieved through Risk Mitigation Techniques. Reduction
may also involve contingency planning (identifying the post-loss needs). Physical (e.g. safety devices) and
psychological (e.g. awareness and commitment) factors should be employed to effect loss control.
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A good policy is risk diversification, i.e. avoiding having all of the risks positively correlated. This can be done
(though perhaps not by all organizations) through a mix of higher and lower risk investment, mix of debt and
equity financing, separate divisions and subsidiaries, forward and backward integration and international
portfolio diversification.
Acceptance: Sometimes the risk is unavoidable or risk may be insignificant or too costly to manage. In these
cases, the risk is generally accepted. Self/captive insurance may be considered here.
Financial Risk Management:
Advantages of financial risk management include;
Reduction in earnings volatility
Reduced average tax liability
Improved credit rating
More opportunities to invest
Protection of cash flow
Better reputation
Methods of financial risk management include;
Risk diversification
Risk sharing
Risk transfer
Internal strategies (e.g. vesting and monitoring of and ceilings of credit limits with credit triggers)
Risk hedging (future and forward contract, call or put options, swaps)
Risk Hedging:
Forward Contract (Commitment to undertake a future transaction at a set time and price)
Future Contract (Commitment to an additional transaction in the future)
Call or Put Options (Grants an option on a party to buy or sell at a certain price in the future)
Swaps (Parties agree to exchange payments on different terms, e.g. a borrower borrowing at floating rate
may exchange this liability with one who borrowed at a fixed rate)
What is ALARP Principle?
Risk cannot be eliminated fully; therefore ALARP Principle simply states that residual risk should be as low as
reasonably practicable, taking into account the costly nature of risk reduction.
ALARP simply states that cost of reducing the risk should not exceed the benefit of reducing it.
Such principles are applied to areas which are generally not in the control of the company, like health
and safety risks at oil rigs, construction, chemical, coal mines companies.
Control Activities: (SPAM-SOAP)
S Segregation of Duties (Each duty and task should be taken separately and should have different
persons responsible for running it. Each task then runs effectively, which reduces the risk of error.)
P Physical Control (Tight security and procedures is needed to control the access to assets. Access
must be limited to the authorized personnel only.)
A Authorization and Approval (Approval for every document is needed with specified limitation to the
authority.)
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Monitoring:
COSO provides that the entirety (not just financial) of ERM should be monitored (assessment by appropriate
personnel of design and operation of control on a suitable timely basis) and modifications made as necessary.
Any weaknesses should be reported, assessed and root causes to be corrected (control procedures only makes
correction, monitoring corrects root cause of the problem).
This may be achieved through ongoing management activities (routine review of reconciliations etc.), separate
evaluations (by audit committee/internal audit, includes annual reviews of control procedures) or both.
Effective and efficient monitoring requires:
A proper foundation (proper tone at the top of organization, effective organizational structure, people
with appropriate skills and authority, objectivity and competencies)
Monitoring procedures based on prioritizing risks and identifying persuasive information
Assessing and reporting results
Monitoring Procedures: (QuaSC-ASAP)
Qua Quality assurance reviews
S Self assessment
C Continuous monitoring programs
A Analysis/follow up of operating reports
S Supervisory review of controls
A Audit committee enquiries
P Period evaluation and testing of controls by internal audit
Internal Audit:
Internal audit is an independent appraisal function established within an organization to examine and evaluate
its activities as a service to the organization. The objective of internal audit is to assist members of the
organization in the effective discharge of their responsibilities. To this end, internal audit furnishes them with
analysis appraisals, recommendations, counsel and information concerning the activities reviews: UK Institute
of Internal Auditors.
Role of Internal Audit Function:
Review of accounting and internal control system
Examination of financial and operating information
Review of economy, efficiency and effectiveness of operations
Review of compliance with laws
Review of safeguarding of assets
Review of implementation of corporate objectives (effectiveness of planning, CG, communication etc.)
Identification and assessment of significant risks, monitoring overall risk management policy and
reporting to (Risk Audit)
Special investigations into particular areas (e.g. suspected fraud)
Turnbull report recommends that listed companies without internal audit function should annually review the
need to have one and those having such function should annually review the scope, authority and resources.
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Whether or not an organization needs an internal audit function would depend on:
Scale and diversity of operations
Number of employees
Change in key risks
Problems with internal control systems
Increased number of unexplained events
Risk Audit:
Risk identification
Risk assessment
Review of internal controls
Reporting
Risk Audit can be performed by Internal and External Auditors.
