P1- study notes

P1 BY DR. PARMINDAR SINGH

These slides are meant for students taking the

P1 subject for ACCA.

These slides are not meant for the purpose of

selling, editing and anything else whatsoever

without the permission of Dr. Parmindar Singh.

The author also does not allow these slides to be

used by other lecturers, students and any other

agents for the purpose of lecturing, tutoring and

any other forms of delivery without the authors consent.

Governance, Risk and Ethics

PAPER P1

SYLLABUS OUTLINE LESSON TOPIC (OVERVIEW)

1 Corporate governance an introduction

2 Stakeholders

3 Agency model and transaction costs

4 Ethics and morality

5 Corporate social responsibility

6 Environmental accountability

7 Profession and public interests

8 Rule-based and principle-based approach

9 Principle-based approach overall

10 Combined code on corporate governance

11 Sarbanes-Oxley Act 2002

12 Board size, structure and culture

13 Risks and risk management

14 Internal controls

15 Internal audit

Focused areas for P1

June 2014

Dear students,

These focused areas are, as the name implies just to highlight important areas for consideration in

the June 2014exams.

However, it is the responsibility of the student to cover all areas of the P1 syllabus to ensure that

they are thoroughly prepared.

1. Stakeholder distinguish stakeholders; justifying the type of stakeholders and stakeholder engagement.

2. Ethics Kohlberg, relativism and absolutism, code of ethics, ethical stances, threats (FIASS), encouraging ethical behavior, general ethics question.

3. CSR Gray, Owen and Adams (especially social ecologist, socialist and radical feminist and others), importance of CSR, social and environmental audit

pressures (TBL).

4. Environment environmental and social footprint, environmental accountability, environmental audits

5. Profession and public interest public interest, accounting as a value-laden profession.

6. Governance public-listed governance rules-based and principles-based; non public-listed governance family-based corporate governance; Governance (Combined) Code (read all and more focus on risk committee, remuneration

committee, roles of chairman, shareholders AGM, EGM, proxies); principles of good governance (FIT-PRAR-JI). Also focus on the term business model and

characteristics of good annual reports; 2-tier boards; institutional investor

intervention

7. Risks types of risks, differentiation one risk from another, risk auditing, risk correlation, risk management, risk expressions and terms (ALARP,

subjective/objective risks)

8. Internal controls internal control purposes/objecitves/aims/characteristics, internal control challenges/measures, internal control failings (based on scenario),

reasons why internal control cannot provide absolute assurance.

9. Internal audit threats (FIASS), factors to consider, internal audit scope/remit, internal auditor (recruit or promote from within).

NOTES ON PROFESSIONAL MARK

REQUIREMENTS FOR P1 1. Letter

Should have senders address details (company name, address line 1, address line 2)

Date

Letter should commence with Dear XXXX Write letter in first person, such as I, we, your board, our company etc. Conclude letter with suitable sentence, thanking the reader for their interests and

time

Use Yours faithfully where the addressee is anonymous, such as shareholders or use Yours sincerely if the addressee is named.

2. Presentation

Write your answers in first person

When writing notes for presentation write in short sentences, focus on key points.

3. Briefing notes/management reporting

Should be written in third person, the company, XYZ Ltd, the board

Well structured focused on key points.

4. Press statement

Clear short paragraphs

Written in third person

Opening paragraph delivering the key message with background information

The rest of paragraphs will give more elaboration

5. Memo

Will have heading called Memorandum Followed by: To:, From:, Date:, Subject:

Style of writing will be precise and factual

Written in first person (identifying author as I)

6. Report

Just like memo, but have a heading called Report Should have an introduction

Finish with summary or conclusion

Use of sub-headings desirable

7. Statement

Have a heading, for example, Chairmans statement at AGM Have an introduction

Use first person

Write a style that could be read out

Make sure flow is logical

Source: Condon, S. (2009), Professional marks, Student Accountant, June, pp. 86-89.

8. Speech

Have an introduction

Use first person

Write a style that could be read out

Make sure flow is logical

Have a proper ending

Analysis of past year questions

Topic Pilot

paper

Supplement

pilot paper

Dec

07

Jun

08

Dec

08

Jun

09

Dec 09 Jun

10

Dec 10 Jun

11

Dec 11 June

12

Dec 12 June 13

Corporate governance 1(a) 4(a) 2(a)

Stakeholders 4(a) 1(a)

(i),

(ii)

1(d) 1(a) 1(d, i) 4(b, c)

Agency model &

transaction costs 2(b) 3(a) 2(c),

4(c)

3(a) 1(c) 1(c) 1(d,

ii)

3(b)

Ethics & morality 3(a),

3(c)

1(a), 1(b), 1(d),

2(d)

1(b) 1(d)

(iii),

2(a),

2(b)

(ii),

2(c)

1(a),

1(c)

(ii),

4(a),

(c)

1(a)

(i),

(ii),

(iii);

2(b)

1(a),

3(b, c)

2(c),

4(c)

1(b) 1(b),

4(a, b,

c)

1(a);

4(c)

1(b),

3(b)

1(c),

4(a)

1(d,ii)

CSR 4(b) 1(c)

(i)

2(c) 4(c) d(ii) 4(a, b,

c)

Environmental

accountability 1(e) 1(d)

(i),

(ii)

1(d,

ii)

2(a, b) 1(b) 1(a) 1(b)

Profession & public

interests 2(b)

(i)

2(a) 3(a) 4(b) 3(a)

Accounting & financial

scandals

Rule & principle-based 3(d) 3(c) 4(a)

(i),

(ii)

3(a) 2(a) 2(b)

Principle-based 3(b) 1(a),

3(c)

3(b) 2(c) 1(d)

(i),

2(a)

2(b),

2(c)

Combined code 1(a),

1(d)

2(a),

2(b)

1(c),

2(c),

3(a),

3(b)

3(b),

3(c)

3(c),

3(d)

1(c),

2(c)

2(a, b) 1(a),

1(c) (i),

3(a,b,c)

d(i),

3(c)

2(b);

3(a, c)

2(a, b,

c),

3(c)

2(c),

2(a)

2(b, i,

ii), 4(a,

b, c)

SOA 2002 3(c) 4(b)

Board size, structure &

culture 1(a),

1(c)

2(b) 4(c)

Risks 1(b),

4(b)

2(a),

2(b)

1(b),

(c)

1(b),

3(c)

4(b),

4(c),

4(d)

1 (d, ii),

3 (a, b,

c)

1(d, i) 2(c),

4(a,b,c)

2(a, b,

c, d)

1(c) (ii,

iii, iv);

3(b)

1(a) 1(b),

1(d, i)

1(a),

3(a,c)

Internal controls 4(a) 1(d) 1(e) 3(a)

(i),

3(b)

1(b),

1(e)

1(b),

1(d, i)

3(b) 1(c)(ii,

iii)

1(a) 1(c) (i) 1(c) 1(d, ii),

3(a),

3(b),

3(c)

1(c),

2(c)

Internal audit

2(a), 2(b), 2(c),

2(d), 3(c)

3(a)

(ii),

3(b)

3(c)

2(a)

Consolidation of

knowledge 2(c),

4(c)

1(c), 1(d) 1(a),

2(c),

4(c)

4(c) 1 (d)

(i, ii),

4(b)

3(a),

3(b)

1(b),

4(a)

Topic Dec 2013

Corporate governance 1(c)

Stakeholders

Agency model & transaction costs 2(b)

Ethics & morality 3(c), 4(c)

CSR 3(c)

Environmental accountability 1(a, I, ii)

Profession & public interests

Accounting & financial scandals

Rule & principle-based 2(a)

Combined code/Governance Code (including Smith

and Higgs report)

1(c), 3(a, b), 4(a, i, ii)

OECD & ICGN

SOA 2002 2(b, c)

Board size, structure & culture

Risks 1(b), 4(b)

Internal controls 1(d, i)

Internal audit

1(d, ii)

Consolidation of knowledge

P1 key words

1. Critically evaluate generally, the answer would want the pros (in

support/benefits) and cons (problems/disadvantages).

