UNVERSITY OF ZAMBIA

GRADUATE SCHOOL OF BUSINESS

CORPORATE GOVERNANCE & BUSINESS ETHICS

GSB5041

March 2017

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RATIONALE

Corporate governance deals with the complex set of relationships between the
corporation and its board of directors, management, shareholders, and other
stakeholders. The course is designed to increase the depth of students’
understanding of corporate governance issues in business. The course puts a strong
emphasis on the relationship between theoretical concepts and real world issues.

AIM

The aim of this course is to enable students understand the framework and general
principles of ethical behaviour, how they may be applied in the work environment
and the role good corporate governance in achieving the organisation’s objectives.

COURSE PREREQUISITE

There is no prerequisite for the course

OBJECTIVES

By the end of this course, the student should be able to:

i. Explain the purpose of business and how they interact with key stakeholders
and the external environment
ii. Explain business organisation structure, functions and the role of corporate
governance
iii. Demonstrate an understanding of the importance of ethics to business
generally and to the professional accountant
iv. Explain the need for members of professional bodies to adopt the highest
standards of ethical behaviour.
v. Explain the various means of regulating ethical behaviour
vi. Explain how ethical dilemmas and conflicts of interest arise and may be
resolved.
vii. Assess the development of corporate governance to meet public concern in
relation to the management of companies.
viii. Assess the impact of corporate governance on the directors and management
structure of public limited companies and how this benefits stakeholders.

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Contents
1.0 Overview on corporate governance......................................................................................................4
2.0 The Business Organisation...................................................................................................................20
3.0 Business organisation,.........................................................................................................................38
4.0 Accounting and Reporting System.......................................................................................................50
5.0 Control and Compliance......................................................................................................................74
6.0 Codes of Corporate Governance.........................................................................................................79
7.0 Professional Ethics in Accounting and Business...................................................................................99
8.0 Ethics and Social Responsibility.........................................................................................................113

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 Unit One

1.0 Overview on corporate governance

1.1 Corporate Governance: An understanding
Before delving further on the subject, it is important to define the concept of
corporate governance. The vast amount of literature available on the subject
ensures that there exist innumerable definitions of corporate governance. To get a
fair view on the subject it would be prudent to give a narrow as well as a broad
definition of corporate governance.

In a narrow sense, corporate governance involves a set of relationships

amongst the company’s management, its board of directors, its shareholders, its
auditors and other stakeholders. These relationships, which involve various rules
and incentives, provide the structure through which the objectives of the company
are set, and the means of attaining these objectives as well as monitoring
performance are determined. Thus, the key aspects of good corporate governance
include transparency of corporate structures and operations; the accountability of
managers and the boards to shareholders; and corporate responsibility towards
stakeholders.

While corporate governance essentially lays down the framework for creating
long-term trust between companies and the external providers of capital, it would
be wrong to think that the importance of corporate governance lies solely in better
access of finance.

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Companies around the world are realizing that better corporate governance adds
considerable value to their operational performance:

 It improves strategic thinking at the top by inducting independent director

who bring a wealth of experience, and a host of new ideas.
 It rationalizes the management and monitoring of risk that a firm
facesglobally.
 It limits the liability of top management and directors, by carefully
articulatingthe decision making process
 It assures the integrity of financial reports
 It has long term reputational effects among key stakeholders, both
internallyand externally

In a broader sense, however, good corporate governance - the extents to

which companies are run in an open and honest manner- is important for overall
market confidence, the efficiency of capital allocation, the growth and
development of countries’ industrial bases, and ultimately the nations’ overall
wealth and welfare.

It is important to note that in both the narrow as well as in the broad definitions,
the concepts of disclosure and transparency occupy centre-stage. In the first
instance, they create trust at the firm level among the suppliers of finance. In the
second instance, they create overall confidence at the aggregate economy level. In
both cases, they result in efficient allocation of capital.

Having committed to the above definitions, it is important to note that ever since
the first writings on the subject appeared in the academic domain, there have been

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many debates on the true scope and nature of corporate governance mechanisms
around the world.

More specifically on the question ‘Who should corporate governance really

represent?’ This issue of whether a company should be run solely in the interest of
the shareholders or whether it should take account the interest of all constituents
has been widely discussed and debated for a long time now. Two definitions of
Corporate Governance highlight the variation in the points of view:

‘Corporate governance is concerned with ways of bringing the interests of

investors and manager into line and ensuring that firms are run for the benefit of
investors’. Corporate governance includes ‘the structures, processes, cultures and
systems that engender the successful operation of organizations.’

1.2 Global Landmarks in the Emergence of Corporate Governance

There were several frauds and scams in the corporate history of the world. It
was felt that the system for regulation is not satisfactory and it was felt that it
needed substantial external regulations. These regulations should penalize the
wrong doers while those who abide by rules and regulations, should be rewarded
by the market forces. There were several changes brought out by governments,
shareholder activism, insistence of mutual funds and large institutional investors,
that corporate they invested in adopt better governance practices and in formation
of several committees to study the issues in depth and make recommendations,
codes and guidelines on Corporate Governance that are to be put in practice. All
these measures have brought about a metamorphosis in corporate that realized that
investors and society are serious about corporate governance.

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1.2.1 Developments in USA

Corporate Governance gained importance with the occurrence of the Watergate

scandal in United States. Thereafter, as a result of subsequent investigations, US
regulatory and legislative bodies were able to highlight control failures that
hadallowed several major corporations to make illegal political contributions and
to bribe government officials. This led to the development of the Foreign and
Corrupt Practices Act of 1977 that contained specific provisions regarding the
establishment, maintenance and review of systems of internal control. This was
followed in 1979 by Securities and Exchange Commission’s proposals for
mandatory reporting on internal financial controls. In 1985, following a series of
high profile business failures in the US, the most notable one of which being the
savings and loan collapse, the Tradway Commission was formed to identify the
main cause of misrepresentation in financial reports and to recommend ways of
reducing incidence thereof. The Tradway Report published in 1987 highlighted the
need for a proper control environment, independent audit committees and an
objective internal audit function and called for published reports on the
effectiveness of internal control. The commission also requested the sponsoring
organizations to develop an integrated set of internal control criteria to enable
companies to improve their control.

1.2.2 Developments in UK

In England, the seeds of modern corporate governance were sown by the Bank of
Credit and Commerce International (BCCI) Scandal. The Barings Bank was
another landmark. It heightened people’s awareness and sensitivity on the issue
and resolve that something ought to be done to stem the rot of corporate misdeeds.

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These couple of examples of corporate failures indicated absence of proper
structure and objectives of top management. Corporate Governance assumed more
importance in light of these corporate failures, which was affecting the
shareholders and other interested parties.

