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ACCA

Paper P1

GOVERNANCE, RISK
AND ETHICS

“Challenges are what make life interesting and


overcoming them is what makes life
meaningful.”
Joshua J. Marine
PAPER P1
GOVERNANCE, RISK AND ETHICS
ACCELERATED REVISION NOTES
Copyright © 2015 by Globaltraining

All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval
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Table of content

CHAPTER 1 | Theory of Governance ............................................................. 4


CHAPTER 2 | Development of Corporate Governance .................................. 6
CHAPTER 3 | The Board of Directors ............................................................ 6
CHAPTER 4 | Directors' Remuneration ......................................................... 9
CHAPTER 5 | Relations with Shareholders and Disclosure .......................... 9
CHAPTER 6 | Corporate Governance Approaches ...................................... 10
CHAPTER 7 | Corporate Social Responsibility & Corporate Governance ... 11
CHAPTER 8 | Internal Control Systems ...................................................... 12
CHAPTER 9 | Audit and Compliance ........................................................... 13
CHAPTER 10 | Risk and the Risk Management Process............................. 14
CHAPTER 11 | Controlling Risk ................................................................... 14
CHAPTER 12 | Ethical Theories .................................................................. 16
CHAPTER 13 | Professional and Corporate Ethics ..................................... 17
CHAPTER 14 | Ethical Decision Making ...................................................... 18
CHAPTER 15 | Social and Environmental Issues ........................................ 19

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Corporate Governance
This concerns the way that a company is
operated and directed and in particular
encompasses the operation of the board and
audit committee, as well as the overall control
and risk management
Directors – The Board Shareholders - Communication
Directors – Remuneration

Accountability & Audit

Syllabus Issues: Board Committees

Governance & Responsibility


The Key
Components Approaches
of
Governance Agency Relationships & Theories

Board of Directors

Board Committees

Corporate Social Responsibility

Control Systems

Control Audit and Compliance


Key Issues
Management Info. Systems
Drawn From C.G

Risk Management

Ethics

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Chapter 1 A
Theory of Governance

Definition:
CG is the system by which companies are directed and controlled in the interests of the
stakeholders.
It is the relationship between the directors, the shareholders and the other stakeholders. It
provides structure through which the objectives of the company are set, the means of
achieving them and monitoring performance.

Why do we need Corporate Governance?

 To increase accountability
 Improve management and therefore improve performance

Purpose Objectives

- monitor the directors - improve accountability and shareholder


value
- balance of power - control the controllers
- fair remuneration - increase transparency and confidence
- auditor independence - build control
- risk management - run in an ethical manner
- ethics

Concepts of CG:

 Fairness
 Openness / Transparency
 Independence
 Responsibility
 Accountability
 Reputation
 Judgment
 Integrity

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Chapter 1 B
Theory of Governance

Agency Relationship:

It is a contact under which one or more persons (the principals) engage another person (the
agent) to perform a service on their behalf that involves delegating some decision-making
authority to him.
It is the result of the separation of ownership and control.
An agent has a fiduciary duty because he is in a position of trust and confidence. This duty
requires full disclosure of information held by the fiduciary, a strict duty to account for any
profits and a duty to avoid conflict of interests.
An agent is accountable to the principal. He is accountable to act in the shareholders’ interests,
provide good information and operate within a legal structure.
Agency Costs:
They arise from the attempts of the principal to monitor the activities of the agent. Examples
are:

 Residual loss
 Incentive schemes and remuneration packages
 Cost of management providing reports
 Activity of commissions
 Cost of meetings with shareholders
 Directors accepting higher risks

How can the problem be resolved?

- profit related pay


- share issue / share options
- meetings with institutional investors
- voting at the AGM
- proposing resolutions for vote
- selling of the shares

TRANSACTION COST THEORY


When a director is trying to make a decision, his analysis of the costs will be limited by his
bounded rationality and opportunistic behaviour.
STAKEHOLDER THEORY
The company has corporate accountability to a broad range of stakeholders.

