2011

Jamaica Water
Properties
A Case Study

The case is about an accounting fraud that involves the Jamaica Water
Ararao
Properties, Inc. The fraud was characterized by misapplication of purchase
Campecino method of accounting for acquisitions, recording fictitious assets, improper
accounting for NOLCO, non-recording of appropriate allowances for uncollectible
Idong
receivables, and misapplication of the percentage-of-completion method of
accounting for long-term contracts. Ernest Grendi made the fraud possible,
company CFO as helped by three senior accountants. These were aimed to
inflate the price of the company stocks because of overstated earnings that
caused them to receive sizable bonuses. However, JWP internal auditors just
tolerated all of these because of their fear of being fired. In addition, Ernst &
 been issuing an unqualified opinion for six consecutive years. This has been seen
as a product of the close relationship between Grendi and his co-conspirators
with E&Y.

Table of Contents
List of figures.............................................................................................................................................4
CASE BRIEF...................................................................................................................................................5
Case Abstract...........................................................................................................................................5
JAMAICA WATER PROPERTIES: A Case Study
Auditors’ Dilemma...................................................................................................................................5
Auditors’ Questions.................................................................................................................................5
Research Questions.................................................................................................................................6
CASE CONTEXT ................................................................................................................................................7

I. Understanding The Entity....................................................................................................................7

A. Jamaica Water Properties Inc..............................................................................................................7
Origins.................................................................................................................................................7
Instability in the 1960s and 1970s.......................................................................................................8
Success in the 1980s............................................................................................................................8
Restructuring and Bankruptcy in the Early to Mid-1990s....................................................................9
Renewed Success in the Mid-1990s and Beyond...............................................................................10
B. The Entity and Its Environment.........................................................................................................12
Financing.........................................................................................................................................612
Investing............................................................................................................................................16
Regulatory Factors.............................................................................................................................18
II. Understanding the Industry...................................................................................................................23
A. The Utilities Industry.........................................................................................................................23
B. Utilities Industry and JWP Inc............................................................................................................24
The Water Utilities Industry...............................................................................................................24
Facilities Management Industry........................................................................................................26
Information Systems Industry............................................................................................................29
Energy Industry..................................................................................................................................31
CASE RESOLUTION.....................................................................................................................................36
RESEARCH QUESTIONS AND CORRESPONDING ARGUMENTS AND SOLUTIONS........................................36
General Responsibilities of Internal Auditor..........................................................................................37
Additional Higher Level of Responsibilities:...........................................................................................38
Duties of Internal Auditor in the Detection of Fraud.............................................................................39

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 Reasons for the Internal Auditors Tolerance to Grendi’s Malpractices.................................................40
Argument 1...........................................................................................................................................40
Grendi being the CFO of JWP must be obeyed...................................................................................40
Counter Argument 1..............................................................................................................................41
Confronted with this situation, the internal audit function should not be intimidated so since the
authority being granted to these key officials are not absolute.........................................................41
Argument 2............................................................................................................................................41
The employees are bound by their Duty of Confidentiality................................................................41
Counter Arguments 2............................................................................................................................42
Argument 3............................................................................................................................................42
Whistle blowing will result to the loss of job......................................................................................42
Counter Argument 3..............................................................................................................................43
Actions to be done to solve the ethical dilemma of whether to conceal the fraud or disclose it..........43
Responsibility of the Management in Fraud Detection.........................................................................44
Measures to Protect the Internal Auditors from Factors that may Adversely Affect the Quality of
Auditors.................................................................................................................................................44
Installation of a Corporate Structure emphasizing the vital role of the audit function.....................44
Establishment of appropriate and sufficient safeguards to reduce or even eliminate exposure to
threats...............................................................................................................................................46
Measures to Encourage Whistle Blowing..............................................................................................47
Protection from being fired or demoted and reinstatement.............................................................47
Compensation for loss of wage..........................................................................................................47
Compensation for costs of making the complaint and possible ensuing juridical procedures..........48
Establishment of Whistle Blowing System.........................................................................................48
Rewards for Whistle blowing.............................................................................................................49
Argument against Rewards....................................................................................................................49
Argument for Whistle Blowing Rewards................................................................................................49
CONCLUSION.............................................................................................................................................50
References:................................................................................................................................................52

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List of figure

Figure 1 Ideal Corporate Structure............................................................................................................45

List of tables

Table 1 General Responsibilities of Internal Auditor.................................................................................37

Table 2 Additinal Responsibilities of Internal Auditor................................................................................38
Table 3 Steps in Solving Ethical Dilemma according to American Accounting Association........................44

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CASE BRIEF

Case Abstract

The case is about an accounting fraud that involves the Jamaica Water
Properties, Inc.The fraud was characterized by misapplication of purchase
method of accounting for acquisitions, recording fictitious assets, improper
accounting for NOLCO, non-recording of appropriate allowances for
uncollectible receivables, and misapplication of the percentage-of-completion
method of accounting for long-term contracts. The fraud was made possible by
Ernest Grendi, company CFO as helped by three senior accountants. These were
aimed to inflate the price of the company stocks as a result of overstated
earnings that caused them to receive sizable bonuses. However, JWP internal
auditors just tolerated all of these because of their fear of being fired. In
addition, Ernst & Young, the company’s external auditor, knowing the
fraudulent activities, have been issuing an unqualified opinion for six
consecutive years. This has been seen as a product of the close relationship
between Grendi and his co-conspirators with E&Y.

Auditors’ Dilemma

JWP internal auditors:a

Their problem focuses on their duty as professional accountants.
Specifically, their problem is on their decision whether to conceal the anomalies
regarding the improper accounting treatments and stay with the company or
should they “blow the whistle” and be fired.

Auditors’ Questions

i. How can the internal auditors determine the appropriate course of

action to deal with threats to independence in the conduct of their
duties and responsibilities as internal auditors?

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Research Questions

i. What are the general responsibilities of internal auditors? In case of

detection of fraud, what are the duties of the internal auditors?

ii. What are the reasons why the internal auditor tolerated the accounting
malpractices of Grendi? What are the actions against the undue
influence of Grendi should the internal auditors have taken?

iii. What are the responsibilities of the management in fraud detection?

With these responsibilities what are the measures they have to take in
order to protect the internal auditors from factors that may adversely
affect the quality of their internal audit?

iv. What measures or controls must the top level management or even the
corporate board employ to ensure and encourage the knowledgeable
employees to “blow the whistle” regarding fraudulent activities?

v. As a way, is it appropriate for corporations and accounting firms that

they should explicitly reward ethical behavior by their employees and
executives? Why?

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CASE CONTEXT

I. Understanding The Entity

A. Jamaica Water Properties Inc.

Jamaica Water Properties Inc. is a transnational technical services firm that specializes in the
areas of systems engineering, facilities management, information systems, and environmental
management systems. JWP is involved in the construction, installation, and maintenance of cost-control
systems for Fortune 1000 companies, institutions, and governments. The firm has 220 offices worldwide
on all continents except Australia.

Begun in the mid-1960s as a water supplier to Long Island and Queens, New York, JWP
transformed itself through acquisition. By the start of the 1980s, JWP was the nation's largest
computer reseller and the biggest electrical and maintenance contractor. Essentially, clients use JWP to
help increase productivity and decrease costs by upgrading their facilities through, for example, more
efficient communication and computer systems. JWP designs, installs, and supports these technical
systems.,,

Through its myriad subsidiaries, JWP also contracts for general electrical systems, electrical power
systems, heating and air conditioniCONCLUSION

In this case, the internal auditors of Jamaica Water Properties, Inc. are caught in the dilemma of
whether to report the fraud that was authorized by the company CFO, which resulted to a major
disaster in the company, to the corporate board of directors (for them to be able to rectify and do some
correcting measures) or not by keeping silent regarding the matter, given the unfavorable consequences
that the internal auditors may face if they are going to disclose the fact to the corporate owners. The
dilemma was never easy for the auditors to deal with because of the fact that the fraud was committed
by a top company officer and was done for the benefit of the organization, though indirectly. And in the
end, the auditors just reported the said fraud when the company was already in great trouble.

Undoubtedly this audit case had put another page in the history of the internal auditing
profession marked with scandals due to unprincipled stands.

In the case of JWP, we believe that the roots of the predicaments include: the company’s poor
internal control structure, the company’s old form of organizational structure, the lack of a whistle-
blowing system in the firm and lastly the high level of trust put by the corporate owners to the company
CFO. All these contributed to the internal auditors’ difficulty in reporting the fraud to the owners.

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 In connection to the dilemma, solutions are available. And, we the researchers strongly pose
that solutions to this dilemma can be categorized into two, namely: solutions that can be established
throughout the company and solutions that can be applied by the auditors to themselves.

First, the company-wide solution is more of a preventive nature rather than as a cure. These
solutions can be established to reduce the company from risks of fraud and to help internal auditors in
the carrying of their function. This category includes all but not limited to the following: (1) shifting to
the modern and more effective form of organizational structure characterized by placing the internal
audit committee directly under the corporate board rather than putting them in the control of the
controllership function; (2) establishing of a whistle-blowing system that will help the employees in the
reporting of dishonest to the owners of the board and that will protect them from the threats modeled
by the their immediate superiors who masterminded such dishonesty to the firm; (3) instituting of a
reward system that will encourage the subordinates who are knowledgeable of deceitful acts committed
by their superiors whether they bring good or bad to the company as long as these are illegal and given
that the corporate owners are not aware of the said activities; lastly, (4) conducting a periodic follow
through or examinations of all the company transactions to determine areas that may bring the
company to difficulties and making immediate investigation for the firm to correct them as soon as
possible. Clearly the above-mentioned are more of a prevention but such can be of cure in nature if
these are done after a company realizes that something fraudulent or problematic is happening in the
organization.

On the other hand, solutions to the dilemma that are applicable to the internal auditors
themselves emphasize detection and correction. These answers are cultivated down to the standards of
practice for professionals that provide guidance in the performance of their duties and responsibilities.
The duties and responsibilities of internal auditors shown in Table 1 and 2 are already part of their
accepted profession which means that they are bound to exercise honesty and independence as part of
their work. Additionally, governing bodies have provided steps in solving ethical dilemmas such as the
one shown in Table 3. For sure, these will help the internal auditors in dealing with the problem. Lastly,
the internal auditors must always put in mind that they should not put their profession at stake by just
keeping themselves silent in the face of several devious activities in their environment. With this in
mind, aided with clean conscience, auditors are kept away from this kind of dilemma and they’ll be
reporting immediately to the higher authorities once they face such.

Delving closely to the most basic, the Institute of Internal Auditors define internal auditing as an
independent, objective assurance and consulting activity designed to add value and improve an
organization’s operations. It helps an organization accomplish its objectives by bringing a systematic,
disciplined approach to evaluate and improve the effectiveness of risk management, control, and
governance processes. This clearly says of the distinction of the internal audit profession from the rest
of the jobs in the business world. With this, the internal auditors of JWP, who became silent of the truth
for an unreasonable period, have broken this distinction making them just the same with the “non-
professional”, Ernest Grendi and the three senior company accountants.

As a generalization the researchers are certain that the fraud challenge represents opportunity
for internal auditors. An opportunity that is good if such trial is responded to in a manner that they can

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identify better and effective control recommendations that foster improved organizational processes
and operations leading to an eventual achievement of the corporate objectives as well as the fulfillment
of the auditors’ duties as professionals having the oath of integrity. And. Therefore David Sokol was right
when he said, “If you ever obtain something by lying, it’s worthless. Integrity is the highest order of the
day.”

herals, wire and cable lines, and telephone equipment, among other services. Its water systems
sales account for less than two percent of JWP's sales, while facilities management (66 percent) and
information systems (32 percent) dominate the company's business.

Origins
The JWP Inc. was launched as the Jamaica Water Supply Company and, for much of its early
history, was the primary provider of water to Nassau County, Long Island, and Queens, New York.
Gradually, the company expanded its geographic market and eventually became one of New York
State’s largest water utilities. The company thus functioned for many years as a regulated monopoly,
with low but stable profits and regulated prices. Prompted with this situation, in the mid-1960s, Martin
Dwyer, one of its top executives, decided to branch out into other businesses. Because of his familiarity
with governmental agencies, Dwyer began offering various contracting and construction services to local
municipalities. Soon, Dwyer’s company was installing telephone lines, working on street lighting
projects, and developing traffic control systems. Over the next several years, the company expanded
into other lines of businesses by acquiring a varied assortment of small firms in the New York City
metropolitan area. As it diversified its product lines, JWP experienced many ups and downs in its bottom
line.

Instability in the 1960s and 1970s

The company changed its name often between 1966 and 1986, the year it adopted the name
JWP Inc. This 20-year period was marked by extreme instability and not in name only. From 1966 to
around 1970, Jamaica Water Supply expanded by buying up other water companies. For example, in
1966 the firm acquired the entire capital stock of Sea Cliff Water Company. In 1968, they acquired most
(80 percent) of Orbit International Inc. of San Juan, Puerto Rico.

With this accumulation through acquisition of other water companies, the firm was ready to
make its first significant move out of the water business. Limited by public regulation, Martin Dwyer
sought to diversify into specialized construction, utility type operations, telephone systems, and electric
lighting. In support of this shift in business focus, the company's most significant move was its 1971
acquisition of the Welsbach Corporation, a Philadelphia-based electrical contracting concern. Welsbach
also installed street lighting and traffic control systems. Welsbach was merged into Jamaica Water, and
the company took on the name Welsbach in 1974. Welsbach had a profit of $659,000 in 1969 and thus
helped push Jamaica's bottom line out of the red. Jamaica's acquisitions throughout the late 1960s also
led the firm to take on an increasingly expanding stock of debt, and, with interest rates rising; the
company's cash flow was severely threatened. Combined with the severe recession of 1973 and 1974,
Jamaica went from a stable water utility company to near bankruptcy in the mid-1970s.