As a result of these corporate failures and lack of regulatory measurers

fromauthorities as an adequate response to check them in future, the Committee of
Sponsoring Organizations (COSO) was born. The report produced in 1992
suggested a control framework and was endorsed a refined in four subsequent UK
reports: Cadbury, Ruthman, Hampel and Turbull.

There were several other corporate failures in the companies like Polly Peck,
British & Commonwealth and Robert Maxwell’s Mirror Group News International
were all victims of the boom-to-bust decade of the 1980s. Several companies,
which saw explosive growth in earnings, ended the decade in a memorably
disastrous manner.

Such spectacular corporate failures arose primarily out of poorly managed business
practices. The publication of a series of reports consolidated into the Combined
Code on Corporate Governance (The Hampel Report) in 1998 resulted in major
changes in the area of corporate governance in United Kingdom. The corporate
governance committees of last decade have analyzed the problems and crises
besetting the corporate sector and the markets and have sought to provide
guidelines for corporate management. Studying the subject matter of the corporate
codes and the reports produced by various committees highlighted the key practical
problem and concerns driving the development of corporate governance over the
last decade.

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1.2.3 Corporate Governance Committees

The main committees, known by the names of the individuals who chaired them
are discussed hereunder

a) Cadbury committee on Corporate Governance – 1992

The stated objectives of the Cadbury Committee was “To help raise
thestandards of corporate governance and the level of confidence in
financialreporting and auditing by setting out clearly what it sees as the
respectiveresponsibilities of those involved and what it believes his expected
of them.The committee investigated the accountability of the board of
directors toshareholders and to society. It submitted its report and associated
“Code ofBest Practices” in 1992 wherein it spelt out the methods of
governance neededto achieve a balance between the essential power of the
board of directors andtheir proper accountability. Its recommendations were
not mandatory. TheCadbury code of best practices had 19 recommendations.
Therecommendations are in the nature of guidelines relating to the board
ofdirectors, non-executive directors, executive directors and those on
reportingand control.

The stress in the Cadbury committee report is on the crucial role of the
boardand the need for it to observe the Code of Best Practices. Its important
recommendations include the setting up of an audit committee
withindependent members.
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b) The Paul Ruthman Committee
The committee was constituted later to deal with the said controversial
pointof Cadbury Report. It watered down the proposal on the grounds
ofpracticality. It restricted the reporting requirement to internal
financialscontrols only as against “the effectiveness of the company’s
system of internalcontrol” as stipulated by the Code of Best Practices
contained in the CadburyReport.The final report submitted by the
Committee chaired by Ron Hampel had some important and progressive
elements, notably the extension of directors’responsibilities to “all relevant
control objectives including business riskassessment and minimizing the risk
of fraud….”
c) The Greenbury Committee
This committee was setup in January 1995 to identify good practices by
theConfederation of British Industry (CBI), in determining
directors’remuneration and to prepare a code of such practices for use by
public limitedcompanies of United Kingdom.

The committee aimed to provide an answer to the general concerns about

theaccountability by the proper allocation of responsibility for
determiningdirectors’ remuneration, the proper reporting to shareholders and
greater transparency in the process. The committee produced the Greenbury
Code of Best Practice which was divided into the four sections:
Remmuneration Committee, Disclosures, Remuneration Policy and Service
Contracts and Compensation. The Greenbury committee recommended that
UK companies should implement the code as set out to the fullest extent
practicable, that they should make annual compliance statements, and that

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 investor institutions should use their power to ensure that the best practice is
followed.

d) The Hampel Committee

The Hampel committee was setup in November 1995 to promote high
standards on Corporate Governance both to protect investors and preserve
and enhance the standing of companies listed on the London Stock
Exchange. The committee developed further the Cadbury report. And it
made the following recommendations.
i. The auditors should report on internal control privately to the directors.
ii. The directors maintain and review all controls.
iii. Companies should time to time review their need for internal auditfunction
and control.

It also introduced the combined code that consolidated the recommendation of

earlier corporate governance reports (Cadbury Committee and Greenbury
Committee).

e) The Combined Code

The combined code was subsequently derived from Ron Hampel
Committee’s Final Report, Cadbury Report and the Greenbury Report. The
combined codeis appended to the listing rules of the London Stock
Exchange. As such, compliance of the code is mandatory for all listed
companies in UK.The stipulations contained in the Combined Code require,
among other things, that the boards should maintain a sound system of
internal control to safeguardshareholder’s investments and the company’s
assets. The directors should, atleast annually, conduct a review of the
effectiveness of the group’s system ofinternal control covering all controls,

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 including financial, operational andcompliance and risk management, and
report to shareholders that they havedone so.
f) The Turnbull Committee
The Turnbull Committee was set up by the Institute of Chartered
Accountantsin England and Wales (ICAEW) in 1999 to provide guidance to
assistcompanies in implementing the requirements of the Combined Code
relatingto internal control.The committee provided guidance to assist
companies in implementing therequirements of the Combined Code relating
to internal control. Itrecommended that where companies do not have an
internal audit function, theboard should consider the need for carrying out an
internal audit annually.The committee also recommended that board of
directors confirm theexistence of procedures for evaluation and managing
key risks.Corporate Governance is constantly evolving to reflect the current
corporate economic and legal environment. To be effective, corporate
governance practices need to be tailor to particular needs, objectives and risk
management structure of an organization.

1.2.4 World Bank on Corporate Governance

The World Bank, involved in sustainable development was one of the earliest
economic organizationsto study the issue of corporate governance and suggest
certain guidelines. The World Bank report on corporate governance recognizes the
complexity of the concept and focuses on the principles such as transparency,
accountability, fairness and responsibility that are universal in their applications.

Corporate governance is concerned with holding the balance between economic

and social goals and between individual and communal goals. The governance
framework is there to encourage the efficient use of resources and equally to

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require accountability for the stewardship of those resources. The aim is to align as
nearly as possible, the interests of individuals, organizations and society.

The foundation of any corporate governance is disclosure. Openness is the basis of

public confidence in the corporate system and funds will flow to those centers of
economic activity, which inspire trust. This report points the way to establishment
of trust and the encouragement of enterprise. It marks an important milestone in
thedevelopment of corporate governance.

1.2.5 Organization for Economic Co-operation and Development (OECD)

Principles

Organization for Economic Co-operation and Development (OECD) was one of

the earliest non-governmental organizations to work on and spell out principles and
practices that should govern corporate in their goal to attain long-term shareholder
value. The OECD were trend setters as the Code of Best practices are associated
with Cadbury report. The OECD principles in summary include the following
elements.

i. The rights of shareholders

ii. Equitable treatment of shareholders
iii. Role of stakeholders in corporate governance
iv. Disclosure and Transparency
v. Responsibilities of the board

The OECD guidelines are somewhat general and both the Anglo-American system
and Continental European (or German) system would be quite consistent with it.