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Chapter 2
Developments of Corporate Governance
UK APPROACH=
Cadbury, Greenbury, Hampel Committees, Higgs, Smith and Turnbull Reports, the Combined
Code (CC), Tyson.
Reasons for development of the CC:
Reduces fraud, corruption, improves perception, investors pay a premium for Cos with CG
Problems with the development of CC:
Reactive and not proactive, impact on companies varies, adds bureaucracy, does not add
value, cannot stop fraud
Insider-dominated systems/ relationship based systems=
Companies listed on the stock exchange but owned and controlled by a small number of major
shareholders.
Advantages: ties between owners and managers, fewer agency costs, lower cost of capital,
no short-termism
Disadvantages: No minority protection, unclear operations and no transparency, misuse of
power, not monitored effectively by banks and shrs, no formal CG structure, no proper NEDs
Outsider Systems=
Where shareholding is more widely dispersed and there is the manager-ownership separation.
Advantages: robust legal and governance regimes, shrs can use their votes
Disadvantages: agency problems, shrs may have short term priorities

Chapter 3 A
The Board of Directors
The roles and responsibilities of the Board of Directors are:

- entrepreneurial leadership
- represent the co to the public
- decide on matters reserved by the board
- determine the co’s mission and strategy
- appoint CEO, Chairman and members of the Board
- set the Co’s values
- ensure management is performing
- establish internal controls
- assess the risk
- assess its own performance
- submit for re-election every 3 years
- appoint NEDs

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- establish remuneration, nomination and audit committees
- manage conflict of interests
Potential Problems:

- boards rely on the management to report information to them


- meet only occasionally
- CEOs are often dominating
- CEOs performance is judged by those that appoint him

Two tier Board


Management Board and Supervisory Board
Advantages:
Clear separation, wider stakeholder involvement, independency of thought, direct power over
the management, effective guard against management
Disadvantages:
Dilution of power, isolation, agency problems between the 2 boards, bureaucracy, confusion
over authority
Unitary Board
Advantages:
NED expertise and empowerment, included in decision making, reduction of fraud and
malpractice, facilitates co-operation
Disadvantages:
NEDs are both managers and monitor the management, time requirements for NED, no
provisions for employee representation.
NEDs:
Half of the members of the Board must be NEDs

Role: strategy, scrutiny, risk and remuneration, appointment and removal of managers
Advantages: external experience and knowledge, wider perspective, comfort factor for 3rd
parties, dual role (members of the Board and independent), improve communication,
compliance with CG.
Problems: lack independence, prejudice against appointing NEDS, well known NEDs attracted
to the best-run companies, may have difficulty imposing their views, their time is limited, may
weaken the board’s unity
Not Independent if:
Receive other remuneration, close family ties, significant shareholding, more than 9 yrs on the
Board, joint-directorship, employees in the last 5 yrs, and material business relationship in the
last 3 yrs.

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Chairman’s Role:
Runs the board, ensures the Board receives information, effective communication, time is
allowed for discussion, induction programme, board appraisal, meeting with NEDs, signs off
accounts
CEO’s Role:
Develops and implements policies, fully accountable, manages resources, builds effective
management team, systems in place, monitors operations, represents the company
Reasons for splitting the role:
Chairman represents the shareholders with no conflict of interest, accountability, temptation,
demanding roles

Chapter 3 B
The Board of Directors

Why have committees?


Reduces board workload, expertise can be used, things taken seriously
Nomination Committee (Chapter 3B) – Higgs Report:
Majority NEDs, chairman should chair the committee, review the structure, size and
composition, succession planning, balance of skills, knowledge and experience, description
of the role, identify and nominate candidates.
Risk Committee (Chapter 11) - Turnbull:
Develop risk awareness, ensure compliance, control risks, review audit findings, make
recommendations
Remuneration Committee (Chapter 4):
Determine directors’ remuneration packages
Audit Committee (Chapter 9) – Smith Report:
Direct the work of internal auditors and communicate with external auditors
Board Evaluation:
No member of the board should evaluate himself. The chairman together with NED’s evaluates
the Executive Directors, NEDs and shareholders evaluate the chairman, the chairman and
Senior Independent Officer evaluate NED’s.