In 1978, Andrew T. Dwyer, the son of founder Martin Dwyer, was put in charge of the ailing
company. It took Dwyer and his associates several years to fend off complete collapse. They

9
restructured the cost structure of the company to increase cash flow, and in the process they lessened
some of the debt that was dragging down the company's growth prospects. To begin with, Dwyer sold
off many of the money-losing ventures, including many of the non-utility holdings. He also began a
complete retrenchment of the water utility component of the company, which at the time comprised 50
percent of the company's business, and set his sights on diversification, offering Jamaica's sophisticated
and technologically advanced plumbing and piping systems technology for other applications.

Dwyer's stated goal at the time was to transform the company once again, this time using its
already developed strengths in developing large computer systems, equipment, and office maintenance
as a base. He started development of heating ventilation and air conditioning systems maintenance and
other systems involved in operating high rise buildings in New York City. By the mid-1980s, Jamaica
maintained everything from electric signs in Times Square to printing presses at the  New York Times.

Success in the 1980s

This general strategy continued to yield positive results as the company adapted existing
technologies to diverse applications. The result was phenomenal growth for the company in the 1980s,
as the company once again completed a fundamental, and profitable, shift in its focus. Dwyer's first
specific target was the fastest growing segment of the economy in the 1980s, the financial services
sector. He aimed at providing all the technical services support required to create high tech and efficient
trading rooms for Wall Street giants such as Merrill Lynch & Co, Inc., including installation and
maintenance of air conditioning, telephones, wiring, cables, and computers. Clients also included
Morgan Stanley, Goldman Sachs, and Salomon Brothers. From here, the company branched out further,
installing energy management systems for Sears and computer rooms for Hewlett-Packard.

In the wake of these very successful endeavors, Dwyer's company won big contracts with
DuPont and also began providing services to hospitals and utilities, including Illinois Bell. One of the
largest deals was a six and one half year; $468 million contract to convert New York City's sludge to
fertilizer pellets to be marketed nationally. From solid waste management and conversion plants, the
company developed and marketed security systems and electrical networks. The company expanded
overseas during this time as well.

By now known as JWP Inc., the company grew not only in the rapidly expanding market for
technical services and the decentralized management style implemented by Dwyer, but also through
smartly managed acquisitions. Dwyer acquired Forest Electric in 1986 and Dynalectric in 1988 to
broaden the company's electrical services repertoire. The acquisition of University Industries in 1988 got
them into the West Coast mechanical services market. To crack the international market, JWP acquired
Drake & Skull Holdings, a British electrical and mechanical services company. Dwyer's JWP gobbled up
two dozen companies from 1984 to 1987, generating scale economies out of mergers and getting a jump
on the competition in the high tech end of the technical services industry.

The successes of these acquisitions were phenomenal. In fact, from 1980 until the end of 1991,
JWP enjoyed 48 quarters of uninterrupted growth. The company grew from 400 employees working out
of five offices in 1980 to over 21,000 employees in 195 offices in 1990. Successful diversification went
hand in hand with the company's move away from water sales as its dominant market. The stable water
sales, which made up over 50 percent of the company's total revenues in 1980, declined to less than 2
percent in 1990, while total net income grew from a loss of $495,000 in 1980 to $59.3 million profit in
1990. At the start of the 1980s, JWP was a $40 million water utility that had lost money for eight straight

10
years and was on the brink of bankruptcy. By 1990, the company was a $3 billion technical services
company. Compound growth from 1985 through 1989 was 179 percent, and JWP became the dominant
maintenance firm in New York. Sales from 1981 to 1986, for example, went from $42 million to $379
million, and net income rose from $1.7 million to $13.5 million.

With the company's expansion into high tech applications, JWP was increasingly getting into the
business of setting up computer systems. Thus, it was a natural outgrowth of the company to begin
selling the computers to its clients. In 1990, this new avenue of growth for JWP meant the purchase of
Neeco, Inc., a desktop computer systems sales company which operated out of Canton, Massachusetts.
In its most important recent acquisition to date, the firm bought Businessland in early 1991, a move that
was considered a natural extension of the firm's experience in selling electrical systems. This deal
pushed total revenues from $744.6 million to $944.9 million. From the Businessland acquisition, Dwyer
created JWP Businessland Inc., a division of JWP Information Services, which had sales of $1.8 billion
worldwide and which operated through its own retail outlets.

Restructuring and Bankruptcy in the Early to Mid-1990s

While the 1980s were a decade of unprecedented growth, the early 1990s saw near bankruptcy
and collapse. Contributing to the decline of JWP was a commercial construction slump, price wars,
intensified competition in the personal computer component of the business, and the burden of
servicing a huge debt accumulated during the boom years of acquisition in the 1980s. JWP's high debt-
equity ratio in particular (1.2 to 1) caused great concern. Profits fell to around $40 million for 1990 and
1991 as the company struggled through the recession that plagued those years. By the fourth quarter of
1992, however, losses were as great as $265 million.

The company's highly leveraged position threatened its very existence, prompting some drastic
action to restructure the company's debt. Meanwhile trouble brewed elsewhere. In April 1992, in their
water business, complaints about high rates charged for water were lodged against JWP's water
subsidiary, Jamaica Water Supply Company, which still served homes in Queens and Nassau County. JWP
planned to sell the unit as part of the corporate restructuring and not, they said, in response to the
consumer complaint controversy. The company put those plans on hold, however, in 1993.

In October 1992, David Sokol presented to the board evidence of what were alleged to be
widespread accounting improprieties, confirming the charges of shareholders, and then resigned as
president of the company. More restructuring decisions led to the sale of ten or more businesses,
including the sale of four environmental businesses to Wheelabrator Technologies Inc. for about $69
million, in order to raise $250 million as the company focused on its traditionally more lucrative
mechanical and electrical services. These moves helped raise needed cash to deal with the heavy debt
load, which at one point was said to be as large as $485 million.

As a major debt restructuring move, in July 1993 JWP sold its Information Services subsidiary to
an investment group in a deal releasing JWP from about $210 million of the company's more than $300
million in outstanding debt. In 1993, Andrew Dwyer resigned as chairman of the board of JWP, and
Edward Kosnik was elected to the post.
Expansion continued, notably on the international front; international operations generated
about $1 billion in revenue in 1992. Coupled with the debt restructuring, long-term growth prospects
brightened. In 1991, JWP acquired Comstock Canada, the largest Canadian electrical and mechanical

11
services firm, with 12 offices in Canada and $200 million in sales. Furthermore, the Businessland project
did business in Canada, the United Kingdom, Germany, and France, selling its interactive personal
computer system integrated to complement its international facilities management. JWP also expected
growth in new markets in transportation projects, pharmaceutical, and biotechnology facilities. The
most promising general source of demand for JWP's services lay in the fact that, in general, businesses
found it increasingly cheaper to outsource the kind of services that JWP provided.

Despite its demonstrated resiliency, JWP announced in October 1993 that it would file for
Chapter 11 bankruptcy protection, after nearly a year of negotiating a financial restructuring with its
creditors. Under the proposed debt restructuring and capitalization plan, JWP's creditors, a group of 50
bankers, insurance companies, and equity funds, exchanged $484 million of the company's debt for
$180 million of new debt and 100 percent control of JWP's equity. The new debt was to be paid from
the proceeds of asset sales.

Renewed Success in the Mid-1990s and Beyond

By early 1995, JWP had emerged from bankruptcy under the leadership of newly elected
chairman, president, and CEO Frank T. MacInnis. The company changed its name to EMCOR Group Inc.
to signal its focus on key business segments related to its electrical and mechanical construction
services. (EMCOR is a fusion of the words electrical, mechanical, and core.) Company headquarters were
moved from Rye Brook, New York, to Norwalk, Connecticut. In 1996, the firm sold its Jamaica Water
Supply unit, leaving behind the company that had originally provided the backbone for the business in
the 1960s.
EMCOR indeed turned over a new leaf with its reorganization and immediately began to reap
the benefits of its new, leaner, business structure. Over the next several years, the company secured its
position as a world leader in its market segments by diversifying its customer base in both the public and
private sectors as well as taking a conservative, long-term approach to business decisions. From 1995 to
2003, the company recorded 32 consecutive quarters of profits, a remarkable feat for any company,
especially one emerging from bankruptcy protection. According to a 2003  Fairfield County Business
Journal article, much of the company's success could be attributed to MacInnis, who "saved it from
going bust, and transformed it from an underdog to the number-two player in the industry--shifting the
company's primary business from water utility to electrical and mechanical construction and facilities
management."
EMCOR bolstered its holdings in 2002 with the purchase of 19 companies from Comfort Systems
USA, which gave it a foothold in the Midwestern U.S. construction and services industry. A second
purchase followed in December when the firm added Virginia-based Consolidated Engineering Services
Inc. to its arsenal. The deal secured EMCOR's position as the leading facilities management concern in
the United States. By now, the company's turnaround from the mid-1990s and its overall success had
garnered industry attention. In 2003 alone, EMCOR was named one of "America's Most Admired
Companies" by  Fortunemagazine, ranked 37 on  Barron's "Top 500 Best Performing Companies" list, and
awarded the Frost & Sullivan Competitive Strategy Award for its expansion efforts in the facilities
management services market.
The soft economy that continued into 2003, however, threatened to challenge the company's
financial achievements. Nevertheless, MacInnis and his management team remained confident that
EMCOR was on a path for success for years to come. Through its "growth through diversity" strategy--
which focused on broadening company services, branching out into new geographical areas, and moving
into new markets sectors--EMCOR appeared to be well positioned for future growth.

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Principal Subsidiaries
Aircond Corporation; BALCO; Betlem Service Corporation; Building Technology Engineers Inc.;
Combustioneer Corporation; Commonwealth Air Conditioning & Heating Inc.; Consolidating Engineering
Services Inc.; Duffy Mechanical Corp.; Dynalectric Companies; EMCOR Energy & Technologies Inc.;
EMCOR Facilities Services Inc.; F & G Mechanical Corporation; Forest Electric Corporation; Gotham Air
Conditioning Service Inc.; Heritage Mechanical Services Inc.; J.C. Higgins Corporation; Labov Mechanical
Inc.; Mandell Mechanical Corporation; Meadowlands Fire Protection Corporation; New England
Mechanical Services Inc.; North Jersey Mechanical Contractors Inc.; Penguin Air Conditioning
Corporation; Poole & Kent Northern Operations; Poole & Kent Southern Operations; R.S. Harritan&
Company Inc.; Trimech Corporation; Tucker Mechanical; Welsbach Electric Corporation; Comstock
Canada Ltd.; EMCOR Drake & Scull Group Inc. (U.K.).

Principal Competitors
Integrated Electrical Services Inc.;
Quanta Services Inc.

B. The Entity and Its Environment

Financing

Virtually all water-related activities, whether structural (infrastructure) or not (planning, data
collection, regulation, public education and so on), require money to develop, implement and carry out.
Even if all the necessary policies and laws are in place, lack of funding will bring necessary actions to a
standstill. Adequate funding and the willingness to invest in water management and infrastructure are
therefore major determinants of the availability of sufficient quantities of water of acceptable quality.

Although water is often described as a ‘gift of nature’, harnessing and managing water for
human and ecological needs entail financial costs. These costs are often widely ignored, underestimated
or underfunded. As result, important functions and assets are neglected and underprovided, while
existing assets and services deteriorate. Three functions are involved in water management, each with
associated costs:

• Water resources management and development, including watershed and river basin
development, storage, flood-risk management, environmental protection and pollution
abatement.

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 • Water services to municipalities and households, commerce and industry, agriculture, and
other economic sectors, including the costs of wastewater treatment, rehabilitation,
operations and maintenance and inadequate infrastructure.
• Integrative functions, such as water sector policy development, research, monitoring,
administration, legislation (including compliance and enforcement) and public information.

The costs associated with these functions are either capital (investment) costs or annual
recurrent costs, both variable and fixed. To function properly, the water sector must cover all costs – not
just those of major physical infrastructure – in a sustainable way. That means ensuring reliable,
predictable finance from government revenues (taxes), the sale of water services or long-term aid
commitments. Financing is often a limiting factor in effectively managing the water sector. The solution
is to focus not only on increasing flows of funds to the sector but also on achieving a realistic balance
between the demand for and supply of financing to ensure financial sustainability.

Demand for funds needs to be rationalized by developing realistic investment plans, minimizing
the recurrent costs of service delivery and ensuring the sustainability of water resources and the safe
and reliable delivery of services to maintain users’ willingness to pay. The logic differs for the three
sources of finance for the water sector. The rationale for local user financing is users’ consumption of
the resource and local authorities’ responsibility in most cases for the main decisions about water
services and tariffs. The rationale for national government finance is often the national or regional
benefits to be gained from managing the resource. Capital investment costs tend to be covered largely
by governments, except where assets are privately owned (for example, farmers w ho have their own
infrastructure). The international community provides mainly ‘catalytic’ funding to jumpstart projects,
which includes providing financial guarantees. Decisions made at the international and national
government levels are most likely to be outside the ‘water box’, while local user concerns more directly
address specific systems for water supply and sanitation.
Sources of financing

There are three sources of revenue for financing water supply and sanitation services:

• User tariffs, including payment for environmental services, which can include cross-subsidies
within the sectoror from other sectors (for example, electricity or other municipal services).

• Public expenditures funded by taxation.