1.2.6 Sarbanes- Oxley Act, 2002

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The Sarbanes-Oxley Act (SOX) is a sincere attempt to address all the issues
associated with corporate failure to achieve quality governance and to restore
investor’s confidence. The Act was formulated to protect investors by improving
the accuracy and reliability of corporate disclosures, made precious to the
securities laws and for other purposes. The act contains a number of provisions that
dramatically change the reporting and corporate director’s governance obligations
of public companies, the directors and officers. The important provisions in the
SOX Act are briefly given below.

i. Establishment of Public Company Accounting Oversight Board (PCAOB):

SOX creates a new board consisting of five members ofwhom two will be
certified public accountants. All accounting firmshave to get registered with
the board. The board will make regularinspection of firms. The board will
report to the Securities and Exchange Commission (SEC). The report will
beultimately forwarded to Congress.
ii. Audit Committee: The SOX provides for new improved auditcommittee.
The committee is responsible for appointment, fixing feesand oversight of
the work of independent auditors. The registeredpublic accounting firms
should report directly to audit committee on allcritical accounting policies.
iii. Conflict of Interest: The public accounting firms should not performany
audit services for a publically traded company.
iv. Audit Partner Rotation: The act provides for mandatory rotation of lead audit
or coordinating partner and the partner reviewing audit onceevery 5 years.
v. Improper influence on conduct of Audits: According to act, it isunlawful for
any executive or director of the firm to take any action tofraudulently
influence, coerce or manipulate an audit.

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 vi. Prohibition of non-audit services: Under SOX act, auditors areprohibited
from providing non-audit services concurrently with auditfinancial review
services.
vii. Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs) are
required to affirm the financials: CEOs and CFOsare required to certify the
reports filed with the Securities andExchange Commission (SEC).
viii. Loans to Directors: The act prohibits US and foreign companies with
Securities traded within US from making or arranging from thirdparties any
type of personal loan to directors.
ix. Attorneys: The attorneys dealing with publicly traded companies arerequired
to report evidence of material violation of securities law orbreach of
fiduciary duty or similar violations by the company or anyagent of the
company to Chief Counsel or CEO and if CEO does notrespond then to the
audit committee or the Board of Directors.
x. Securities Analysts: The SOX has provision under which brokers anddealers
of securities should not retaliate or threaten to retaliate ananalyst employed
by broker or dealer for any adverse, negative orunfavorable research report
on a public company. The act furtherprovides for disclosure of conflict of
interest by the securities analystsand brokers or dealers.
xi. Penalties: The penalties are also prescribed under SOX act for anywrong
doing. The penalties are very stiff.

The Act also provides for studies to be conducted by Securities and Exchange
Commission or the Government Accounting Office in the following area:

i) Auditor’s Rotation
ii) Off balance Sheet Transactions
iii) Consolidation of Accounting firms & its impact on industry

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 iv) Role of Credit Rating Industry
v) Role of Investment Bank and Financial Advisers.

The most important aspect of SOX is that it makes it clear that company’s senior
officers are accountable and responsible for the corporate culture they create and
must be faithful to the same rules they setout for other employees. The CEO for
example, must be responsible for the company’s disclosure, controls and financial
reporting.

1.2.7 Corporate governance: History in India

There have been several major corporate governance initiatives launched in

Indiasince the mid-1990s. The first was by the Confederation of Indian Industry
(CII), India’s largest industry and business association, which came up with the
first voluntary code of corporate governance in 1998. The second was by the SEBI,
now enshrined as Clause 49 of the listing agreement. The third was the Naresh
Chandra Committee, which submitted its report in 2002. The fourth was again by
SEBI — the Narayana Murthy Committee, which also submitted its report in 2002.
Based on some of the recommendation of this committee, SEBI revised Clause 49
of the listing agreement in August 2003.

Subsequently, SEBI withdrew the revised Clause 49 in December 2003, and

currently, the original Clause 49 is in force.

1.2.7.1 The CII Code

More than a year before the onset of the Asian crisis, CII set up a committee to
examine corporate governance issues, and recommend a voluntary code of best
practices. The committee was driven by the conviction that good corporate
governance was essential for Indian companies to access domestic as well as

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global capital at competitive rates. The first draft of the code was prepared by April
1997, and the final document (Desirable Corporate Governance: A Code), was
publicly released in April 1998. The code was voluntary, contained detailed
provisions, and focused on listed companies.

1.2.7.2 Desirable Disclosure

“Listed companies should give data on high and low monthly averages of share
prices in a major stock exchange where the company is listed; greater detail on
business segments, up to 10% of turnover, giving share in sales revenue, review of
operations, analysis of markets and future prospects.” Major Indian stock
exchanges shouldgradually insist upon a corporate governance compliance
certificate, signed by theCEO and the CFO.” If any company goes to more than
one credit rating agency, then it must divulge in the prospectus and issue document
the rating of all the agencies that did such an exercise. These must be given in a
tabular format that shows where the company stands relative to higher and lower
ranking.”

“Companies that default on fixed deposits should not be permitted to accept further
deposits and make inter-corporate loans or investments or declare dividends until
the default are made good.”

The CII code is voluntary. Since 1998, CII has been trying induce companies to
disclose much greater information about their boards. Consequently, annual reports
of companies that abide by the code contain a chapter on corporate governance.

1.2.7.3 Kumar Mangalam Birla committee report and Clause 49

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While the CII code was well-received and some progressive companies adopted it,
it was felt that under Indian conditions a statutory rather than a voluntary code
would be more purposeful, and meaningful. Consequently, the second major
corporate governance initiative in the country was undertaken by SEBI. In early
1999, it set up a committee under Kumar Mangalam Birla to promote and raise the
standards of good corporate governance. In early 2000, the SEBI board had
accepted and ratified key recommendations of this committee, and these were
incorporated into Clause 49 of the Listing Agreement of the Stock Exchanges.

This report pointed out that the issue of corporate governance involves besides
shareholders, all other stakeholders. The committee’s recommendations have
looked at corporate governance from the point of view of the stakeholders and in
particular that of shareholders and investors.

1.2.8 Summary

In this chapter, you have been introduced to the meaning of corporate

governance, the reasons for its emergency, its purpose and some of the major
world countries’ views and their concerns.

You have also learned how major world countries and organisations have struggled
to bring codes and laws to establish trust and confidence of investors and the entire
society in the operation and management of public and private corporate
organisation.

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 Unit 2

The Business Organisation

2.0 Introduction

“All organizations exist in multiple environments. They exist within the culture
and social structure of the larger society, and they coexist in various relations to
other organizations with similar purposes, as well as disparate organizations and
groups of people who may be owners, managers, employees, customers, clients, or
simply ‘the public at large’.” Edgar Schein (Organizational Psychology, Prentice
Hall, 1988).