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Chapter 4
Directors Remuneration

Remuneration Committee:
Arrange remuneration that attracts, retains and motivates directors to achieve the long-term
incentives, decide on the general and specific remuneration packages, transparency, and
remuneration of senior managers as well, agree compensation of loss of office, considers the
balance of NEDs and the diversity of the board
Remuneration:
Purpose: attracts, recruits, retains, motivates
Components: basic, bonus, share options, pension contributions, other benefits
Pay levels are set according to: the job, the skills, performance, contribution in strategy, market
rates

Chapter 5
Relations with the Shareholders and Disclosure

Disclosure:
- information about the Board: composition, independence, frequency and attendance of
meetings
- reports on the committees: remuneration, composition, frequency of meetings
- relations with auditors
- directors’ statement
- statement on the relation with shareholders
- going concern statement
- sustainability reporting
- OFR
Reasons for voluntary disclosure:
Attracts investment, compliance, assurance,

Shareholder intervention:
When? Concerns about strategy, poor performance, domination of management, failure in
internal controls, failure to comply with the laws, excessive remuneration, poor attitudes
towards CSR

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General Meetings:
AGM: once a year, required by law, separate resolutions, 21 days notice, accounts are
approved, 1st AGM must be held the first 18 months and no more than 15 months must pass
from each meeting
EGM: not mandatory, 14 days’ notice, no set agenda

Proxy Voting:
Disclosure: number of shares, number of votes, number of votes for and against and votes
withheld

Chapter 6
Corporate Governance Approaches

Principles Based Approach:


Characteristics: focus on the objectives and not the mechanisms, ‘comply or explain’ basis
Advantages: not inflexible like legislation, less time and money is spent, companies develop
their own approach, companies have the choice and can explain their reasoning, and it is up
to the investors to decide to invest or not.
Criticisms: very broad and little guidance, confusion as to if it is compulsory or not
Rules based Approach:
Characteristics: a set of detailed legislation
Advantages: Clarity, no leeway, standardized for all firms therefore fairer, sanctions for non-
compliance
Criticisms: rigid, must follow and not want to follow, no room to maneuver
THE SOX ACT=
Auditor Independence – no extra services
Audit committee – must have one. 3 NEDs
Public Oversight Body – setting standards
Internal Control Report – must be audited
Increased Disclosures
Whistle blowing provisions
Key effects of SOX:
Personal liability for directors, improved: communication with shrs, perception, internal control,
external audit, governance. Fairer relations

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Criticisms of SOX:
Costs of documenting internal controls, no extra services for auditors led to doubling the audit
fees, reduced flexibility and responsiveness.
The OECD Guidance=
CG structures should be credible and understood across the national borders. The principles
of OECD are not binding. It deals with fair treatment of all shareholders, the rights of shrs,
disclosure and transparency and Board responsibilities.
The ICGN
It tries to enhance the guidance of OECD and to provide practical guidance. It deals with
issues like the Board (structure, skills and committees), Shareholders, audit and ethics.
The contribution of the international codes:
They highlight the significance of CG, emphasise the dangers, provide benchmarks and
promote specific good practice.
Limitations:
Represent the absolute minimum, no legislative power

Chapter 7
CSR and Corporate Governance

Carolls model of CSR:

 Economic responsibility
 Legal responsibility
 Ethical responsibility
 Philanthropic responsibility

1. Reaction
Strategies….
2. Defense
3. Accommodation
4. Proaction

Stakeholder classifications
1. Narrow vs Wide
2. Primary vs Secondary
3. Active vs Passive
4. Voluntary vs Involuntary

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Instrumental vs Normative views on Stakeholders (Donaldson and Preston)
Stakeholder Mapping (Mendelow)
- Mendelow’s Power Matrix (interest and power)

Chapter 8
Internal Control Systems

Internal controls = (Turnbull)


A management process.
It is the management of risks. It is about the achievement of objectives.
Internal Controls system =
A system of financial or other controls. The components are internal controls.
Internal Control and Risk Management are fundamental components of good corporate
governance. They are the responsibility of the board o directors.
However it is a process that must be present throughout the company.

