P1 - Notes Haroon Tabraze

Paper P1 Haroon Tabraze
Agency theory: Agency is a contract under which one party (the principal) engages
another party (the agent) to perform some service on their behalf. As part of this, the
principal will delegate some decision-making authority to the agent.
There are two problems in such a delegation.

The desires / goals of the principal and agent have a conflict; and
It is difficult or expensive for the principal to verify what the agent is actually
doing (whether he is working appropriately).
Principal: are the share holders, who cannot run management due to:
Wide ownership base, especially in companies listed on stock exchanges
Lack of interest in the management due to limited risk and liability
Possible short term motive of capital gains in stock market (have ability to simply
sell shares if company is in trouble)
Agent: is employed by Principal to manage the company (management)

They are delegated the task to run the company
Agent does not share the Principal's motive of profit maximization, and is more
interested in his remuneration
Agency Costs: are incurred by Principals to monitor working of their agents (because of
lack of trust)
i.e. Internal and External Audits
Accountability: is the need to explain and justify any failure to fulfill responsibility
Agent is accountable to the Principal (by whom he is employed) when he accepts
to undertake the task given to him
Fiduciary: The person on whom duty is imposed is called 'fiduciary
Fiduciary responsibilities:
A fiduciary is expected to be extremely loyal to the person to whom they owe the
duty (Principal);
They must not put their personal interests before the duty, and
Must not profit from their position as a fiduciary, unless the principal consents.
The fiduciary relationship is highlighted by good faith, loyalty and trust.
Stakeholders: any person or group which get affected by the running of the organization
Corporate governance includes the relationships among the many players involved (the
stakeholders) and the goals for which the corporation is governed. The principal players
are the shareholders, management and the board of directors. Other stakeholders
include employees, suppliers, customers, banks and other lenders, regulators, the
environment and the community at large.
Corporate governance deals with issues of accountability and fiduciary duty, essentially
advocating the implementation of guidelines and mechanisms to ensure good behavior
and protect shareholders.
Another key focus is the economic efficiency view, through which the corporate
governance system should aim to optimize economic results, with a strong emphasis on
shareholders welfare.
Haroon Tabraze www.ca.com.pk Page 1

Principal Agent Relationship:

The nature of the relationship is that of Trust. Management has to act in the best
interest of the shareholders
Directors have fiduciary responsibility towards shareholders
Directors have Fiduciary responsibility as everyone below them in the organization
chart is monitored by them.
The relationship works because:

management is given incentives on good performance, and
the shareholders monitor their performance closely.
Agency Costs:
Agency loss is zero when the agent takes actions that are entirely consistent with the
principal’s interests. As the agent’s actions diverge from the principal’s interests, agency
loss increases
Monitoring costs: are expenditures paid by the principal to measure, observe and control
an agent’s behavior. They may include:
Cost to provide data to shareholders (financial statements)
Cost of audits of financial statements,
Cost to hold Annual General Meetings,
Executive compensation contracts, remuneration schemes, incentives and
ultimately the cost of firing managers.
Too much monitoring will reduce managerial entrepreneurship
Certain aspects of monitoring may also be imposed by legislative practices. In the UK

companies are required to provide statements of compliance with the Cadbury and
Greenbury reports on corporate governance.
Bonding Costs: Given that agents ultimately bear monitoring costs, they are likely to set
up structures that will see them act in shareholder’s best interests, or compensate them
accordingly if they don’t. The cost of establishing and adhering to these systems are
known as bonding costs
Residual Loss: Despite monitoring and bonding, the interest of managers and
shareholders are still unlikely to be fully aligned. Therefore, there are still agency losses
arising from conflicts of interest. These are known as residual loss. i.e. Directors
furnishing themselves with expensive cars.
How to control Agency problems:

Management’s compensation should be based on market estimation of how
well they take care of shareholders interests (based on prior experience with
other companies).
If Directors do not perform well, they lose their job through resolution by
shareholders in the annual meeting
Board of Directors should largely be composed of independent directors
(holding large blocks of shares in the company).

Holding regular meetings between stakeholders

Hiring independent auditors (agents of shareholders) to monitor shareholders
interest
Threatening management with Divestment as last resort.
Auditors:
Have their own interest i.e. fee, reputation
When auditor is independent from management, only then he can serve
interest of shareholders
Auditor has to deal with management to conduct audit, and to get his fee, so
he may be perceived not to serve shareholders completely.
For effective monitoring, auditor should be technically competent and up-to-
date with current business approaches.
Agent accountability:
Directors are accountable to the shareholders
Directors should prove that they are discharging their duties efficiently (clean
audit report, good results, compliance with codes)
If shareholders are not satisfied with performance, they can remove the
management
There are number of Codes of Conduct issued by Government and Stock
Exchanges which needs to be complied (voluntarily)
Stakeholder theory:
Companies are large, and should discharge accountability to all stakeholders
(not only shareholders)
Typical stakeholders are employees, customers and suppliers, community,
government, environment, future generations
Stakeholders provide company with a contribution (infrastructure i.e. road)
and expect the company to satisfy their interest (give employment to locals).

Directors and Board of Directors
"A company is an entity distinct alike from its shareholders and its directors. Some of its powers
may, according to its articles, be exercised by directors; certain other powers may be reserved
for the shareholders in general meeting. If powers of management are vested in the directors,
they and they alone can exercise these powers. The only way in which the general body of
shareholders can control the exercise of powers by the articles in the directors is by altering the
articles, or, if opportunity arises under the articles, by refusing to re-elect the directors of whose
actions they disapprove. They cannot themselves usurp the powers which by the articles are
vested in the directors any more than the directors can usurp the powers vested by the articles in
the general body of shareholders."
Shaw & Sons (Salford) Ltd v Shaw
Board of Directors can exercise their powers in meeting of BOD

Sufficient notice has to be given to all directors of these meetings
A quorum must be present before any business may be conducted
Failure to give notice may negate resolutions passed at a meeting
Duties of Directors
1. Acting in Good Faith: the directors must act "bona fide" in what they consider—not what
the court may consider—is in the interests of the company. Difficult Questions arise i.e. it
may be for the benefit of a corporate group as a whole for a company to guarantee the
debts of a "sister" company. Similarly, conceptually at least, there is no benefit to a
company in returning profits to shareholders by way of dividend
2. Proper Purpose: in many instances an improper purpose is readily evident, i.e. a director
looking to make money for himself, or divert an investment opportunity to a relative; such
breaches usually involve a breach of the director's duty to act in good faith. Greater
difficulties arise where the director, whilst acting in good faith, is serving a purpose that is
not regarded by the law as proper.
3. Unfettered Discretion: Directors cannot, without the consent of the company, fetter their
discretion (in relation to the exercise of their powers), and cannot bind themselves to vote
in a particular way at future board meetings. The company remains bound, if it made a
specific contract, but the directors retain the discretion to vote against taking the future
actions (they may cancel the contract itself.)
4. Conflict of Duty and Interest: A) where a director enters into a transaction with a
company, there is a conflict between the director's interest (to do well for himself out of
the transaction) and his duty to the company (to ensure that the company gets as much
as it can out of the transaction). B) Directors must not, without the informed consent of
the company, use for their own profit the company's assets, opportunities, or information.
C) Directors cannot compete directly with the company without a conflict of interests
arising. Similarly, they should not act as directors of competing companies, as their duties
to each company would then conflict with each other
5. Care and Skill: A director need not exhibit in the performance of his duties a greater
degree of skill than may reasonably be expected from a person of his knowledge and
experience
Companies Act:
Approve interim dividend and recommend final dividend
Approve interim and final financial statements
Approve significant changes in accounting policies
Approval and removal of key staff (company secretary)
Remuneration of Auditors
Recommendation for appointment / removal of auditors

The Combined Code states:
1. Every company should be headed by an effective board, which is collectively responsible

for the success of the company.
2. The board's role is to provide entrepreneurial leadership of the company within a
framework of prudent and effective controls which enables risk to be assessed and
managed.
3. The board should set the company's strategic aims, ensure that the necessary financial
and human resources are in place for the company to meet its objectives and review
management performance.
4. The board should set the company's values and standards and ensure that its obligations
to its shareholders and others are understood and met.
5. All directors must take decisions objectively in the interests of the company.
6. As part of their role as members of a unitary board, NED's should constructively challenge
and help develop proposals on strategy.
7. NED's should scrutinize the performance of management in meeting agreed goals and
objectives and monitor the reporting of performance.
8. NED's should satisfy themselves on the integrity of financial information and that financial
control and systems of risk management are robust and defensible.
9. NED's 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.
Code Provisions
The board should meet sufficiently regularly to discharge its duties effectively.
There should be a formal schedule of matters specifically reserved for its decision.
The annual report should include a statement of how the board operates, including a high
level statement of which types of decisions are to be taken by the board and which are to
be delegated to management.
The annual report should identify the chairman, the deputy chairman (where there is
one), the chief executive, the senior independent director and the chairmen and members
of the nomination, audit and remuneration committees.
It should also set out the number of meetings of the board and those committees and
individual attendance by directors.
Where directors have concerns which cannot be resolved about the running of the
company or a proposed action, they should ensure that their concerns are recorded in the
board minutes.
On resignation, a non- executive director should provide a written statement to the
chairman, for circulation to the board, if they have any such concerns.
The Company should arrange appropriate insurance cover in respect of legal action
against its directors.
Failures:
In a number of "corporate scandals" of the 1990s, one notable feature revealed in
subsequent investigations is that boards were not aware of the activities of the managers
that they hired, and the true financial state of the corporation.
Most boards largely rely on management to report information to them, thus allowing
management to place the desired 'spin' on information, or even conceal or lie about the
true state of a company.
Boards of directors are part-time bodies, whose members meet only occasionally and may
not know each other particularly well. This unfamiliarity can make it difficult for board
members to question management.
CEOs tend to be rather forceful personalities. In some cases, CEOs are accused of
exercising too much influence over the company's board.

Directors may not have the time or the skills required to understand the details of
corporate business, allowing management to obscure problems.
The same directors who appointed the present CEO oversee his or her performance. This
makes it difficult for some directors to dispassionately evaluate the CEO's performance.
Directors often feel that a judgment of a manager, particularly one who has performed
well in the past, should be respected. This can be quite legitimate, but poses problems if
the manager's judgment is indeed flawed.
All of the above may contribute to a culture of "not rocking the boat" at board meetings.
Non Executive Directors (NED's)

A non-executive director (NED, also NXD) or outside director is a member of the board of
directors of a company who does not form part of the executive management team.
He or she is not an employee of the company or affiliated with it in any other way.
They are differentiated from inside directors, who are members of the board also serving
as executive managers of the company (most often as corporate officers).
Strategy Role: contribute to development of strategy of the company; challenging the strategy
produced by Executive Directors and offering advice
Scrutinizing Role: Review the performance of management. Hold management accountable for its
decisions taken and results obtained.
Risk Role: Ensure Company has adequate system of internal controls and system of risk
management in place.
People Role: Appointment, remuneration, appraisals of senior management, succession planning
Lack of unity and trust can put pressure on board operation.

The quality of NED willing to serve may be poor
Board Balance:
The board should include a balance of executive and NED's (and in particular independent non-
executive directors) such that no individual or small group of individuals can dominate the
board's decision taking.
1. The board should not be so large as to be unwieldy.