• Transfers in the form of external aid, from official or philanthropic sources. External borrowing
(debt, equity and bonds, facilitated by risk-management instruments such as guarantees) can
help spread payments over time for large upfrontinvestments and manage the overall cost of
financing.

Reviewing and revising investment needs (the demand side of financing) by reducing costs are
as important in closing the financing gap as finding new sources of funds. The full cycle of expenditures
has to be considered, from operation and maintenance to technological choices about equipment and
its eventual replacement or upgrading. For example, improving collection efficiency and reducing
unaccounted for losses in distribution systems can make more water available for new consumers and
help fund operations. Demand-side considerations also include such underlying determinants as

14
coverage levels, services levels and environmental regulations. Fund disbursements can be accelerated,
so that disbursement delays do not cause new funding to be postponed. Inefficient budgeting and
budget allocation processes can lead to such disbursement delays. To ensure that funds are disbursed
more efficiently during the budget period, funds can be allocated to regions of a country or to local
authorities according to their relative capacity to implement projects. Finalizing the budget process
before the budget year starts makes it possible to begin disbursements in the first quarter of the year.

A strategic financial plan, based on an in-depth examination of all demand- and supply-side
aspects affecting the financing gap, will help ensure the financial sustainability o f projects. It will direct
investment choices towards the most financially and functionally appropriate processes and
technologies, thus maximizing benefits. And it will make projects more attractive to external financiers
by reducing the perception of risk. Many funds move through the water system but is used inefficiently.
Examples include high payments to informal providers outside the public networks, payments to corrupt
operators to obtain water from networks and large public subsidies that end up in the wrong hands.
Households spend large sums on coping strategies, such as time and money spent on alternative sources
of water and on household water filters.

Tariffs – pricing water and willingness to pay.

The obvious source of finance for the recurrent costs of water services is user charges,
supplemented by government subsidies. The continuing under pricing of water to consumers
encourages waste and use of water for low-value purposes in all sectors, depriving the sector of
essential funds. This is a major contributor to underinvestment in water infrastructure, management,
services, and imposes heavy costs on society. Maintaining the quality and reliability of services is
essential (box 4.4), even if there is a parallel push for increased access, since these characteristics affect
users’ willingness to pay. Transparency, accountability and operational efficiency in service provision are
also essential to user satisfaction. Affordability also needs to be determined. It is based on macro
affordability of
 of investment choices (driven by coverage, service levels, technology and other choices)
 the cost efficiency of service provision
 household affordability, determined by current expenditure on water and sanitation
services (including the hidden costs of securing access when people lack access to
formal services and the consequences of access to unsafe services)
 their willingness to pay for improved service levels.

Charging for water.

Although prices can be strong drivers of positive change in a well functioning economic system,
in practice,prices have had a relatively minor role in managing water demand. Many people are deeply
ambivalent about using water prices to manage water resources or are strongly opposed to pricing
water at the cost required to deliver it to consumers, especiallyin the politically sensitive segments of
agriculture and urban households. As a result, water is often grossly underpriced.
One survey of municipal water utilities in low-income countries found that 89% had no cost
recovery measures in place, 9% had partial cost recovery of operation and maintenance costs, and only
3% made any effort to recoup the costs of capital outlays.A common yardstick for assessing the
affordability of water charges for households is that payments should not exceed 3% (insome cases 5%)
of net household income. In practice, surveys show that in developed countries households connected

15
to urban public systems pay on average 1% of incomes on water bills, including the cost of sewerage,
which may be double that for water. Such an average is not a very reliable indicator, however, especially
given the wide variability among income levels in a country. Generally speaking, poorer groups tend to
pay a higher share of household income for water.
In developing countries, the picture is complicated by the widespread use of informal and
small-scale private water distributors charging full market prices; in these cases the poorest households
can pay 3%–11% of income on water. As recognition of this inequitable economic burden on the poor
has spread, pressure on governments and service providers has increased to ensure delivery of a
minimal supply of potable water to all households at a reasonable price.
Achieving this objective would require tariff rates based on a household’s ability to pay and
subsidies that cover the excess cost of service delivery for those who can least afford to pay.

Where pricing is used to cover water supply costs (for example, cities committed to water
demand management, private irrigation schemes, markets for irrigation water and penalties for water
pollution), it is an important driver of reforms.

Where prices cannot adjust to financial realities, stresses emerge as water shortages, water
waste, inefficient water use, adequate water infrastructure investments and poor water-related
services. Water quality may be inconsistent, and maintenance and rehabilitation of distribution systems
may be neglected. Capital investment may also be inadequate, resulting in the failure to develop
adequate water supply and sanitation services. However, even in situations where pricing is actively
used to cover water supply costs, the long history of water as a public good means that water prices
have been heavily subsidized by tax-fundeddistributions from individuals and corporations that may not
be direct beneficiaries of the services provided.

Government financing from public revenues.

The public sector accounts for more than 70% of investment in the water sector.34 There are
marked differences in how – and how much – governments finance and subsidize the water sector. In
many poor countries, where fiscal constraints are severe, water supply is only one of many priority
sectors that governments are under domestic pressure or international commitment to finance. Funding
for infrastructure has varied with economic development and urbanization. At earlier stages the central
government generally supports infrastructure provision through subsidies and administrative
assistance . As countries develop, the portion of central government support declines, and the cost of
environmental services is transferred to users, polluters and local governments. Some countries that
have benefited from debt relief or from the oil and commodities boom have transformed their public
finances, but this has not necessarily translated into improved water service provision. Several emerging
market economies, with large concentrations of poor, unserved populations, are in stronger budgetary
positions than they were a decade ago, though this is being placed at risk by the recent fluctuations in
the cost of oil, power and food and the global financial crisis, with subsidies rising accordingly. Improving
budgetary circumstances provide opportunities for increasing investments in the development of the
water sector.

Financing through external aid.

16
 Official development assistance from donor countries and multilateral donors to the water
supply and sanitation sector increased during the 1970s and 1980s but decreased during the 1990s, with
less aid for large infrastructure, before rising again in 2000.Support from multilateral agencies remained
relatively stagnant from the 1970s – when it was about the same as bilateral assistance – until about
2000, when both sources of financial aid began to increase. But it still remained substantially less than
official development assistance from bilateral sources. Leaders at the meeting of the G-8 in Evian,
France, in June 2002 made a commitment to give priority to the water sector. Official development
assistance increased substantially in the years immediately thereafter. While the amount going to the
water supply and sanitation sector increased, aid to the other water sectors remained relatively
unchanged (table 4.4). However, overall lending for water remained at less than 6% of total official
development assistance, and the share of total lending declined. External assistance from philanthropic
sources, such as foundations and religious groups, highlights an awareness of the importance of water
and sanitation. Although these funds are generally much lower than those from multilateral and
bilateral sources, a few of the largest foundations (for example, the Bill and Melinda Gates Foundation)
can rival some bilateral sources.

Recent financing initiatives – a new financing agenda

Over the last five years there have been several key initiatives on shaping the agenda of
international water financing, notably the World Panel on Financing Water Infrastructure (chaired by
Michel Camdessus), the Task Force on Financing Water for All (chaired by Angel Gurria) and the UN
Secretary-General’s Advisory Board on Water and Sanitation (UNSGAB). Financing Water for All, the
report of the World Panel on Financing Water Infrastructure, addresses the financial architecture of the
global water sector, including many proposals to improve its governance.35 The Gurria task force report
focuses on factors influencing the demand for finance and the scope for developing the financial
capacity of subnational entities.The UNSGAB stresses the importance of capacity building, especially in
local authorities, and inspired creation of the Global Water Operators Partnership Alliance for peer
group support.

Investing

Investment in water management capacity

The water sector has been plagued by lack of political support, poor governance, under
resourcing and underinvestment. These ills are manifested in non-transparency, lack of accountability,
unsustainable economics, high levels of unaccounted for water and low revenue collection. They have
led to infrastructure deterioration, the breakdown of services and ultimately customer dissatisfaction.
Figure 4.2 illustrates how this combination of factors creates a vicious cycle of low funding, weak
political support and poor service provision. Breaking this vicious cycle will require more than
investments in hardware.

17
 Investment is also required in the operation and maintenance of physical infrastructure so that
it meets appropriate standards and functions efficiently. Operations and maintenance are neglected
nearly everywhere in favor of new infrastructure investments, regardless of the country’s level of
development. In the United States bringing water supply and sewerage infrastructure up to current
standards will cost more than $1 trillion over the next 20 years, with hundreds of billions more required
for dams, dikes and waterway maintenance.15 The World Business Council for Sustainable Development
estimates that the total costs of replacing
ageing water supply and sanitation infrastructure in industrial countries may be as high as $200 billion a
year.16 Investment in physical infrastructure must be accompanied by the ‘soft’ infrastructure of
policies and legal systems (as described earlier) and human capacity.17 Yet much bilateral aid for
sanitation and drinking water fails to achieve a balance between soft and hard infrastructure .

In most urban public water systems charges often barely cover the recurrent costs of operation
and maintenance, leaving little or no funds to recover the capital costs of modernization and expansion.
A survey of such systems in 132 cities in high-, middle and low-income countries found that 39% did not
recover even their operation and maintenance costs (true of 100% of cities in South-East Asia and the
Maghreb).18 Moreover, water infrastructure deteriorates over time. To keep it functioning properly
requires routine repairs, service and replacement of worn parts. These activities, easy to postpone, are
widely neglected. T he result is infrastructure that deteriorates to a level that can no longer provide
reliable access to safe drinking water to those who are nominally receiving the service. Leakage (loss)
rates of 50% are not uncommon in urban distribution systems. Much of the apparatus for treating
wastewater is also failing.

According to a report by the Task Force for the Implementation of the Environmental Action
Program for Eastern Europe, Caucasus and Central Asia, municipal water utilities have now become the
main polluters of surface waters in many East European, Caucasus and Central Asian countries. The task
force reports that up to 90% of nitrogen and phosphorus discharges into the Black and Caspian Seas
originate from riverine inputs, which mostly transport municipal wastewaters.19 In rural areas neglect
of operation and maintenance budgets and cost recovery contribute to widespread non-functionality. A
recent survey of almost 7,000 rural water schemes in Ethiopia found that 30%- 40% were non-
functional.20 A shortage of finance for wages, fuel, materials and spare parts was a common factor.

The deficit in financing, especially for operation and maintenance costs, is a substantial addition
to the investment costs of achieving the Millennium Development Goals. Although governments often
turn to external aid to fill financing gaps, donors also seem to favour financing new infrastructure over
operation and maintenance.

High costs of new and remedial Infrastructure

While operation and maintenance costs have been especially neglected, water infrastructure
has not been funded at anything close to the required level. Many networks and installations in mature
economies are ageing and deteriorating. Member states of the European Union are committed to
upgrading their water and wastewater treatment systems to comply with EU environmental legislation.
But many urban water systems in Eastern Europe, Caucasus and Central Asia are in poor condition, with
no similar plans for upgrades. In developing and emerging market economies the pace of growth and
urbanization, combined with rising environmental expectations, is creating the need for costly new
investments.

18
The cost of new water supply is rising.

In developed countries and in many places elsewhere, the easiest investments for exploiting
water resources have already been made. With available dam sites decreasing, water tables falling and
the distances between the point of abstraction and water use increasing, the costs of exploitation and
supply are rising. Costs are also pushed up by the growing need to treat water before use.

Sanitation has been severely neglected.

Estimates of the cost of achieving the 2015 Millennium Development Goal target for sanitation
vary widely, due to differences in approach and a weak information base. The World Health
Organization estimates the total annual cost of meeting the targetat just over $9.5 billion. If estimates of
current costs are correct, resources in the sanitation sector would have to be almost doubled to meet
the 2015 target (although estimates of current spending probably underestimate the contributions by
households to their own sanitation services). If the full cost of tertiary wastewater treatment for waste
streams in urban areas is added, the total rises to $100 billion, the current value of total annual official
development assistance. More cost-effective alternatives need to be explored – urgently – if the
sanitation target is to be met.

UN-Water Global Annual Assessment of Sanitation and Drinking-Water: 2008 Pilot Report –
Testing A New Reporting Approach(GLAAS report) looks at the constraints to progress towards the
sanitation target from the human resources, institutional capacity and financial system capacity
perspectives. Operation, maintenance and rehabilitation remain critical challenges. Respondents to the
GLAAS survey indicated that flooding events and earthquakes were the main causes of damage to
infrastructure.Increased weather variability linked to climate change and armed conflict bring added
risk. African countries, recognizing the urgencyof the situation, signed the eThekwini Declaration in
February 2008 in Durban, South Africa, committing them to prepare or update national sanitation and
hygiene policies, allocate budget funds for sanitation, improve sanitation information and monitoring
tools and increase capacity. The declaration also called on external support agencies to provide financial
and technical assistance for sanitation and hygiene promotion and to improve aid coordination.

Regulatory Factors

International and regional water policy

International goals and objectives for water resources, negotiated at UN meetings, conferences
and summits or in ministerial-level sessions of the World Water Forum, can be viewed as political
benchmarks. Because the political negotiations involved in global and regional conventions or water-
sharing agreements are meant to avoid conflicts between different water uses or users, they serve as
drivers for water management. The global policy framework for water began with the Stockholm
Declaration of 1972, followed by other important international milestones over the years.
Ratifying conventions means assenting to implement the actions and activities agreed to by the
involved parties. Implementation requires that the proper institutions exist, that national laws are
compatible with convention requirements and that political and financial measures are in place to

19
ensure popular participation. It also requires a policy framework with operational goals, objectives and
follow-up processes. As an example, the EU Water Framework Directive, negotiated by the EU member
states, requires intranational, multilevel institutional structures, including legal systems, to ensure
implementation of the directive for transboundary river basins and groundwater as well as national river
basins.