Components of an Internal Control System (COSO Framework)

 Control Environment ( Attitude/ Actions/ Awareness)


 Risk Assessment
 Control Activities ( Supervision/ Authorisation/ Physical/ Segregation …)
 Monitoring
 Information Systems

ADEQUATE INFORMATION necessary by management.

Qualities:

 Timeliness Will depend on the level of


management and use of info.
 Objectivity
 Quantifiability
 Accuracy
 Certainty
 Completeness
 Breadth
 Details

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Chapter 9
Audit and Compliance

Internal audit =
A key reviewing and monitoring activity.
Undertaken by management
In large organizations the internal audit function will be a separate department.
Auditor Independence=
Equally important for external auditor and internal auditor.
Must Be And Be Seen To Be Independent!
Independence of mind
Independence of appearance
Potential risks if auditors not independent:

 Fail to report control breaches ( ignore discrepancies)


 Back down on matters of principle ( accept explanations without checking)
 Turn a blind eye to unethical practices ( give undeserved positive feedback)

Internal audit function INDEPENDEPENCE achieved by:

 Separation from senior management


 No connection to activities reviewed
 Communication
Threats to independence

 Self interest
 Self review
 Advocacy
 Familiarity
 Intimidation

Audit Committee = (Smith Guidance)


A committee of the board, consisting entirely of non- executive directors (at least 3 in larger
companies) of whom AT LEAST ONE HAS HAD RECENT AND RELEVANT FINANCIAL
EXPERIENCE.
Smith = the audit committee meet with internal auditors at least once a year, without
management present to discuss audit related matters.

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If the company does not have an internal audit function, the committee should consider
annually whether there is a need. AND. The reasons for the absence should be
explained in the annual report.
The audit committee should have annual procedures for ensuring the independence
and objectivity of the external auditors.

Chapter 10
Risk and the Risk Management Process

Turnbull Committee has identified risk management as key to effective internal control.
Risk Management =
The process of reducing the possibility of adverse consequences either by reducing the
likelihood of an event or its impact.
Process:

 Risk Identification ( Potential Risks)


 Risk Analysis ( consider impact and prioritise)
 Risk Planning ( strategy)
 Risk Monitoring (assess)

Why manage risk?

 To identify new risks


 To identify changes
 To ensure best use of opportunities.

Chapter 11
Controlling Risk

The RISK MANAGER is a member of the risk management committee.

Typical activities carried out by a risk manager:

 Identification and evaluation of risks


 Implementation of risk mitigation strategies
 Seeking opportunite8is to improve risk management strategies
 Monitoring the status of risk mitigation strategies
 Developing, implementing and managing risk management programmes
 etc

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The role of the Risk Committee
Risk Committee

Raise Risk Awareness Implement Update Company Risk


Processes to Profile and Appetite
monitor and
report risk

Embedding Risk in Systems =


Ensuring that risk management is included within the Control Systems of an organisation.

Embedding Risk in Culture =


This is affected by whether the culture is open or closed.

Necessity of Risk=
Incur Risk To

Increase
Gain Competitive
Advantage Financial Return

Risk Attitudes and the Organisation =

Risk Attitude Varies With Organizational

Size Structure Development

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Chapter 12
Ethical Theories

What is ethics? Concerned with right and wrong and how a conduct can be judged as good or
bad.
Relativism/ non-cognitivism: all moral statements are subjective. Many sets of moral riles,
different beliefs to everyone
Strengths: cultural differences, different people different morals due to different experiences
Weaknesses: some universal truths exist, leads to ‘anything goes’, no objectivity and final truth
exists
Absolutism: there are objective, unchanging, universally applicable truths. One set of moral
rules that never changes
Strengths: some absolute truths do exist, lays down clear rules
Weaknesses: no account for evolving norms, what is the source? What happens if 2 absolute
truths contradict?
Directors choose to interpret the rules in the light of relativism
Kohlberg’s Cognitive moral development theory:
It looks into how the decision is reached and not what the decision is.
1.1 Pre-conventional – Obedience and Punishment
1.2 Pre-conventional – Purpose and Exchange
2.1 Conventional – Interpersonal accord & Conformity
2.2 Conventional – Social accord and system maintenance
3.1 Post-conventional – Social contract & individual rights
3.2 Post-conventional – Universal ethical principles