2. The board should be of sufficient size that the balance of skills and experience is
appropriate for the requirements of the business and that changes to the board's
composition can be managed without undue disruption.
3. To ensure that power and information are not concentrated in one or two individuals,
there should be a strong presence on the board of both executive and non-executive
directors.
4. No one other than the committee chairman and members is entitled to be present at a
meeting of nomination, audit or remuneration committee, but others may attend at the
invitation of the committee.
a) The board should identify in the annual report each NED it considers to be independent.
b) The board should determine whether the director is independent in character and
judgment and whether there are relationships or circumstances which are likely to affect,
or could appear to affect, the director's judgment.
c) The board should state its reasons if it determines that a director is independent
notwithstanding the existence of relationships or circumstances which may appear
relevant to its determination, including if the director:
has been an employee of the company or group within the last five years;

has, or has had within the last three years, a material business relationship with
the company either directly, or as a partner, shareholder, director or senior
employee of a body that has such a relationship with the company;
has received or receives additional remuneration from the company apart from a
director's fee, participates in the company's share option or a performance-related
pay scheme, or is a member of the company's pension scheme;
has close family ties with any of the company's advisers, directors or senior
employees;
holds cross-directorships or has significant links with other directors through
involvement in other companies or bodies;
represents a significant shareholder;
or has served on the board for more than nine years from the date of their first
election.
d) Except for smaller companies, at least half the board, excluding the chairman, should
comprise NED's determined by the board to be independent. A smaller company should
have at least two independent NED.
e) The board should appoint one of the independent NED to be the senior independent
director. The senior independent director should be available to shareholders if they have
concerns which contact through the normal channels of chairman, chief executive or
finance director has failed to resolve or for which such contact is inappropriate.
Chairman and chief executive
There should be a clear division of responsibilities at the head of the company between the
running of the board and the executive responsibility for the running of the company's business.
No one individual should have unfettered powers of decision.
The chairman is responsible for leadership of the board, ensuring its effectiveness on all
aspects of its role and setting its agenda.
The chairman is also responsible for ensuring that the directors receive accurate, timely
and clear information.
The chairman should ensure effective communication with shareholders.
The chairman should also facilitate the effective contribution of NED's in particular and
ensure constructive relations between executive and non-executive directors.
Chairman sets agenda of the Board Meeting and chair these meetings
1. The roles of chairman and chief executive should not be exercised by the same individual.
2. The division of responsibilities between the chairman and chief executive should be clearly
established, set out in writing and agreed by the board.
3. The chairman should (on appointment) meet the independence criteria set out below.
4. A chief executive should not go on to be chairman of the same company. If exceptionally
a board decides that a chief executive should become chairman, the board should consult
major shareholders in advance and should set out its reasons to shareholders at the time
of the appointment and in the next annual report.
The chairman should hold meetings with the NED's without the executives present.
Led by the senior independent director, the NED's should meet (without the chairman
present) at least annually to appraise the chairman's performance.
CEO's Responsibility:
1. Take responsibility for the performance of the company
2. Report to the Chairman and Board of Directors
3. Manage Financial and physical resources
4. Build and maintain effective team
5. Put adequate operational, financial, planning and risk management systems
6. Represent the company to major suppliers, customers, professional associations

Information and professional development of Directors
a) The chairman is responsible for ensuring that the directors receive accurate, timely and
clear information.
b) Management has an obligation to provide such information but directors should seek
clarification or amplification where necessary.
c) The company should provide the necessary resources for developing and updating its
directors' knowledge and capabilities.
d) Under the direction of the chairman, the company secretary's responsibilities include
ensuring good information flows within the board and its committees and between senior
management and NED, as well as facilitating induction and assisting with professional
development as required.
e) The company secretary should be responsible for advising the board through the chairman
on all governance matters.
f) The chairman should ensure that new directors receive a full, formal and tailored induction
on joining the board. As part of this, the company should offer to major shareholders the
opportunity to meet a new non-executive director
g) The board should ensure that directors, especially non-executive directors, have access to
independent professional advice at the company's expense where they judge it necessary
to discharge their responsibilities as directors.
h) Committees should be provided with sufficient resources to undertake their duties.
i) All directors should have access to the advice and services of the company secretary, who
is responsible to the board for ensuring that board procedures are complied with.
j) Both the appointment and removal of the company secretary should be a matter for the
board as a whole.
Performance evaluation of Directors
1. Individual evaluation should aim to show whether each director continues to contribute
effectively and to demonstrate commitment to the role (including commitment of time for
board and committee meetings and any other duties).
2. The chairman should act on the results of the performance evaluation by recognising the
strengths and addressing the weaknesses of the board and, where appropriate, proposing
new members be appointed to the board or seeking the resignation of directors.
3. The board should state in the annual report how performance evaluation of the board, its
committees and its individual directors has been conducted.
4. The NED's, led by the senior independent director, should be responsible for performance
evaluation of the chairman, taking into account the views of executive directors
Re-election of Directors
• All directors should be submitted for re-election at regular intervals, subject to continued
satisfactory performance.
• The board should ensure planned and progressive refreshing of the board.
• All directors should be subject to election by shareholders at the first annual general
meeting after their appointment, and to re-election thereafter at intervals of no more than
three years.
• The names of directors submitted for election or re-election should be accompanied by
sufficient biographical details and any other relevant information to enable shareholders to
take an informed decision on their election.
• NED should be appointed for specified terms subject to re-election and to Companies Acts
provisions relating to the removal of a director.
• The board should set out to shareholders in the papers accompanying a resolution to elect
a NED why they believe an individual should be elected.
• The chairman should confirm to shareholders when proposing re-election that, following
formal performance evaluation, the individual's performance continues to be effective and
to demonstrate commitment to the role.

• Any term beyond six years (e.g. two three-year terms) for a non-executive director should
be subject to particularly rigorous review, and should take into account the need for
progressive refreshing of the board.
• NED may serve longer than nine years (e.g. three three-year terms), subject to annual re-
election. Serving more than nine years could be relevant to the determination of NED's
independence.
Nomination Committee
There should be a nomination committee which should lead the process for board appointments
and make recommendations to the board.
A committee that is a subset of a larger committee is called a subcommittee. [Where the larger
group has a name other than "committee" - for example, "Board" or "Commission", the smaller
group(s) would be called committee(s), not subcommittee(s)]
Nomination Committee is a Board committee. Board delegates certain responsibilities to its

committees because:
It generally includes only those people who have expertise in the task; thereby reducing the
size of the committee and increasing efficiency in decision making
It reduces Board's workload, as difficult tasks are delegated to Subcommittees
The nomination committee should make its terms of reference, explaining its role and the
authority available delegated to it by the board.
1. A majority of members of the nomination committee should be independent NED.

2. The chairman or an independent NED should chair the committee
3. The chairman should not chair the nomination committee when it is dealing with the
appointment of a successor to the chairmanship.
4. The nomination committee should evaluate the balance of skills, knowledge and experience
on the board and, prepare a description of the role and capabilities required for a particular
appointment
5. For the appointment of a chairman, the nomination committee should:
a. Prepare a job specification, including an assessment of the time commitment
expected, recognizing the need for availability in the event of crises.
b. A chairman's other significant commitments should be disclosed to the board before
appointment and included in the annual report.
c. Changes to such commitments should be reported to the board as they arise, and
included in the next annual report.
d. No individual should be appointed to a second chairmanship of a FTSE 100 company.
6. For NED's:
a. The terms and conditions of appointment of NED's should be made available for
inspection.
b. The letter of appointment should set out the expected time commitment.
c. NED's should undertake that they will have sufficient time to meet what is expected of
them.
d. Their other significant commitments should be disclosed to the board before
appointment, with a broad indication of the time involved and the board should be
informed of subsequent changes.
e. The board should not agree to a full time executive director taking on more than one
non-executive directorship in a FTSE 100 company nor the chairmanship of such a
company.
7. A separate section of the annual report should describe the work of the nomination
committee, including the process it has used in relation to board appointments.
8. An explanation should be given if neither an external search consultancy nor open advertising
has been used in the appointment of a chairman or a NED.

9. The chairman should arrange for the chairmen of the audit, remuneration and nomination
committees to be available to answer questions at the AGM and for all directors to attend.
Duties of the nomination Committee

The committee should:
1. Be responsible for identifying and nominating for the approval of the board, candidates to
fill board vacancies as and when they arise;
2. Before making an appointment, evaluate the balance of skills, knowledge and experience
on the board and, in the light of this evaluation, prepare a description of the role and
capabilities required for a particular appointment;
3. Review annually the time required from a non-executive director. Performance evaluation
should be used to assess whether the non-executive director is spending enough time to
fulfill their duties;
4. Consider candidates from a wide range of backgrounds and look beyond the "usual
suspects";
5. Give full consideration to succession planning in the course of its work, taking into account
the challenges and opportunities facing the company and what skills and expertise are
therefore needed on the board in the future;
6. Regularly review the structure, size and composition (including the skills, knowledge and
experience) of the board and make recommendations to the board with regard to any
changes;
7. Keep under review the leadership needs of the organization, both executive and non-
executive, with a view to ensuring the continued ability of the organization to compete
effectively in the marketplace;
8. Make a statement in the annual report about its activities;
9. The process used for appointments and explain if external advice or open advertising has
not been used; the membership of the committee, number of committee meetings and
attendance over the course of the year;
10. Make available its terms of reference explaining clearly its role and the authority
delegated to it by the board;
11. And ensure that on appointment to the board, non-executive directors receive a formal
letter of appointment setting out clearly what is expected of them in terms of time
commitment, committee service and involvement outside board meetings.
The committee should make recommendations to the board:

As regards plans for succession for both executive and NED's;
As regards the re-appointment of any NED at the conclusion of their specified term
of office;
Concerning the re-election by shareholders of any director under the retirement by
rotation provisions in the company's articles of association;
Concerning any matters relating to the continuation in office of any director at any
time; and
Concerning the appointment of any director to executive or other office other than
to the positions of chairman and chief executive, the recommendation for which
would be considered at a meeting of the board.
Induction Program:
Contain selected written text, and presentations about the Company structure,
subsidiaries, joint ventures
Gives understanding about markets, people, suppliers, auditors
Annual accounts, interim financials, KPI's, treasury polcicies
Provide them company's vision and mission and an idea about strategy
Outline of director's duties and responsibilities
Advice on share dealing and disclosure of sensitive information
Should not overload the director with excess information

Terms of reference
The following are the terms of reference of the Nomination Committee ('the Nomination Committee') of
HBOS and the HBOS Group.
1. Membership
1.1 Membership of the Nomination Committee will include the Chairman, the Chief Executive, the Deputy
Chairman, the Senior Independent Director, together with at least two further Non-Executive Directors. The
membership will at all times consist of a majority of independent Non-Executive Directors.
1.2 The Chairman of the Nomination Committee will be the Chairman or an independent Non-Executive
Director.
1.3 The Secretary of the Nomination Committee is appointed by the Chairman of the Committee.
A quorum of the Nomination Committee will comprise at least two members, one of whom shall be the
Chairman of the Committee or the Chairman (if different) or one further independent Non-Executive
Director (if the same).
2. Attendance
The Nomination Committee may invite other persons to attend meetings where appropriate to assist in the
effective discharge of the Nomination Committee's duties.
3. Frequency of Meetings
The Nomination Committee will meet as required but at least twice in each year. Any Nomination
Committee member or the Secretary may call for meetings as necessary.
4. Authority
4.1 The Nomination Committee is authorized by the HBOS Board to undertake any activity within its terms
of reference.
4.2 The Nomination Committee is authorized by the HBOS Board to seek appropriate professional advice
inside and outside of the Group as and when it considers this necessary.
4.3 Although normally decisions are reached on a consensus, in the event of a disagreement, decisions on
any matter are made by the majority, with the Chairman of the meeting having a second, casting vote in
the event of a tie. A Nomination Committee member who remains opposed to a proposal after a vote can
ask for his or her dissent to be noted in the minutes.
5. Principal Duties
The Nomination Committee is authorized by the Board to:
5.1 ensure that there is a formal, rigorous and transparent procedure for the appointments of new
Directors to the Board;
5.2 review the composition of the HBOS Board and consider and advise the HBOS Board as to any changes,
which may be required to achieve a balanced and appropriately experienced and qualified Board;
5.3 as necessary to make recommendations to the Board on the independence of any existing or proposed
Non-Executive Director in line with the criteria set out in the Board Control Manual under the section
Independent Non-Executive Directors;

5.4 satisfy itself that plans are in place for orderly succession for appointments to the Board and other
senior management (levels 7 and 8) positions, and will search for, consider and make recommendations to
the HBOS Board in relation to the appointment of Directors of HBOS, including the position of Chairman;
5.5 ascertain, when required, the time commitments required of Non-Executive Directors, individually and
collectively to fulfil the duties required;
5.6 make recommendations to the Chairman of HBOS as required in respect of the membership of the
Board Committees of the HBOS Board, and the Chairmanships thereof;
5.7 make publicly available its terms of reference, explaining its role and the authority delegated to it by
the Board;
5.8 be available in the person of the Chairman of the Nomination Committee to answer Shareholders’
questions about the activities of the Nomination Committee at the Annual General Meeting.
5.9 make a statement in the Company's Annual Report and Accounts detailing its activities and the
process it has used to make any recommendations in respect of appointments to the Board;
5.10 for the appointment of a Chairman of the Board, the Nomination Committee should prepare a job
description, including an assessment of the time commitment expected, recognising the need for availability
in the event of crises. A Chairman's other significant commitments should be disclosed to the Board before
appointment and included in the Annual Report. Changes to such commitments should be disclosed to the
Board as they arise and included in the next Annual Report;
5.11 ensure that on appointment to the Board, Non-Executive Directors receive a formal Letter of
Appointment setting out a job description and clearly what is expected of them in terms of time
commitment, committee service and involvement outside Board meetings.
5.12 Appointment (and removal) of Director Trustees and (subject to the requirements of the Pensions
Act 1995) other Trustees of the Group's Pension Schemes in place from time to time in particular, where
necessary, in accordance with the Definition of Independence of Director Trustees set out in the Terms of
Reference of the Nomination Committee
Remuneration Committee
1. The remuneration committee should judge where to position their company relative to
other companies.
2. They should use such comparisons with caution, in view of the risk of an upward ratchet
of remuneration levels with no corresponding improvement in performance.
3. They should also be sensitive to pay and employment conditions elsewhere in the group,
especially when determining annual salary increases
4. The performance-related elements of remuneration should form a significant proportion of
the total remuneration package of executive directors and should be designed to align
their interests with those of shareholders and to give these directors keen incentives to
perform at the highest levels.
5. Executive share options should not be offered at a discount save as permitted by the
relevant provisions of the Listing Rules.
6. Levels of remuneration for NED's should reflect the time commitment and responsibilities
of the role.
7. Remuneration for NED's should not include share options.
8. If, exceptionally, options are granted, shareholder approval should be sought in advance
and any shares acquired by exercise of the options should be held until at least one year
after the NED leaves the board.
9. Holding of share options could be relevant to the determination of a NED's independence.