2. Assess Mr. Xs understanding of his role as XXX explain whats wrong with his

understanding.

3. Construct the case for - in support of the argument.

4. Define give meaning.

5. Explain elaborate more and should be longer than simply defining.

6. Criticise to find issues in opposition to the points raised.

7. Assess whether there is any element of truth or otherwise.

8. Distinguish between X and Y differentiate between X and Y.

9. Discuss similar to explain and you can give your point of view (in support or to

oppose).

10. Explore find out more about a particular issue.

11. Advise telling what ought to be done in a polite manner.

12. Identify find out from the scenario about something (stakeholders, issues etc.).

Issues Key words

Reward/remuneration ARM = attract, reward, motivate

Information ACT = accurate, complete, timely

NED KSA = knowledge, skills, abilities

Annual report FBU = fair, balanced, understandable

Annual report Contains information about performance,

business model and strategy

Induction FFT = full, formal and tailored

NED induction BPS = business, people, stakeholders

CORPORATE GOVERNANCE

The Cadbury Committee defined corporate

governance as the system by which companies

are directed and controlled

Corporate governance is the relationship among

various participants in determining the

direction and performance of corporations

(Monks & Minow, 2002, p. 1). The primary

participants are (1) the shareholders, (2) the

management (led by the CEO) and (3) the BODs.

. Owners/principals/shareholders

Shareholders

Government Non-government SOE GLC Individuals families Institutions

: public-listed firms : private companies : NGO charitable firms, religious bodies, foundations, SIG : pension funds, mutual funds, hedge

funds, private equity funds

INSTITUTIONAL SHAREHOLDERS

Dedicated

Transient

CORPORATE GOVERNANCE PERSPECTIVES

Shareholder model/agency model is of the view that there is good corporate governance when agents (management/CEO, board) take action to maximize shareholders wealth. Hence agents fiduciary duty lies only to shareholders; however, this model also recognizes that agents may tend to pursue their own interests (i.e. act opportunistically) at the expense of shareholders and therefore, there must be proper mechanisms in place (monitoring, bonding) to ensure that agents do not act opportunistically and consequently pursuing shareholders interests.

Stakeholder model is of the view that there is good corporate governance when agents take care of the interests of the organizations stakeholders. These stakeholders may be shareholders and employees or the diverse range of stakeholders of an organization such as customers, suppliers, community and others. All stakeholders have an inherent worth and none should be exploited for the benefit of some. Therefore, agents must attempt to treat each stakeholder fairly. Hence agents fiduciary lies to all stakeholders communitarian position.

Stewardship model is of the view that good corporate governance occurs when agents view themselves as stewards/guardians of the corporations and diligently work to attain high levels of corporate profits and shareholders returns. Stewards or agents will not shirk their responsibilities. Being stewards of the organization, agents will never pursue their own self-interests, and therefore there is no monitoring of agents/management.

Enlightened shareholder value a corporate governance approach where an agent takes the interests of its diverse stakeholders only in so far as to promote and advance the long-term value of shareholders.

Political model a corporate governance approach where government (being the sole- or major shareholder) decides how rewards, resources, power, privileges, among others are allocated. Government will also decide on appointments to be made as well as strategies to be pursued. Government will also use the firm to pursue its own agenda.

Cultural model is of the view that good corporate governance occurs when a healthy, dynamic and adaptive culture of the organization moulds, shapes and gels the running of an organization so that it is well directed and controlled.

CORPORATE GOVERNANCE

Monistic

Dualistic

Pluralistic

NEDs

Shareholder activism

Small board size

External auditors and internal auditors

Rating agencies

Laws and regulations

Internal controls

Risk management

Mission, ethics, culture, strategy

BENEFITS OF GOOD CORPORATE GOVERNANCE

Attracts greater investments into firms, both foreign and domestic (McKinsey & Co.) with good corporate governance, many investors, both foreign and domestic will be attracted to the firm. As such, the firm will be highly sought after and consequently, its share price will be in great demand. Hence its share price may move northwards.

Reduces cost of capital

Attracts patient capital

Reduce risk

Stimulates performance and improves share price

Enhance marketability of products and services by creating confidence among stakeholders

Improve leadership standing

Demonstrates transparency and accountability

STAKEHOLDERS

Definition

Types classification

DEFINITION

Stakeholders are those whom the firms operations has benefited or burdened (Steiner & Steiner).

Stakeholders can also be defined as the individuals

or groups who can affect, and are affected by, the

strategic outcomes achieved and who have

enforceable claims on a firms performance (Freeman).

CLASSIFICATION OF STAKEHOLDERS

Narrow and wide stakeholders (Evans and

Freeman) narrow stakeholders are those that are most affected by the organizations policies. Examples include shareholders, employees,

customers, suppliers. Wide stakeholders are those

that are less affected and may include government,

indirect customers, the wider community and other

peripheral groups

Active and passive stakeholders (Mahoney) active stakeholders are those who seek to participate in the organizations activities. Examples are management and employees. Passive stakeholders include shareholders, government and local communities.

Internal (internal actors employees and their representatives, board of directors, sub-board management, company secretary) and external stakeholders (shareholders, stock exchanges, auditors and governments and regulators).

Voluntary and involuntary stakeholders voluntary stakeholders will include employees, customers, suppliers and shareholders. Involuntary stakeholders will include local communities, natural environment, future generations and most competitors

Legitimate and illegitimate stakeholders legitimate stakeholders are those that an organization recognizes as having a valid claim on an organizations operations and acknowledges its existence and vice-versa for illegitimate stakeholders

Recognized and unrecognized stakeholders -

recognized stakeholders are those that an

organization views as a legitimate stakeholder

and acknowledges its existence and vice-versa for

unrecognized stakeholders.

Known-about and unknown stakeholders

Mendelow power-interest matrix

Level of interest (in organizational strategies)

Low High

Low

Power

High

A. B. Minimal effort Keep informed

(e.g. community)

C. D. Keep satisfied Key players (e.g. institutional investors)

Low High

Mendelows power-interest matrix

STAKEHOLDERS

Identify all stakeholders non should be omitted

Classify stakeholders accurately

Undertake proper stakeholder relationship

management

A proper stakeholder relationship management

will give an organization competitive advantage Hillman and Keim

Stakeholder relationship management

Stakeholder engagement

Shareholders Employees Community Customers

AGMs, Meetings, Town-hall meetings, CRM Meetings PA, rewards open day, Annual dinner, CSR programs Family day,

QUESTIONS

Required:

(a) Distinguish between voluntary and involuntary stakeholders,

identifying both types of stakeholders in Hesket Nuclear. Assess the

claims of THREE of the involuntary affected stakeholders identified.