Internal Auditor vs. External Auditor:
Internal Auditor
An activity designed to add value to organizations
operations.
Reports to board or audit/risk committee
Often an employee of an organization
External Auditor
An exercise leading to an expression of opinion on the
financial statements.
Reports to shareholders
Independent of the management and the company
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Relativism
There are many sets of moral rules and these rules will
change over time in one society.
These sets of moral rules will be different in different
societies.
In absolutism, truth in one culture may be imposed as
Truth is less likely to be imposed because of
truth in another culture.
acceptance of different sets of moral rules and beliefs.
Now, absolutism tends to believe that each culture (or In relativism, ethics and moral beliefs continue to
society) has its own truths and that truth should be
change as due to acceptance of ideas from different
protected in that culture.
races, religions, sects etc.
However, some truths are universal (or international)
Since, greater acceptance of moral and ethical codes,
irrespective of culture, religion or geography. For e.g. truths will continue to evolve and may change over
murder anti-social act, not killing women and children. times.
Advantage: This theory lays unambiguous rules that
Advantage: Flexibility and acceptance of values and
people are able to follow to know that their actions are beliefs of others. More inclined towards justification
right.
of an action and conditions behind it.
Disadvantage: Failure to take account of evolving
Disadvantage: Anything goes philosophy.
norms (Is it ok tell a lie to save an innocent life?).
Dogmatic vs. Pragmatic Approach:
The idea of absolutism and relativism can be illustrated further with two similar concepts;
Dogmatic Approach: It takes the view that there is one truth and this truth is to be imposed in all
situations. This viewpoint corresponds to absolutism.
Pragmatic Approach: It attempts to find the best route through a specific moral situation. This
corresponds to relativism as attempting to find a solution based on given belief
system of the individuals involved.
2) Deontological & Teleological Theory:
Deontological
Right or wrong is based on the action itself.
A non-consequentialist approach.
Teleological
Whether a decision is right or wrong depends on the
consequences or outcomes of that action.
A consequentialist approach.
An action can only be deemed right or wrong when the
morals/attitude behind taking that action is known,
As long as the outcome is right (beneficial), the action
hence not dependent upon the outcome of decision.
is irrelevant.
Key Maxims: An action to be morally right need to
satisfy all these three tests;
Consistency. Acts that are desirable to become
universal law, mean action can only be right if
everyone can follow the same underlying
principle.
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Acceptability of solution does not necessarily depend on the method of reasoning. In fact, moral actions are not
necessarily always decided by formal reasoning.
Assuming individual development. Individuals make different decisions in different circumstances (they have
multiple ethical stances). Hence situational influences (issue-related factors such as moral intensity/magnitude
of consequences and moral framing/language and context related factors such as reward mechanism, authority,
organizational culture and national and cultural context etc.)
Positions on Social Responsibility by Gray, Owen & Adams: Relativism (Corporate Perspective)
Gray, Owen and Adams provide seven positions to view social responsibility;
1) Pristine Capitalist (Only shareholders wealth maximization is everything. Any act of socially
responsibility that reduces shareholders wealth is destroying shareholder values and is beyond the
mandate being given to agents/directors.)
2) Expedients (Recognizing some social responsibility expenditure may be necessary to strategically
position an organization to maximize its profits. Therefore, some form of social responsibility can be
taken if it increases overall image or profitability.)
3) Proponents of Social Contract (Business enjoys a license to operate which is granted by society as long
as business acts in appropriate way, so businesses need to be aware of the norms acceptable by society.)
4) Social Ecologist (Recognizes that a business has social and environmental footprints, therefore it must
accept responsibility of minimizing footprints.)
5) Socialist (Actions of business are those of the capitalist class oppressing other class of people. Business,
therefore, should be conducted in a way to redress and reprimand imbalances or inefficiencies in society
and going beyond shareholders to stakeholders.)
6) Radical Feminist (Society and business should be based on feminine characteristics such as equity,
dialogue, compassion and fairness. It is argued that society and business are based on masculine values
representing aggression, power, assertiveness, hierarchy, domination and competitiveness.)
7) Deep Ecologist (Humans have no more intrinsic right to exist than any other species. It is argued that
just because humans are able to control and subjugate social and environmental systems does not mean
that they should. A full recognition of each and every stakeholder claims would halt the business to
continue as it normally does.)
Ethics in Exam: (Solving Ethical Dilemmas)
AAA Model: (FIN-ABCD)
The American Accounting Association Model was set out in a report by Langenderfer and Rockness in 1990
and as follows;
F What are the FACTS of the case?