10. Where a company releases an executive director to serve as a NED elsewhere, the
remuneration report should include a statement as to whether or not the director will
retain such earnings and if so, what the remuneration is.
Service Contracts and Compensation
• The remuneration committee should carefully consider what compensation commitments

(including pension contributions and all other elements) their director's terms of
appointment would entail in the event of early termination.
• The aim should be to avoid rewarding poor performance. They should take a robust line
on reducing compensation to reflect departing directors' obligations to mitigate loss.
• Notice or contract periods should be set at one year or less. If it is necessary to offer
longer notice or contract periods to new directors recruited from outside, such periods
should reduce to one year or less after the initial period.
• The remuneration committee should consult the chairman and/or chief executive about
their proposals relating to the remuneration of other executive directors.
• The remuneration committee should also be responsible for appointing any consultants in
respect of executive director remuneration.
• Where executive directors or senior management are involved in advising or supporting
the remuneration committee, care should be taken to recognize and avoid conflicts of
interest.
• The chairman of the board should ensure that the company maintains contact as required
with its principal shareholders about remuneration in the same way as for other matters.
a) The board should establish a remuneration committee of at least three, or in the case
of smaller companies two, members, who should all be independent NED's.
b) The remuneration committee should make available its terms of reference, explaining
its role and the authority delegated to it by the board.
c) Where remuneration consultants are appointed a statement should be made available
of whether they have any other connection with the company.
d) The remuneration committee should have delegated responsibility for setting
remuneration for all executive directors and the chairman, including pension rights and
any compensation payments.
e) The committee should also recommend and monitor the level and structure of
remuneration for senior management.
f) The definition of "senior management" for this purpose should be determined by the
board but should normally include the first layer of management below board level.
g) The board itself or, where required by the Articles of Association, the shareholders
should determine the remuneration of the NED within the limits set in the Articles of
Association.
h) Where permitted by the Articles, the board may however delegate this responsibility to
a committee, which might include the chief executive.
i) Shareholders should be invited specifically to approve all new long-term incentive
schemes (as defined in the Listing Rules) and significant changes to existing schemes,
save in the circumstances permitted by the Listing Rules.

Purpose of the remuneration system:

• pays for work performed by the employee
• attracts, motivates and retains the right employees
• provides pay equity for different groups of employees
• supports developing careers
• supports growing from within the organization
Remuneration includes base salary (basic), bonuses, economic benefits (other than cash), share
options, pension contributions etc.
Remuneration should be sufficient to:

• keep the board motivated to increase performance
• give rewards when someone show good results
• board feels they are being paid appropriately for their efforts
• their remuneration is at pace with the market rates
Linking remuneration to company strategy:

To achieve maximum return, an organization's remuneration strategy must be integrated with
business and human resource strategies.
Basic Salary:
• It is usually set in relation to peer groups (industry specific, equal size ventures)
• High basic salary gives a guaranteed payment without any regard to performance.
• High basic salary may reduce incentive for any improvements
• Low basic salary with performance bonuses, urges board to work with more productivity
• If the basic salary is too low, it will de-motivate the board
Performance related elements (bonus, incentives):

• Measurement criteria needs to be established
• If the market is in recession, directors will be penalized without any fault of theirs.
Shares / share options:

• It is long term incentive scheme, enabling to retain directors
• Director's make profit if share value increases (sharing the shareholders goal)
• This alignment in goals overcomes the agency problem
• Options can be phased, instead of given in one block, to increase time duration
Legal issues:
• Compensation commitments (including pension) should be considered for the case of early
termination
• Compensation package should not reward poor performance
Ethical issues:
• In high profile corporate failures, directors were perceived to receive excessive
remuneration in relation to their performance
• In underperforming, or privatized utilities, public perception of excess pay rises
Regulatory issues (UK Directors Remuneration Report Regulation 2002):

• Directors to submit remuneration report to members in AGM
• Report must provide full details of director's remuneration
• Report is clear, transparent, and understandable to shareholders
After the high profile corporate scandals:

• Directors are given extra responsibilities, and have more potential liabilities
• They require more remuneration to compensate the extra demand on them

Activity 1
Flick plc (quoted on LSE) is planning to acquire 20% stake in UUL (also listed on LSE). Flick plc is
considered to be adhering to the principles of good corporate governance.
UUL is predominantly a family owned concern, with 51% shares vested with the Johnson family.
Mr. Johnson is the Chairman board of directors, while Mr. Smith (son of Mr. Johnson) is the CEO.
There are 8 members in the board of director of UUL (including Chairman and CEO), of which 5
belong to the Johnson family and work as full time paid directors. Other 3 directors are
representative of Global Bank Limited, which leads the consortium of the lender institutions.
Required:
1. Comment on the board structure of UUL? Does it comply with the Code?
2. How can Flick plc insist on putting their director on the board? Describe whether
the director should be a paid director or NED?
3. What role does a NED play in a company? Describe?
4. What effect will the acquisition have on Flick plc, if it acquires UUL in current state,
without any change? Consider the case where Flick plc requires more funds for the
acquisition.
Corporate Governance is:
The system by which companies are directed and controlled, in the interests of shareholders and
stakeholders
Purpose of Corporate Governance:

• Monitor those parties which control resources owned by investors in a company
• To improve corporate performance and accountability
• To improve long term shareholder value
Fairness: sense of equality in dealing with internal and external stakeholders, and ability to reach
equitable judgment in a given ethical situation
Openness / transparency: transparent relationship with shareholders to reduce their agency cost.
Development of systems and procedures to form an appropriate culture in organization
Independence: between executive and non-executive directors and from personal influence of
one party
Probity / honesty: honestly reporting financial position, and providing perception of honesty to all
stakeholders
Responsibility: willingness to accept liability on decisions made, defining clear roles
Accountability: Developing risk management and control systems
Reputation: developing personal reputation, reputation of company and reputation of profession
Judgment: Ability to reach conclusions after weighing issues and giving them consideration
Integrity: Highest standard of honesty and observing strict moral and ethical code.
Non-Profit Organizations:
• Stakeholders are fund providers, regulators, general public
• Volunteer trustees manage alongwith paid or unpaid management team
• Donors demand information – accountability

Corporate Social Responsibility (CSR) is a concept which encourages organizations to

consider the interests of society by taking responsibility for the impact of the organization's
activities on customers, employees, shareholders, communities and the environment in all
aspects of its operations.
This obligation is seen to extend beyond the statutory obligation to comply with legislation and
sees organizations voluntarily taking further steps to improve the quality of life for employees
and their families as well as for the local community and society at large.
Companies complying with good CSR practices:

• Are rewarded with extra customers
• Attract better and committed employees; and retain these employees
• Get independence from government legislations (by voluntarily compliance)
• Reduce risk of getting 'bad reputation' by doing right things
Criticism to CSR:
• Free market operation: Company's principal motive is to maximize profit. Company does
not have moral responsibility for its actions
• Image building: Companies put up CSR programs to build their image only
Stakeholders:
Traditional stakeholders were four parties: investors, employees, suppliers, and customers.
Stakeholder theory argues that there are other parties involved, including governmental bodies,
political groups, trade associations, trade unions, communities, associated corporations,
prospective employees, prospective customers, and the public at large. Sometimes even
competitors are counted as stakeholders.
Motivation for companies to act in relation to concern of stakeholders:

• Possible impact on profit: company believes not reacting to stakeholders input will
decrease their profits.
• Moral responsibility: Company accepts a responsibility to sustain social cohesion
Impact on Corporate Governance:

Social accounting disclosures are made in the annual report
• Ethical accounting: internal code of practices at an individual level, and how company
maintains it
• Environmental accounting: organization's impact on the environment
• Social Accounting: Impact on employee condition, health and safety, equal opportunities,
human rights etc.
• Sustainable accounting: incorporating all of the above
Ownership and property:

• Owner has right to use property in any way he like
• Owner has right to regulate anyone else's use of his property (land – right of way)
• Owner has right to sell his property
• Owner is responsible that his use of property does not damage others
Shareholders are owners, but company is a separate legal entity

Shareholders participate in the risk and reward of ownership to a limited extent
Shareholders are responsible for company's action to a small extent:

• Large shareholders (institutional) can influence greater corporate accountability
• Making other shareholders aware of the company policies and its consequences
• Choosing to invest in companies with proven ethical track record only.

Disclosure and communication to shareholders

• Shareholders are owners, therefore have a right to obtain sufficient information to enable
them to make investment decisions
• AGM is the only opportunity where directors interact with shareholders
• Annual report is the only means of communication of information to shareholders
Best Practice Corporate Governance

Annual report should include
• A statement from the BOD regarding how it operates and the type of decisions it takes.
• Identify Chairman, CEO, Senior NED, Committee members, and attendance of all directors
• Explain reason for Chairman and CEO to be same person
• All NED's which board considers to be independent to be identified
• Director's other commitments
• Details of the work of the nomination committee
• How board's, committee's and individual directors performance is evaluated
• Remuneration report by the committee
• Explanation by directors of their responsibility to prepare accounts and report business as
going concern
• Report on effectiveness of internal controls
• Work of the audit committee
• Committee recommendations and reasons for not implementing them
• How audit objectivity and independence are safeguarded when non-audit services are
provided
• Measures taken in order to promote institutional shareholder's dialague
Mandatory disclosure: This is required to be made by law

Voluntary disclosure: The company choose to disclose information if they wish
Annual report is the tool to make voluntary disclosures
Why companies make voluntary disclosures:

• To become accountable to shareholders
• Provide more information to shareholders (in terms of agency theory)
• To increase investment in the company, as investors are attracted by increase disclosures
and transparency
• To give assurance to shareholders that management is competent and loyal to their
interests
• To provide information to various stakeholders
• To improve public understanding
• to act as marketing tool
Provisions of the Combined Code

• The board should present a balanced and understandable assessment of the company's
position and prospects.
• The board's responsibility to present a balanced and understandable assessment extends
to interim and other price-sensitive public reports and reports to regulators as well as to
information required to be presented by statutory requirements.
• The directors should explain in the annual report their responsibility for preparing the
accounts and there should be a statement by the auditors about their reporting
responsibilities.
• The directors should report that the business is a going concern, with supporting
assumptions or qualifications as necessary.
Dialogue with Shareholders

• The board as a whole has responsibility for ensuring that a satisfactory dialogue with
shareholders takes place
• Whilst recognizing that most shareholder contact is with the chief executive and finance
director, the chairman (and the senior independent director and other directors as

appropriate) should maintain sufficient contact with major shareholders to understand

their issues and concerns
• The chairman should ensure that the views of shareholders are communicated to the
board as a whole.
• The chairman should discuss governance and strategy with major shareholders.
• Non-executive directors should be offered the opportunity to attend meetings with major
shareholders.
• The senior independent director should attend sufficient meetings with a range of major
shareholders to listen to their views in order to help develop a balanced understanding of
the issues and concerns of major shareholders
• The board should state in the annual report the steps they have taken to ensure that the
members of the board, and in particular the non-executive directors, develop an
understanding of the views of major shareholders about their company, for example
through direct face-to-face contact, analysts' or brokers' briefings and surveys of
shareholder opinion.
Constructive Use of the AGM

• The board should use the AGM to communicate with investors and to encourage their
participation.
• The company should count all proxy votes and, except where a poll is called, should
indicate the level of proxies lodged on each resolution, and the balance for and against the
resolution and the number of abstentions, after it has been dealt with on a show of hands.
• The company should ensure that votes cast are properly received and recorded.
• The company should propose a separate resolution at the AGM on each substantially
separate issue and should in particular propose a resolution at the AGM relating to the
report and accounts.
• The chairman should arrange for the chairmen of the audit, remuneration and nomination
committees to be available to answer questions at the AGM and for all directors to attend
• The company should arrange for the Notice of the AGM and related papers to be sent to
shareholders at least 20 working days before the meeting.
Evaluation of Governance Disclosures

• Institutional shareholders should consider carefully explanations given for departure from
this Code and make reasoned judgments in each case.
• They should give an explanation to the company, in writing where appropriate, and be
prepared to enter a dialogue if they do not accept the company's position.
• They should avoid a box-ticking approach to assessing a company's corporate
governance.
• They should bear in mind in particular the size and complexity of the company and the
nature of the risks and challenges it faces.
INTERNAL CONTROL AND REVIEW
• Management should ensure that company's objectives are achieved

• Management places policies and procedures to minimize risk of failure to achieve
company's objectives
• Control Environment is the overall philosophy of management for internal controls
• Control Environment is part of the company culture, style and employee attitudes

Importance of Internal Controls

• A sound system of internal control contributes to safeguarding the shareholders’
investment and the company’s asset
• Effective financial controls including the maintenance of proper accounting records, are an
important element of internal controls
• They help ensure that the company is not unnecessarily exposed to avoidable financial
risks and that financial information used within the business and for publication is reliable.
• They also contribute to the safeguarding of assets, including the prevention and detection
of fraud.
The system of internal control should:

• be embedded in the operations of the company and form part of its culture;
• be capable of responding quickly to evolving risks to the business arising from factors
within the company and to changes in the business environment; and
• include procedures for reporting immediately to appropriate levels of management any
significant control failings or weaknesses that are identified together with details of
corrective action being undertaken
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.
Risk Management:
The process by which executive management, under board supervision, identifies the risk arising
from business and establishes the priorities for control and particular objectives.
Code Provisions:
• The board should, at least annually, conduct a review of the effectiveness of the group's
system of internal controls and should report to shareholders that they have done so.
• The review should cover all material controls, including financial, operational and
compliance controls and risk management systems
• The board should establish an audit committee of at least three, or in the case of smaller
companies' two, members, who should all be independent non-executive directors.
• The board should satisfy itself that at least one member of the audit committee has recent
and relevant financial experience.
The main role and responsibilities of the audit committee should be set out in written terms of
reference and should include:
• to monitor the integrity of the financial statements of the company, and any formal
announcements relating to the company's financial performance, reviewing significant
financial reporting judgments contained in them;
• to review the company's internal financial controls and, unless expressly addressed by a
separate board risk committee composed of independent directors, or by the board itself,
to review the company's internal control and risk management systems;
• to monitor and review the effectiveness of the company's internal audit function;
• to make recommendations to the board, for it to put to the shareholders for their approval
in general meeting, in relation to the appointment, re-appointment and removal of the
external auditor and to approve the remuneration and terms of engagement of the
external auditor;
• to review and monitor the external auditor's independence and objectivity and the
effectiveness of the audit process, taking into consideration relevant UK professional and
regulatory requirements;
• to develop and implement policy on the engagement of the external auditor to supply
non-audit services, taking into account relevant ethical guidance regarding the provision
of non-audit services by the external audit firm;

• and to report to the board, identifying any matters in respect of which it considers that
action or improvement is needed and making recommendations as to the steps to be
taken.
1. The terms of reference of the audit committee, including its role and the authority
delegated to it by the board, should be made available.
2. A separate section of the annual report should describe the work of the committee in
discharging those responsibilities.
3. The audit committee should review arrangements by which staff of the company may, in
confidence, raise concerns about possible improprieties in matters of financial reporting or
other matters.
4. The audit committee's objective should be to ensure that arrangements are in place for
the proportionate and independent investigation of such matters and for appropriate
follow-up action.
5. The audit committee should monitor and review the effectiveness of the internal audit
activities. Where there is no internal audit function, the audit committee should consider
annually whether there is a need for an internal audit function and make a
recommendation to the board, and the reasons for the absence of such a function should
be explained in the relevant section of the annual report.
6. The audit committee should have primary responsibility for making a recommendation on
the appointment, reappointment and removal of the external auditors.
7. If the board does not accept the audit committee's recommendation, it should include in
the annual report, and in any papers recommending appointment or re-appointment, a
statement from the audit committee explaining the recommendation and should set out
reasons why the board has taken a different position.
8. The annual report should explain to shareholders how, if the auditor provides non-audit
services, auditor objectivity and independence is safeguarded.
GUIDANCEONINTERNALCONTROL
(The Turnbull Guidance)
The guidance is based on the adoption by a company's board of a risk- based approach to
establishing a sound system of internal control and reviewing its effectiveness.
This should be incorporated by the company within its normal management and governance
processes. It should not be treated as a separate exercise undertaken to meet regulatory
requirements
• A company's objectives, its internal organization and the environment in which it operates
are continually evolving and, as a result, the risks it faces are continually changing.
• A sound system of internal control therefore depends on a thorough and regular
evaluation of the nature and extent of the risks to which the company is exposed.
• Since profits are, in part, the reward for successful risk- taking in business, the purpose of
internal control is to help manage and control risk appropriately rather than to eliminate
it.
The board must ensure that the system of internal control is effective in managing risks. It
should consider:
• the nature and extent of the risks facing the company;
• the extent and categories of risk which it regards as acceptable for the company to bear;
• the likelihood of the risks concerned materializing;
• the company's ability to reduce the incidence and impact on the business of risks that do
materialize; and
• the costs of operating particular controls relative to the benefit thereby obtained in
managing the related risks.

Internal Control Guideline:
1. It is important that risk management and control are not seen as a burden on business,
rather the means by which business opportunities are maximized and potential losses
associated with unwanted events reduced.
2. Companies set themselves strategic and business objectives, then manage risks that
threaten the achievement of those objectives.
3. Internal control and risk management should supplement entrepreneurship, but not
replace it.
4. Increased shareholder value is the reward for successful risk taking and the role of
internal control is to manage risk appropriately rather than to eliminate it.
Risk can be defined as real or potential events which reduce the likelihood of achieving business
objectives. Or, put another way, uncertainty as to the benefits. The term includes both the
potential for gain and exposure to loss.
Internal control is one of the principal means by which risk is managed. Other devices used to
manage risk include:
• The transfer of risk to third parties,
• Sharing risks,
• Contingency planning and the withdrawal from unacceptably risky activities.
Of course companies can accept risk too. Getting the balance right is the essence of successful
business – to knowingly take risk, rather than be unwittingly exposed to it.
Example: the objective of a coal miner is to maximize coal output. More digging, means more
output, resulting in a risk of mine collapse, resulting in injury and delayed outputs.
Pit props (wooden supports) can manage risk of mine collapse. Too many props (over control)
can delay digging, and few props (under control) will not be able to manage the collapse.
Responsibility for the Internal Control system:

• The board is ultimately responsible for the system of internal controls
• The board will normally delegate to the management, the task of establishing, operating
and monitoring of the system of internal controls
• The responsibility of the board cannot be delegated
• The management should identify and evaluate the risks faced by the company, and design
and operate appropriate internal controls
• The operation and monitoring of internal controls should be undertaken by individuals who
possess necessary skills and competences.
Internal controls commonly comprise of:

1. Control Environment: Tone of the organization, control consciousness by its people,
managements philosophy and working style, and the way management assigns authority
and responsibility
2. Identification and evaluation of risks and control objectives: Objectives should be
internally consistent and linked at different levels. Risk assessment should include effect
of both internal and external factors
3. Control activities: are policies and procedures that help ensure the management directives
are being followed. They include approvals, authorizations, verifications, reconciliations
and segregation of duties.
4. Information and communication process: Information must be identified, captured and
communication in the required time frame. Reports containing information are required to
be generated.
5. Monitoring the effectiveness of internal control system: regular management and
supervisory activities where internal control deficiencies are reported upstream.

Control should be capable of responding quickly to evolving risks.

Resilience refers to company's capability to respond and adapt to unexpected risks and
opportunities, and to make decisions. Control needs to be close to the associated risks – the
shorter the chain, the quicker the action.
Cost of control should be balanced against the benefits, including the risk it is designed
to manage.
When SONY was designing its WALKMAN, the CEO stated that in order to achieve 50% reduction
in size, he would be willing to accept higher level of failure in R&D projects, and he had to visibly
demonstrate its acceptance.
Internal Controls should include procedures of reporting immediately to appropriate

levels of management, with details of corrective action.
It should not be assumed that breakdown of controls is an isolated instance. Often major
disasters are accumulation of small insignificant events, which if analyzed correctly, would have
given indication of the problem and necessary warning.
Control can help minimize errors, but cannot provide absolute assurance that they will
not occur.
A control system cannot be designed to provide protection with certainty.
The system of control should be embedded in the operations of the company and
should form part of its culture.
People, who are accountable to achieve objectives, should also be accountable to maintain
effective controls to achieve those objectives. By making individuals accountable, likelihood of
effective operation of controls increases.
Activity 2
A photocopier salesman was offered a bonus for meeting a particular sales target. The copiers
were sold with a standard three years warranty. The salesman was able to provide the purchaser
extended warranty cover by inaccurately putting dates on the warranty card. This gave him
advantage over his competitors in selling, and he sold the required number of copiers every
month.
Most common weaknesses in control system:

1. Philosophy: Understood, but not written, open to misinterpretation
2. Roles and responsibilities: absence of clear responsibilities in the organization
3. Performance appetite: lack of understanding of organizations' appetite of risk taking
4. Information reporting: Boards either get too much information (overload), or too little
(under informed)
5. Behavior: Disincentives for employees to behave properly
Reviewing the effectiveness of Internal Control

Responsibilities:
• Reviewing the effectiveness of internal control is an essential part of the board's
responsibilities. The board will need to form its own view on effectiveness after due and
careful enquiry based on the information and assurances provided to it.
• Management is accountable to the board for monitoring the system of internal control and
for providing assurance to the board that it has done so.
• The role of board committees in the review process, including that of the audit committee,
is for the board to decide and will depend upon factors such as the size and composition of
the board; the scale, diversity and complexity of the company's operations; and the
nature of the significant risks that the company faces.
• The board takes responsibility for the disclosures on internal control in the annual report
and accounts.

Board responsibilities
• Effective monitoring on a continuous basis is an essential component of a sound system of
internal control. The board cannot, however, rely solely on the embedded monitoring
processes within the company to discharge its responsibilities.
• It should regularly receive and review reports on internal control.
• Internal controls considered by the board should include all types of controls including
those of an operational and compliance nature, as well as internal financial controls
• The board should define the process to be adopted for its review of the effectiveness of
internal control.
• This should encompass both the scope and frequency of the reports it receives and
reviews during the year, and also the process for its annual assessment.
• When reviewing reports during the year, the board should:
a) consider what are the significant risks and assess how they have been
identified, evaluated and managed;
b) Assess the effectiveness of the related system of internal control in managing
the significant risks, having regard, in particular, to any significant failings or
weaknesses in internal control that have been reported;
c) Consider whether necessary actions are being taken promptly to remedy any
significant failings or weaknesses; and
d) Consider whether the findings indicate a need for more extensive monitoring of
the system of internal control.
Annual Assessment by Board:

• In addition, the board should undertake an annual assessment for the purposes of making
its public statement on internal control to ensure that it has considered all significant
aspects of internal control for the company for the year under review and up to the date
of approval of the annual report and accounts.
• The assessment should consider issues dealt with in reports reviewed by it during the year
together with any additional information necessary to ensure that the board has taken
account of all significant aspects of internal control for the company for the year under
review and up to the date of approval of the annual report and accounts.
• Should the board become aware at any time of a significant failing or weakness in internal
control, it should determine how the failing or weakness arose and re-assess the
effectiveness of management's ongoing processes for designing, operating and monitoring
the system of internal control.
Management Responsibilities:
• The reports from management to the board should, in relation to the areas covered by
them, provide a balanced assessment of the significant risks and the effectiveness of the
system of internal control in managing those risks.
• Any significant control failings or weaknesses identified should be discussed in the reports,
including the impact that they have had, could have had, or may have, on the company
and the actions being taken to rectify them.
• It is essential that there be openness of communication by management with the board
on matters relating to risk and control.
Process of reviewing effectiveness of Internal Controls

a) Identify Company's business objectives
b) Identify and assess the risks which threatens achievement of these business objectives
c) Design internal controls to manage those risks
d) Operate the internal controls with their design specification
e) Monitor the controls to ensure they are operating properly
f) Directors should review effectiveness of these internal controls
g) Report to the shareholders that they have done the review.

Sarbanes Oxley Act (Responsibilities)

1. Board is likely to delegate the authority to obtain information on internal controls to
the Audit Committee.
2. CEO and CFO have to attest that the control system has been reviewed.
3. Independent auditor has to express an opinion on management's assessment of the
effectiveness of the Internal Controls.
4. Auditors have to verify management's assessment by independent testing
Internal Audit
Internal audit is one of the most influential and value added service available to the Board. The
scope of internal auditing within an organization is broad and may involve internal control topics
such as:
• Efficacy of operations,
• Reliability of financial reporting,
• Deterring and investigating fraud,
• Safeguarding assets, and
• Compliance with laws and regulations.
Internal auditors are not responsible for the execution of company activities; they advise
management and the Board of Directors (or similar oversight body) regarding how to better
execute their responsibilities.
Code provisions:
• Companies which do not have an internal audit function should from time to time review
the need for one.
• The need for an internal audit function will vary depending on company specific factors
including:
a) Scale, diversity and complexity of the company's activities,
b) number of employees, and
c) Cost/benefit considerations
d) any trends or current factors relevant to the company's activities, markets or
other aspects of its external environment, that have increased, or are expected
to increase the risks faced by the company
e) Internal factors such as organizational restructuring or from changes in
reporting processes or underlying information systems.
f) adverse trends evident from the monitoring of internal control systems
g) an increased incidence of unexpected occurrences
• Senior management and the board may desire objective assurance and advice on risk and
control
• An adequately resourced internal audit function (or its equivalent where, for example, a
third party is contracted to perform some or all of the work concerned) may provide such
assurance and advice.
• There may be other functions within the company that also provide assurance and advice
covering specialist areas such as health and safety, regulatory and legal compliance and
environmental issues
• If the company does not have an internal audit function and the board has not reviewed
the need for one, the Listing Rules require the board to disclose these facts.
Audit Committee (internal audit)