(12 marks)

Answer:

- Define voluntary stakeholders

- Give examples

- Define involuntary stakeholders

- Give examples

- Assess claims of THREE of the involuntary

affected stakeholders

(d) Distinguish between narrow and wide stakeholders and

identify three narrow stakeholders in Global-bank (based

on Evan & Freemans definition) from information in the case. Assess the potential impact of the events described on

each narrow stakeholder identified. (10 marks)

Answer:

- Define narrow stakeholders

- Define wide stakeholders

- Identify three narrow stakeholders

- Assess impact on the narrow stakeholders

identified

AGENCY THEORY

Agency theory

Agency costs

Fiduciary duty

Increasing fiduciary duty of board

1932 Berle and Means (US)

Owner Controller

Jensen and Meckling (1976)

Fiduciary duty Principal Agent (CEO)

(ROAD)

Appoint, place some degree of trust and confidence, provide resources Principal conflict Opportunistically to address Agency costs Agency conflict

Increases agent opportunism

Agency costs

increase

Adverse selection

Management style poor Low PET Compounded by Information asymmetry BOD ineffective poor internal controls external and Risk management internal auditor not I&O

AGENCY COSTS Jensen and Meckling defines agency costs as the sum of:

Monitoring management (the agent),

Bonding the agent to the principal (economic bonding) and,

Sum of all the previous residual losses.

Information asymmetry

Ineffective Board of directors

Management style poor high turnover of staff

Poor internal controls and risk management

External and internal auditors not I&O

Agency costs can therefore increased due to:

REDUCING AGENCY COSTS Remuneration - performance-based incentive plans performance shares,

performance bonuses and other remuneration (incentives must be aligned to shareholders long-term interests).

Direct intervention by shareholders (especially institutional investors)

The threat of firing (reduced by golden handshake/severance pay and empire building)

The threat of takeover (sometimes agents resist this takeover through greenmail and poison pill) (or use of white knight or white squire)

An effective board of directors chairman, nomination committee, audit committee, risk management committee and other committees, INEDs

Triple-bottom line reporting

Internal audit risk management, internal controls and governance

External audit

Empire building (managerial self-interest)

Pursing unprofitable acquisitions

Managerial entrenchment

Harder to be laid-off

Remuneration increases

-Greenmail approaching shareholders of acquiring firm to buy back shares at a premium

-Poison pill (i) share rights option, (ii) borrowing on terms that require immediate repayment of all loans if the firm/target is acquired, (iii) selling-off at bargain prices the assets that originally made the firm a desirable target

-White knight friendly acquirer

-White squire friendly investor

INCREASING FIDUCIARY DUTY

Political-economic argument

Profits

Legitimate theory

Competitive advantage

QUESTIONS (c) Explain what an agency relationship is and examine

the board of HPCs current agency relationship and objectives. Briefly explain how these would differ if HPC

was a company with private shareholders. (10 marks)

Answer:

- What is agency relationship

- Examine current principal and agent

- Explain current objectives

- How current principal and agent changes if

company owned by private shareholders

ETHICS

Kohlbergs moral development

Ethical relativism and absolutism

Tucker

AAA

Teleological utilitarianism

Deontological Kantian ethics

JSWs ethical stances

Code of ethics (benefits and problems)

IFAC/ACCA code of ethics principles of professionalism

Threats to professionalism

Level Stage Description

1 1. Person acts in such a way in order to

avoid punishment or to receive rewards.

2. Person acts because it is his/her self-

interests to act in such a way.

2 3. Person acts in such a way so as to

nurture long-term relationships of

mutual support with members on ones in-group/immediate circle or those close

to them.

4. Consists of upholding the law, order, LR,

regulations, and policies. Here the in-

group expands to include ones larger community.

3 5. Conceives morality as compliance with

the social contract. Rules are

understood to be relative to a particular

group but are upheld in the interests of

impartiality.

6. Morality based on commitment to self-

selected universal principles for

governing social cooperation.

Kohlbergs moral development

ETHICAL RELATIVISM AND ABSOLUTISM

Ethical relativism is a theory that what is right (i.e.

ethical/moral) is determined by what a culture or

society say is right. What is right in one place may

be wrong in another more pragmatic/flexible/practical

Ethical absolutism where there are a set of

principles that can be applied, irrespective of culture

and society. These set of principles falls under

normative theories of ethics more rigid and firm

PRAGMATIC APPROACHES

Profitable?

Legal?

Fair?

Right?

Sustainable or

environmentally

sound?

What are the facts of the case?

What are the ethical issues of the case?

What are the norms, principles, and values related to the case?

What are the alternative courses of action?

What is the best course of action that is consistent with the norms, principles, and values identified in step 3?

What are the consequences of each possible course of action?

What is the decision?

Tucker AAA

NORMATIVE THEORIES

Bentham an act is morally right if it

promotes the greatest

net human

welfare/net happiness

in the long run.

Kants categorical imperative can be broken down into two

postulates:

What makes an action right is

that the agent would be

willing to be so treated were

the positions of the parties

reversed (Universal

Acceptability)

Humanity as an End, never

as merely a Means i.e. human beings has an

inherent worth and should

not be exploited

Teleological -

utilitarianism

Deontological Kantian ethics

ETHICAL STANCES - JSW

Short- term shareholder interests is of the view that organizations have acted ethically if it can perform her economic and legal

responsibilities, i.e. the adage, the business of business is business

Tends to adopt an agency model, i.e. to maximize shareholders interests/wealth

Long-term shareholder interest is of the view that an organization has acted ethically by promoting and advancing the long-term value

of shareholders by taking care of its other stakeholders (constituents)

All expenses incurred in taking care of other stakeholders are

Classified as marketing expenses/PR

Has an instrumental view on CSR; adopts an enlightened

Shareholder view on CG

Multiple stakeholder obligations is of the view that an organization has acted ethically by taking care of all its stakeholders (dualistic or pluralistic)

and therefore must be seen to be acting fairly to all its stakeholders

Has a normative view on CSR

Adopts a stakeholder approach to CG

Shaper of society is of the view that an organization has acted ethically if it is able to influence society with its ideals, values, beliefs, principles

and doctrines

Mainly for non-profit oriented firms: religious bodies, SIG/NGOs, charitable

organizations

ENCOURAGING ETHICAL BEHAVIOUR

Self-regulation SOP, policies, code of ethics

Whistle-blowing

Ethics Ombudsman

Appoint senior executives to oversee matters (IKEAs CEO)

Leadership by example

Internal controls

HRM practices

Culture

CODE OF ETHICS

Code of ethics can also be defined as a statement of principles a business

agrees to abide by voluntarily over the course of its operations

Benefits of code of ethics Problems

Clarifies company expectations of

employee conduct in various situations

Ineffective from the work of some researchers

Makes clear that the company expects

its people to recognize the ethical

dimensions in decisions and actions

Not influential in determining a persons ethical decision-making behavior

Enhance reputation and brand equity Inflexibility

Communication sending the right message about good business practices

to stakeholders as well as to indicate

firm is committed to ethical behavior

Lack of clarity

Helps to create cohesive corporate

culture

Irrelevant

Can help firm avoid adversity such as

fines, sanctions and litigations self-regulation

Globalization imperative codes may transcend local laws and culture

Improve employee commitment

IFAC/ACCA CODE OF ETHICS/PRINCIPLES OF

PROFESSIONALISM

Professional behaviour - Complying with laws and regulations, listing requirements