International and regional legal frameworks

International water law is part of public international law. The rules of international law apply to
sovereign states. But because there is generally no higher authority to enforce such rules, individual
countries must generally ensure their own compliance. The first step in enforcement is identifying the
applicable rules. These rules are found in treaties, international custom, general principles of law and
the writings of ‘learned publicists’. Treaties usually provide the most accessible source of law, but the
other sources cannot be ignored. In the non-navigational uses of international watercourses, rules of
customary law are often invoked by countries in the absence of codified law. A treaty applies only to
parties to the treaty and only after the treaty has come into force and is thus legally binding. Finally, the
normative content (requirements) of the treaty rules must be established and agreed to by all parties
involved to determine whether a country’s actions are in accordance with its treaty obligations.

Law may also be developed at a regional level. Such law typically supersedes national law.
Treaties may operate regionally between two or more countries. Regional bodies such as the European
Union may also create law for their members. EU law, unlike international law, can be directly binding
on its members and has strong enforcement mechanisms. In most cases the directly applicable law is
national law, which ensures implementation of any international treaties that a country has signed.
Within national law the specific law-making powers and hierarchies of laws are determined by the
constitutional arrangements within a jurisdiction. National law also includes customary law as well as
water laws directly relating to water resources (for example, pollution control and water abstraction
permits). In addition to the formal legal framework and the customary laws that national law formally
codifies and recognizes, there are also water rules and rights by which water user collectives and other
actors abide.

These hybrid sets of water rules, common in most parts of the world, are often crucial in
everyday water affairs and conflictresolution. There are also many other areas of law not directly
addressed to water issues that nevertheless affect management of the water environment. These
include land use planning, environmental assessment, nature conservation and environmental law.
Public health laws influence the supply of water and sanitation, as does land tenure reform. Individuals
are reluctant to invest in sanitation where they have no security of tenure, nor will water companies lay
pipes in such land. Legal provisions on freedom of information and access to justice, human rights and
other constitutional measures are also important parts of a governance framework.
Conflicts and regional instability (or stability) can influence water demand and use, particularly
in water-scarce regions. This is the case where competition arises between different water uses within a
country or where water disputes exist between countries, as between Bangladesh and India over the
Ganges River and among the riparian countries along the Danube River. (This subject is discussed further
in chapter 9.) There are more than 400 registered agreements over shared watersheds,2 most between
two riparian countries. Although the UN Convention on the Law of the Non-navigational Uses of
International Watercourses was adopted by the UN General Assembly in 1997, it has not yet been
ratified by a sufficient number of countries to enter into force. One of the most successful conventions

20
on water resources is the regional United Nations Economic commission for Europe Convention on the
Protection and Use of Transboundary Watercourses and International Lakes, convened in Helsinki in
March 1992. This convention, entered into force in 1996 and currently ratified by 35 countries, serves as
a driver for water management in participating countries.

National legal framework: managing water resources and service delivery

Law and policy are interconnected; with particular legislation derived from water policy in many
cases.4 Making laws operational is often a painstaking process, because of the need to develop
implementation regulations and manuals on interpreting the law. Often implementation is by trial and
error, requiring feedback and the establishment of practices and cases on how to interpret aspects of
water law. For developing countries the long-term goal of such legislation is poverty reduction through a
well managed and sustainable water sector.
Associated goals include efficient service delivery, protection of consumer rights, financial
sustainability and service coverage to the poor in both urban and rural areas. Governance of the water
sector is complex and involves actors beyond the water sector. The actors can be national legislatures
and governments, other sector agencies, local governments, river basin authorities, representatives of
indigenous peoples, consumer bodies, private companies and others. Who is involved may differ with
the issues concerned – for example, surface waters, groundwater, coastal waters or wetlands. Effective
action on such a complex group of interests requires open communication and strong coordination
facilitated by an appropriate legislative and regulatory framework.
The Government of Australia recognized this need when it adopted the Commonwealth Water
Act in 2007 and subsequent regulations. There are fundamental differences between managing water
resources and delivering water services. Managing water resources involves a wide range of institutions
at local, state, national, regional and international levels. Delivering water services (including
administration) usually falls under the authority of elected local officials and specific local institutions. It
is misleading, therefore, to discuss resources management and services delivery in the same
institutional context. Decentralization, for example, can affect how water resources and water
distribution services are managed. It is a political process, however, not necessarily a waterspecific
solution to providing improved water services. It requires that water institutions integrate the physical
watershedand administrative boundaries, nesting these within each other at different scales. Success
with such integration for catchment bodies below the river basin scale has been limited, however, with
evidence from countries like South Africa suggesting that such integration may often be too complex to
implement.

Key policy and regulatory issues

Although water allocation systems can be difficult to establish, managing competing water uses
requires clear, widely accepted allocation rules, especially where water is scarce. Water allocation
systems should balance equity and economic efficiency. Environmental concerns also require equal
attention, though they are often neglected in the process. In Chile, for example, the environment is not
granted any water licenses, while in South Africa decision-makers are debating how to put water law on
environmental protection into practice. Lawmakers must address public policy implications, including
equity and water reallocations in times of drought or other emergencies. And permit systems should be

21
sufficiently flexible to adapt to global changes and climate variability. Much water governance takes
place outsideformalized legal systems, particularly in developing countries (figure 4.1). Such traditional’
rights systems form a dynamic mixture of rules, principles and organizational forms of different origins.
They combine local, national and global rules and often mix indigenous, colonial and contemporary
norms and rights. Important sources for these complex, local rights systems tend to be state laws,
religious laws (whether formal or indigenous), ancestral laws, market laws and the rights frameworks of
multiple water project interventions, which often set their own regulations. Local water rights thus exist
in conditions of legal pluralism, where rules and principles of different origins and legitimization coexist
and interact.7 In the eyes of water users in many parts of the world, legitimate water authority and
water rights are not restricted to official law. Water users also clearly distinguish water rights as defined
by lawyers (officially codified or recognized) from their own, living rights systems.

Understanding the nature of water rights in each system and water territory thus requires taking
into account their multilayered bundles: their rights to use and withdraw, operate, supervise and
manage, and control. Focusing only on the local level is clearly inadequate. Multistakeholder platforms
or other arenas for achieving common goals and establishing patterns of governance – which include
recognizing informal water rights, empowering marginalized social and ethnic groups and representing
all interested parties in allocation and decision-making – have the potential to ensure fairer and
smoother reallocation of water resources.

Implementing regulations

Water resources management is underpinned by a functioning legal system that includes:

• Water resources legislation, the province of the legislature and the executive.
• Implementation and administration of legislation, the province of the executive.
• Adjudication of civil disputes among water litigants, the province of the judiciary.
• Prosecution of criminal offenders by the executive and the judiciary.

Following adoption of a law by the legislature, the executive needs to address relevant details
not included in the legislation by preparing implementation regulations. Neither legislation nor
implementation regulations will make much difference, however, unless they are effectively
administered by the water resources administration. Nor will they secure rights in the resource unless a
judiciary can adjudicate disputes effectively, impartially, expeditiously and transparently. Finally, the
legislation needs vigorous enforcement and systematic monitoring, using a set of indicators to gauge
effectiveness and improve system performance.

Recent policy developments

A number of policies and financing tools have been developed to respond to this new agenda:39

• Increasing commitments of official development assistance for water – and in more user-
friendly forms.

22
 International aid for water has bottomed out and commitments are starting to rise,
led by a few donor agencies.

• Using official development assistance to leverage other financial sources.

An approach that has made a promising beginning in Kenya and elsewhere is to use
output-based aid to promotemicrofinance.

• Establishing national water financing strategies.

Governments in Africa, Eastern Europe and the Caucasus and Central Asia and
elsewhere are producing coherent financing strategies, supported by programmers of
the Organization for Economic Co-operation and Development, the EU WaterInstitute,
the World Bank Water and Sanitation Program and other agencies and programmers.

• Promoting finance to sub sovereign entities.

In most countries responsibility for water services is devolved to sub-sovereign layers of
administration. Donors have been adapting their products and procedures to facilitate
the provision of finance to sub-sovereign agencies.

• Establishing facilities to provide finance at decentralized levels

Much of the development of household water and sanitation services arises from
community initiatives, organization and finance. Among recently created finance
facilities that operate at this level are the African Water Facility, the EU Water Facility
and the Rural Water Supply and Sanitation Initiative of the African Development Bank.

• Developing guarantees and risk-sharing instruments.

Guarantees and other forms of credit enhancement can lift local borrowers and bond
issuers over the critical threshold of creditworthiness and mitigate specific risks.
International financial institutions and other agencies have improved their capacity for
risk sharing, and several new bodies have been formed specifically for this purpose
(such as GuarantCo).40

• Developing local capital markets and local-currency finance.

A number of countries (such as India and South Africa, some countries in Latin America
and South-East and East Asia) have municipalities and utilities with sufficient financial
standing to attract loan finance or to issue their own bonds. A significant proportion of
the unserved populations (almost a half for water and more than a third for sanitation)
live in countries classified as middle income, with the potential to raise sub sovereign
finance of this type.

• Increasing role of small-scale local water providers.

It is estimated that small-scale providers serve 25% of the urban population in Latin
America and East Asia and 50% in Africa and South East Asia.41

• Instituting tariff reform and the principle of sustainable cost recovery.

In most cases tariffs will be the main source of revenue for covering the recurrent costs
of water services, although fullcost recovery through tariffs is rarely feasible in poor

23
 countries. Sustainable cost recovery focuses on securing all three of the basic sources of
revenue for water and sanitation services (tariffs, taxes and external aid) as predictable
sources of revenue for water operators, which can be used to leverage other sources of
funding.

• Paying for environmental services.

Environmental goods and services take many forms, including potable water supply,
irrigation water, flood control benefits, water for transportation and aesthetic benefits.

II. Understanding the Industry

A. The Utilities Industry

The utilities industry includes companies that generate, transmit, and distribute electrical
power, distribute natural gas, treat and distribute fresh water, and treat wastewater, among others. The
Federal Government, as well as many State and local governments, also provide electric, gas, water, and
wastewater treatment services and employ a significant number of workers in similar jobs, but they are
not included in this industry.

The services provided by the utilities industry are heavily regulated. In most places, they operate
as monopolies because it is generally not desirable to have several competing systems of pipes or power
lines in a single area. Public utility commissions ensure that companies act in the public interest and
often set the rates that utilities are allowed to charge. In recent years, however, legislative changes have
established and promoted competition in parts of the utilities industry where it is feasible. This is
especially prevalent in the electric power industry, where wholesale providers of electricity now face
competition from a number of non-utility generators.

24
 The various segments of the utilities industry vary in the degree to which their workers are
involved in production activities, administration and management, or research and development.
Industries such as water supply, that employ relatively few workers, employ more production workers
and plant operators. On the other hand, electric utilities generally operate larger plants using very
expensive, high technology equipment, and thus employ more professional and technical personnel.

The utilities industry is unique in that urban areas with many inhabitants generally have
relatively few utility companies. For example, there were about 52,000 community water systems in the
United States in 2008 serving more than 292.3 million people. The 29,100 smallest water systems served
only 4.9 million people while the 400 largest systems served more than 133.1 million. This shows that
economies of scale in the utilities industry allow a few large companies to serve large numbers of
customers in metropolitan areas more efficiently than many smaller companies. In fact, some utility
companies, predominately serving large metropolitan areas, offer more than one type of utility service
to their customers.

Unlike most industries, the utilities industry imports and exports only a small portion of its
product. To some degree, this is because transporting electricity, fresh water, and natural gas are
somewhat challenging. It also is the result of a national policy that utilities should be self-sufficient,
without dependence on imports for the basic services a certain country requires.

Take for example the water and sewage systems industry that continues to face challenges. As
urban areas continue to grow and demand greater amounts of water, sources of fresh water are being
exhausted. At the same time, companies are having difficulty complying with Federal and State water
quality regulations. In many areas, aging infrastructure is a significant problem, and will have to be
replaced during the projection period.

All utilities continue to be affected by the anticipated baby boom retirements, which are
expected to dramatically reduce the supply of domestic utility workers. As a result, the utilities industry
is teaming up with universities, community colleges, and trade schools to train new workers and prepare
the utility workforce of the future.

The diversity of production processes in the utilities industry is reflected in the size of the
establishments that make up the industry. Utilities provide career opportunities for persons with varying
levels of experience and education. However, because the utilities industry consists of many different
companies and products, skills developed in one segment of the industry may not be transferable to
other segments.

B. Utilities Industry and JWP Inc.

Jamaica Water Properties Inc. is classified as a public utility venturing into diversified nature of
services and products. Such utilities cater different entities with different nature of operations. These
services can be categorized into three broad classifications: water utilities, facilities management, and
information systems.

25
The Water Utilities Industry

The Water Utility Industry is made up of domestic companies responsible for the safe and timely
distribution of water and other related services, such as wastewater treatment. Most water systems are
local or regional, but some companies have operations across many states.

Since water is an essential resource, it would be easy to assume that the stocks of these
companies would be high fliers. Demand from the industrial, agricultural and residential markets is
expanding and the supply of potable water is shrinking. Big earnings and share-price gains have not
been the case, however. The industry is subject to regulation, which can raise service costs, while
limiting rates and return on investment.

This sector is mature and capital intensive. Water utility stocks are not growth issues, but they
do usually offer solid yields and regular dividend increases. Too, they are good holdings for capital
preservation. Heavy infrastructure outlays have led to highly levered balance sheets, and the companies
have had to carefully manage significant operating costs and interest expense to maintain attractive
dividend payout ratios. This group of equities often gains popularity when economic times are especially
harsh and the broader stock market is in a downturn. Operations are seasonal, with demand highest
during the summer months. Periods of excessively dry or wet weather can cause near-term share-price
volatility, but such swings are generally not dramatic.