Organisations in one form or another have always been an integral feature of

human civilisation. Although the origins of modern organisations can be traced
back thousands of years they continually evolve and the organisations of today are
clearly very different. The beginning of the 20th century with the emergence of
large corporate entities, and the work of writers such as Frederick Taylor on
scientific management and Max Weber on bureaucracy, drew attention to the
importance of the work organisation.

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All organisations have some function to perform. Organisations exist in order to
achieve objectives and to provide satisfaction for their members. Organisations
enable objectives to be achieved that could not be achieved by the efforts of
individuals on their own. It must be remembered that organisations are structures
of people. Through co-operative action, members of an organisation can provide a
synergistic effect.

Organisations are an integral part of society involving both public and private
sectors.For example, in their discussion of the new public services, Farnham and
Horton define organizations as:

“… Social constructs created by groups in society to achieve specific purposes by

means of planned and co-ordinated activities. These activities involve using human
resources to act in association with other inanimate resources in order to achieve
the aims of the organisation.”

There are then many different types of organisations which are set up to serve a
number of different purposes and to meet a variety of needs. Organisations come in
all forms, shapes and sizes.Consider the diversification among such organisations
as, for example: Firm of accountants; Hotel; School; Leisure centre; Retail shop
Quarry works; Local authority Government department; Airport; Pharmaceutical
company;Motor car manufacturer; Bank; Hospital;Nationalized industry etc. all
these are forms of organisation, others for-profit while others are not-for-profit.

The structure, management and functioning of these organisations will all vary
because of differences in the nature and type of the organisation, their respective
goals and objectives, and the behaviour of the people who work in them.

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2.1 TYPES OF BUSINESSES ORGANISATIONS
2.1.1 What is a Business Organisation?

A business organisation is defined variously to suit one’s requirements. In our

studies we shall define a business organisation as: “a person, firm, company or
other organisation which makes or produces some kind of service usually for the
purpose of making profits.”

- Profit is excess of Income over Expenditure

- Loss is excess of Expenditure over Income

Business can be organized at different levels with a major limiting factor being
resources (capital). Businesses range from basic simple business to a more
complex one.

2.1.2 SOLE TRADER

This is the type of business owned and operated by one person. However, the
person running this business can have employees. The sole trader, as an individual
will provide the resources and skills to operate the business.

2.1.3 PARTNERSHIP

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This is a type of business where two or more persons put their resources together to
carry on business for the purpose of making profits. There is a limit as to the
number of partners depending on the type of business to be carried on.

2.1.4 COMPANY

This is a formal association of persons for business purposes. A company is legally

incorporated under company law. Members of a company are called shareholders.

Companies are usually limited (Ltd) meaning that if the company goes into
liquidation because of debts, each member will only lose the cost of his shares i.e.
amount contributed in the business and no more.

2.1.5 TYPES OF LIMITED COMPANIES

(a) PRIVATE COMPANIES

They are private in the sense that membership is restricted to well-known

individuals and members are few in numbers.Private companies usually have the
word “LIMITED” at the end of thename. Other countries use the word
“PRIVATE”.They do not invite members of the public to subscribe for shares
andmembers are not allowed to transfer their shares without agreement of the other
shareholders.

(b) PUBLIC COMPANIES

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They offer shares to the public and there is no limit to membership. Shareholders
can transfer shares without restrictions. Such a company must include the words
PUBLIC LIMITED COMPANY (Abbr. PLC) after its name.

2.2 BUSINESS STAKEHOLDERS

A stakeholder in a company is someone who has an interest or ‘stake’ in it, and is

affected by what the company does. Each stakeholder or stakeholder group can
therefore expect the company to behave or act in a particular way, with regard to
the stakeholder’s interest. A stakeholder can also expect to have some say in some
of the decisions a company takes and some of the actions it takes. The balance of
power between different stakeholder groups, and the way in which power is
exercised, are key issues in corporate governance.

A public company has a number of different stakeholder groups:

 Its members or equity shareholders are the owners. In a small company, the
owners may also be the directors. In a large public company, the directors
may own some shares, but are not usually the largest shareholders. The
interests of the shareholders are likely to be focused on the values of their
shares and dividend payments. However, the powers of shareholders in large
public companies are usually fairly restricted and shareholders have to rely
on the board of directors to act in their best interests.
 A different situation arises when there is a majority shareholder or a
significant shareholder. A shareholder with a controlling interest is able to
influence decisions of the company through an ability to control the
composition of the board of directors. When there is a majority shareholder,
the interest of minority shareholders may be disregarded.

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 The board of directors has responsibilities for giving direction to the
company. It delegates most executive powers to itself, such as decisions
about raising finance, paying dividends and making major investments.
Executive management is also held accountable to the board for their
performance.
 A board of directors is made up of both executives and non-executives.
Executive directors are individuals who combine their role as director with
their position within the executive management of the company. Non-
executive directors perform the functions of director only, without any
executive responsibilities. Executive directors combine their stake in the
company as a director with their stake as a fully paid employee, and their
interests are therefore likely to differ from those of the non-executives.
 The board may take decisions collectively, but it is also a collection of
individuals, each with his or her personal interests and ambitions. Some
individuals are more likely to dominate the decisions by a board and to exert
strong influence over their colleagues. In particular, the most influential
individuals are likely to be the chairman, who can either be a non-executive
or alternatively can have some executive responsibilities, and the chief
executive officer (CEO). The chairman is responsible for the functioning of
the board. The CEO is the senior executive director, and is accountable to
the board for the executive management of the company. The term ‘CEO’
derives for the US, but is now widely used in the UK (where the term
‘managing director’ is also used). The main interest of individual executive
directors is likely to be power and authority, a high remuneration package
and a wealthy life-style.
 Management is responsible for running the business operations and is
accountable to the board of directors (and more particularly to the CEO).
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 Individual managers, like executive directors, may want power, status, and
high remuneration. As employees, they may see their stake in their company
in terms of the need for a career and an income.
 Employees have a stake in their companies because it provides them with a
job and an income. They too have expectations about what their company
should do for them, and these could be security of employment, good pay
and suitable working conditions. Some employee rights are protected by
employment law, but the powers of employees are generally limited.
 Lenders and other creditors have an indirect interest in a company, because
they expect to be paid what they are owned. If they deal with the company
regularly, or over a long time, they will expect the company to do business
with them in accordance with their contractual agreements. If the company
becomes insolvent, unpaid creditors will take a more significant role in its
governance, depending on the insolvency law in the country, for example by
taking legal action to take control of the business or its assets.
 Representatives of investment institutions have some influence over public
companies whose share are traded on the stoke market. Representative
bodies include the Association of British Insurers (ABI) and National
Association of Pension Fund (NAPF) in the UK, and the International
Corporate Governance Network, an association of ‘activists’ institutional
investors around the world. These bodies may try to coordinate the activities
of their members, for example, by encouraging them to vote in a particular
way on resolutions at the annual general meetings of companies in which
they are shareholders. These bodies represent the opinions of the investment
community generally.
 The general public is also stakeholders in large companies, often because
they rely on the goods and services provided by a company to carry on their
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 life. For example, households expect utility companies to provide
uninterrupted supply of water, electricity, or gas to their homes, or a reliable
telephone connection. Commuters expect a rail company to be an obligation
to provide a convenient and reliable transport service to and from work, and
at a reliable price. Pressure groups such as environment protection groups,
sometimes try to influence the decisions of companies.