- Complies with policies and procedures

- Kind, understanding, considerate,

courteous, helpful, empathetic, P&Qs

Objectivity - Rational, impartial/unbias

- Independent

- Emotionally detached

- Under no undue

pressure/duress/influence

- Practices professional skepticism -

facts

Professional competence and due care

- Keeping up-to-date CPD

- Practices due diligence: analyse

meticulously, all facts covered before

making decisions

Integrity

- Strong internal moral code/principles/

high PET

- Level 3 stage 6 (Kohlberg)

- Honest, truthful

- Never compromising on principles

Confidentiality

- Values confidentiality and keep things

confidential unless needed by law

- Confidential information obtained not to

be used for ones personal advantage nor for the advantage of any 3rd parties

POPIC

THREATS TO PROFESSIONALISM

Familiarity threat external auditor knowing someone in client firm; internal auditor auditing areas where he/she familiar with people in those areas

Intimidation threat external auditor receiving bribes etc. and

subsequently being blackmailed or intimidated; external auditor being intimidated into completing tasks as unqualified even though there are irregularities as demanded by FD of client firm or by lead partner

Advocacy threat upon receiving bribes or gifts, senior

accountant advocating/promoting the giver of bribes/gifts for certain projects/contracts

Self-review threat internal auditor review or providing

assurance on earlier work where he has provided consultancy Self-interest threat external auditor auditing client firm where

he has some vested interests; senior accountant providing inside tips to outsiders where benefits will be reaped by both parties

CSR GRAY, OWEN AND ADAMS

Position Description

Pristine capitalist Is of the view that organizations have acted in a socially responsible manner if they are able to safeguard the interests of shareholders and creditors; in

short, performing their economic and legal responsibilities. (related to the business of business is business and short-term shareholder interests

Expedients Is of the view that organizations have a limited responsibility in performing its corporate social responsibility especially if such a behavior can help to promote the organizations self-interests.

Proponents of the social contract Organizations believe they should behave in a way broadly in conformance with the ethical norms in society because there is effectively a contract or

agreement between the organizations in power and those who are affected

by the exercise of this power and an organizations survival and prosperity is dependent on it.

Social ecologist Is of the view that organizations, especially large organizations have caused much social and environmental degradation; as such, organizations must now fully

pledge and undertake its CSR to redeem itself.

Socialists Is of the view that organizations can only perform its CSR if society as a whole is a socialist or an egalitarian community where organizations are expected to

treat its workers and other stakeholders equally and therefore one class of

workers (the capitalists, shareholders, bourgeois) do not oppress lower-class

workers or the proletariats.

Radical feminists Is of the view that organizations can only be successful in undertaking its CSR if the society/country has a feminine culture.

Deep ecologists Is of the view that organizations can only start to practice its CSR if it starts to respect the rights of the down-trodden and also to appreciate that human

beings have no greater rights to resources or life than other species.

IMPORTANCE OF CSR

Profits

Improve customer loyalty

Globalization imperative

Successful implementation of strategies

Competitive advantage

Gen. Y

SOCIAL AND ENVIRONMENTAL AUDIT PRESSURES

Environmental issues as a source of risk reputational damage, liabilities

Profits

Potential employees

Investors

TRIPLE BOTTOM-LINE

Political-economic argument

Legitimate theory

Shareholders

Financial performance

Environmental disasters

Laws/regulations

Stakeholder theory

ENVIRONMENT

Environmental footprint - Environmental footprint shows the impact that a businesss activities have upon its environment, in terms of:

An organizations consumption of resources such as energy, water, land, feedstock (grains, edible plants etc.) and,

An organizations harm to its

environment in terms of pollution, emissions, spillages (in respect to oil, chemicals, contaminants etc.)

Large environmental/carbon footprint = negative environmental footprint

Small environmental/carbon footprint = positive environmental footprint

More social contributions than harm = positive social footprint

More harm than social contributions = negative social footprint

VOLUNTARY INITIATIVES

Carbon trading

Reducing, reusing and recycling

Alternative energy sources wind, geothermal, solar, landfills (methane gas), biogas digester (methane gas), biofuels

Pursuing sustainable development

Equator principles discouraging lending to infrastructure projects that pollute

Working closely with NGOs to reduce environmental footprint

Awards/certificates LEEDs, Green mark certification

SUSTAINABLE DEVELOPMENT BRUNDTLAND COMMISSION REPORT

a process of change in which the exploitation of resources, the direction of investments, the orientation of technological development, and institutional change are made consistent with future as well as present needs.

Brundtland Commission Reports also mentions the need to internalize all externalities

- Repletion rate depletion rate

- Internalize all externalities

ENVIRONMENTAL ACCOUNTABILITY

Triple bottom-line reporting

Full-cost accounting EMS Environmental certification

EMS

Defining environmental goals and missions

Developing adequate and effective environmental policies and procedures

Properly documenting and communicating the established environmental policies and procedures to affected personnel

Monitoring these policies and procedures and ensuring compliance with them

ENVIRONMENTAL AUDIT

Agree upon metrics (and objectives/targets)

What to measure emissions (pollution, waste, greenhouse gases) and consumption (energy,

water, feedstock etc.) (see GE)

Performance of company measured against these

metrics

Report on levels of compliance or variance

GENERAL ELECTRIC

PROFESSION AND PUBLIC INTERESTS

A profession is an occupation for which the

necessary preliminary training is intellectual in

character, involving knowledge and to some

extent learning as distinguished from mere skills

It is an occupation which is pursued largely for

others and not merely for oneself

It is an occupation in which the amount of

financial return is not the accepted measure of

success

PUBLIC INTERESTS

Taking care of the interests of all stakeholders

who have a direct or indirect impact on what

happens to a firm

Example, external auditor, accountants and

other accounting professionals have to take care

of the public interests as employees,

shareholders, government, customers, suppliers

and others will be impacted on the goings-on in

the firm

Performs job according to job description

Accept and obey instructions from superior

consistent with job requirements

Be a team player and should not rebel

Act in the best interest of the firm

Work to ensure profitability and harmony of

firm

Responsibilities of employees

PROFESSIONAL ACCOUNTANT

Practice professional skepticism

Maintain the reputation of the accounting/audit

profession

POPIC

Maintain I&O and should not be under any threats

Maintaining fiduciary duty to shareholders and

maintain public interest

PRINCIPLES AND RULES-BASED GOVERNANCE SIMILARITIES AND DIFFERENCES

Improve corporate governance effective board no duality (rule-based does not mention this), formation of sub-committees

Protect whistleblowers

Enhance external auditor independence

Ensure proper internal controls

Improves disclosure financial statements etc.

Increased top management accountability

Rules-based regime require mandatory compliance while principles-based adopts comply or explain

Rule-based regime was passed by the US congress and this law resulted in the formation of an oversight board called the PCAOB, while principles-based regime was initiated by both private and government sector such as FRC and DTI

Rule-based considered more of a knee-jerk reaction to corporate scandals such as Enron while principle-based more meticulously planned

PUBLIC-LISTED COMPANIES

No opportunism

Easy to compare across firms

Less meticulous scrutiny

Provide fair-level playing field

More disclosure

Lesser information asymmetry

Costs

Flexibility

Relative ease of

adoption

Developing country

mindset

Benefits of rules-based Benefits of principles-

based

Country Name of code/report

Italy Preda code

Spain Olivencia code

South Africa King report

France Vienot report

Netherlands Peters report culminated in Tabaksblat code

Germany Cromme code

Belgium Lippens code

UK Governance code (Combined code)

Countrys code of corporate governance

WHY CG VARY?