Regulation
Water utilities are tightly regulated. They fall under federal, state and municipal jurisdiction. The
Food and Drug Administration tries to maintain the safety of drinking water and the federal legislature
and courts work to ensure fair distribution of supplies among the states. State and local authorities also
endeavor to assure water quality and protect consumer rights. Periodically, water utilities, seeking to
earn a fair return on assets, submit general rate cases to state regulators. Rate hikes are sought to cover
the cost of expanding and/or improving service. Also, hikes may be required to make system repairs,
sometimes after unusual events cause damage. Regulators typically review the prevailing cost of
borrowing, when determining allowed rates of return.
Utility authorities are generally inclined to grant reasonable returns; they don't want to be
blamed for any service problems. They will allow variations in determining rates, including price caps
and weather normalization formulas, for example, as long as customer bills do not become overly
burdensome. It's important to note that in tough times, when state budgets are under pressure, the tax
component of utility bills may rise, which could limit the profitability of a utility if it can't implement an
offsetting rate increase. At times, heightened concerns about water safety, due to threats from aging
systems, natural contamination and possibly terrorism, prompt authorities to beef up returns to keep
water companies' operations and finances healthy.

Standards
Whatever the ownership structure, water quality standards and environmental standards
relating to wastewater are usually set by national bodies, such as (in the UK) the Drinking Water
Inspectorate and the Environment Agency. In the United States drinking water standards are set by the

26
U.S. Environmental Protection Agency (EPA). U.S. pollution control standards are developed jointly by
EPA and state environmental agencies pursuant to the Clean Water Act. For countries within
the European Union, water-related directives are important for water resource management and
environmental and water quality standards. Key directives include the Urban Wastewater Treatment
Directive 1992 (requiring most towns and cities to treat their wastewater to specified standards), and
the Water Framework Directive 2000, which requires water resource plans based on river basins,
including public participation based on Aarhus principles.

Capital Spending
A point of investor interest in water utilities is an account called Allowance for Funds Used
during Construction, or AFUDC. It is a non-cash credit, similar to capitalized interest, found on the
income statement. It is based on the current cost of financing. Over time, this cost is recovered from
ratepayers as depreciation rises. AFUDC % to Net Profit on the Value Line page enables investors to
gauge the level of a company's investment in its system. A high percentage of AFUDC is commensurate
with heavy capital outlays. During periods of elevated spending, it's common for outlays to temporarily
exceed cash flow.

Growth Opportunities
Water utilities seek to enlarge operations either by way of merger and acquisition activity or by
venturing into non-regulated markets. Large companies have the financial wherewithal to target for
takeover the many small private or municipal entities scattered around the U.S. They benefit from
greater economies of scale. Over the years, non-regulated businesses, such as telemarketing,
construction management, public works and military services, and utility billing, have had mixed success.
Many money-losing ventures had to be shuttered or divested. Managements have found that it's best to
stay close to activities that are very similar to core operations. Still, profitable unregulated assets can lift
actual returns on investment above those specified by utility authorities. All said, water utility stocks are
conservative holdings, providing a measure of stability and income, with modest risk, to investor
portfolios.

Business Risks

 Water conservation cuts into revenues because most contracts are tied to water consumption
 Water use is weather dependent
 Water utilities are highly regulated
 The use of water rises and falls with the business cycle
 The infrastructure is aging and increasingly prone to failure
 There is some resistance to water utility privatization and some privatization failures

Facilities Management Industry

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 Facility management is an interdisciplinary field primarily devoted to the maintenance and care
of commercial or institutional buildings, such as hospitals, clinics, hotels, resorts,
schools, officecomplexes, sports arenas or convention centers. Duties may include the care of air
conditioning, electric power, plumbing and lighting systems, cleaning, decoration, grounds
keeping and security. Computer programs can assist some or all of these duties. These duties can be
thought of as non-core or support services, because they are not the primary business of the owner
organization (e.g., the core function of a school is teaching, and custodians or HVAC system
maintenance personnel are support personnel.)It is the role of the facility management function
(whether it is a separate department or small team) to coordinate and oversee the safe, secure, and
environmentally-sound operations and maintenance of these assets in a cost effective manner aimed at
long-term preservation of the asset value, and also other janitorial duties such as making sure the
environment is properly cleaned and sanitized for its tenants. In those cases where the operation of the
facility directly involves the occupants and/or customers of the owner organization, the satisfactory
delivery of facility-related services to these people will be an important consideration too; hence, the
term "end-user satisfaction" is often used both as a goal and a measure of performance.

The term facility management is similar to property management although not exactly the
same. While both manage the day to day operations of a facility the property such as cleaning,
maintenance and security, similar to Janitors, one must not confuse it with such a title. The property
manager has an expanded role which includes leasing and marketing activities whereas the facility
manager role focuses on existing tenants who usually are owner occupants. An important feature of
facility management is that it takes account of human needs of its tenants in the use of buildings and
other constructed facilities. These softer factors complement the harder factors associated with the
maintenance and care of engineering services installations.

According to Atkin and Brooks, an important concept in the facility management field is that
of outsourcing, where the owner enters into an arrangement with external organizations to provide one
or more services in preference to their being provided through internal arrangements. The reasons for
this action can vary, including lack of in-house resources, lack of expertise and pressure to reduce costs.
Unfortunately, confusion can exist because of the close association that facility management has with
outsourcing. The two concepts are not synonymous; rather, outsourcing is one means for providing
facility-related services to the owner organization.
Facility management is performed during the operational phase of a building’s life cycle, which
normally extends over many decades. As such, it will represent a continuous process of service provision
to support the owner’s core business and one where improvement will be sought on a continuous basis.
It is essential that decision-making in the preceding design and construction phases is therefore properly
informed about operational requirements if the facility is to provide optimal support to the owner’s
business. In this connection, facility management can be seen as an integral part of a coordinated and
controlled process of design, engineering, construction and operations. Where a facility is provided on
a turnkey basis, for example design-build-finance-operate (DBFO), the consortium responsible for the
delivery of the physical asset and then operating the core service will need to understand implicitly the
day-to-day demands in managing that facility. Under such arrangements – typically public-private
partnerships (PPP) – owner-operators must fully integrate operational thinking into early design
decision-making.
A major challenge facing facility owners is reducing demand for energy for economic reasons,
but also because energy consumption goes hand-in-hand with carbon emissions. Reducing energy

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during the operational phase of a facility's life similarly reduces carbon emissions. When considering
that 30-40% of a country's total carbon emissions is attributable to buildings and other constructed
facilities, it is clear that operations and, hence, facility management have a significant role to play.

Services Extended

Mechanical Systems

 HVAC/R (Heating, Ventilating, Air conditioning and Refrigeration)

 Indoor Air Quality
 Temperature Control
 Preventative Maintenance (Scheduled maintenance to prevent break down)
 Predictive Maintenance (Use of equipment or tests to predict when maintenance will be
needed)
 Elevator Maintenance

Power Systems

 Normal power
 Electrical Substations
 Switchgear
 Emergency power systems
 Uninterruptible power supply (UPS) systems
 Standby generators

Building Systems

 Building Automation Systems (BAS)

 Building Monitoring systems (monitoring capabilities only)
 Security and Locks
Life/Safety Systems
 Sprinkler systems
 Smoke/fire detection systems
 Fire Extinguishers
 Gaseous Extinguishers
 FM-200
 FE-25
 Halon
 Signage
 Evacuation Plans

Space Management

 Office Space Layout

 Furniture Placement and Systems

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Market Growth

The industry has continued to benefit from a growth in outsourcing and has experienced
positive performance in recent years.  Annual growth for the market is recorded at between 6-8% since
2004, reflecting a generally buoyant sector with demand derived from a broad spectrum of key end use
sectors within public and private markets. Research found that 47% of the FM industry experienced
growth in sales revenue, although those companies reporting growth in 2008 experienced substantially
lower sales than in 2007, reflecting a downturn in volume demand, and expectations are that the
number of companies reporting static sales will increase substantially in the short term.  This highlights
the mixed scenario in terms of trading conditions in the FM market at present, with sales increasingly
reliant on a decreasing number of larger companies in the industry, with those more able to service
public sector applications now indicated to be primarily supporting market growth.   

However, reports indicate that client loyalty in the FM market is being steadily eroded by price
competition in 2010, with many of the commodity sectors within the market, such as property
maintenance, office support etc, becoming increasingly price sensitive.   This trend was fuelled by the
recent recession and resulted in multi-service FM providers gaining further share of the market in 2009,
with these companies often able to offer greater cost savings than single service FM contractors.   

Also, the Facilities Management market has become increasingly characterized by closer
relationships between suppliers and contractors, as greater efficiencies and lower procurement costs
are sought.  During 2009, several FM companies established programs specifically designed to improve
supplier relationships to ensure that material and equipment suppliers were aligned with customer
relationship principles and accountable for their own supply chains. Furthermore, these supplier
improvement programs vary in scope, though typically include audits in relation to CRM, sustainable
procurement and may even include a ‘best practice’ policy to which suppliers are expected to adhere. 

Some reports also review the structure and current health of the facilities managementindustry,
with just over 65% of FM contractors viewed as having either an ‘excellent’ or ‘good’ credit rating,
reflecting a core strength in the market in terms of financial standing. However, the impact of the
recession is clearly evident, with around 11% of the companies active in the Facilities Management
market are viewed as being at imminent risk of failure.

By the end of 2010, the overall FM market is expected to grow to a value of around £87.7 billion,
reflecting sustained public expenditure coupled with a return to stronger growth from the private
sector. MTW’s SWOT analysis, a market research group, identifies a number of key market influencers
which are expected to further drive the market in 2011, despite increasing uncertainty regarding short
and medium term public spending budgets.   

In order to compete successfully in the FM service market and fulfill the clients' needs in the
near future, service providers need to be able to offer a wider range of FM services. In addition, it is
important that the suppliers become stronger in the area of technical service competence. As the
service companies are developing their internal technical competences, the clients might become more

30
confident in outsourcing more technically demanding FM services. These market trends might explain
why buyers in the FM service market are more ahead in using supply models like the integrated service
provider model as opposed to using supply models like the specialized service provider model.

Information Systems Industry

Information Systems

Information Systems (IS) is an academic/professional discipline concerned withthe strategic

managerial and operational activities involved in the gathering, processing, storing, distributing and use
of information, and its associated technologies, in society and organizations.As an area of study, IS
bridges the multidisciplinary business field and the interdisciplinary computer science field that is
evolving toward a new scientific discipline. 
The theoretical foundations of information and computations therefore support an information
systems discipline such that undergraduate students have unique opportunities to explore the
academics of various business models as well as related algorithmicprocesses within a computer science
discipline.Typically, information systems or the more common legacy information systems include
people, procedures, data, software, and hardware (by degree) that are used to gather and
analyze digital information.Specifically computer-based information systems are complementary
networks of hardware/software that people and organizations use to collect, filter, and process, create,
& distribute data(computing). Computer Information System(s) (CIS) is often a track within the computer
science field studying computers and algorithmic processes, including their principles, their software
&hardware designs, their applications, and their impact on society. Overall, an IS discipline emphasizes
functionality over design.
 In general, information systems are focused upon processing information within organizations,
especially within business enterprises, and sharing the benefits with modern society.

There are various types of information systems, for example: transaction processing systems,
office systems, decision support systems, knowledge management systems, database management
systems, and office information systems. Critical to most information systems are information
technologies, which are typically designed to enable humans to perform tasks for which the human
brain is not well suited, such as: handling large amounts of information, performing complex
calculations, and controlling many simultaneous processes.

Market Trend

Today, the outsourcing of selected organizational activities is an integral part of corporate

strategy. Historically, third party participation in a company's business has generally focused on the
manufacture of parts and components and the provision of auxiliary services such as legal and travel
services. A more recent phenomenon, however, involves third party participation in the management of

31
the information systems (I/S) function. An increasingly competitive and cost conscious environment has
caused organizations to reevaluate their approach to the management of many staff functions, including
information systems. The outsourcing of information systems is a growing trend that has piqued the
interest of companies such as IBM, EDS, and Anderson Consulting, among others. Estimated revenues
for the outsourcing industry vary from $7 to $12 billion for 1992, growing to as much as $38 to $50
billion in 1995. In the United States alone, the industry is predicted to grow at an annual rate of 20
percent.
The outsourcing of information systems is also gaining momentum globally. In a 1992 survey of
European information system executives, 71 percent indicated that they were planning to outsource
some operations. This represented a doubling of interest from the previous year. The evolving global
economy dearly has helped stimulate this trend. Organizations typically have unique I/S needs when
clients are located in a variety of foreign countries. At the same time, the systems that tie these
organizations together often face an array of political, cultural, language, and logistics challenges unique
to different host countries. Consequently, the use of outsourcing may offer an effective strategic
alternative to system development in situations that tend to inhibit satisfactory development and
operation of such systems.

Entities also opt to hire firms for services of systems customization and/or in-house
development of information systems. This is also reflective of such growth of the technical services
industry. On the other hand, threats associated with such growth of the information systems industry
resulting from businesses integration to mechanical systems include threats to entry such as capital
requirements, access to distribution channels, switching costs and other barriers to entry. In addition,
bargaining power from clients and threat of possible vertical integration pose some business risk in such
industry.