1. The audit committee should approve the appointment or termination of appointment of
the head of internal audit.
2. In its review of the work of the internal audit function, the audit committee should:
a. ensure that the internal auditor has direct access to the board chairman and to the
audit committee and is accountable to the audit committee;
b. review and assess the annual internal audit work plan;
c. receive a report on the results of the internal auditors' work on a periodic basis;

d. review and monitor management's responsiveness to the internal auditor's findings

and recommendations;
e. meet with the head of internal audit at least once a year without the presence of
management;
f. monitor and assess the role and effectiveness of the internal audit function in the
overall context of the company's risk management system.
Organizational structure of Internal Audit

• Internal audit function reports to the audit committee
• In large organizations internal audit function will be a separate department
• In small companies it may be the responsibility of individuals to perform some specific
tasks related to internal audit.
• Some companies may outsource their internal audit function
Independence requirements:
• Internal auditors should be independent of executive management and should not have
any involvement in the activities of the system they audit.
• Head of internal audit should directly report to a senior independent non-executive
director, or the audit committee
• The head of the internal audit should have direct access to the chairman
• The audit committee should approve appointment, termination and remuneration of the
internal audit head.
Threats to auditors (both internal auditors and external)

These threats generally apply to external auditors
1. Self-interest Threats: where financial interest is involved

• Direct financial interest in clients business
• Loan or guarantee to or from audit client or any of its directors/ officers
• Undue dependence on total fee from an audit client
• Concern about possibility of losing the engagement
• Potential employment with the audit client
• Contingent fees relating to audit engagement
2. Self review threats: where auditor reviews a matter which he was previously responsible
• Member of audit team being a previous director, officer or an employee of the audit
client and is in a position to influence the engagement
• Performing services for an audit client which affect the current engagement
• Preparing original data used to generate financial information or preparing other
records
3. Advocacy threats: where auditor is perceived to promote interests of the client
• Dealing in shares, or other securities of the client
• Acting as advocate on behalf of client in a litigation or in resolving disputes
4. Familiarity threats: where auditor has a close relationship with the client
• A member of audit team having a close family member who is a director, or officer
of the client
• A former partner of the firm being director or officer of the client
• Long association of a senior member of the team with the audit client
• Acceptance of gifts and hospitality form the audit client or its directors
5. Intimidation threats: where auditor receives some sort of threat
• Threat of replacement over a disagreement
• Pressure to reduce extent of work to be performed in order to reduce fee
• Dominant personality in a senior position, controlling dealings with the auditor
Ethical threats to independence

1. Pressure from an overbearing director / officer not to report adverse findings
2. Audit team member misleading about his experience and competence (expert required)
3. Auditor asked to act contrary to a technical or professional standard

Audit Committee and External Audit (Code Provisions)

• The audit committee should have primary responsibility for making a recommendation on
the appointment, reappointment and removal of the external auditors.
• If the board does not accept the audit committee’s recommendation, it should include in
the annual report, and in any papers recommending appointment or reappointment, a
statement from the audit committee explaining its recommendation and should set out
reasons why the board has taken a different position.
• If the audit committee recommends considering the selection of possible new appointees
as external auditors, it should oversee the selection process.
• The audit committee should assess annually the qualification, expertise and resources,
and independence of the external auditors and the effectiveness of the audit process.
• The assessment should cover all aspects of the audit service provided by the audit firm,
and include obtaining a report on the audit firm’s own internal quality control procedures.
• If the external auditor resigns, the audit committee should investigate the issues giving
rise to such resignation and consider whether any action is required.
Terms and Remuneration:

• The audit committee should approve the terms of engagement and the remuneration to
be paid to the external auditor in respect of audit services provided.
• The audit committee should review and agree the engagement letter issued by the
external auditor at the start of each audit, ensuring that it has been updated to reflect
changes in circumstances arising since the previous year.
• The scope of the external audit should be reviewed by the audit committee with the
auditor.
• If the audit committee is not satisfied as to its adequacy it should arrange for additional
work to be undertaken
• The audit committee should satisfy itself that the level of fee payable in respect of the
audit services provided is appropriate and that an effective audit can be conducted for
such a fee.
Independence, including the provision of non-audit services

1. The audit committee should have procedures to ensure the independence and objectivity
of the external auditor annually, taking into consideration relevant UK professional and
regulatory requirements.
2. This assessment should involve a consideration of all relationships between the company
and the audit firm (including the provision of non-audit services).
3. The audit committee should consider whether, those relationships appear to impair the
auditor’s judgment or independence.
4. The audit committee should seek reassurance that the auditors and their staff have no
family, financial, employment, investment or business relationship with the company
(other than in the normal course of business).
5. The audit committee should seek from the audit firm, on an annual basis, information
about policies and processes for maintaining independence and monitoring compliance
with relevant requirements, including current requirements regarding the rotation of audit
partners and staff
6. The audit committee should agree with the board the company’s policy for the
employment of former employees of the external auditor, paying particular attention to
the policy regarding former employees of the audit firm who were part of the audit team
and moved directly to the company.
7. The audit committee should monitor application of the policy, including the number of
former employees of the external auditor currently employed in senior positions in the
company, and consider whether in the light of this there has been any impairment, or
appearance of impairment, of the auditor’s judgment or independence in respect of the
audit.
8. The audit committee should monitor the external audit firm’s compliance with applicable
United Kingdom ethical guidance relating to the rotation of audit partners, the level of fees

that the company pays in proportion to the overall fee income of the firm, office and
partner, and other related regulatory requirements
9. The audit committee should develop and recommend to the board the company’s policy in
relation to the provision of non-audit services by the auditor.
10. The audit committee’s objective should be to ensure that the provision of such services
does not impair the external auditor’s independence or objectivity.
11. In this context, the audit committee should consider:
a. whether the skills and experience of the audit firm make it a suitable supplier of
the non audit service;
b. whether there are safeguards in place to ensure that there is no threat to
objectivity and independence in the conduct of the audit resulting from the
provision of such services by the external auditor;
c. the nature of the non-audit services, the related fee levels and the fee levels
individually and in aggregate relative to the audit fee;
d. the criteria which govern the compensation of the individuals performing the audit.
12. The audit committee should set and apply a formal policy specifying the types of non-
audit work:
a. from which the external auditors are excluded;
b. for which the external auditors can be engaged without referral to the audit
committee;
c. for which a case-by-case decision is necessary.
13. In determining the policy, the audit committee should take into account relevant ethical
guidance regarding the provision of non-audit services, and in principle should not agree
to the auditor providing a service if:
a. the external auditor audits its own firm’s work;
b. the external auditor makes management decisions for the company;
c. a mutuality of interest is created;
d. the external auditor is put in the role of advocate for the company.
14. The annual report should explain to shareholders how, if the auditor provides non-audit
services, auditor objectivity and independence is safeguarded.
Annual audit cycle

1. At the start of each annual audit cycle, the audit committee should ensure that
appropriate plans are in place for the audit.
2. The audit committee should consider whether the auditor’s overall work plan, including
planned levels of materiality, and proposed resources to execute the audit plan appears
consistent with the scope of the audit engagement, having regard also to the seniority,
expertise and experience of the audit team.
3. The audit committee should review, with the external auditors, the findings of their work.
4. In the course of its review, the audit committee should:
a. discuss with the external auditor major issues that arose during the course of the
audit and have subsequently been resolved and those issues that have been left
unresolved;
b. review key accounting and audit judgments;
c. review levels of errors identified during the audit, obtaining explanations from
management and, where necessary the external auditors, as to why certain errors
might remain unadjusted.
5. The audit committee should also review the audit representation letters before signature
by management and give particular consideration to matters where representation has
been requested that relate to non-standard issues.
6. The audit committee should consider whether the information provided is complete and
appropriate based on its own knowledge.
7. As part of the ongoing monitoring process, the audit committee should review the
management letter (or equivalent).
8. The audit committee should review and monitor management’s responsiveness to the
external auditor’s findings and recommendations.

9. At the end of the annual audit cycle, the audit committee should assess the effectiveness
of the audit process. In the course of doing so, the audit committee should:
a. review whether the auditor has met the agreed audit plan and understand the
reasons for any changes, including changes in perceived audit risks and the work
undertaken by the external auditors to address those risks;
b. consider the robustness and perceptiveness of the auditors in their handling of the
key accounting and audit judgments identified and in responding to questions from
the audit committees, and in their commentary where appropriate on the systems
of internal control;
c. obtain feedback about the conduct of the audit from key people involved, e.g. the
finance director and the head of internal audit; and
d. review and monitor the content of the external auditor’s management letter, in
order to assess whether it is based on a good understanding of the company’s
business and establish whether recommendations have been acted upon and, if
not, the reasons why they have not been acted upon.
Communication with shareholders:

• The terms of reference of the audit committee, including its role and the authority
delegated to it by the board, should be made available.
• A separate section in the annual report should describe the work of the committee in
discharging those responsibilities.
• The audit committee section should include:
a) a summary of the role of the audit committee;
b) the names and qualifications of all members of the audit committee during the
period;
c) the number of audit committee meetings;
d) a report on the way the audit committee has discharged its responsibilities;
• The chairman of the audit committee should be present at the AGM to answer questions,
through the chairman of the board, on the report on the audit committee’s activities and
matters within the scope of audit committee’s responsibilities.
Risk and Risk Management
• Financial risk is often defined as the unexpected variability or volatility of returns. It

includes both potential worse-than-expected as well as better-than-expected returns.
• Means of assessing risk vary widely between professions. For example, a doctor manages
medical risk, while a civil engineer manages risk of structural failure.
• A professional code of ethics is usually focused on risk assessment and mitigation (by the
professional on behalf of client, public, society or life in general).
Risk management
• Risk management is the human activity which integrates recognition (identification) of
risk, risk assessment (analysis), development of strategies to manage it (planning), and
monitoring of risk using managerial resources.
• The strategies include transferring the risk to another party, avoiding the risk, reducing
the negative effect of the risk, and accepting some or all of the consequences of a
particular risk.
• Some traditional risk managements are focused on risks stemming from physical or legal
causes (e.g. natural disasters or fires, accidents, death and lawsuits). Financial risk
management, on the other hand, focuses on risks that can be managed using traded
financial instruments.
• Objective of risk management is to reduce different risks related to a preselected domain
to the level accepted by society. It may refer to numerous types of threats caused by
environment, technology, humans, organizations and politics.

• Risk management is the process of reducing the possibility of adverse consequences

either by reducing the likelihood of an event or its impact.
• Management needs to monitor risks on ongoing basis:
a) To identify new risks that may affect the company
b) To identify changes to existing and known risks (amend strategy)
c) To ensure best use is made of the opportunities
Strategic Risks
These are risks associated with adopting a particular strategy
• A company aiming to achieve growth by acquisitions have more risk compared to the
company growing through slow and gradual increase in sales
• Developing new products is more risky than to enhance the existing ones.
• Strategic risks should be identified by the senior management
Operational Risks
These are risks arising from business operations
• Potential loss in business (through failed or inadequate internal processes, people and
systems)
• Risk of fraud by employee
• Poor quality of production / lack of production (stock out)
Activity 3
A new mobile phone company has recently launched operations. What are its strategic and
operational risks?
Some common business risks:

1. Market Risk:
a. Market saturation
b. A new product not being accepted in market
c. Competitors offering better product
d. Sales / demand of product may fall due to change in technology / or taste
e. Increase in price of raw materials (where price of company’s product is inelastic)
f. Change in economic condition of the country (growth / recession)
g. Change in international market conditions
2. Credit Risk
a. Non-payment by customers
b. Organization’s credit policy (terms / credit limits / credit period)
c. Credit rating / Assessment procedures
3. Liquidity:
a. Poor cash flow management
b. Difficulty in raising new finances (due to problems in operations)
c. High gearing (debt to equity ratio)
d. Company may not meet its commitments
e. Fluctuation in interest rates
4. Technology Risk
a. Products change quickly due to change in technology
b. Low investment in R&D
c. Competitors have better products
5. Legal or litigation risk
a. Breach of legal statutes by the company (Companies Act etc)
b. Breach of contract by company or third parties
6. Health/ Safety/ Environmental Risk
a. Safety of workers
b. Safety of the community (pollution, toxic wastes)
c. R&D (testing on animals)

7. Product Reputation Risk

a. Quality of production
b. Product recalls due to quality
c. Business in sectors perceived to be bad (e.g. tobacco)
8. Business Probity (decency) Risk
a. Directors getting increases while company is in loss
b. Questionable transactions (bribes, kickbacks)
c. Active lobbying (e.g. arms and ammunition / tobacco)
9. Currency Risk
a. Transactions in foreign currencies
b. Change in currency rate
c. Competitors price getting attractive due to change in rate
10. Derivative Risk
a. Dealing in derivatives (financial instruments)
b. Not using hedging and continuing with open positions
Activity 4
A telecommunication company has announced to launch WiFi based service. WiFi is a new
technology, which enables voice and data to be exchanged on wireless network, at speeds upto
1GB per second. This speed limit has been tested in labs only, and a commercial deployment is
yet to be made. Equipment manufacturers (phone sets, computer cards) are in the R&D stage
and hope to start commercial production by middle of 2008. Price and quality of equipment is not
yet confirmed.
Activity 5
Due to power shortage, and rising fuel prices, Government of Pakistan has decided to provide
incentives to the alternative power generation sector. Electricity can be generated through wind,
and solar processes. Cost of generating equipment is three times the cost of conventional
generating equipment (using fossil fuel). Due to rapid R&D in the sector, it is estimated that cost
of alternative energy equipment will decrease by 1/3rd by end of 2008.
Activity 6
A young designer, just out of Fashion College, has decided to launch her own clothing line. She
perceives the current fashion to change within the next 6 months, and believes if she launches
her clothing line now, she will have a head start.
Generic Risk: that affects all businesses in the market. i.e. increase in interest rate will affect all
business with borrowings.
Sector Specific Risk: that is specific to an industry sector. i.e. environmental legislation effecting
oil exploration companies
Impact of risk on stakeholders:

• Business risk initially affects the company
• Consequently, stakeholders will also be affected
• Stakeholders can reduce the risk to them by distancing from the company
Shareholders: loss of value of their investment / income

Directors: loss of income / poor reputation
Managers/ employees: loss of income / poor reputation / demotivation
Customers: sale returns / warranties / guarantees / loss in sale
Suppliers: loss in volume of purchases / price / quality
Government: Lower taxes / employment / exports / infrastructure

Probability and Severity (Impact) of Risk

This tool is used to quantify the likelihood (or frequency) and impact (or consequence) of
identified risks in order to prioritize risk response activities. Experts advise that the probability
should be evaluated first, followed by estimating the potential severity of the consequences. It
helps identify the risks that are most urgent or must be avoided, those that should be transferred
or reduced, and those it is reasonable to retain.
Activity:
For each event listed below, rate the potential financial severity and the probability or frequency
of the event at this time in your life. We are concerned only with negative financial impacts. Use
these definitions to help you rate the severity of an event:
1 Financially devastating, possibly resulting in bankruptcy

2 A huge financial impact that would radically change your lifestyle
3 An uncomfortable but manageable financial impact
4 Very little financial impact; you could cover it with an emergency fund
Use these guidelines to categorize the probability or frequency of an event:

1 Almost certain to happen, or happens very frequently
2 More likely to happen than not to happen, or happens often
3 Could happen, or happens infrequently
4 Unlikely to happen, or almost never happen
Let's look at one event as an example. If you are a young parent with pre-school children, you
are the major breadwinner in your family, and you have no life-threatening health problems,
then you will probably rate the financial impact of your death as a 1 or 2 (ignoring for the
moment any life insurance you have) and the probability a 3 or 4. However, if you are 90, in poor
health, and have no financial dependents, you will likely consider the financial severity of your
death either a 3 or 4 and the probability a 1 or 2.
How to manage / handle the risk

In the above activity, take example of the risk of totaling car in accident. The risk of accident can
be handled as follows:
a) Bear the financial risk and do not seek to reduce it. For example, continue driving car
without taking any insurance.
b) Transfer the risk to another party. For example take insurance for the car.
c) Reduce or control the risk. For example wear seat belts / drive at slow speed (reduce injury)
d) Remove the risk and avoid it entirely. For example you sell the car and use public transport.


External reporting of risk

• Identify reporting situation: i.e. internal control failure
• Check compliance with legislation (companies act) or ethical guidance (code)
o Reporting may be voluntary or required by statute
• Make report if required (for third parties), and document the reasons
o In extreme case third parties will make a report (auditors) if the company is
unaware of a reporting situation
o Some reporting systems are geared towards internal reporting (audit committee)
Reporting by Directors:
a) Overall responsibility of maintaining control systems
b) Appoint internal auditors and internal audit committee to review and maintain internal
controls
c) Internal auditors test controls on regular basis and report their findings to the board
d) Review the report on internal controls and suggest improvements
e) Report to shareholders that a review of internal control has been done
Reporting by Auditors:
a) Identify and document internal controls
b) Test those controls
c) Report material deficiencies in the audit report
Role of Risk Committee

a) Raise awareness about risk within the organization
b) Ensure adequate and efficient risk management processes are in place to identify, monitor
and report risks
c) Report to the board, and make recommendations about the risk appetite of the company
d) Develop and review the risk management policy of the company
e) Appropriate communication to all employees and management levels regarding the Risk
Policy and their responsibilities.
f) Where applicable, obtain expert advice on risk management processes.
• In most companies board will establish Risk Management Committee (based on size)
• Where no such committee is formed, audit committee will perform similar duties
Risk Manager:
• Is a member of Risk Management Committee, and reports directly to the committee and
the board
• His role is more operational rather than strategic
• Policies are set by the Risk Management Committee and implemented by the risk manager
Responsibilities of Risk Manager:

1. Identifies and evaluate risks affecting the organization and its operation and
business.
2. Designs appropriate internal controls to manage identified risks
3. Monitors the status of internal controls through internal audit reports
4. Develops and implements a risk awareness program within the organization
5. Maintain good working relationship between the committee and the board
6. Provide assurance to external auditors in appraising risks and internal controls
within the organization
7. Produce reports (based on jurisdictions) on risk management , including statutory
reports (SOX)
Risk Auditing (SOX requirement)

• Can be external or internal
• An auditor reviews the risk monitoring process and identifies and deficiencies
• He makes recommendations for improvement of the process

Importance of Risk Awareness:

a) Risk awareness should be at all levels in the organization:
i. Strategic Level: Awareness of risk at the highest level. It includes identifying
new threats (competitors, technology), and monitoring of the existing risk
management function of the organization.
ii. Tactical Level: Awareness of risk at department / division level. It includes
monitoring the business functions of each department and identifying threats,
which may impede the business at middle management level (credit policy)
iii. Operational Level: Awareness of risk at a day-to-day business running basis.
Individual threats on their own may not be significant at this level, but may add
up over time, and disrupt business (customer dissatisfaction, stock out).
b) In absence of risk awareness, organization and its people are not geared up to identify
new risks
c) Continued monitoring of existing risks is required to ensure business runs smoothly
⇒ Risk and uncertainty are so pervasive in our lives that we deal with them all the time.
⇒ Risk management already exists, in some form, before risk managers and auditors
come along to try to "implement" it.
Embedding risk management system within the Internal Control System

A sound system of internal control reduces but cannot eliminate risk.
An organization should not have a separate system of risk management; they
should include the risk management processes into their system of internal
controls
The risks to business are ever changing because of evolving and expanding
operations. An effective internal control system would be able to identify existing
and new threats to business with similar efficiency.
In USA it is a statutory requirement (SOX)
Risk manager (or a risk expert) needs to work closely with management while they
design the internal control system
Risk manager should regularly review reports on monitoring of internal control to
identify whether controls are capable to identify all risks.
Embedding risk management system within the Culture and Values of Organization
Culture is:
• Commonly held and relatively stable set of attitudes, values and norms
• Basic assumptions and beliefs that are shared by members of an organization.
Risk management needs to be incorporated in the policies and procedures of the

organization
Employees should be aware of the importance of risk management system,
otherwise they will not be able to identify potential threats or monitor risks
The “tone at the top” gives a significant message of awareness to the staff
An open culture (open to new ideas) will significantly increase efficiency of risk
management
Risk management function may be included in individual job descriptions, and
aligned with performance indicators expected at time of appraisals
Diversifying Risk
• Spreading risk effectively reduces it
• Operational risk may be diversified by producing in different geographical regions
• Poor performance of one division / product may be offset by good performance of the
other
• Diversification only works where returns are negatively correlated (move opposite)
• Financial risk can be diversified by investing in different sectors or by hedging (it can
decrease potential for loss, along with potential for gain).

• Risk cannot be eliminated entirely, it can only be reduced

• Diversification into different segments / operations may reduce focus of the senior
management on business issues.
• With diversification, monitoring may become ineffective.
Activity 7
A service department has been challenged to improve its performance by a certain amount on
various metrics. The improvement cannot be achieved without innovation as new resources are
not available.
To meet this challenge, a plan is devised with over 30 improvement actions, some more specific
than others. The plan is extensively circulated and the plan document is formally approved at a
high level.
A monitoring group meets regularly to assess progress against the plan and deal with problems.
Measures of progress have been identified. Actions have been prioritized rigorously.
What risk managing activities do you see here, and what could be improved?
Risk Avoidance: A risk strategy where organization avoids risk.

⇒ It is the most effective way to manage risk, especially when the risk appetite of the
organization is low
⇒ It means not entering into a new project because of the risks that will arise
⇒ For continuing business, risk avoidance will not be a good decision, because competitors
may increase their product range, or market share.
⇒ Risk avoidance may be feasible when risk cannot be transferred to another party, or
activities have a very high chance of failure.
Risk Retention: The organization decides to retain risk

⇒ The organization may have a higher risk appetite
⇒ Risk may be retained when the consequences of risk taking are less than the cost to
manage it
⇒ Organization may estimate a very low probability of the event happening, and may take a
chance by assuming risk
⇒ When the cost of transferring risk to another party is higher than the benefit,
organizations may choose to take the risk.
Attitudes towards risk taking

⇒ The overall approach towards risk management determines formulation of risk strategy
⇒ The risk appetite, and risk capacity indicates how much risk can organization take.
⇒ Organizations may take risky projects if they have large risk appetite
⇒ Once risk capacity has been reached, organizations may refuse to take more risk and try
to transfer risk, or avoid it altogether.
⇒ Organization may make a portfolio of projects (to diversify risk)
⇒ Size, structure of organization does not correlate with its risk appetite
⇒ A small, newly formed company may take more risk to get its product in the market, and
an old business may become risk averse to protect its market share
⇒ A new business, a new product carries more risk
⇒ Small product range carried more risk (product failure)
⇒ A developed company (with functioning board and senior management) will carry less risk
than a newly formed company
⇒ Divisionilized structure carries less risk as loss of one division may be offset by others
⇒ A business operating in different geographical areas would face higher risk
⇒ A large organizations would face many problems (due to large number of stakeholders,
and interaction with environment), and will face emerging risks all the time.

Answer to activity 7:
a. The plan has been documented (reducing risk of miscommunication), has been
reviewed widely, and has formal approval;
b. There is a monitoring group that meets regularly and they have measures of progress
(needed because things may not go according to plan); and
c. Actions have been prioritized (reflecting an awareness of uncertainty as to how many
of the actions can be carried out).
d. Bearing in mind that innovation was required, group seems over-confident that their
improvements will be effective and that their prioritization is correct.
e. More should have been said in the plan about using experience to find out as early as
possible which actions appear to be effective, and to generate improved actions
f. The monitoring group is only assessing progress against the plan, and this again
reflects an assumption that the plan is correct. Progress should be assessed against
the most recent forecasts and revised plans that reflect what has been learned so far.
Necessity of risk taking

• A risk avoidance approach may lead to stagnation, or decline of business
• Transferring risk has associated costs, which needs to be accounted for.
• Incurring an acceptable amount of risk makes the business more competitive.
• Taking higher risk projects may provide higher returns, which may enable the business to
have extra surplus to invest elsewhere
Professional Values and Ethics
Relativism:
• There are many sets of moral rules. Rules change over time.
• An action is right or wrong depends on the moral norms of the society in which it is
practiced. Different societies have different rules.
• The same action may be morally right in one society but be morally wrong in another.
• For the ethical relativist, there are no universal moral standards (standards that can be
universally applied to all peoples at all times).
• The only moral standards against which a society's practices can be judged are its own.
• It is the opposite of moral absolutism
Absolutism:
• It is the view that moral rights are absolute and never change
• There is one set of rules which is always true.
• Moral rights will hold true in all situations and are common to all societies.
• Moral “truth” of once society can be imposed on another
Directors, auditors have a set of rules to follow (legislation). They may choose to interpret
it differently (relativism).
Kohlberg’s stages of human moral development
These are planes of moral adequacy conceived by Lawrence Kohlberg to explain the development
of moral reasoning. His theory holds that moral reasoning, which is the basis for ethical behavior,
has six identifiable developmental constructive stages - each more adequate at responding to
moral dilemmas than the last.
Level 1 (Pre-Conventional): Reasoners in the pre-conventional level judge the morality of an

action by its direct consequences.
1. Obedience and punishment orientation

Individuals focus on the direct consequences that their actions will have for
themselves. For example, an action is perceived as morally wrong if the person

who commits it gets punished. The worse the punishment for the act is, the more
'bad' the act is perceived to be. Employee take ethical decision because they will
get rewarded, or they think company will punish them.
2. Self-interest orientation
Right behavior being defined by what is in one's own best interest. Stage two
reasoning shows a limited interest in the needs of others, but only to a point where
it might further one's own interests. Employee covers a colleague in understanding
that colleague will cover him when required
Level 2 (Conventional): Persons who reason in a conventional way judge the morality of
actions by comparing these actions to societal views and expectations
3. Interpersonal accord and conformity

Individuals are receptive of approval or disapproval from other people as it reflects
society's accordance with the perceived role. They try to be a good boy or good girl
to live up to these expectations, having learned that there is inherent value in
doing so. Stage three reasoning may judge the morality of an action by evaluating
its consequences in terms of a person's relationships, which now begin to include
things like respect and gratitude.
4. Authority and social-order maintaining orientation

It is important to obey laws, dictums and social conventions because of their
importance in maintaining a functioning society. A central ideal or ideals often
prescribe what is right and wrong, such as in the case of fundamentalism. If one
person violates a law, perhaps everyone would - thus there is an obligation and a
duty to uphold laws and rules. When someone does violate a law, it is morally
wrong. i.e. Employee gets an increase in salary due to pressure groups.
Level 3 (Post-Conventional): Realization that individuals are separate entities from society
now becomes salient. One's own perspective should be viewed before the society.
5. Social contract orientation

Individuals are viewed as holding different opinions and values. Along a similar
vein, laws are regarded as social contracts rather than rigid dictums. Those that do
not promote the general welfare should be changed when necessary to meet the
greatest good for the greatest number of people. This is attained through majority
decision, and inevitably compromise. In this way democratic government is
ostensibly based on stage five reasoning.
6. Universal ethical principles

Moral reasoning is based on abstract reasoning using universal ethical principles.
Laws are valid only insofar as they are grounded in justice, and that a commitment
to justice carries with it an obligation to disobey unjust laws. This can be done by
imagining what one would do being in anyone's shoes. While Kohlberg insisted that
stage six exists, he had difficulty finding participants who consistently used it. It
appears that people rarely if ever reach stage six of Kohlberg's model. i.e.
Purchasing manager stops purchasing from a company which does not comply with
environmental regulations
• Individuals move from stage 1 to 6, as they mature from a child to adult. Each level is
further divided into two levels.
• Higher levels provide more ethical methods of reasoning
• Most individuals operate at level 3 and 4, and decisions are made in accordance with what
the individual perceives others to believe and expect from him.
• Whistleblowers would be at the last level (6).