National culture

Laws (common/civil)

Concentrated/diffused ownership

Financing options (capital market/equity or

banks)

NATIONAL CULTURE - HOFSTEDE

Power-distance

Uncertainty avoidance

Individualism collectivism

Masculinity femininity

Power distance

Uncertainty Avoidance

Individualism collectivism

Masculinity femininity

High

High

High

High

Low

Low

Low

Low

High uncertainty

avoidance High individualism

Larger board size

(unitary)

Two-tier board for

continental Europe

Higher basic

component

remuneration

More risk averse

Smaller board size

More risk taking

board

Can have CEO duality

Variable or

performance-related

component

remuneration higher

NATIONAL CULTURE

HIGHER FEMININITY

Higher percentage of women in board

Greater quality of work life

Greater altruism

OWNERSHIP STRUCTURE

Diffused shareholder base very broad

Concentrated shareholder base narrower

DIFFUSED OWNERSHIP

Major shareholder not a controlling shareholder.

E.g. Steve Jobs wife is now the major shareholder of Walt Disney (with around 7.3%

shares)

Major shareholder cannot decide on CEO

selection nor non-executive director selection the other shareholders also need to vote therefore agents are not directly chosen by major

shareholder

Agency conflict and independent NED

CONCENTRATED OWNERSHIP

Exists controlling shareholder via dual/triple class shares or pyramidal structure

There exists principal-principal conflict and gray

NEDs

DUAL-CLASS SHARES (RESTRICTED VOTING

SHARES)

Type/class A Type/class B

Facebook type A 1 voting right; Type B 10 voting rights

TRIPLE-CLASS SHARES

Type A Type B

Type C

Zynga Type A 1 vote; Type B 10 votes; Type C 70 votes

PYRAMIDAL STRUCTURE

A

B C

D E F G

H

WHY CORPORATE GOVERNANCE CAN

CONVERGE?

Transnational entities (OECD, UN, ICGN,

CACG, IMF)

FDI

Cross-listing

Diffusion of corporate governance code Cadbury Code

Harmonization of accounting principles

TRANSNATIONAL ENTITIES

These organizations try to disseminate good

corporate governance values across the world

As a result, many countries have been influenced

by their works

Consequently, there is convergence

FDI

In the form of international JVs, international

M&As, international strategic investments

Through FDIs, countries corporate governance interact

Therefore, as time goes by, the corporate

governance will converge

CROSS-LISTING

Listing is more than one stock exchange board

As time goes by, the best practices with regards

to corporate governance will converge

CADBURY CODE

Research shows that Cadbury code triggered

many countries to realize the importance of CG

As a result, many countries adopted and adapted

the best provisions of CG using Cadbury code as

their benchmark

HARMONIZATION OF ACCOUNTING

PRINCIPLES

Most countries are moving towards IFRS

As countries financial statements become relatively similar, companies annual report will also become more similar

Eventually, this may also impact on CG and

therefore corporate governance can also converge

Hence one size does not fit all

CORPORATE GOVERNANCE

PRINCIPLES OF GOOD CG

Fairness

Independence

Transparency

Probity

Responsibility

Accountability

Judgment

Integrity

Reputation

PRINCIPLES OF GOOD CORPORATE

GOVERNANCE

Fairness the directors must practice proper deliberations; they should be unbias, non discriminatory, rational as well as objective

Independence Board of directors must have non-executive directors that are independent

Transparency - DATA

Probity/honesty telling the truth, not misleading stakeholders, honest, practice candour, directors should not mislead, or deceive

Responsibility directors (NEDs) have to monitor agents, attend regular meetings, give suggestive contributions, protecting shareholders/stakeholders interests

Accountability effective committees,

giving suggestive

contributions, attend

regular board meetings

Judgment adequate balance of knowledge,

skills, abilities, and

experience to contribute

towards organizational

prosperity

Integrity morally right, strong internal moral code, virtuous

Reputation reputation as an asset to the organization. By fulfilling other principles of corporate governance, the reputation of a firm can be enhanced

ACCOUNTABILITY

- Directors should explain in the annual report their responsibility for preparing the annual report, and state that they consider the annual report and accounts, taken as a whole, is fair, balanced, and understandable and provides the information necessary for shareholders to assess the companys performance, business model and strategy.

- There should be a statement by the auditor about their reporting responsibilities.

- The directors should explain in the annual report an explanation on how the company generates and preserves value over the longer term (the business model).

- The directors should report in annual and half-yearly financial statements that the business is a going concern, with supporting assumptions or qualifications as necessary.

AN EFFECTIVE BOARD (FROM GOVERNANCE CODE)

- Should have a chairman that demonstrates good leadership - Should have non-executive directors who are independent (including a

senior independent non-executive director (INED)) with the right balance of skills, knowledge and experience

- Excluding the chairman, at least half of the board must be INED (for small firms, below FTSE 350, at least two)

- Board members to meet regularly and attendance should be regular - No duality of posts between chairman and CEO - Formation of committees audit, nomination, remuneration, risk etc.

which has the right balance of skills, experience, knowledge and independence

- Should maintain a sound system of risk management and internal control systems

- Company should arrange appropriate insurance cover in respect of legal action against its directors

Against CEO duality reduce unfettered powers, improves monitoring role of

NEDs, improves organizational

performance, reduce conflict of interests,

reduces agent opportunism

For CEO duality single unified leader, no guarantee of significant improvement

in organizational performance (Dalton et

al.)

CHAIRMAN Provide leadership

Ensures directors receive accurate, clear and timely information

Setting boards agenda

Communication with shareholders (through annual report)

Promoting a culture of openness and debate

Facilitate effective contribution of NEDs

Ensure constructive relations between EDs and NEDs

Ensure sufficient communication with shareholders (to discuss governance and strategy issues)

Ensure that directors continually update their skills and knowledge

Ensure sufficient resources allocated

CRITERIA FOR INDEPENDENCE

Should NOT have been an employee of the company or group within the last five years

Should NOT have or had had within the last three years any material business relationship with the company either directly or as a partner, director, or senior employee of a body that has such a relationship with the company

Should NOT have received or receives additional remuneration from the company apart from a directors fee, should not participate in the companys share option or a performance-related pay scheme, should not be a member of the companys pension scheme

Should NOT have close family ties with any of the companys advisers, directors, or senior employees

Should NOT hold cross-directorships or has significant links with other directors through involvement in other companies or bodies

Should NOT represent a significant shareholder

Should NOT have served on the board more than nine years from the date of the first election

NEDS

Strategy NEDs should constructively challenge and help develop strategies

Performance NEDs should scrutinize the performance of management in meeting agreed goals and objectives and monitor the reporting of performance

Risk NEDs should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible

People NEDs are responsible for determining appropriate levels of remuneration of executive-directors and have a prime role in appointing, and where necessary removing, executive directors and in succession planning

For NEDs Higgs, improves organizational performance (Choi et al.), reduce group think

Against NEDs - costs (director fees, insurance,

induction, CPD), time, competencies, control (financial

vs strategic), independence

-Audit committees should have at least three members, who should all be

INEDs (or in the case of smaller companies, i.e. below FTSE 350, two)