Energy Industry

There is a broad, global focus today on energy as an economic, geopolitical and strategic
resource. In addition, there is a greater focus than ever before on the impact of energy consumption on
the environment. Worldwide, investment in the development and implementation of clean, renewable
energy technologies and conservation will be a major priority of governments and industry, subject to
fluctuations in the economy and the price of crude oil and natural gas. The emphasis will vary widely
from nation to nation, ranging from cleaner ways to burn the world’s immense stores of coal; to the
construction of advanced-technology nuclear generating plants that are exponentially safer than older
models (with China leading the way in nuclear implementation); to the use of advanced, more cost-
effective renewable technologies based on solar, wind and wave power.

Nonetheless, with the exception of hydroelectric power, renewable energy sources remain
vastly more costly to implement than fossil fuel-based generators (primarily coal and natural gas). This
means that they require significant government subsidies, loan guarantees or incentives in order to
cover the capital costs. As governments in developed economies in Europe, along with the United
States, continue to struggle with large deficits and debts, their willingness to back costly renewable
energy projects may be dampened significantly. Japan, on the other hand, while facing economic
challenges of its own, will maintain a keen interest in alternative energy sources, since it has essentially
no fossil fuel supplies of its own.

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 The most important emerging nations are investing heavily in alternative energy sources, while
continuing to use large quantities of fossil fuels. China leads the world in investment in new nuclear
plants, and it is installing vast numbers of wind turbines. India is likewise planning multiple new nuclear
plants. Brazil continues to be a leader in the low cost production and use of ethanol as a transportation
fuel, while developing the world’s most important new offshore oil and gas fields at a rapid clip.

The financial crisis of 2008-09 put a damper on the growth of energy consumption. In the United
States, for example, consumption of electricity and oil declined significantly from 2007 peaks. Total
energy consumption in America dropped by 6.9% in 2009 compared to 2007. In fact, analysts at BP
report that global primary energy consumption dropped by 1.1% during 2009, the largest drop since
1980. This is clear evidence that the Great Recession made consumers more cost conscious while
slowing down industrial and transportation use of energy. The drop in electricity demand in the U.S.
means there is less urgency, at least for the short term, to build new electric plants, which may delay the
start of expensive new nuclear facilities.

Emerging economies will continue to burn a lot of coal and fossil fuels. This is where the growth
in consumption is essentially unavoidable, in rapidly rising economies such as India and China. Total
Chinese energy consumption rose by 7.0% in 2008, despite the global recession, and rose by another
8.7% in 2009. In contrast, consumption in all of Europe fell by 6% in 2009. China’s primary energy
consumption grew to be 19.5% of the world’s total, in 2009, equal to that of the U.S. India’s
consumption grew 6.6% in 2009, to 4.2% of total world consumption. (These figures are from BP.)

The global energy numbers:

Oil : According to the latest data available from analysts at energy giant BP, the world produced 79.9
million barrels of oil daily in 2009, down 2.6% from 2008. This includes unconventional petroleum
output from such sources as oil shale, oil sands and natural gas liquids. However, it does not include
alternative sources such as biomass and coal derivatives. Consumption in 2009 averaged 84.0 million
barrels of oil per day, down by 1.7% from 2008. (In the U.S., consumption of oil fell by 4.9% to 18.6
million barrels daily, accounting for 21.7% of global consumption in 2009, down from 23.9% in the peak
year of 2007. China, excluding Hong Kong, accounted for 10.4%, while India accounted for 3.8% of global
consumption.)

Proven reserves worldwide totaled 1.333 trillion barrels at the end of 2009, up slightly from the
previous year (not including oil sands). OPEC member nations hold 77.2% of those reserves. The addition
of BP’s estimate of Canadian oil sands, at 143.3 billion proven barrels, increases the world’s total proven
reserves to 1.476 trillion barrels.

Natural Gas : According to BP, global production of natural gas was 2,987 billion cubic meters in 2009,
down 2.1% from the previous year. Production in the U.S. increased by 3.5%, to 593.4 billion cubic
meters, a 2.1% share of the world’s total.

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Global consumption was 2,940 billion cubic meters, down by 2.1% over the previous year. (The U.S.
consumed 22.0% of that total. Europe and Eurasia consumed 35.9%.)

Proven reserves totaled 187.49 trillion cubic meters: enough to last several decades at today’s
consumption rates. Massive discoveries of natural gas in shale formations in the U.S. and elsewhere are
rapidly altering the gas industry. Likewise, vast investments in LNG infrastructure are enabling
international shipment of gas from production areas to major markets, particularly to China.

Coal : Analysts at BP estimate that global production of coal was 3,408 million tons of oil equivalents in
2009, up 2.4% over the previous year. Consumption was 3,278 billion tons, virtually unchanged from the
previous year.

The largest emerging nations are hooked on coal. China, excluding Hong Kong, accounted for
46.9% of the world’s consumption, up from 42.6% during the previous year. India accounted for only
6.9% of global consumption, but its usage was up 7.5% over the previous year. The U.S., where much of
electric generation is fired by coal, used only 17.1%, and American consumption was down 11.5% over
the previous year, thanks to a weak economy and to electricity utilities switching to natural gas as a fuel
for generators. Europe and Eurasia used 13.9%, and on sumption was down 11.4% over 2008.

Global coal reserves are massive, at 826,001 million tons or enough to last about 250 years at
today’s consumption rates. The U.S. holds 28.9% of those reserves, Europe and Eurasia 33.0%, China
13.9% and Australia 9.2%.

America’s energy numbers:

In the U.S., the Department of Energy estimates oil production was 5.3 million barrels per day from
526,000 wells during 2009. While production in many of America’s largest fields, such as the North Slope
in Alaska, is down substantially, investments in offshore production and enhanced recovery in older
fields has paid off. Nonetheless, total production is down dramatically from the 1985 peak of 8.97
million barrels of oil per day. (Part of the problem is that Alaskan production peaked in 1988 at 2.0
million barrels daily, and had dropped to 685,000 barrels daily by 2008.)

However, as the nation’s natural gas industry has been growing, and new production has ensued
thanks to wells in shale, the total production picture has improved dramatically when “natural gas plant
liquids,” or oil that is stripped from natural gas during processing, are included. Under this view, total oil
production was 7,196 barrels daily in 2009 (including 1,886 barrels of natural gas liquids), up 5.1% from
the previous year.

America’s use of petroleum has led to an increase in annual net petroleum imports from 3,161
thousand barrels per day in 1970 to 9,700 thousand barrels per day in 2009. This figure has been
dropping steadily since a 2005 peak.

Meanwhile, only 148 refineries operate in America as of 2009, down by about 50% from 1980.
These remaining refineries have invested heavily in additional capacity. However, America also imports
substantial quantities of finished refinery products, including gasoline.

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 Total American consumption of energy of all types was 94,578,267 billion BTUs in 2009, having
grown about 50% since 1970. However, 2009 consumption represented a significant drop of more than
6% from the 2007 peak of 101,599,750 billion BTUs.

In terms of BTUs consumed, use by Americans soared from 227 million BTUs per year per capita
in 1950 to 331 million BTUs by 1970, but has remained relatively flat ever since. That is, while the
number of automobiles and aircraft per capita has grown dramatically; along with vast growth in the
percentage of homes and buildings that are air conditioned; combined with tremendous increases in the
number of appliances, computers and entertainment devices per person; efficiency has grown to the
extent that the energy consumption of an average American declined from a peak in 2000 of 351 million
BTUs yearly, to only 308 million in 2009.

While America’s economy and population have been growing, energy use per unit of economic
output has fallen dramatically. On an inflation-adjusted basis, energy consumption per dollar of GDP
dropped from 17.99 thousand BTUs in 1970 to only 7.28 thousand BTUs in 2009.

According to the U.S. Department of Energy, electric generation in America as of 2008 used the
following ratio of fuels: coal 44.95% (down from 48.5% the previous year); nuclear 20.09% (up from
19.6%); natural gas 23.45% (up from 21.6%); and renewable, which includes hydroelectric, wind and
solar, at 10.52% (up from 9.0%). Most of that “renewable” energy source is hydroelectric, which
America has used for decades. Other sources such as solar and wind are growing rapidly, but at only
about 3.59% of total generation, they clearly have a long way to go to make a significant impact.

U.S. consumers have shown a true sea change in their preferences and priorities as a result of
higher energy prices, and the era of the gas-guzzling, giant family truck or SUV as a standard is over.
Meanwhile, consumers and businesses alike are increasingly willing to invest more in the initial cost of
green buildings, high-efficiency appliances and equipment and energy-saving vehicles, with the promise
of lower energy costs for daily operation.

Thanks to the development of advanced technologies for producing gas from America’s
immense shale formations, available gas reserves are growing at a rapid rate, with no end in sight. This
trend is revolutionizing the gas industry, while keeping natural gas prices at very modest levels.

Oil Prices and Total Reserves:

Ever since William Hart dug America’s first successful gas well in Fredonia, New York in 1821,
and “Colonel” Edwin Drake drilled the first true U.S. oil well in the state of Pennsylvania in 1859, the
ability of oil and natural gas to power electric generation plants, transportation, homes and industry has
created both immense economic advances and significant controversy. Many times it has been assumed
that the world would quickly run out of oil. In 1939, the U.S. Department of the Interior warned
that America’s oil reserves totaled only enough to fuel the nation for about 13 years. Similar
misjudgments were announced on a regular basis in the mid to late 1900s by the federal government
and by a continuing stream of respected reports and books by various authors. In fact, rather than
becoming scarcer over time, energy, including oil and gas, became much more plentiful. Energy prices
can fluctuate wildly. Nonetheless, over much of history the trend has often been lower prices on an
inflation-adjusted basis, when a combination of advancing technologies, determined entrepreneurs and

35
alternative sources exponentially expanded the total amount of energy and reserves available for
consumption. The breakthrough in shale gas in recent years is a perfect example.

An estimate of crude oil resources on a global basis, published by Cambridge Energy Research
Associates in 2006, was 4.82 trillion barrels—enough to take care of the world’s needs for more than
100 years . This number included oil shale and other sources that are relatively difficult to tap.
Technologies will continue to be enhanced, enabling the recovery of significant portions of these
resources, as long as the market price of energy is high enough to justify necessary investments in
technology, exploration, development, production and distribution.

There have long been periods of major fluctuations in price for oil, coal and natural gas. Energy
consumers of all types, from residential consumers to transportation firms to industrial plants, have
seen oil and gas prices swing wildly, and they have often suffered the economic effects of greatly
increased energy costs. Strong global demand for energy combined with political strife in many oil
exporting nations could easily lead to a long-term period of relatively high market prices, both for crude
oil and natural gas. The price of Arabian light crude oil rose from about $1.85 per barrel in 1972 to about
$40 in 1981 during an “energy crisis,” the peak price for many years to come. Adjusted for inflation, that
$40 barrel of oil would have been $100 or so in 2009 dollars.

More recently, during 1986 and again in 1998, the price of a barrel of oil plummeted to about
$10 in a short period of time. However, prices generally rose from 2003 through early 2008. In the fall of
2005, the post-Hurricane Katrina price of a barrel of light U.S. crude oil peaked just shy of $70 as the
extent of the damage to production became apparent. The price of natural gas more than doubled from
June through October 2005, rising from about $6 to nearly $16 per million BTUs for spot market prices,
compared to $4.59 on average during July 2010.

In mid-2006, the price of light U.S. crude peaked at about $80. By late 2007, it had neared $100.
By mid-2008 it was over $145, but plummeted quickly into the $60s when the global financial crisis of
2008 slowed economies worldwide. Another significant factor in the price of a barrel of oil is the value
of the U.S. dollar relative to other currencies. During much of 2009-10, the dollar was in a lengthy slide
in value, causing the price of oil (which is valued in U.S. dollars on world markets) to rise. Of course, the
value of the dollar is not the sole factor regulating the price of a barrel of oil, but it is a very important
contributing factor.

Recent high prices for oil and gas put a new emphasis on production from alternative (or
“unconventional”) oil sources such as tar sands in Canada and oil shale in the U.S. These fields are
significantly more expensive to produce than conventional fields. Meanwhile, offshore exploration and
production will continue to be emphasized in many parts of the world, with sophisticated rigs drilling
ever deeper to tap massive reservoirs, using technologies that enable the rigs to go to depths
undreamed of 20 years ago. Vast new investments in very deep offshore wells in the Gulf of Mexico
brought significant new production to the American market. However, it remains to be seen what the
effect on new drilling and production will be from stringent new federal regulations applied to offshore
operations in 2010. Meanwhile, outside the U.S., the industry is investing quickly and heavily in deep
wells offshore of Africa, Brazil and elsewhere.

Consumers and business organizations alike are attempting to insulate themselves from high
energy costs. Many are reacting with new conservation efforts. For example, Toyota’s hybrid-powered

36
automobiles have been a huge success. Greatly enhanced building materials and appliances that provide
much greater energy efficiency are becoming standard in developed nations. Meanwhile, the growing
industrial base and middle class in many parts of the globe, particularly India and China, are putting new
strains on energy supplies while energy emissions are creating new environmental concerns.

In 1892, Thomas Alva Edison established the Pearl Street Station in New York City—the world’s
first central electric power station. By the 1920s, electricity was in common use in American buildings
and homes, and millions of automobiles were clogging American streets.

A significant portion of oil consumption is used as fuel for transportation, including cars, aircraft
and trucks. There is no end in sight to the need for power and fuel in developed and emerging
economies such as the U.S., the European Union, Japan, India and China. Although the world has made
an immense investment in electric supply infrastructure, as much as one-third of the world’s population
either has no access to, or cannot afford, a steady supply of electricity.