2.3 BUSINESS EXTRNAL ENVIRONMENT

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The task environment consists of stakeholders with whom organizations interacton
a fairly regular basis. These stakeholders include domestic and
internationalcustomers, suppliers, competitors, government agencies and
administrators, localcommunities, activist groups, unions, and financial
intermediaries. MichaelPorter, an economist at Harvard University, assimilated
years of economic researchinto a simple model that helps determine the influence
of the first three ofthese stakeholders—suppliers, customers, and competitors—on
competition inan industry.

27
Competitive Forces

Michael Porter integrated the theory of industrial organization economics into

a“user friendly” model of the forces that drive industry competition. Industries
areoften difficult to define, but in general they refer to a group of organizations
thatcompete directly with each other to win orders or sales in the
marketplace.Porter’s model includes suppliers, customers, and industry
competitors.

Competitors are further divided into three types: existing competitors,

potentialcompetitors, and indirect competitors. The influence of potential
competitors on industry competition is determined by the strength of entry barriers,
in otherwords, the forces that discourage new firms from entering the industry.
Indirectcompetitors sell products that can be substituted for products sold by
existingcompetitors, such as contact lenses and corrective surgery as substitutes for
glasses. According to Porter, the five forces largely determine the type and levelof
competition in an industry and, ultimately, the industry’s profit potential.

Existing Competitors
In most industries, competitive moves by one firm affect other firms in the
industry, which may incite retaliation or countermoves. Competitors jockey with
each other for market share and for the favorable comments of investment analysts.
In many industries, every new product introduction, marketing promotion, and
capacity expansion has implications for the revenues, costs, and profits of other
competitors. Overall profitability is most susceptible to negative pressures from
competitive rivalry in industries characterized by the following:
1) Slow industry growth, which means that competitors must steal market share
if they intend to grow.

28
 2) High fixed costs, which mean that firms are under pressure to increase sales
to cover their costs and earn profits.
3) Lack of product differentiation, which puts a lot of pressure on prices and
often leads to price-cutting strategies.
4) A large numbers of competitors, which means that the total market must be
divided in more ways.
5) High exit barriers, which means that firms may lose all or most of their
investments in the industry when they withdraw from it. Therefore, they are
more likely to remain in the industry even if profits are low.
In many industries, competition is so intense that profitability is suppressed to
almost nothing, as has been the case at various times in the airline, small computer,
and fast food industries.

Potential Competitors/Entry Barriers

Several forces determine the ease with which new competitors can enter an
industry and, therefore, how many new entrants can be expected. New entrants
increase competition in an industry, which may drive down prices and profits.
They may add capacity, introduce new products or processes, and bring a fresh
perspective and new ideas—all of which can drive down prices, increase costs, or
both. Forces that keep new entrants out, providing a level of protection for existing
competitors are called entry barriers. Examples of entry barriers that are found in
many industries include the following:

1) Economies of scale, which occur when it is more efficient to produce a

product in a larger facility at higher volume.
2) Large capital requirements, also known as start-up costs, can prevent a small
competitor from entering an industry.

29
 3) High levels of product differentiation, which means that some firms enjoy a
loyal customer base, making it harder for a new firm to draw away
customers.
4) High switching costs, which apply not only to suppliers, can also serve as an
entry barrier protecting established firms in an industry.
5) Limited access to distribution channels, which may prevent new companies
from getting their products to market.
6) Government policies and regulations that limit entry into an industry,
effectively preventing new competition.
7) Existing firm possession of resources that are difficult to duplicate in the
short term, such as patents, favorable locations, proprietary product
technology, government subsidies, or access to scarce raw materials.
8) A past history of aggressive retaliation by industry competitors toward new
entrants.
Taken together, these forces can result in high, medium, or low barriers. In
industries with high entry barriers, few new firms enter the industry, which reduces
the competitive intensity and stabilizes profits for industry incumbents. When entry
barriers are low, new firms can freely enter the industry, which increases rivalry
and depletes profits. Examples of industries that are traditionally associated with
high barriers to entry are aircraft manufacturing (due to technology, capital costs,
and reputation) and automobiles manufacturing (due to capital costs, distribution,
and brand names). Medium-high barriers are associated with industries such as
household appliances, cosmetics, and books. Low entry barriers are found in
industries such as apparel manufacturing and most forms of retailing. One of the
most powerful effects of the Internet has been the ability to circumvent traditional
barriers to entry. For many Americans, Amazon.com is as synonymous with book
retailing as Barnes and Noble. Amazon, however, never had to face the
30
extraordinary expense of leasing or buying land, building large bookstores in
premium retail locations, stocking and maintaining inventories in remote locations,
and hiring and training a workforce experienced in the nuances of book retailing.
They circumvented those barriers to entry by going straight to consumers with an
exclusive Internet strategy.

Indirect Competitors/Substitutes
If organizations provide goods or services that readily substitute for the goods and
services provided by an industry, those organizations become indirect competitors.
For example, aspirin, ibuprofen, and acetaminophen are all substitute pain
relievers. In the service sector, credit unions are substitutes for banks and bus
travel is a substitute for airline travel. Close substitutes can place a ceiling on the
price that an industry can be charged for a good or service. For example, if the
price of naproxen (e.g., Aleve) pain reliever/fever reducer becomes too high, many
consumers who typically prefer it may switch to aspirin, acetaminophen (e.g.,
Tylenol), or ibuprofen (e.g., Advil). Although Porter does not explicitly address
other factors in his original model, other stakeholder groups exist that can
influence an industry’s profitability. Special interest groups and government
agencies, for example, take actions that cause organizations to invest money,
which can influence cost structures and profits. For example, improvements in
automotive fuel efficiency and safety are largely the result of pressures from
consumer groups and regulators.
Customers

Although all customers are important, some are more importantthan others. For
instance, when retail giant Home Depot announced that it wouldno longer buy
carpet from Shaw Industries (because Shaw, a carpet manufacturer, was moving
into retail), Shaw’s stock dropped by 11 percent in one day.