A woman was near death from a special kind of cancer. There was one drug that the doctors
thought might save her. It was a form of radium that a druggist in the same town had recently
discovered. The drug was expensive to make, but the druggist was charging ten times what the
drug cost him to produce. He paid $200 for the radium and charged $2,000 for a small dose of
the drug. The sick woman's husband, Heinz, went to everyone he knew to borrow the money, but
he could only get together about $ 1,000 which is half of what it cost. He told the druggist that
his wife was dying and asked him to sell it cheaper or let him pay later. But the druggist said:
"No, I discovered the drug and I'm going to make money from it." So Heinz got desperate and
broke into the man's store to steal the drug for his wife.
Should Heinz have broken into the laboratory to steal the drug for his wife? Why or why not?
Stage one (obedience): Heinz should not steal the medicine because he will consequently be put
in prison which will mean he is a bad person. Or: Heinz should steal the medicine because it is
only worth $200 and not how much the druggist wanted for it; Heinz had even offered to pay for
it and was not stealing anything else.
Stage two (self-interest): Heinz should steal the medicine because he will be much happier if he
saves his wife, even if he will have to serve a prison sentence. Or: Heinz should not steal the
medicine because prison is an awful place, and he would probably languish over a jail cell more
than his wife's death.
Stage three (conformity): Heinz should steal the medicine because his wife expects it; he wants
to be a good husband. Or: Heinz should not steal the drug because stealing is bad and he is not a
criminal; he tried to do everything he could without breaking the law, you cannot blame him.
Stage four (law-and-order): Heinz should not steal the medicine because the law prohibits
stealing, making it illegal. Or: Heinz should steal the drug for his wife but also take the
prescribed punishment for the crime as well as paying the druggist what he is owed. Criminals
cannot just run around without regard for the law; actions have consequences.
Stage five (human rights): Heinz should steal the medicine because everyone has a right to
choose life, regardless of the law. Or: Heinz should not steal the medicine because the scientist
has a right to fair compensation. Even if his wife is sick, it does not make his actions right.
Stage six (universal human ethics): Heinz should steal the medicine, because saving a human life
is a more fundamental value than the property rights of another person. Or: Heinz should not
steal the medicine, because others may need the medicine just as badly, and their lives are
equally significant.
Approaches to ethics
1. Deontological approach:
a) is an approach to ethics that focuses on the rightness or wrongness of actions themselves,
as opposed to the rightness or wrongness of the consequences of those actions
b) It is sometimes described as "duty"- or "obligation"-based ethics, because deontologists
believe that ethical rules "bind you to your duty.
c) Action is only right or wrong when morals for taking the action are known
d) For example to end starvation, someone may suggest to kill all people.
The Divine Command Theory (The most famous deontological theory)

In his theory, Kant claimed that an action is morally wrong if it is inconsistent with the status of a
person as a free and rational being, and that, conversely, acts that further the status of people as
free and rational beings are morally right. Therefore, Kant claimed, we all have a duty to avoid
the first type of act and perform the second type of act.

• Act only according to that maxim by which you can also will that it would become a
universal law. (exploitation of labor – managers in developed countries may not want
themselves to be exploited elsewhere)
• Act in such a way that you always treat humanity, whether in your own person or in the
person of any other, never simply as a means, but always at the same time as an end.
(child labor – right of children to safe upbringing being ignored)
• Act as though you were through your maxims a law-making member of a kingdom of
ends.
2. Teleological approach:
a) Teleological' theories are those that are concerned with outcomes or consequences.
b) The rightness of an action is determined by its consequences
c) A teleologist, explains the rightness of actions in terms of the goodness of the state of
affairs that occurs because of that action.
d) If some action genuinely brings about greater good in the world, then it is a right action,
and this rightness is independent of the nature of the action or the intentions of the
person carrying out the action.
e) As long as outcome is right, action itself is irrelevant
Egoism:
a) A view stating “what is best for me”? Egoist will pursue his own goal and interests
b) Egoist will also do what appears to be right in society
Utilitarianism
a) A view stating “what is good for most of people”?
b) Action is right if it does the greatest amount of good to greatest number of people
c) It is highly subjective, because it introduces concept of utility – economic value of action
International Accounting Education Standards Board ethics framework

There are four levels of learning to be imparted to accountants
a) Ethics knowledge: knowledge about fundamental theories, professional values, and
attitudes.
b) Ethics sensitivity: Application of ethics knowledge gathered in stage 1 to actual work
performed by accountants (using case studies)
c) Ethics Judgment: Application of knowledge and practical situations to form reasoned
judgments
d) Ethical behavior: explaining how an accountant should behave in different situations.
American Accounting Association Model

It is a framework within which decisions could be made
1) What are facts of the case?
2) What are the ethical issues in the case?
3) What are norms, principles, and values related to the case?
4) What are the alternative courses of action?
5) What is the best course of action consistent with norms, principles and values?
6) What are consequences of each possible course of action?
7) What is the decision?
Tuckers 5 question model: The decision should be

1) Profitable?
2) Legal?
3) Fair?
4) Right?
5) Sustainable or environmentally sound?

Social Responsibility:
a. Social responsibility is an ethical or ideological theory that an entity whether it is a
government, corporation, organization or individual has a responsibility to society.
b. This responsibility can be "negative," in that it is a responsibility to refrain from acting
(resistance stance) or it can be "positive," meaning there is a responsibility to act
(proactive stance).
c. It involves an idea that it is better to be proactive toward a problem rather than reactive to
a problem
d. While primarily associated with business and governmental practices, activist groups and
local communities can also be associated with social responsibility, not only business or
governmental entities. Social responsibility is voluntary; it is about going above and
beyond what is called for by the law (legal responsibility).
Businesses can use ethical decision making to strengthen their businesses in three main ways:
a) The first way is to use their ethical decision making to increase productivity.
This can be done through programs that employees feel directly enhance their benefits
given by the corporation, like better health care or a better pension program.
When the company is perceived to feel that their employees are a valuable asset and
the employees feel they are being treated and such, productivity increases.
b) A second way is by making decisions that affect its health as seen to those stakeholders
that are outside of the business environment.
Customers and Suppliers are two examples of such stakeholders.
For example, when people realized that some bottles of Tylenol contained cyanide they
quit buying Tylenol, stocks dropped and Johnson & Johnson lost a lot of money. But
they chose to loose even more money and announced a major recall of their product.
They lost money to be socially responsible, but in the long run they gained the trust of
their customers.
c) A third way that business can use ethical decision making to secure their businesses is by
making decisions that allow for government agencies to minimize their involvement with
the corporation.
For instance if a company is proactive and follows the EPA guidelines for admissions on
dangerous pollutants and even goes an extra step to get involved in the community
and address those concerns that the public might have; they would be less likely to
have the EPA investigate them for environmental concerns.
“A significant element of current thinking about privacy, however, stresses "self-
regulation" rather than market or government mechanisms for protecting personal
information”.
Most rules and regulations are formed due to public outcry, if there is not outcry there
often will be limited regulation.
Seven positions on social responsibility (Gray, Owen and Adams):

1) Pristine Capitalist: Needs of shareholders are most important, and company strives for
maximum profits.
a. There is no concept of CSR.
b. Business has no moral responsibility except to their shareholders
c. Share holders expect maximum profits
2) Expedients: Business needs some ethical guidance (legislative, or self-imposed)
a. Social responsibility is to the extent that it serves an interest to the business
b. Business cannot use resources without taking consideration on impact on society,
otherwise it will loose profits
3) Proponents of social contract: People give up some rights to receive
a. Decisions made by companies are justified if they serve public interest
b. Companies must serve requirements of society to some extent
c. Companies behave according to society's norm. If society wants more reporting
(through legislation), then company provides it.

4) Social ecologist: recognition of the overall concern for environment that companies have
caused.
a. Companies can help in eliminating the problems caused by them, if possible.
b. Policies and procedures change in areas where resources are used.
5) Socialist: Capital should not be allowed to dominate society and human life, and its
influence should be decreased.
a. Change the system where capitalists manipulate resources (workers) & make profit
b. Economic system becomes secondary objective, primary objective being welfare
6) Radical feminist: Business run on masculine views (aggression, achievement).
a. Introducing feminist views of compassion, co-operation
b. Radical change in the structure of society in order to move to feminist views
7) Deep ecologist: Human beings do not have more rights to resources than other life forms
a. Environmental considerations have to be accounted for
b. Business cannot run if it destroys environment
Short term shareholders interest:

Business to provide annual return to shareholders
Small shareholders require annual dividend
Large shareholders may be interested that business retain its earnings to expand, and
provide long term capital growth
Long term shareholders interest:

The business continues and expands
Long term shareholders are also concerned with security of their investment
Multiple stakeholder obligations:

Organizations need to involve all stakeholder groups in decision making
This may create a conflict situation, as different stakeholders will have different
priorities. (employees want more benefits, at the cost of shareholders profits)
Involving stakeholders will create a pressure on the organization to meet their
obligations
Shaper of society:
Businesses have power to change society by applying their positioning power (increase
in fast food chains have changed eating habits)
Individuals cannot change society by themselves, however they can exert force if they
act in a group.
Organizations must strive to improve the society (R&D in solar powered cars).
Cultural context of ethics and CSR:

The extent of application of ethics and CSR varies according to society's culture
a) Economic considerations:
i. These relate to ability of organization to stay in business and give returns
ii. In some countries emphasis is on profitability and interest of shareholders
iii. In some countries, loss making companies may be bailed out by
governments in the interest public
b) Legal considerations:
i. An organization will follow the laws of the jurisdiction in which it operates.
ii. In some countries, government role is minimized, giving wider liberty to
organizations to operate
iii. Some governments impose laws even when they are perceived to be
excessive (minimum wages, working hours)
c) Ethical considerations:
i. It is what society expects from the organizations
ii. In some countries businesses are perceived to operate ethically

iii. In some countries environmental activists and consumer societies are very
active and vocal
d) Philanthropic:
i. These are activities which organizations do because they believe it will be
for welfare of people
ii. In some countries individuals and organizations have shown big
philanthropic acts
iii. In some countries, governments provide funding for most of the welfare
schemes (partly due to large tax collections)
Profession:
It is an occupation, vocation or career where specialized knowledge of a subject, field,
or science is applied
It is usually denoted to occupations that involve prolonged academic training and a
formal qualification
Professions are usually regulated by professional bodies that may set examinations of
competence, act as an licensing authority for practitioners, and enforce adherence to
an ethical code of practice.
Professions are at least to a degree self-regulating, in that they control the training
and evaluation processes that admit new persons to the field, and in judging whether
the work done by their members is up to standard.
This differs from other kinds of work where regulation (if considered necessary) is
imposed by the state, or where official quality standards are often lacking
A profession tends to dominate, police and protect its area of expertise and the
conduct of its members, and exercises a dominating influence over its entire field
which means that professions can act monopolist
Professional:
It is a worker required to possess a large body of knowledge derived from extensive
academic study (usually tertiary), with the training almost always formalized.
Professionals usually have autonomy in the workplace—they are expected to utilize
their independent judgment and professional ethics in carrying out their
responsibilities
This holds true even if they are employees instead of working on their own. Typically a
professional provides a service (in exchange for payment or salary), in accordance
with established protocols for licensing, ethics, procedures, standards of service and
training / certification.
Public interest:
The public interest refers to the "common well-being" or "general welfare."
While nearly everyone claims that aiding the common well-being or general welfare is
positive, there is little, if any, consensus on what exactly constitutes the public
interest.
There are different views on how many members of the public must benefit from an
action before it can be declared to be in the public interest
It is also possible that in some cases advancing the public interest will hurt certain
private interests.
There is risk of "tyranny of the majority" in any democracy, since minorities' interests
may be overridden.
One view is that individuals are free to act, as long as they do not harm others
Actions of a majority of shareholders may affect the minority shareholders
Actions of the organization itself may harm the public i.e. pollution