Fuels for electric generation vary widely around the globe, but coal, oil and natural gas are
common sources. In Europe, a large ratio of electricity is generated by nuclear plants, especially in
France, and massive investments are being made in European solar and wind generation. As 2010 drew
to a close, a looming question was whether America and major nations in Europe will resume
construction of nuclear generation plants. New, advanced generation nuclear technologies can provide
much greater operating efficiencies with vastly increased safety over the plants constructed in earlier
years.

CASE RESOLUTION

RESEARCH QUESTIONS AND CORRESPONDING ARGUMENTS AND SOLUTIONS

1. What are the general responsibilities of internal auditors? With regards to detection of fraud,
what are the duties of the internal auditors?

Internal auditing, as defined by the Institute of Internal Auditors (IIA), is an independent,

objective assurance and consulting activity designed to add value and improve an organization's

operations. It helps an organization accomplish its objectives by bringing a systematic,

37
disciplined approach to evaluate and improve the effectiveness of risk management, control,

and governance processes.

There is theoretically no restriction on what internal auditors can evaluate and report

about within an organization. But, internal audit projects tend to vary from one company to

another, reflecting particular objectives of owners, directors, and senior management. Internal

auditors typically operate under a board-approved charter that defines their role, objectives,

and scope. The following five directives from the IIA's Statement of Responsibilities of Internal

Auditing  are included in most charters:

 Review the reliability and integrity of financial and operating information and the means

used to identify, measure, classify, and report such information;

 Review the systems established to ensure compliance with those policies, plans, procedures,

laws, regulations, and contracts which could have a significant impact on operations and

reports, and determine whether the organization is in compliance;

 Review the means of safeguarding assets and, as appropriate, verify the existence of such

assets;

 Appraise the economy and efficiency with which resources are employed; and,

 Review operations or programs to ascertain whether results are consistent with established

objectives and goals and whether the operations or programs are being carried out as

planned.

The tables below then further shows the general responsibilities and additional higher level

responsibilities of internal auditors as being prescribed by the IIA to serve as guideposts of

the professional in the conduct of its work.

General Responsibilities of Internal Auditor

38
 1. Disclosing or declaring any impairment to independence or objectivity that may exist.
2. Performing assigned tasks in an independent and self-directed fashion
3. Completing assigned tasks in a timely, thorough, accurate and well-documented manner
4. Submitting all completed work papers to the Director of Internal Audit for final review and
approval.
5. Completing other tasks as assigned
6. Conducting oneself in a professional manner at all times; avoiding those situations that would
lead to criticism by the area being audited, or by the general public

7. Assuming a friendly and cooperative demeanor with the audited area’s staff
Disagreements should be reported to the Director of Internal Audit

8. Conducting work so as to minimize disruption of the audited area’s workflow or ability to

service their customers

9. Acquainting oneself with the premises, responsible employees, and the location of records
early in the audit

10. Requesting any files that may be needed. Management of the audited area should be made
aware that the Internal Auditor has those files.

11. Safeguarding all files / records that have been entrusted to the Auditor’s possession.
12. Returning all files / records to the person or area they were obtained from.
13. Maintaining all records in the same or better condition than that in which they were found.
14. Retaining all records on premises - never removing vital documents from the premises.
15. Returning all documents taken to the Internal Auditor’s work area to the records custodian by
the end of the day if such return is requested.
Table 1 General Responsibilities of Internal Auditor

Additional Higher Level of Responsibilities:

 Developing a familiarity with the organization and functions of the unit to be audited.
 Pre-planning the audit in accordance with the scope and complexity of the area under review.

 Ensuring that an assessment of risks is incorporated into, or forms the basis of all audit work
planned and performed.

 Accepting responsibility and accountability for the audit work performed on assigned projects.

 Managing the audit in relation to time and resource budgets.

 Ensuring that audit findings and recommendations made during the course of the audit are
promptly communicated to management.

39
  Ensuring that all Worksheets issued are properly constructed, supported, and communicated.

 As work papers are completed, ensuring that all objectives have been accomplished and all
conclusions are properly supported.

 Ensuring that the audit or review is conducted with the least amount of disruption to the
audited area as is possible.

 Conducting an “Exit Review” or briefing at the culmination of field work.

 Drafting and seeking approval for a formal Audit Report.

 Finalizing the audit file(s), and ensuring that all supporting documentation is properly retained.

 Performing follow-up work as necessary subsequent to the audit.

Table 2 Additional Responsibilities of Internal Auditor

Table 1 highlights the responsibilities of internal auditors in the conduct of their duty. These
responsibilities shall be observed to allow auditors to function efficiently and effectively. Concerning the
Jamaica Water Properties Case, a clear deviation from the first and second responsibilities was
committed. This was manifested in the internal auditors’ failure to disclose and declare the tension that
arises as a result of Grendi’s abuse of power.

Duties of Internal Auditor in the Detection of Fraud

Internal auditors' roles with regard to fraud might be as identifiers, investigators, resident experts,
and educators. In many organizations, the internal audit function will be better suited than any other to
bring fraud to the surface, conduct or participate in investigations, and raise management awareness
about fraud. Yet many internal auditors hesitate to be identified with fraud, apparently because they
believe that participating in investigations will somehow damage the image and effectiveness of the
internal audit department.

With these, internal auditors should have sufficient knowledge of fraud to be able to identify
indicators that fraud might have occurred. If significant control weaknesses are detected, additional
tests conducted by internal auditors should include tests directed toward the identification of other
indicators of fraud. Unless trained professionally in the investigation of white collar crime, internal
auditors are not expected to have knowledge equivalent to that of a person whose primary
responsibility is to detect and investigate fraud. Also, auditing procedures alone, even when carried out
with due professional care, do not guarantee that fraud will be detected.

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 If fraud or improprieties are asserted or discovered, the audit committee—through the external
auditors, internal auditors, or forensic accounting consultants, as appropriate—should investigate, and,
if necessary, retain legal counsel to assert claims on the organization’s behalf. Forensic accounting
consultants, in particular, may be needed to provide the depth of skills necessary to conduct a fraud
investigation, and if it is desirable to get an independent assessment.

The audit committee is responsible for ensuring that an investigation is undertaken. Criteria should
be in place describing the audit committee’s level of involvement, based on the severity of the offense.
Most audit committees want to obtain information about all violations of the law and the organization’s
policies.

Internal auditing will assist in the investigation of fraud in order to: (1) determine if controls need to
be implemented or strengthened, (2) design audit tests to help disclose the existence of similar frauds in
the future, and (3) help meet internal auditing’s responsibility to maintain sufficient knowledge of fraud.
At the conclusion of the investigation, the Internal Audit Director will issue a report on internal control
findings, conclusions, recommendations, and corrective actions planned or taken.

2. What are the reasons why the internal auditor tolerated the accounting malpractices of
Grendi? What are the actions against the undue influence of Grendi should the internal
auditors have taken?

Reasons for the Internal Auditors Tolerance to Grendi’s Malpractices

With the far-reaching authority that Andrew Dwyer, the Chief Executive Officer (CEO) granted
upon Ernest Grendi, the Chief Financial Officer (CFO) of Jamaica Water Properties, and his intransigent
and intimidating personality to establish complete control over JWP’s accounting function. He also used
his menacing personality to neutralize JWP’s various control functions, particularly the company’s
internal audit staff. A JWP internal auditor subsequently reported that the fear of being fired had
deterred him from challenging the company’s improper accounting treatments. Another JWP internal
auditor expressed a similar sentiment when he reported that he had feared being “crushed like a flea” if
he questioned the company’s improper accounting decision.

Furthermore, in the contract of employment, then employee as an agent has an obligation to

work as directed, to protect confidential information and to be loyal.

41
 The employees are then caught in the dilemma of revealing the fraud and losing their job or
concealing it and retaining their job.

The following are the arguments and the corresponding counter arguments that are present in this case:

Argument 1

Grendi being the CFO of JWP must be obeyed.

With the authority being granted by Andrew Dwyer, the Chief Executive Officer (CEO) of JWP,
he is authorized and deserves to be followed by his subordinates. Grendi was granted with far-reaching
authority that had bypassed the internal audit committee’s challenging the improper accounting
practices fabricated by Grendi and his co-conspirators who are also in the biggest posts in the firm.
Grendi, being the key man of the fraud was assisted by his brother, Joseph, who was also an officer of
JWP, and by John K. McQuade, the company's vice president for finance, and Phillip M. McGinn, the
company's controller. All four men are certified public accountants.

Counter Argument 1

Confronted with this situation, the internal audit function should not be intimidated so since the
authority being granted to these key officials are not absolute.

The authority granted to Grendi by the CEO encompasses only those who are under his direct
supervision and control. Moreover, their duty to obey has exceptions. The exceptions are as follows:

1. If it's illegal or unethical

2. If it's threatening to physical condition
3. If it's impossible or impractical
4. If it violates ordinary customs

Furthermore, as provided by the performance standards issued by the IIA, Section 1110 –
Organizational Independence states that “The chief audit executive must report to a level within the
organization that allows the internal audit activity to fulfill its responsibilities. The chief audit executive
must confirm to the board, at least annually, the organizational independence of the internal audit
activity.”

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 Organizational independence is effectively achieved when the chief audit executive reports
functionally to the board. Section 1110.A1 further provides that the internal audit activity must be free
from interference in determining the scope of internal auditing, performing work, and communicating
results.

Provided these provisions, internal auditors should not fret against reporting to higher level of
management, most specifically those charged with governance, concerning any irregularities, improper
accounting treatments and/ or fraud existing. In the long run, being unable to disclose such
circumstances will gravely affect the company and eventually, the job that they are being so anxious of
losing will definitely transpire as a result of severe and irrepressible episode when the issues go public.

Argument 2

The employees are bound by their Duty of Confidentiality

An agent (employee) is to uphold confidentiality of information obtained or learned during

employment, even if the employment is terminated.

Counter Arguments 2

1. The law of agency excludes an obligation to keep confidential information about the
commission of a crime.

The JWP internal auditors might misconstrued to some extent the duty of confidentiality that
had consequently undermined their professional competence of asserting that such improper
accounting practices will eventually lead to the collapse of the firm. Being bound with such duty of not
disclosing sensitive information does not mean that concealment of fraudulent transactions is justified.
Going back with the argument presented in counter argument 1, keeping things confidential does not
include those that are unethical. Clearly, the JWP auditors were being caught in between disclosing such
anomaly or not. As we see it, they might have had wanted to but were not given enough power and
authority to do so; most especially, in disclosing such anomalies of Grendi which in this case, the abusive
accounting practices which included misapplying the purchase method of accounting for acquisitions,
recording fictitious assets, improper accounting for net operating loss (NOL) carry forwards, failing to
record appropriate allowances for uncollectible receivables and misapplying the percentage-of-
completion method of accounting for long-term contracts.

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 2. Internal Auditing Attribute Standard 1340- Disclosure of Non- compliance.

The Standards for the Professional Practice of Internal Auditing provided by the Institute of
Internal Auditors, particularly under Attribute Standard 1300 – Quality Assurance and Improvement
Program, more specifically in 1340 – Disclosure of Non-compliance states that, “although the internal
audit activity should achieve full compliance with the Standards and internal auditors with the Code of
Ethics, there may be instances in which full compliance is not achieved. When non-compliance impacts
the overall scope or operation of the internal audit activity, disclosure should be made to senior
management and the board.” Clearly the internal auditors of JWP are bound to report the fraud which
was authorized by the company CFO to the corporate board to maintain their integrity as professional
auditors.

Argument 3

Whistle blowing will result to the loss of job.

Conflict between Grendi and the internal auditors will arise if the latter will contest the
malpractices of Grendi. Considering the extent of Grendi’s power, will surely fire those who are against
him.

Counter Argument 3

As a matter of fact, even though the internal auditors conceal the fraud, their job is not secured.
Concealing the fraud makes them accomplices to the crime. Thus, they will be subject to whatever
consequence the concealment will bring. Additionally, the status of their job would even be vulnerable
given that the ill effects of the improper accounting malpractices will eventually result to the firm’s fall.
The effect, which on that early stage of having seemingly slim or indirect to their tenure, will, as the case
explodes, eventually gulp the job that they are protecting.

Hence, the internal auditor in the process of decision-making may use the following questions as
guide in assessing whether to blow the whistle or not:

1. Is the situation of sufficient moral importance to justify whistle-blowing?

2. Do you have all the facts and have you properly understood their significance?
3. Have all internal channels and steps short of whistle-blowing been exhausted?
4. What is the best way to blow the whistle?
5. What is my responsibility in view of my role in the organization?
6. What are the chances for success?

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 The bottom line is that internal whistle blowing is preferable and just as opposed when the
issue goes public causing a lot of casualties.

Actions to be done to solve the ethical dilemma of whether to conceal the fraud or disclose it.

One of the ways in resolving ethical dilemma is the seven-step American Accounting Association
model. This is summarized as follows:

Solving Ethical Dilemma

Steps Description

Define the problem, including identifying all stakeholders

Determine the facts
involved.

Using the facts to identify the ethical issues requires an in-

Define the ethical issue(s) depth understanding of the Code.

From step 2, it should become clear what the major

principles, rules and values involved are apart from the Code,
Identify the major principles, rules
identify whether other laws, rules or regulations are also
and values
involved.

Specify the alternatives List all possible alternatives from doing nothing to resigning.
Comparison Compare steps 3 and 4 to see if there is a clear decision.
Assess all the consequences for the remaining possible
Assessment
decisions.
Make your decision, which must be in compliance with the
Decision Making
Code, laws, rules and regulations.
Table 3 Steps in Solving Ethical Dilemma according to American Accounting Association

3. What are the responsibilities of the management in fraud detection? With these
responsibilities what are the measures they have to take in order to protect the internal
auditors from factors that may adversely affect the quality of their internal audit?