-The chairman of the company should not be an audit committee member

(except for smaller firms, below FTSE 350)

-Appointments to the audit committee should be made by the board on

the recommendation of the nomination committee, in consultation with

the audit committee chairman

-Appointments should be for a period of up to one year, extendable

through re-election, so long as members continue to be independent

-At least one member of the audit committee should have significant,

recent and relevant financial experience, for e.g. as an auditor, or a

finance director of a listed company

-It is recommended that there should be not fewer than three meetings

during the year. No one other than audit committees chairman and members is entitled to be present at audit committee meetings. External

auditor will be invited regularly to attend meetings as well as the

finance director

-The audit committee should review and approve the internal audit

functions remit; should approve the appointment or termination of the head of internal audit; should ensure that the internal auditor has direct

access to the board chairman and to the audit committee and is

accountable to the audit committee; meet with the head of internal

audit at least once a year without the presence of management; review

and assess the annual internal audit plan

Audit Committee

AUDIT COMMITTEE ROLES

To provide advice to the board on whether the annual reports and accounts taken as a whole is fair, balanced, and understandable and provides the information necessary for shareholders to assess companys performance, business model and strategy

To monitor the integrity of the financial statements

To review the companys internal financial control systems

To review the companys internal control and risk management systems (if there is no risk committee)

To monitor and review the effectiveness of the companys internal audit function (if no internal audit function, then the need to consider annually whether there is a need for internal audit function and make recommendations to the board, and the reasons for the absence of such a function)

To recommend to the board for it to put forward to the shareholders in relation to the appointment, re-appointment and removal of external auditors (if board does not accept, then board must explain why in annual report or in any relevant papers) as well as their remuneration and terms of engagement

For FTSE 350 companies, the audit committee should put the external audit contract out to tender at least every ten years (if the board does not accept audit committees recommendation, it should include in annual report or in any papers the reasons for not accepting)

To review and monitor the external auditors independence and objectivity and the effectiveness of the audit process

To develop and implement a policy on the engagement of the external auditor to supply non-audit services

Be an avenue for whistle-blowers

Advantages of external auditor providing non-

audit services to audit client reduce client costs (economies of scope for client), external auditor

has better holistic understanding, reduce fraud

and internal controls

Problems increase threat of economic bonding, affect external auditors I&O, self-review threat, reduce share price

- Should ideally be made up of INEDs (however, EDs may also be

members)

- Ideally should be chaired by an INED

- Some recommends majority should be insiders from operations

Risk committee

RISK COMMITTEE ROLES

Approving the organizations risk management strategy and risk management policies

Reviewing reports on key risks prepared by business operating units, management and auditor

Assessing overall exposure to risk and ensuring it remains within limits set by the board

Reviewing the firms internal control systems

Assessing the effectiveness of the organizations risks management systems

Providing early warning to the board on emerging risk issues and significant changes in the companys exposure to risks

Problems of combining audit committee with risk

management committee competency, time, focus (finance matters)

Advantages of combining audit committee with

risk management committee holistic, effective

Some organizations therefore have separate audit

and risk management committee

NOMINATION COMMITTEE

Appointments to the board must be made on merit and against a set of objective criteria and with due regard for the benefit of diversity, including gender

Care must be taken to ensure that appointees have enough time, that there is an appropriate balance of skills and experience within the company and the board

To encourage the use of external advice or open advertising (and to explain if it was not used)

A majority of members must be INEDs and is chaired by either the chairman of the board or an INED (but chairman of board must not chair the meeting if it is concerning the succession of board chairman)

NOMINATION COMMITTEE ROLES

Prepare job description for a particular post (after evaluating the balance of skills, knowledge, and experience needed)

Prepare a job specification for the post

Plans for orderly succession for both executive and NEDs; reviewing regularly the leadership needs of the organization, both EDs and NEDs

Regularly review the size, structure and composition of the board and make recommendations, when necessary

Any NED beyond six years should be subject to a particularly rigorous review

To make recommendations to the re-appointment of any NED

To monitor and convey to the board to ensure that a full time ED does not take more than one NED or chairmanship of a company (normally a large company, e.g. FTSE 100 company

BOARD SIZE

Problems unwieldy (3Cs, free-rider), costs, time, decreased organizational performance

Benefits improves organizational performance (Dalton et al.), greater stakeholder representation,

do not need to use same persons for committees

Remuneration committee should consists of at

least three (or in the case of smaller

companies, two) INEDs

The company chairman may also be a member

of the remuneration committee but may not

chair the committee

Remuneration Committee

REMUNERATION COMMITTEE ROLES

Setting remuneration for EDs, chairman, and company secretary (the remuneration of NEDs shall be a matter for the chairman and EDs or shareholders)

To ensure level of remuneration is sufficient to attract, retain,

and motivate directors to run the company; however, should avoid paying more than what is necessary

Should ensure that remuneration of executive directors be

aligned to corporate and individual performance Determining targets for any performance-related pay schemes Determining the policy for and scope of pension arrangements

for each ED Determining the total individual remuneration package of

each ED

Fixed/basic component salary, contractual bonuses, allowances, perks (company car, insurance coverage etc.)

Variable/performance-related component options of shares, restricted share grants (also used in golden parachute), performance bonuses, any long term incentive plans

Combined code recommends that variable component should be of a significant proportion than fixed component

WHY REMUNERATION CAN DIFFER

ACROSS COMPANIES AND COUNTRIES

National culture

Organizational life cycle small, large, public-listed, delisted etc.

Costs direct, indirect, reputation

Shareholders

Motivation

gender

Hence, one size does not fit all

INSTITUTIONAL SHAREHOLDERS INTERVENTION

Companys strategy acquisition or disposal strategy too risky

Companys operational performance Independent directors failing to hold

executive management properly to account

Internal control failings

Inadequate succession planning

Unjustifiable failure to comply with combined code

Inappropriate remuneration levels, incentive or severance packages

NED ORIENTATION

Business nature of the firms business and operations

People the people in the organization; whos who

Stakeholders major shareholders, key customers, suppliers etc.

BPS

OECD FRAMEWORK FOR GOOD CG

Ensuring the basis for an effective corporate

governance framework

The rights of shareholders and key ownership

functions

The equitable treatment of shareholders

The responsibilities of the board

Disclosure and transparency

The role of stakeholders in corporate governance

Traits Public-listed firm Private firm NGOs (charities,

foundations etc.)