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According to Porter, customers tend to exhibit a powerful force on competition
inan industry if the following conditions exist:

1) There are a small number of customers. In this case, losing one

customermakes a big difference.
2) The customers make high-volume purchases.
3) The purchases customers make from the industry are large relative to
theamount expended for items from other industries. Here customers
willexpend considerable effort to shop for the best price.
4) The products customers are buying are undifferentiated (also known
asstandard or generic). This means that customers are not concerned
aboutwhich company they buy from.
5) The customers earn low profits. Customers who earn low profits areunder
constant pressure to keep the costs of their purchases down.
6) The customers can easily get accurate information on the selling
industry’scosts and demand. This gives them a real edge during negotiations.
7) The customers can easily integrate backward and become their own
suppliers.Both Sears and General Motors have been known to buy
suppliercompanies when they are unhappy with pricing.
8) Customers can easily switch from one seller to another.

In combination, these forces determine the bargaining power of customers, that is,
the degree to which customers exercise active influence over pricing andthe
direction of product development efforts. The large discount retailers such asWal-
Mart, Kmart, and Target are powerful because of high-volume purchases andthe
ease with which they switch from one manufacturer to another for manyproducts.

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Suppliers

Suppliers to industries provide equipment, supplies, componentparts, and raw

materials. The labor and capital markets from which firms drawtheir employees
and investment funds are also a source of supply. Powerful supplierscan raise their
prices and therefore reduce profitability levels in the buyingindustry. They can also
exert influence and increase uncertainty for the buying industryby threatening to
raise prices, reducing the quality of goods or services provided,or not delivering
supplies when needed. In general, supplier power isgreater under the following
circumstances:

1) Only a few suppliers are available.

2) Few substitutes exist for the product or service that is supplied. (Thesefirst
two conditions limit the ability of the buying industry to use
alternativesupply sources as a bargaining tool.)
3) Suppliers are not dependent on the buying industry for a large percentageof
their total sales. This means that the loss of one sale is not very important.
4) Suppliers know that the buying industry must have the product or servicethat
suppliers provide to manufacture their own products.
5) Suppliers have differentiated their products, which mean that the buying
industry is willing to pay more for certain brands.
6) Suppliers make it costly to switch suppliers. IBM built its
mainframebusiness by making IBM mainframes incompatible with other
brands,thus preventing buyers from switching.
7) Suppliers can easily integrate forward and thus compete directly withtheir
former buyers.

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These forces combine to determine the strength of suppliers and the degree to
which they can exert influence over the profits earned by firms in the industry. The
notebook computer industry, for instance, is one that is particularly susceptible to
the power of suppliers. Most of the industry competitors purchase microprocessors,
batteries, operating system software, and flat-panel displays from suppliers.
Consequently, the manufacturing costs, performance characteristics, and
innovativeness of the notebook computer are largely in the hands of suppliers.

Auditors

External auditors are responsible for auditing the company’s financial statements
and providing reasonable assurance that they are presented fairly and in conformity
with GAAP and that they reflect true representation of the company’s financial
position and results of operation. Auditors are also required to express an opinion
on the effectiveness of the design and operation of ICFR. The external audit
function is intended to lead credibility to financial reports and reduce information
risk that financial reports are biased, misleading, inaccurate, incomplete, and
contain material misstatements that were not prevented or detected by the ICFR
system.

The audit function performed by external auditors can play an important role in
achieving effective corporate governance. The external audit function can be
viewed as a value-added function when lending credibility to published financial
reports. However, audit failures at the turn of the twenty-first century that caused
the demise of Andersen, one of the Big Five public accounting firms, raised serious
concerns as to whether the audit function has a positive impact on the effectiveness
of corporate governance. Flesher, Previts, and Samson positive trace the origin of
auditing to a governance procedure by Pilgrims and Puritans. They argue that that

34
auditing was developed long before the establishment of the accounting profession
and regulations requiring financial statements of public companies to be audited by
independent auditors. They provide evidence that traces auditing to the corporate
governance practices of early business enterprises. Accounting has envolved from
number crunching to a service activity for management, and now in light of
emerging corporate governance reforms, a function that leads credibility,
dependability, and objectivity to the preparation of reliable, useful, and transparent
financial reports and effective internal controls.

Creditors

Lenders and creditors are considered as the second tier of stakeholders in the
company. A typical ownership structure of a public company usually consists of
three distinct components: debt security held by creditors, internal equity securities
held by directors and officers, and external equity held by shareholders. Debt and
equity securities may have a different impact on the company’s corporate
governance structure.

The proportion of debt equities to the total capital of the company determines the
extent of debt holders’ concerns that management may be motivated to transfer
wealth from them to shareholders and also determines the agency costs assumed by
debt holders and their demand for monitoring. Thus, debt holders demand some
control over managerial actions by entering into debt covenant contracts designed
to protect their interests and determine whether breaches of contractual provisions
have occurred.

The extent to which an organisation derives its funding from equity or debt may
significantly affect the business decisions of the company. Because creditors tend
to be more conservative in weighing business risks (shareholders are usually more

35
likely to encourage business decisions that would result in large capital gains,
although creditors do not benefit from such gains), companies largely funded by
creditors often choose to minimize risk instead of maximizing wealth.

The Community

The general public is also stakeholders in large public companies and they play as
external factors that influences the decisions and operations of the companies,
often because they rely on the goods and services provided by a company to carry
on their life. For example, households expect utility companies to provide
uninterrupted supply of water, electricity, or gas to their homes, or a reliable
telephone connection. Commuters expect a rail company to be an obligation to
provide a convenient and reliable transport service to and from work, and at a
reliable price. Pressure groups such as environment protection groups, sometimes
try to influence the decisions of companies.

Government Agencies
Government agencies and the media at large also constitute the external
environment of business entities. Governments do play the roles of regulatory
systems and setting up of limits and operations of large companies for the smooth
running of their national economies and monetary exchange rates. They do this
through their various ministries of finance, commerce, trade and industries. In
behalf of their citizens, government agencies also do ensure that public companies
are providing quality, standard and consistency services to the satisfaction of
customer demands.
Media Pressure
The Media houses have a big role to play in public companies that concerns the
welfare of the general citizenry. Media Pressure works like whistleblowers (usually

36
the get their information from whistleblowers) of public companies in disclosing
the misconducts or improper operations of the companies in as far as their
obligations is concerning in providing the goods and/or services to the people. In
this act, the government, the general public and the stakeholders and shareholders
of the companies are alerted and subsequent actions are undertaken. Their
communications to the public drastically affects the course of actions to be taken
by managements of various companies. They also help public companies to know
how their goods and/or services are being perceived by the general public and what
other competitors are on the stage of action as they are.