Criticism:
Based on American males, based on k’s own moral values, it argues that it is the motivation
that is important and not the result, assumes that an action is decided after formal process of
reasoning, assumes that individual progress
Deontological Approach:
Concerned with the application of universal ethical principles. It does not look at the
consequence but at the principles for taking the action.
Kant’s 3 maxims:
1. act according to the maxim that can hold as universal law (principle of consistency)
2. Treat people as an end in themselves and not as a means to an end (Human Dignity)
3. Act as you were a law making member (principle of Universality)

Criticisms: must think of the consequences, people do not apply the principles to themselves

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Teleological Approach:
A consequentialist theory. As long as the outcome is right.
Utilitarianism: the greatest good principle. Not absolute
Criticism: very subjective, effect on minorities
Egoism: what is best for me. The egoist will also do what is right to the society because it
makes them feel better (the invisible hand)
Criticism: does not always leads to the benefit of the society, short-term desires= long-term
desires, ethics of the thief and short-termist.
Ethical education:
Ethical knowledge, sensitivity, judgment, behaviour
Tucker’s 5 question decision making model:
A decision must be tested and should be: profitable, legal, fair, right and sustainable
Gray’s 7 viewpoints on Social responsibility:
Pristine Capitalist, expedients, proponents of social contract, social ecologist, socialist, radical
feminist, deep ecologist
Variables of the cultural content of ethics:
Economic, legal, ethical, philanthropic

CHAPTER 13
Professional and Corporate Ethics

Corporate Ethics =
Applications of ethical values to business behaviour.
Many companies provide details of their ethical approach in a corporate and social
responsibility (CSR) report. Elements of the CSR Report: Purpose and values, Employees,
Customer relations, Shareholders and other providers of funds, Suppliers, Community,
Imlpementation.
Professional codes of Ethics =
Professional codes of ethics are issued by most professional bodies, the ACCA Code was
revised and re-issued in 2006.
Fundamental Ethical Principles =

 Integrity
 Objectivity
 Competence
 Confidentiality
 Professional behaviour

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Conflict of Interest =
Professional Code of Ethics

Conflicts of Safeguards Conflict resolution


interest
 Profession  Obtain all necessary
 Self-interest  Work environment Information.
 Self-review  Individual  Consider courses of
 Advocacy action
 Familiarity
 Intimidation

Chapter 14
Ethical Decision Making

The Four Stages of ethical decision making can be summarized as follows:


1. Recognize Moral Issue
2. Make moral Judgement
3. Establish Moral Intent
4. Engage in moral behaviour

Ethical decision making could involve (and vary) the following:


- Lying about products can increase sales
- Realising that lying to customers is wrong
- Decide to be honest
- Tell the truth

This will be affected by:


- Individual factors (unique characteristics of the individual making the decision)
- Situational factors ( particular factors in the decision area)
Decision Making Process of Kohlberg:
1.1 Pre- conventional – obedience and punishment
1.2 Pre-conventional – Instrumental purpose
2.1 Conventional- Interpersonal accord and conformity
2.2 Conventional – Social accord and system maintenance
3.1 Post conventional – Social contract and individual rights
3.2 Post- conventional – Universal ethical principles.

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Ethical Behaviour Depends on:
- Issue Related factors ( moral intensity/ moral framing)
- Context Related factors (rewards/ authority/ bureaucracy….)

Ethical Dilemma =
Rules-Based Approach

Principles-Based Approach

Most Professional Institutes Use This


Approach

Chapter 15
Social and Environmental Issues

Economic Activity =
Should consider
- The Social Footprint
- Sustainability
- The Environmental Footprint

EMS – Environmental Management System. This is a voluntary initiative of the organization


to create its own environmental system. This is based on guidance by ISO 14000.
EMAS – Eco-Management and Audit Scheme. This is a EU initiative to which the
organization can apply for certification after designing its own EMS.
Sustainability (Brundtland Commision Definition) – Utilising resources without compromising
the future generations’ ability to also enjoy these resources.
Mass balance: Quantifiable way of measuring sustainability.

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