Family business

Owner Shareholders Shareholders Founder and perhaps

descendent

Patriarch/

matriarch

Board Ideally, BODs have

the right balance of

KSA,

competencies, and

there is

independence;

professionally

managed

BODs consist of

shareholders/owners

Consists of Board of

governors/trustees

Made up mainly

of family

members

Committees Ideally proper

committees

May or may not have

committees

May or may not May or may not

Succession planning Ideally proper

succession

planning with NC;

properly managed;

sometimes

difficulties in

finding the right

candidate

Succession planning not

formal

Succession planning

not important as the

board will ensure that

the ideology of the

founder lives on even

after the demise of

founder

Successor will

be another

family member

and therefore

succession

planning

generally not a

big issue

Governance Based on LR and

CG perspective principles-based or

rules-based

Based on requirements of

shareholders

Based on founders ideologies and culture

of the NGO

Based on family

member needs

Feud/conflict AGMs, EGMs professionally

managed

Reconciled among owners

may be violent and not professionally managed

Addressed by reverting

to founders values Feud could be

family rivalry to

wrest control of

board decisions

RULES-BASED APPROACH SARBANES-OXLEY ACT

Title number Description

I Public Company Accounting Oversight Board (Sec. 101-109)

II Auditor independence (Sec. 201-209)

III Corporate Responsibility (Sec. 301-308)

IV Enhanced financial disclosure (Sec. 401-409)

V Analyst conflict of interest (Sec. 501)

VI Commission resources and authority (Sec. 601-604)

VII Studies and reports (Sec. 701-705)

VIII Corporate and criminal fraud accountability (Sec. 801-807)

IX White-collar crime penalty enhancement (Sec. 901-906)

X Corporate tax returns (Sec. 1001)

XI Corporate fraud and accountability (Sec. 1101-1107)

EXTERNAL AUDITOR INDEPENDENCE

- Section 201 SOA prohibits external auditor from providing internal audit outsourcing services, financial IS

design and implementation, bookkeeping and financial

statement services, management and HR functions,

actuarial services, investment advisor, appraisal or

valuation services, audit-related legal services.

- Section 203 lead audit partner and reviewing partner to rotate the audit engagement every 5 years

- Section 207 audit firm rotation

SECTION 302

The CEO and CFO must certify in a statement that

accompanies the audit report: the appropriateness of the

financial statements and disclosures; that the statements

fairly present, in all material respects, the operations and

financial conditions of the company; and that all significant

deficiencies in internal controls have been disclosed to the

auditors and audit committee.

Also states that the officers are responsible for internal controls, have evaluated its effectiveness in the last 90 days,

have presented in their report their conclusions about the

effectiveness of their internal controls and have discussed any

changes in internal controls, including corrective actions

during the period under review.

SECTION 404

Internal control over financial reporting (ICOFR)

Managements report a. Describe framework used to evaluate internal controls COSO, CObIT b. An assessment of its ICOFR effectiveness

Auditors report (3 reports) 1. Assessment of the effectiveness of the framework used 2. Attest on managements assessment of ICOFR effectiveness 3. Presentation of financial statements: true and fair

WHISTLEBLOWING

Section 301 Audit committee should be the avenue for whistleblowers

Section 806 no public company or any officer, employee, contractor, or agent of such company may discharge, demote, suspend, threaten, harass or in any other manner discriminate against any whistleblowers

Section 1107 makes it a crime for anyone knowingly with the intent to retaliate, to interfere with the employment or livelihood of any person a whistleblower who provides a law enforcement officer any truthful information relating to the possible commission of a SOA violation offense fines and imprisonment of up to 10 years

Benefits of SOA Problems of SOA

Accounting and financial scandals still persists post-SOA

Costs of compliance increased

Reduce IPOs

Reduce economic growth of company

Alteration of business practices, e.g. IS

Improves auditors independence

Improve internal controls

CEO and CFO must certify financial statements increased accountability

Improvements in ICOFR

All companies that are public listed must have code of ethics (Section 406)

Improvements in risk management (Section 409)

Whistleblower protection

BOARD STRUCTURE

One-tier/unitary board

Chairman

NEDs

EDs

Two-tier board

Supervisory board

Chairman

NEDs

Bank representatives,

Controlling shareholder

representatives, employee

representatives

EDs

Management board

EDs

Works

council

Advantages Disadvantages

All directors have equal legal

and executive status all are held responsible and can be

held accountable for board

decisions

Uncomfortable tidiness in

having one group of directors

supervising or controlling

another group on the same

board

More viewpoints are likely to

be expressed in board

deliberations and discussions

No employee representation;

no banks involved as in

German model

Intellectual strength of the

board increased

Time requirements both in board meetings and

committee meetings for NEDs

Strategies can be more

robustly scrutinized

More free-flow of information

can take place resulting in

better decision-making

Improves relationship and

cooperation between different

types of directors

Unitary board

Advantages Disadvantages

Two-tier board clearly

separates the role of the

chairman and CEO

Management board can

only nominate directors

to supervisory boards but

cannot oppose inequality

Employee, shareholders

and banks

representation in

supervisory boards and

employee representation

in works council

All the above advantages

for unitary board can

somehow be lacking in

two-tier boards

Two-tier board

RISKS A POSSIBILITY/CHANCE THAT AN UNFAVOURABLE EVENT WILL OCCUR

Sources of risks exogenous and

endogenous

ICAEW financial risks, operational

risks, compliance

risks,

business/strategic

risks, any other risks

(FOCBA)

Any other risks:

Legal

Political

Technological

Natural disaster

Health, safety and environmental

Probity

Reputational

Credit risks is the risk to a company from the failure of its debtors to meet their obligations on time

Liquidity risks is the risk of loss to a mismatch between cash inflows and cash outflows

Currency risks is the possibility of loss or gain due to future changes in exchange rates

Market risks also known as systematic risk (or non-diversifiable risk) occurs due to external events such as political (wars), economic (inflation, recession, high interest rates) etc. Company-specific risks are also known as diversifiable or unsystematic risks

Derivative risks CDOs, CDS

Risks that can affect day-to-day businesses, such as:

Errors or omissions by employees

Product failure

Health and safety

Failure of IT systems

Fraud

Loss of key people

Loss of suppliers etc.

Financial risks Operational risks

Failing to follow all

requirements of the

laws, regulations,

policies and

procedures

Strategic risks are risks that relate to the fundamental and key decisions that the directors take about the future of the organization. Strategic risks occurs if the decisions made by board and top management fails to improve organizational performance, losing out in terms of competitive advantage, failing to create new markets etc. Can lead to strategic drift.

Compliance risks Strategic/business risks

If correlation is positive, then risks covary,

i.e. risk A increases then risk B also

increases and vice-versa.

Some risks can covary, for example,

environmental risks and reputational risks

If correlation is negative, then risks are

inversely proportional, for example,

reputational risks and share price

Risks correlation

Risk identification nature/source of risks

Risk assessment likelihood and impact of each risk

Risk review analyse the controls the organization has in the event the risk

materializes

Risk reporting prepare reports on risks and submit to the board

Risks audit

Selim and McNamee:

- Risk assessment risk identification, risk measurement, and risk prioritization.

- Risk response acceptance, transference, avoidance or reduction.

- Risk communication internal and external stakeholders.

Risk management process

Risk assessment: - Selim and McNamee IMP - COSO - Turnbull

Risk management

Risk assessment

Identify risks

Categorize the risks

Acceptable risks Unacceptable risks

Likelihood? (H, M, L)

Ability? (Y/N) Impact? (H, M, L)

Costs Benefits

Risk assessment - Turnbull

Risk assessment

Turnbull:

- Identifying the nature and the extent of risks facing the company - Categorising the risks which it regards as acceptable for the company to

bear - Assessing the likelihood (probability) of the risks concerned materializing - Assessing the companys ability to reduce the incidence/risks and impact

on the business of risks that do materialize - Assess the costs of operating particular controls relative to the benefits

thereby obtained in managing the related risks

Risk assessment

COSO:

- Estimating the significance of the risk - Assessing the likelihood of the risk occurring - Considering how the risk should be managed, and assessing what

actions to be taken

Consequences

Low High Low

Likelihood

High

Acceptance Transference Risks are not significant. Insure risks, outsource and implement contingency plans to pass to 3

rd parties

Keep under view.