37
 UNIT 3

Business organisation
3.1 Business Organisation
A business organisation is defined variously to suit one’s requirements. In our
studies we shall define a business organisation as: “a person, firm, company or
other organisation which makes or produces some kind of service usually for the
purpose of making profits.”
3.2 Business Structure
The primary formal relationships for organizing are responsibility, authority,
andaccountability. They enable us to bring together functions, people, and other
resources for the purpose ofachieving objectives. The framework for organizing
these formal relationships is known as the organizationalstructure. It provides the
means for clarifying and communicating the lines of responsibility, authority,
andaccountability.
3.2.1 Major Types of Organizational Structure
Although there are a number of variations of organizational structure, we shall
discuss line and stafforganizations and committee organization here.
Line Organization
The line organization is the simplest organizational structure. It is the "doing"
organization, in that thework of all organizational units is directly involved in
producing and marketing the organization's goods andservices. There are direct
vertical links between the different levels of the scalar chain. Since there is a
clearauthority structure, this form of organization promotes greater decisionmaking
and is simple in form tounderstand.On the other hand, managers may be

38
overburdened when they have too many duties. The figure belowillustrates a
simple line organization.

Line and Staff Organization

When staff specialists are added to a line organization to "advise; "serve;” or
“support" the line in somemanner, we have a line and staff organization. These
specialists contribute to the effectiveness and efficiency ofthe organization. Their
authority is generally limited to making recommendation to the line organization
Sometimes this creates conflict. However, such conflict can be reduced by having
staff specialists obtain someline experience, which will tend to make them better
understand the problems facing the line managers they support. Such functions as
human resources management and research and development are typical
stafffunctions.

39
The figure below provides an example of such a structure.

Committee Organization
When a group of people is formally appointed to consider or decide certain
matters, this type of structureis a committee. Committees can be permanent
(standing) or temporary and usually supplement line and stafffunctions. Sometimes
ad hoc or temporary committees are set up to deal with a specific problem. Once
thiscommittee makes its recommendations, it is dissolved. On the other hand,
permanent committees usually act inan advisory capacity to certain organizational
units or managers. For example, committees are used to a largeextent in
universities. They may report to a dean or department chair. Certain committees,
called pluralcommittees, have the authority to order, not only to recommend. These
committees are usually reserved for a very high level, such as the board of
directors. An example is an executive committee of the board forcompensation or
for succession planning.Although committees have a number of advantages, they

40
also have a number of disadvantages, particularly being excessively time
consuming. Hence they should be managed effectively.
Organizational Structure and Environment and Technology
Most studies that have been conducted on the relationship between organizational
structure and theenvironment have concluded that the best organizational structure
is contingent to some degree on the conditionsin the environment. Several studies
have also shown a relationship between technology and structure. In fact, these
researchers even suggest that technology itself determines structure. These studies
and others have led toa contingency approach to organizational structure.
Contingency Approach
This approach indicates that the most appropriate organizational structure depends
not only on theorganizational objectives but also on the situation, which includes
the environment, the technology employed, therate and pace of change, the
managerial style, the size of the organization, and other dynamic forces.

YOU SHOULD REMEMBER

The framework for organizing the formal relationships of responsibility,
authority, and accountability is known as the organizational structure. There
are a number of variations of organizational structure, including line, line and
staff, and committee. Most studies of organizational structure indicate a
relationship to the environment as well as to the technology employed.
Consequently, a contingency approach to organizational structure has developed,
which indicates that a number of dynamic forces can and do affect structure.

41
3.3 Business Functions and Processes
When two or more people work together to achieve a group result, it is an
organization. After the objectives of an organization are established, the functions
that must be performed are determined. Personnel requirements are assessed and
the physical resources needed to accomplish the objectives determined. These
elements must then be coordinated into a structural design that will help achieve
the objectives. Finally, appropriate responsibilities are assigned. Determining the
functions to be performed involves consideration of division of labor; this is
usually accomplished by a process of departmentalization.

Grouping related functions into manageable units to achieve the objectives of the
enterprise in the mostefficient and effective manner is departmentalization. A
variety of means can be utilized for this purpose. Theprimary forms of
departmentalization are by function, process, product, market, customer,
geographic area, andeven matrix (also called project organization). In many
organizations, a combination of these forms is used.

Perhaps the oldest and most common method of grouping related functions is by
specialized function, such as marketing, finance, and production (or operations).
Sometimes this form of departmentalization may create problems if individuals
with specialized functions become more concerned with their own specialized area
than with the overall business. An example of departmentalization by function is
shown below:
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Function

President

Operations Marketing Finance

Process

Departmentalization can also take place by process. This type of

departmentalization, which often exists in manufacturing companies, is illustrated
in Figure below.

President

Painting &
Treatment of Finishing
Patern Design
Material

43
Product

Whenever specialized knowledge of certain products or services is needed,

departmentalization by product may be best. This usually occurs in large
diversified companies. This form of departmentalization is illustrated in Figure
below.

Vice President
Marketing

Lincoln Mercury Ford

Market
When a need exists to provide better service to different types of markets,
departmentalization by market may be the appropriate form. An example of a
business serving nonprofit markets, which uses the market form of
departmentalization, is shown in Figure below.

Vice
President

Northeast Midwest Western

Region Region Region

44
Matrix (Project Organization)
Departmentalization by matrix, or project, has received considerable use in recent
years, particularly in such industries as aerospace (e.g., NASA). In this method,
personnel with different backgrounds and experiences that bear on the project are
assembled and given the specific project to be accomplished within a certain time
period. When the project is completed, these specialized personnel return to their
regular work assignments. An example of this form is illustrated in Figure below;
it often takes the shape of a diamond.

Combination Approach
Many organizations, particularly large, physically dispersed and diversified
organizations, utilize severaldifferent forms of departmentalization. The figure
below is an organizational chart showing the use of several forms
ofdepartmentalization.

45
 You Should Remember
Determining the functions to be performed in an organization involves
consideration of division of labor; this is usually accomplished by a process of
departmentalization. The primary forms of departmentalization are by function,
process, product, market, customer, geographical area, matrix (project) or some
combination of these forms.

3.3.1 Business Processes

In order to provide a standard classification approach for use in the MLS program,
a set of eight business processes was identified that defines the full range of
activities a firm engages in to conduct its business. Within these processes are
business functions that describe in greater detail the specific activity that a firm

46
performs in order to produce its product, provide its service, or otherwise achieve
its objective. The processes begin with the procurement of inputs and end with
those services provided after the sale of the good or service. The eight processes
are grouped into core business processes and support business processes. Core
business processes relate most directly to the basic business of the firm, with
operations representing the key industry activity of the company. Support business
processes facilitate core business processes.
Core business processes. Following are the five core business processes
characterizing any firm:
1) Procurement, logistics, and distribution. Those activities associated with
obtaining and storing inputs, and storing and transporting finished products
to customers.
2) Operations. Those activities which transform inputs into final outputs, either
goods or services.
3) Product or service development. Activities associated with bringing a new,
improved, or redesigned product or service to market. Among these
activities are research, marketing analysis, design, and engineering.
4) Marketing, sales, and customer accounts. Activities aimed at informing
existing or potential buyers. These activities include promotion, advertising,
telemarketing, selling, and retail management.
5) Customer and aftersales services. Support services provided to customers
after they purchase the good or service. Such activities include training,
help-desk services, call-center services, and customer support for guarantees
and warranties.