Influence of Accounting as a profession

Overall influence of accounting is limited to:
a) Extent of organizational reporting
b) Conflicts of interest between accounting firms in selling their services
c) Long term relationship with client
d) Overall size of the accounting firms
e) Focus on growth and profit
Accounting is seen in the society as a profession involved with accountability

a) Accountants are not seeking new methods of fulfilling the accountability role
b) Profession has various barriers to new initiatives
i. Accountants are rule followers, rather than rule makers (they serve
capitalists – by checking their financial numbers according to a set of rules)
ii. Education is geared towards explaining rules, rather than finding faults
iii. Accountants employed by organizations are constrained by their employers
(discouraged from undertaking those activities)
iv. Accountants enjoy the status-quo because breaking it may result in loosing
their position
v. Minority of accountants responsible for corporate scandals have implied a
lack of trust in the accountancy profession
c) In many situations accountancy does not require expertise in any specific field
d) Accountants should be involved in new initiatives because
i. They will be business opportunities
ii. They may compliment the existing skills of the accountants (i.e. MIS)
iii. Any development in accountability will be in public interest, and will
increase the public perception (image) about accountants
Provision of services may pose many ethical challenges such as:

• If organization is in financial difficulties, auditor needs to ensure that accounts do
not show a favorable picture
• Showing a negative picture (qualifications) may push organization into bankruptcy
• Not qualifying the report of the organization may still lead it to bankruptcy (slowly)
• Deciding on what type of modified report is to be issued is difficult
• Providing additional services may jeopardize independency of auditors
• Auditor may become too dependant on the fee from a single client
• It is cost beneficial (for shareholders) that auditor provides additional services
(because of his knowledge about clients business)
• Long term relationship with the client may cause familiarity to the audit firm, which
may increase detection risk
• Many countries limit length of time a audit partner can provide a specific service (5
years in USA, and 7 years in UK).
• Larger accountancy firms gain economies of scale, and reduce training and other
costs
• Large firms may not be able to provide personalized services to clients, and actual
quality of service may fall
• The big 4 audit firms are competitive, and attempt to reduce cost and increase
revenues, which may be detrimental to public interest
• Possibility of legal action inhibits cost cutting measures.
Influence of accounting – power and wealth

a) Accountants have specialist skills, which can be used in public interest
b) Society have an objective of distributing power and wealth, and accountants can assist
in fulfilling that objective
i. They can ensure that organizations disclose emoluments of directors (preventing
directors to give themselves large emoluments)
ii. Advising Government on tax regimes which are more equitable (lower taxes on
lower salaries)

iii. Advising on the contents of company law for increased creditor protection
Accounting and public interest

a) Accountants do not generally act against public interest
b) In some situations, lack of proper disclosure in financial statements may be against
public interest. For example, not providing information on illegal actions of the
company (ENRON) may allow actions to continue and harm public interest
c) In some situations disclosing too much information may be harmful to the public
interest, and keeping it confidential may be a requirement (disclosing price sensitive
information before it has been authorized to be issued)
d) Accountants need to evaluate each situation and act accordingly
Corporate ethics
• It includes many areas from board strategies to how company negotiates with
employees and suppliers
• Many companies provide details of their ethical approach in a CSR report
• Corporate ethics will cover the following
i. Purpose and value of business: it provides reason of continuing the business
(mission statement)
ii. Employees: policies regarding rights of employees in relation to working
conditions, recruitment, development and training, rewards, health and safety,
retirement, redundancy, and discrimination
iii. Customer relations: policies regarding responsibility towards customers (past,
current and future) in relation to product quality, pricing, after sales service
iv. Shareholders and investors: investors require a fair return on their investment
and the company must commit to provide timely and accurate information to
enable investors to make their decisions
v. Suppliers: policies relating to settling invoices, co-operating with suppliers to
maintain quality, not using bribery to secure contracts, and attempting selection
of suppliers on basis of ethical criterion i.e. 'not using child labor'
vi. Society / community: explaining in the CSR report how the company complies
with law, how it protects obligations relating to environment, policy on making
donations (to educational or charitable organizations)
Purpose of a code of ethics:

• Provides a framework for conflict resolution. It provides guidelines for settling disputes
• It is a code, therefore may be interpreted in different ways
• It may be ambiguous
• It may not provide effective punishment for breaching it
• Effective code has participation from all groups effected by it
• It has stringent disciplinary proceedings in case of breach
• Publicity is made for a disciplinary actions to deter other members from taking unethical
decisions

Professional codes of ethics

1. Professional bodies issue codes of ethic to be adhered by their members / students
2. These codes of ethics are constantly revised / modified
3. Professional codes are aimed to discourage members / students from indulging in
unethical practices
4. Incase where unethical practices are proven, disciplinary action is taken
5. Maintenance of professional code of ethics helps accountancy profession to be acting in
public interest
Contents of a professional code:

a) Introduction: Background / enforcement / who it affects
b) Fundamental principle: key principle to be followed by members / students
c) Conceptual framework: how principles are to be applied / spirit of the principle
d) Detailed application: examples / scenarios
Fundamental Principles:
1. Integrity: straightforwardness / honesty / fair dealing / not misleading
2. Objectivity: unbiased / not involving conflict of interest
3. Competence: Professional knowledge / skills. Due care
4. Confidentiality: information of clients not to be disclosed without authority
5. Professional behavior: comply with laws / regulations, avoid actions to discredit
profession (marketing, treating people with courtesy)
These principles apply to all members (whether in industry or practice)
Conflict of Interest:
1. Framework is needed because it is impossible to define all situations where threats to
fundamental principles exist
2. Different assignments create various threats requiring mitigating actions
3. Framework uses guidance (principles based) to identify threats
4. This approach is preferable to rules based approach
5. where conflict arises in application of fundamental principle, code of ethics provides
guidelines on how to resolve those conflicts
Potential threats
1. Self-interest Threats: where financial interest is involved

• Direct financial interest in clients business
• Loan or guarantee to or from audit client or any of its directors/ officers
• Undue dependence on total fee from an audit client
• Concern about possibility of losing the engagement
• Potential employment with the audit client
• Contingent fees relating to audit engagement
2. Self review threats: where auditor reviews a matter which he was previously responsible
• Member of audit team being a previous director, officer or an employee of the audit
client and is in a position to influence the engagement
• Performing services for an audit client which affect the current engagement
• Preparing original data used to generate financial information or preparing other
records
3. Advocacy threats: where auditor is perceived to promote interests of the client
• Dealing in shares, or other securities of the client
• Acting as advocate on behalf of client in a litigation or in resolving disputes
4. Familiarity threats: where auditor has a close relationship with the client
• A member of audit team having a close family member who is a director, or officer
of the client
• A former partner of the firm being director or officer of the client
• Long association of a senior member of the team with the audit client

• Acceptance of gifts and hospitality form the audit client or its directors
5. Intimidation threats: where auditor receives some sort of threat
• Threat of replacement over a disagreement
• Pressure to reduce extent of work to be performed in order to reduce fee
• Dominant personality in a senior position, controlling dealings with the auditor
Conceptual Framework
a) Provides initial set of assumptions / values / definitions which are agreed upon by
all stakeholders
b) It is easy to understand
c) Provides generalized guidance
Ethical conflict resolution:

1. Obtain facts about ethical issues
2. Obtain understanding of relevant fundamental principles
3. Obtain knowledge about alternate courses of action available
4. Consider consequences of each course of action
5. Consider consultation:
a. From colleagues with more experience
b. With those in charge of governance
c. Advice from professional body
6. Decide the best ethical course of action (including withdrawing)
Ethical Threats: situation where a person / organization is tempted not to follow code of ethics
a) Requirements of employer to act contrary to rules / regulations
b) Pressure to prepare false / misleading information
c) Employee misleading his employer about his level of expertise / experience
(including time planning)
d) Employee or his close family members holding financial interest in the company
e) Incentives (inducements) offered to encourage unethical behavior
f) Pressure on employee to offer inducements to other accountants / employees
g) Pressure on employees to disclose confidential information
h) Whistle blowing situations
Ethical Safeguards: provides guidance to remove ethical threats

a) Professional knowledge
• Education / Training / CPD
• Corporate Governance regulations
• Monitoring of work / Quality Control
b) Work environment
• Internal Control System
• Review / Monitoring procedures
• Disciplinary procedures
• Organizational code of ethics
• Risk procedures
c) Individuals (staff)
• Mentoring
• Recording contentious issues
• Professional standards
Threats to independence: (including, not limiting to)

1. Financial Interest (holding shares / substantial fees from one client)
2. Close family members
3. Self interest threats
4. Overdue fees
5. Gifts / bribes
6. Self review (being on board of an assurance client)

Ethical Decision Making (Kohlberg's theory):

1. Recognize moral issue (lying about product will increase sales)
2. Make moral judgment ( lying is wrong)
3. Establish Moral Intent (decide to be honest)
4. Engage in moral behavior (tell the truth)
Moral decisions will depend on:

a) Individual factors i.e. gender / age / experience
b) Situational patterns: causes which make individual decide to do something
Issue related factors:

a) How important is the decision to the decision maker
b) The higher importance, higher chance of making an ethical decision
Moral intensity:
1. Concentration of efforts: how many people are affected by the decision
2. Proximity: Relationship between decision maker and the people who are affected
by his decisions
3. Timing: How soon the consequences of decision will arise
4. Magnitude: what will be the magnitude of consequences of the decision
5. Consensus: How other people perceive the decision to be
6. Probability: likelihood of the consequences happening in result of the decision
Moral framing: How the issue is related to the work force

• Use of moral words (integrity, honesty, lying, stealing)
• 'Toning down' the impact of ethical decisions
Context related factors

a) System of rewards and punishment: rewards based on achievements
b) Authority: junior managers follow instructions
c) Bureaucracy: employee follow rules, and seldom thinks of consequences
d) Work roles: job position expected to have integrity (internal audit)
e) Organizational group norms: culture of the organization
f) National context: culture of the society
Economic activity:
1. Social footprint: sustainability in three areas is measured
a. Social capital: social network and mutually held knowledge
b. Human capital: Individual skills and knowledge
c. Constructed capital: physical infrastructure
2. Environmental footprint: measures sustainability in terms of:
a. Resources consumed by the company
b. Harm brought to environment due to pollution by the company
Environmental reporting
a) Resource consumption and pollution should be measured (quantitatively or
qualitatively)
b) Transparency, openness and responsibility dictates that environmental footprint
should be measured and reported
c) External stakeholders should be aware of the impact on environment by the
company
d) Investors should be aware of the potential loss arising from environmental
legislation happening in future
----- The End -----

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Paper P1 Haroon Tabraze

There are two problems in such a delegation.

Agent: is employed by Principal to manage the company (management)

Fiduciary: The person on whom duty is imposed is called 'fiduciary

Haroon Tabraze www.ca.com.pk Page 1

Principal Agent Relationship:

The relationship works because:

Certain aspects of monitoring may also be imposed by legislative practices. In the UK

How to control Agency problems:

Haroon Tabraze www.ca.com.pk Page 2

Holding regular meetings between stakeholders

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Directors and Board of Directors

Board of Directors can exercise their powers in meeting of BOD

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The Combined Code states:

1. Every company should be headed by an effective board, which is collectively responsible

Haroon Tabraze www.ca.com.pk Page 5

Non Executive Directors (NED's)

People Role: Appointment, remuneration, appraisals of senior management, succession planning

Lack of unity and trust can put pressure on board operation.

1. The board should not be so large as to be unwieldy.

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Chairman and chief executive

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Information and professional development of Directors

Performance evaluation of Directors

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Nomination Committee is a Board committee. Board delegates certain responsibilities to its

1. A majority of members of the nomination committee should be independent NED.

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Duties of the nomination Committee

The committee should make recommendations to the board:

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The Nomination Committee is authorized by the Board to:

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Service Contracts and Compensation

• The remuneration committee should carefully consider what compensation commitments

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Purpose of the remuneration system:

Remuneration should be sufficient to:

Linking remuneration to company strategy:

Performance related elements (bonus, incentives):

Shares / share options:

Regulatory issues (UK Directors Remuneration Report Regulation 2002):

After the high profile corporate scandals:

Haroon Tabraze www.ca.com.pk Page 14

Corporate Governance is:

Purpose of Corporate Governance:

Responsibility: willingness to accept liability on decisions made, defining clear roles

Accountability: Developing risk management and control systems

Reputation: developing personal reputation, reputation of company and reputation of profession

Haroon Tabraze www.ca.com.pk Page 15

Corporate Social Responsibility (CSR) is a concept which encourages organizations to

Companies complying with good CSR practices:

Motivation for companies to act in relation to concern of stakeholders:

Impact on Corporate Governance:

Ownership and property:

Shareholders are owners, but company is a separate legal entity

Shareholders are responsible for company's action to a small extent:

Haroon Tabraze www.ca.com.pk Page 16

Disclosure and communication to shareholders