I What are the ethical ISSUES in the case?
N What NORM, principles and values are related to the case?
A What is the ALTERNATIVE course of action?
B What is the BEST course of action that is consistent with these norms, principles and values?
C What are the CONSEQUENCES of each possible course of action?
D What is the DECISION?
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Both IFAC and ACCA identify the following ethical threats to compliance with the fundamental principles;
Self-Interest Threat
1) Financial interest (e.g. owning shares)
2) Close business relationships (partnership with client, distribution/marketing for clients etc.)
3) Employment with client (staff moving to client may result in him attempting to impress future
employer, partner becoming finance director means over-familiarity with audit firms system 2
years should pass before a partner may take up such employment, other staff should let the firm
know ASAP he becomes interested in employment with a client.)
4) Partner on client board (although secretarial services may be fine as long as purely administrative)
5) Family and personal relationship (appropriate disclosures requirements should be in place.)
6) Gifts and hospitalities (unless clearly insignificant)
7) Loans and guarantees (unless by a financial institution and on normal commercial basis)
8) Overdue fees (this amounts to extending loan to client)
9) Contingent/percentage fees.
10) High percentage of fees from one client/group. (generally, should not exceed 15% of firms total
earned fee, but in cases of listed companies/public interest companies, the figure should be 10%)
11) Lowballing (quoting significantly lower fee than predecessor firm)
12) Recruitment (management decisions should not be taken by audit firm, although they may review a
shortlist prepared by the client.)
In many cases, materiality of the interest will have to be considered. Clearly insignificant interests do not pose a
threat. Where there is a risk, safeguards may include;
1) Disposing of the interest.
2) Removing the individual from team.
3) Informing the audit committee of the client.
4) Using independent partner (or professional) to review the work,
5) External/internal quality control review.
6) Modifying assurance plan/resigning.
7) Taking steps to reduce dependency on the client.
8) Consulting third parties such as ACCA.
9) Complying with all assurance standards.
Self-Review Threat
This threat may arise mainly due to multiple services that assurance service providers may offer (e.g.
book-keeping, valuation, actuarial services, internal audit, management functions, legal services, human
resources and designing and implementation of financial information systems). Sarbane-Oxley rules
prohibit these, through many are generally allowed in UK with suitable safeguards. Other services
include IT services, temporary staff cover and legal services etc.
The rules mainly deal with public listed companies and public interest companies i.e. companies which
due to their size, nature or product are in the public eye.
This threat may take the following forms:
1) Recent services with assurance client.
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Advocacy Threat
The obvious example of this threat is when the client is offered legal advice, but other examples include
advising on debt reconstruction and negotiations with a bank on behalf of the client.
The firm should determine the materiality of the risk and ideally use different departments for these
services. Disclosures to clients audit committee should also be considered. Where the risk is too high,
withdrawal from engagement may be the only option.
Familiarity Threat
Familiarity may arise due to family/personal relationship with client, employment/recent services with
assurance client, or long association with client. Staff rotation, second partner review and independent
quality control review are the relevant safeguards.
Intimidation Threat
Intimidation may involve actual or threatened litigation or second litigation. In case of the latter, the
second firm cannot give formal audit opinion (as only the appointed auditor can do that), but the fear for
the first firm will be to lose the client to the second firm for the following year. In any event, the second
firm should seek the firsts permission before taking on the work and must ensure it has all the
information to give the opinion.
Ethical safeguards against the threats are also covered by both IFAC and ACCA. Such safeguards may be
professional/legal or internal to the firms.
Amongst professional/legal safeguards include;
Educational training and experience requirements.
Continuing professional development requirements.
Corporate governance regulations.
Professional standards.
Professional/regulatory monitoring and disciplinary proceedings.
Accountancy Profession & Public Interest:
IFACs Code of Ethics defines professionalism in terms of professional behavior. Professional behavior
imposes an obligation on professional accountants to act in the public interest. They should comply with
relevant laws and avoid any action that may discredit the profession. Public interest is the collective well-being
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of the community of people and institutions that the professional accountant serves. These are who matter and
not individual client/employer.
Attributes of a modern professional include: maintaining confidentiality, upholding ethical standards, preparing
(and interpreting) financial information and statements, communicating effectively and managerial skills.
Critics have maintained that the accountants definition of public interest is too closely tied with their own selfinterest. The objection is that this model leads to accountant being seen as a servant of capital. It results in lack
of equality, fails to increase social welfare or equally distribute maximized profits, does not address
environment all concerns and focuses narrowly on utilitarianism. It is also said that the rules are too passive,
lacking a positive duty to detect and report fraud, prefers client confidentiality over disclosure in public interest
and provision of non-audit services etc.