Reduction Avoidance Take some action, e.g. Take immediate action e.g. insurance, contingency terminate operations etc. planning, internal controls, culture of ethics, code of ethics, risk management, HRP, HRD, internal audit

Risk management strategy/response/treatment

Risk terms and expressions: 1. Dynamic nature of risk assessment

- Risks are not static

- Risk assessment therefore should not be one-off but continual

2. Importance and nature of management responses to changing risk assessments

- Since risk assessment is continual, some risks can change in likelihood

and importance

- Therefore, proper responses will be needed

3. Risk appetite and risk policy - If the board or firm has a higher appetite for risks, then the risk policies

would reflect this higher risk appetite

4. External reporting on internal controls and risks - Less information asymmetry

- Improve investor confidence (more transparent)

5. ALARP principle in risk assessment - Some risks are subjective and cannot be eliminated; others cant even

be imagined

- At best, one should try to minimize the risks as much as possible, given

the constraints of costs versus benefits through transference and

reduction

- Some risks have to be accepted as the costs of eliminating the risks

exceeds its benefits

6. Difficulties of risk perception - Some risks are harder to quantify and therefore more difficult to

perceive its likelihood and impact

- If risks are objective/quantifiable, risk perception becomes easier and

vice-versa

7. Covariant risk - Risks are positive correlated

8. Techniques and policies to mitigate business and financial risk - TAR approaches such as insurance, outsourcing, strategies (JV,

franchising, licensing); hedging

Turnbull guidance: A system that encompasses the policies, processes, tasks, behaviours and other aspects of a company that, taken together:

Facilitate its effective and efficient operation by enabling it to respond appropriately to significant business, operational, financial, compliance and other risks to achieving the companys objectives. This includes the safeguarding of assets from inappropriate use or from loss and fraud and ensuring that liabilities are identified and managed;

Help ensure the quality of internal and external reporting. This requires the maintenance of proper records and processes that generates a flow of timely, relevant and reliable information from within and outside the organization;

Help ensure compliance with applicable laws and regulations, and also with internal policies with respect to the conduct of business

Internal controls

CHARACTERISTICS/

BENEFITS/OBJECTIVES/PURPOSES/AIMS OF INTERNAL

CONTROL

Operations can proceed efficiently and effectively

Respond to risks in a timely manner

Safeguarding assets

Reliable/quality reporting both financial and non-financial, external and internal reporting

Proper data/record collection, processing and

maintenance

Compliance to laws, regulations, policies and

procedures

Achieving strategic objectives

Internal controls and risk management Review/approve BOD/committee Design

DIOM CEO Some responsibility all employees Embed in culture

COSO:

Control environment

Risk assessment

Control activities

Information and communication

Monitoring

CRAIM

Elements of internal control

CONTROL ENVIRONMENT

Strategies for dealing with risks

Structure assigning the right people to the right tasks, having a proper organizational structure (matrix, flat/tall, centralized/decentralized etc.), authority, responsibility and accountability clearly defined, proper communication so that employees are aware what is expected of them

Systems proper risk policies in place, process/activities adjusted to reflect changes in risks, proper internal audit in place

Staff competent personnel through HRP, orientation/induction, HRD, rewards, performance appraisal, promotion and discipline, proper BOD and committees

Style right management style (setting tone at the top), commitment to competence, integrity, and fostering a climate of trust

Skills competent personnel (knowledge, skills)

Super-ordinate goals integrity and ethical values, code of conduct, proper culture based on trust

CONTROL ACTIVITIES

All activities, processes, systems, policies,

procedures in place to ensure no internal control

failing

Examples: SPAM-SOAP:

Segregation of duties, physical controls,

authorization and approval, management

controls, supervision controls, organization

controls, arithmetic and accounting controls,

personnel controls

INFORMATION AND COMMUNICATION

Proper information systems in place to provide real-time information about internal and

external events

Information is relevant, accurate, reliable,

sufficient, complete, concise etc. and IS

constantly reassessed to ensure functionality

Information must be about the firm as well as

about the environment

Information must flow vertically, laterally,

inside-out and outside-in

Proper channels of communication in place for

whistleblowers

MONITORING

Monitoring can be done periodically as well as

ongoing (control self assessment etc.)

Aim:

Emerging risks

Deficiencies in internal controls and risk

management systems

So as to make the necessary

adjustments/modifications to ensure

sound/robust internal controls and risk

management systems

A sound system of internal control reduces, but cannot

eliminate, the possibility of poor judgment in decision-making;

human error; control processes being deliberately

circumvented by employees and others; management

overriding controls; and the occurrence of unforeseeable

circumstances.

A sound system of internal control therefore provides

reasonable, but not absolute, assurance that a company will

not be hindered in achieving its business objectives, or in the

orderly and legitimate conduct of its business, by circumstances

which may reasonably be foreseen. A system of internal control

cannot, provide protection with certainty against a company failing

to meet its business objectives or all material errors, losses, fraud,

or breaches of laws or regulations.

INTERNAL AUDIT

IIA:

A systematic and disciplined approach to provide an independent and objective:

assurance and

consulting activity on

risk management, internal controls and governance

that is designed to add value to an organizations operations

OBJECTIVES/FUNCTIONS/SCOPE OF INTERNAL

AUDIT

Evaluate and improve risk management process

Evaluate and improve internal controls

Social and sustainability audits

External audit assistance

Corporate takeovers and mergers

Project management

The operation of the organizations corporate governance arrangements

Examination of financial and operating information check for suitability, reliability and integrity, financial audits

Review of the economy, efficiency and effectiveness of operations operations audit

Review of the safeguarding of assets

Review of the implementation of corporate objectives

Special investigations, e.g. suspected fraud

Review of compliance with legislation, regulations and codes of practices

Follow-up action taken to remedy weaknesses identified by internal audit reviews

and ensuring that good practice is identified and communicated widely

Testing to ensure robustness stress-, compliance-, load testing; security issues

NEED FOR INTERNAL AUDIT

The scale, diversity and complexity of the

companys activities

The number of employees

Cost-benefit considerations

Changes in organizational structures, reporting

processes or underlying information systems

Changes in key risks

Problems with internal control systems

An increased number of unexplained or

unacceptable events

RECRUITMENT OF INTERNAL AUDITOR

Advantages

Fresh perspective

Emotionally

detached independent and

objective

May transfer best

practice from

outside

Disadvantages

May not understand

organization

initially and

therefore may take

time to contribute

Possibly lack

cooperation from

others

Costly

OUTSOURCING INTERNAL AUDIT

Improve focus and cost

Outsourcer may have more expertise improve efficiency

Less subject to high turnover of staff from internal audit

Skills of internal audit may be only be required for a short time in each year

Conflict of interest if outsourced service is

provided by external

auditor illegal in US

Lack of knowledge or

awareness of the

organization objectives,

culture or business

High costs

perhaps poor quality

Advantages Disadvantages

has access to

Reports to and accountable to

Approves or terminate

Duty

approve consulting &

& review IA remit assurance

Reviews and

Approve IC and I,O,M IC & RM

RM

Develops/design

IC & Risk management

Recommends the appointment, re-appointment and removal

Decides on engagement policies and remuneration

Reviews the effectiveness of the audit process

Audit

committee CEO

Internal

Auditor Chairman

External

auditor