Responsibility of the Management in Fraud Detection

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 As elucidated in the PSAs, the primary responsibility for the prevention and detection of fraud
rests with both those charged with governance of the entity and management. It is important that
management, with the oversight of those charged with governance, place a strong emphasis on fraud
prevention, which may reduce opportunities for fraud to take place, and fraud deterrence, which could
persuade individuals not to commit fraud because of the likelihood of detection and punishment. This
involves a commitment to creating a culture of honesty and ethical behavior which can be reinforced by
an active oversight by those charged with governance. In exercising oversight responsibility, those
charged with governance consider the potential for override of controls or other inappropriate influence
over the financial reporting process, such as efforts by management to manage earnings in order to
influence the perceptions of analysts as to the entity’s performance and profitability.

Measures to Protect the Internal Auditors from Factors that may Adversely Affect the Quality of
Auditors

Installation of a Corporate Structure emphasizing the vital role of the audit function

The firm should increase the influence of its internal auditors.   The ideal situation will be that the
internal auditor directly reports to the board of directors and their findings and opinions should be more
adequately and properly treated.   And this may be depicted with the following figure:

Figure 1 Ideal Corporate Structure

The JWP internal auditors have not acted with independence and in a self-directed fashion when
they allow Grendi to manipulate them in his hands. Their accommodation to Grendi’s malpractices
clearly violates their professional and ethical duty to observe independence and objectivity.
Furthermore, it is on their shoulders the duty of ensuring, at the very minimum, four important
objectives of internal controls which include the following:

46
  Reliability and integrity of financial and operational information;
 Effectiveness and efficiency of operations and programs;
 Safeguarding of assets; and
 Compliance with laws, regulations, policies, procedures, and contracts.

On the other hand, confronted with the menacing personality of Grendi as further inhibited in
his resistance to take into consideration the action for reflecting adjustments on the gross improper
accounting treatments of the company’s operations, these professional ethical requirements of JWP’s
internal auditors were challenged and posed with threats to such exercise of independence and
objectivity. The internal auditors contemplated on reporting such anomalies but were deterred by such
intransigent and intimidating personality of Grendi. Given this circumstance, the internal auditors lack of
confidence to disclose wrongdoings and irregularities was evidently caused by their lack of voice to the
board itself. They were not given enough influential capacity to air out these things that’s why they felt
intimidation and got discouraged to stand up and contest Grendi’s creative accounting tactics. The
auditors have been given the responsibility but not enough of the authority to rectify such practices.

Yet again, Stated in Section 1110 – Organizational Independence of the IIA Performance
Standards, “The chief audit executive must report to a level within the organization that allows the
internal audit activity to fulfill its responsibilities. The chief audit executive must confirm to the board, at
least annually, the organizational independence of the internal audit activity. The internal audit activity
must be free from interference in determining the scope of internal auditing, performing work, and
communicating results.”

Furthermore, Section 1100 – Independence and Objectivity states that “The internal audit
activity must be independent, and internal auditors must be objective in performing their work.”
Independence is the freedom from conditions that threaten the ability of the internal audit activity to
carry out internal audit responsibilities in an unbiased manner. To achieve the degree of independence
necessary to effectively carry out the responsibilities of the internal audit activity, the chief audit
executive has direct and unrestricted access to senior management and the board. This can be achieved
through a dual-reporting relationship. Threats to independence must be managed at the individual
auditor, engagement, functional, and organizational levels. While, objectivity is an unbiased mental
attitude that allows internal auditors to perform engagements in such a manner that they believe in
their work product and that no quality compromises are made. Objectivity requires that internal
auditors do not subordinate their judgment on audit matters to others. Threats to objectivity must be
managed at the individual auditor, engagement, functional, and organizational levels.

It is but recommended that the ideal structure would be that of depicted in Figure 1 where the
internal audit committee can effectively and efficiently exercise the scope of its responsibilities.

Establishment of appropriate and sufficient safeguards to reduce or even eliminate exposure to

threats

According to the HANDBOOK OF THE CODE OF ETHICS FOR PROFESSIONAL ACCOUNTANTS

2010 EDITION 100.13 Safeguards are actions or other measures that may eliminate threats or reduce
them to an acceptable level. They fall into two broad categories:

47
 a) Safeguards created by the profession, legislation or regulation;
b) Safeguards in the work environment

According to paragraph 100.14, safeguards created by the profession, legislation or regulation

includes:
 Educational, training and experience requirements for entry into the profession
 Continuing professional development requirements
 Corporate governance regulations
 Professional standards
 Professional or regulatory monitoring and disciplinary procedures
 External review by a legally empowered third party of the reports, returns, communications or
information produced by a professional accountant

According to 300.14, Safeguards in the work environment include:

 The employing organization’s systems of corporate oversight or other oversight structures

 The employing organization’s ethics and conduct programs
 Recruitment procedures in the employing organization emphasizing the importance of
employing high caliber competent staff
 Strong internal controls
 Appropriate disciplinary processes
 Leadership that stresses the importance of ethical behavior and the expectation that employees
will act in an ethical manner
 Policies and procedures to implement and monitor the quality of employee performance
 Timely communication of the employing organization’s policies and procedures, including any
changes to them, to all employees and appropriate training and education on such policies and
procedures
 Policies and procedures to empower and encourage employees to communicate to senior levels
within the employing organization any ethical issues that concern them without fear of
retribution
 Consultation with another appropriate professional accountant

4. What measures or controls must the top-level management or even the corporate board
employ to ensure and encourage the knowledgeable employees to “blow the whistle”
regarding fraudulent activities?

Measures to Encourage Whistle Blowing

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Protection from being fired or demoted and reinstatement

Most often than not, employees who are knowledgeable of the existence of fraud are
intimidated and are afraid of being fired or demoted from their current position. This provides an
assurance of not being kicked out from the company the employee is currently working.

All employees should be able to report serious occurrences without fear of retaliation,
discrimination or disciplinary action. The company should protect the whistleblower’s employment,
remuneration and career opportunities for a reasonable period of time.

Compensation for loss of wage

The disclosure of fraud resulting from whistle blowing may lead to legal proceedings requiring
physical presence of the whistle blower. This will disable him from doing his job leading to loss of wage.
This will ensure that he will be compensated for the loss of wage during the course of the investigation.

Compensation for costs of making the complaint and possible ensuing juridical procedures
Whistle blowing requires costs, may it be financial such as legal fees or non-financial such as
psychological stress. There should be a just compensation of these costs so as not to discourage
employees from disclosing fraud undertaken by the firm.

Establishment of Whistle Blowing System

Enterprises are encouraged to provide a whistle blowing system that is commensurate with
their size and resources. The Whistle blowing systems aims to ensure that the company considers any
legitimate concern, whether raised by an employee, agent, supplier or customer, in full confidence and
that the same category of person deals with all reports of potential legal wrongdoing, at the earliest
possible opportunity.

The following are the important points that must be considered by the enterprise in the establishment
of the Whistle Blowing System:

 Senior officers of the company should be in charge of the management and administration of
the whistle blowing procedures. Alternatively, a company can designate an independent firm to
investigate any reported concerns.
 A company should ensure that any communication channels stipulated in its procedures are
adequate and in the languages of all countries where the company operates.
 A whistle blowing system, as part of a company's voluntary integrity procedures, will only be
successful if it is not over-regulated from the outside.
 The company should consider domestic legislation, when determining if reporting under a
whistle blowing procedure is compulsory or voluntary and if a worker can report anonymously
as well as on a disclosed basis.

49
  All whistleblowers' reports should be diligently acknowledged, recorded and screened. A
whistleblower whose report is not considered bona fide should be so advised as soon as
possible and that report should be disregarded. All reports should be investigated in the strictest
of confidence, and the whistleblower should be informed of the outcome of the investigation.
 The person who is the subject of the investigation should also be informed as soon as possible,
in order to allow that person to make suitable objections.

Confidentiality of Information

Companies should ensure that the confidentiality of the information revealed through whistle
blowing and the identity of the whistleblower is kept confidential for as long as possible, subject as
required by law.

Rewards for Whistle blowing

As an incremental inducement for employees to disclose information regarding the discovery of
fraud, the reward system may be involved. The type of reward may it be financial or non-financial is at
the discretion of the firm. This may be promotion, increase of salary, acknowledgement etc.

5. As a way, is it appropriate for corporations and accounting firms that they should explicitly
reward ethical behavior by their employees and executives? Why?

As presented previously, one of the methods suggested to encourage employees to disclose

information regarding fraud committed by those in charge of governance is to provide rewards or
incentives. The argument for whistle blowing rewards and argument against will follow.

Argument against Rewards

Rewards for whistle blowing is open to abuse

With the rewards for those who blow the whistle regarding the incurrence of fraud by the firm,
there is a possibility of making up a false accusation for the purpose of self-interest. Moreover, the
financial benefit derived from it will induce individuals to do such act at the expense of the firm.

Argument for Whistle Blowing Rewards

Rewards serves as a compensation for the whistle blower.

50
 There is a necessity of informing them since in a way or another, they will directly or indirectly
be affected. With this, the danger that the whistle blowing act might imposed into the whistle blower is
compensated by the protection and incentives that is given to the whistleblower.

The bottom line is to inculcate a culture of ethical awareness and consciousness to ensure the
proper conduct of duties at all levels. Gearing towards this may take a substantial period of time, but its
effect would be of significant impact. Also, the firm should not provide opportunities of inducing
employees in whatever position, on doing grave practices. There should be proper organization of every
corporate structure to reduce, at a very minimum level the possible conduct of fraud, whether such
opportunity may be perceived or actual.

CONCLUSION

In this case, the internal auditors of Jamaica Water Properties, Inc. are caught in the dilemma of
whether to report the fraud that was authorized by the company CFO, which resulted to a major
disaster in the company, to the corporate board of directors (for them to be able to rectify and do some
correcting measures) or not by keeping silent regarding the matter, given the unfavorable consequences
that the internal auditors may face if they are going to disclose the fact to the corporate owners. The
dilemma was never easy for the auditors to deal with because of the fact that the fraud was committed
by a top company officer and was done for the benefit of the organization, though indirectly. And in the
end, the auditors just reported the said fraud when the company was already in great trouble.

Undoubtedly this audit case had put another page in the history of the internal auditing
profession marked with scandals due to unprincipled stands.

In the case of JWP, we believe that the roots of the predicaments include: the company’s poor
internal control structure, the company’s old form of organizational structure, the lack of a whistle-
blowing system in the firm and lastly the high level of trust put by the corporate owners to the company
CFO. All these contributed to the internal auditors’ difficulty in reporting the fraud to the owners.

In connection to the dilemma, solutions are available. And, we the researchers strongly pose
that solutions to this dilemma can be categorized into two, namely: solutions that can be established
throughout the company and solutions that can be applied by the auditors to themselves.

First, the company-wide solution is more of a preventive nature rather than as a cure. These
solutions can be established to reduce the company from risks of fraud and to help internal auditors in

51
the carrying of their function. This category includes all but not limited to the following: (1) shifting to
the modern and more effective form of organizational structure characterized by placing the internal
audit committee directly under the corporate board rather than putting them in the control of the
controllership function; (2) establishing of a whistle-blowing system that will help the employees in the
reporting of dishonest to the owners of the board and that will protect them from the threats modeled
by the their immediate superiors who masterminded such dishonesty to the firm; (3) instituting of a
reward system that will encourage the subordinates who are knowledgeable of deceitful acts committed
by their superiors whether they bring good or bad to the company as long as these are illegal and given
that the corporate owners are not aware of the said activities; lastly, (4) conducting a periodic follow
through or examinations of all the company transactions to determine areas that may bring the
company to difficulties and making immediate investigation for the firm to correct them as soon as
possible. Clearly the above-mentioned are more of a prevention but such can be of cure in nature if
these are done after a company realizes that something fraudulent or problematic is happening in the
organization.

On the other hand, solutions to the dilemma that are applicable to the internal auditors
themselves emphasize detection and correction. These answers are cultivated down to the standards of
practice for professionals that provide guidance in the performance of their duties and responsibilities.
The duties and responsibilities of internal auditors shown in Table 1 and 2 are already part of their
accepted profession which means that they are bound to exercise honesty and independence as part of
their work. Additionally, governing bodies have provided steps in solving ethical dilemmas such as the
one shown in Table 3. For sure, these will help the internal auditors in dealing with the problem. Lastly,
the internal auditors must always put in mind that they should not put their profession at stake by just
keeping themselves silent in the face of several devious activities in their environment. With this in
mind, aided with clean conscience, auditors are kept away from this kind of dilemma and they’ll be
reporting immediately to the higher authorities once they face such.

Delving closely to the most basic, the Institute of Internal Auditors define internal auditing as an
independent, objective assurance and consulting activity designed to add value and improve an
organization’s operations. It helps an organization accomplish its objectives by bringing a systematic,
disciplined approach to evaluate and improve the effectiveness of risk management, control, and
governance processes. This clearly says of the distinction of the internal audit profession from the rest
of the jobs in the business world. With this, the internal auditors of JWP, who became silent of the truth
for an unreasonable period, have broken this distinction making them just the same with the “non-
professional”, Ernest Grendi and the three senior company accountants.

As a generalization the researchers are certain that the fraud challenge represents opportunity
for internal auditors. An opportunity that is good if such trial is responded to in a manner that they can
identify better and effective control recommendations that foster improved organizational processes
and operations leading to an eventual achievement of the corporate objectives as well as the fulfillment
of the auditors’ duties as professionals having the oath of integrity. And. Therefore David Sokol was right
when he said, “If you ever obtain something by lying, it’s worthless. Integrity is the highest order of the
day.”

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