Threat for Employee Accountant:
There may be inevitable conflicts for an employee accountant in the following areas:
1) Confidentiality (note the accountants duty, in the public interest, to report an errant employer)
2) Interest served (accountant has a duty to wider stakeholders group)
3) Organizational vs. Professional Norms
4) Requirements for obedience
The main threat is pressure from employer to act contrary to law or technical/professional standards or to
mislead auditor etc. Lack of time, lack of information, insufficient training/experience and inadequate resources
are other factors leading to threats, as are financial interests (inside information).
Safeguards include using formal procedures within the organization, consultation with ACCA or lawyers and
disclosures where relevant. Finding sufficient time and expertise/training will also help in certain cases.
Bribery & Corruption:
Bribery is the offering, giving, receiving or soliciting of any item of value to influence the actions of an official
or other person in charge of a public/legal duty. Corruption is deviation from honest behavior and includes not
just bribery but also abuse of a system, bid rigging and cartels etc.
Failing to report bribery is also an offence now under three Bribery Act 2011. Organizations are liable if their
employees pay bribe (unless they can show adequate procedures to prevent bribery were in place)
Bribery leads to lack of honesty, good faith and to conflict of interest (personal gain/exposure vs. duty),
misallocation of resources threatening fair market. Facilitation payments need to be carefully considered to
ensure bribe is not paid.
The UK guidance setting up adequate procedures is based on 6 principles;
1) Proportionate procedures (risk, nature, size and complexity of risk/business)
2) Top level commitment
3) Risk assessment (certain businesses/countries are more prone)
4) Due diligence
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5) Communication (embedding awareness through formal and unambiguous statements with zero tolerance
policy, general and specific training, anti-bribery codes, strong internal controls and effective whistle
blowing/disclosures arrangements)
6) Monitoring and review (risk is dynamic)
Corporate Social Responsibility (CSR):
CSR refers to organizations considering and managing their impact on variety of stakeholders including; local
community, environment, customers, suppliers, shareholders, employees etc. A corporation is an artificial
person in law and therefore it has same rights and responsibilities as of human beings.
According to Carroll, CSR encompasses the economic, legal, ethical and philanthropic expectations placed
on organizations by society at a given point in time.
Corporate Citizenship:
Corporate Citizenship is the business strategy that shapes the vales underpinning a companys mission and the
choices made by its officers as they engage with society. Three core principles are minimizing harm,
maximizing benefit and being accountable and responsive to stakeholders.
Corporate Citizenship has also been criticized as bringing in consideration that interfere with free market
notion. Economic self-interests, it is said ,ensures maximum economic growth and hence maximum social
welfare.
Social/Environmental Effects of Economic Activity:
While businesses can certainly have positive effects, the adverse effects include depletion of natural resources,
noise and aesthetic impacts, residual air and water emissions, long-term waste disposal, uncompressed health
effects and change in the local quality of life.
Sustainability:
Sustainability is about only using resources (inputs) at a rate that allows them to be replenished and confining
emissions (outputs) of waste to levels that do not exceed the capacity of the environment to absorb them. In
other words, sustainability is not a fixed state of harmony but a process of change in which exploitation of
resources is consistent with future as well as present needs.
This concept of needs was central to the UN World Commission on Environment and Development, the report
stated that what was required was political, economic, social, production, technological, international and
administrative systems.
Sustainability raises obvious questions such as;
For whom should we sustain? (humans, other species, future generations)
How should we sustain? (social, environmental, economic sustainability)
How long should we sustain and at what cost? (compensation vs. preservation)
Week sustainability proponents argue that sustainability should only be about human beings and that natural
environment can be considered as a resource. They do however accept that a better mastery of natural resource
should be pursued. Supporters of strong sustainability, however, advocate far more fundamental changes they
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want sustainability for all species and want a complete re-think of how man sees economic growth. They are for
preservation rather than compensation.
Reporting:
Global Reporting Initiative (GRI) is a reporting framework aiming to develop transparency, accountability,
reporting and sustainable development. Reporting on SEE (social, environmental, economic) importance should
be routine, comparable to financial reporting (triple bottom line: people, planet, profit or TBL/3BL).
The advantages of these special reporting are better risk-management, reduction in environmental footprint and
favorable publicity, but the disadvantages include higher cost, vagueness, confusing signals and
misunderstandings.
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