Support business processes - Three support business processes characterize a firm:

47
 1) General management and firm infrastructure. Corporate governance
(legal, finance, planning, and public and government relations), accounting,
building services, management, and administrative support.
2) Human resource management. Activities associated with recruiting, hiring,
training, compensating, and dismissing personnel.
3) Technology and process development. Activities related to maintenance,
automation, design or redesign of equipment, hardware, software,
procedures, and technical knowledge.

Summary of Business Functions and Processes

Core business processes
Strategic management. Those activities carried out at the highest managerial levels. Included are the formation,
implementation, and evaluation of cross-functional decisions that enable the organization to achieve long-term
objectives. Among such operations are the following:
Coordinating activities
Identifying new investments,
acquisitions, and divestments
Setting product strategy
Procurement, logistics, and distribution. Those activities associated with obtaining and storing inputs and with
storing and transporting finished products to customers:
Buying Shipping
Distributing Receiving
Loading Transporting
Packing Warehousing
Operations. Those activities which transform inputs into final outputs, either goods or services. In most cases,
business functions categorized as operations will equate with the industry code of the establishment or the
activity most directly associated with that code. The specific function—the production of a good or the
provision of a service—will relate to the specific industry. Operations activities are as follows:
Assembling products Managing production
Producing goods Managing services
Providing services Conducting quality assurance or quality control

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 Fabricating components
Product or service development. Activities such as the following, associated with bringing a new, improved, or
redesigned product or service to market (many of these activities are research, marketing analysis, design, and
engineering activities):
Developing business plans Developing products or services
Analyzing markets Researching products or services
Designing products or services Testing
Marketing, sales, and customer accounts. Activities aimed at informing existing or potential buyers (many of
these activities are promotion, advertising, telemarketing, selling, and retail management activities):
Advertising Conducting market research
Managing accounts Coordinating media relations
Billing, MerchandizingBranding or managing products
Processing orders Collecting payments
Selling, MarketingTelemarketing

Customer and aftersales service. Activities, including training, help desks, call centers, and customer support
for guarantees and warranties, that provide support services to customers after purchase of the good or service:
Offering call center services Maintaining and repairing products
Providing customer relations Providing technical support
Providing customer service or support Providing warranty support
Installing products

Support business processes

General management and firm infrastructure. Corporate governance (legal, finance, planning, and public and
government relations), accounting, building services, management, and administrative support activities:
Accounting Managing fraud
Providing administrative support Providing general management
Providing cafeteria services Managing government relations
Providing clerical support Providing housekeeping services
Managing contracts Providing investor relations
Managing documents Providing legal and regulatory support
Providing facility or maintenance services Planning
Managing finances Maintaining security
Human resources management. Activities associated with recruiting, hiring, training, compensating, and
dismissing personnel:
Providing employee assistance Hiring and firing personnel
Managing human resources Recruiting
Offering labor relations services Training
Managing payroll and compensation

Technology and process development. Activities related to maintenance, automation, design or redesign of
equipment, hardware, software, procedures, and technical knowledge:
Developing computer systems Providing Internet services
Maintaining or repairing computer systems Designing processes
Managing data Developing and testing software
Processing data Providing software and information technology
Engineering services

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3.4 Business Governance

Unit Four

Accounting and Reporting System

Financial statements and reporting are the principal way in which directors make
themselves accountable to shareholders and, in general, are the most regular
channels of information between two groups. Doubts about the honesty of
transparency of financial reports can have a significant negative effect on investor
confidence and share value. This is way accurate financial reporting and the roles
of the independent external auditor are central to good governance.

This chapter considers the relevance of financial reporting to good corporate

governance and how financial reports could become misleading. It then goes on to
look at the role of the external auditors, the issue of auditor independence and the
responsibilities of the directors for financial reporting. After reading and

50
understanding the contents of the chapter, studying the case examples and working
through all the sample questions, you should be able to:

 Understand the importance for good corporate governance of understandable

and honest financial statements.
 Appreciate the ways in which financial statements could become misleading.
 Understand the role of external auditors and the purpose of the audit report.
 Appreciate the need for auditor independence.
 Discuss the threats to auditor independence and the measures that could be
taken to reduce these threats, including regulation of the audit profession.
 Understand the role of the audit committee.
 Understand how auditors are appointed and their fees decided.
 Understand the responsibilities of the directors for the financial statements
of their company and the meaning of a going concern statement.

4.1 Financial reporting and corporate governance

The annual report and the accounts of a company (and the interim financial
statement of a company) are the principal way in which the directors make
themselves accountable to the shareholders. The financial statements present a
report on the financial performance of the company over the previous financial
year and the financial position of the company as at the end of that year. The
director’s report and other statements that are published in the same document
provide supporting information, much of it in narrative form rather than in
numbers. Shareholders and other investors use the information in the annual report
and accounts to assess the stewardship of the directors and the financial health of
the company.

51
It is an important document for corporate governance it is a means by which the
directors are made accountable to the shareholders, and provides a channel of
communication from the directors to shareholder. It should therefore be:

 Clear and understandable to a reader with reasonable financial awareness;

 Reliable and believable.
The reliability and honesty of the annual report and accounts could be undermined
by:

 Fraud or errors in the preparation of the financial statements;

 ‘Window dressing’ of financial performance or financial position through
the use of accounting policies (methods) that hide the true position of the
company.
So-called ‘aggressive’ accounting policies might be permissible within existing
accountancy regulations and standards, and accepted by the company’s external
auditors. Nevertheless, they have the effects of hiding information from
shareholders, at least in the short term. The financial performance of the company
for the current financial year might be flattered by using certain accounting
policies, but in the longer term, (say, in one or two years’ time) the ‘bad news’ will
eventually emerge.

4.2 Financial reporting and investor confidence

As we saw in chapter 1, the Cadbury Committee was set up as a direct consequent

of concerns about the quality of financial reporting in the UK and the ability of the
auditing profession to provide sufficient assurance to the investment community
about the reliability of company financial statements. Similar concerns were
experienced in the US during the stock market depression of 2012. If investors

52
have doubts about the honesty or transparency of financial reporting, they will hold
back from investing, and share value will suffer as a result.

The problem also extends to the corporate bond markets. Many companies have
borrowed heavily by issuing bonds to investors. Bond investors rely on bond
credit rating in making their investment decisions. Investors are unlikely to
purchase a company’s bond unless they have been rated for creditworthiness by at
least one, and more usually two, top rating agencies. In the US, the top three
agencies are Moody’s, Standard and Poor’s and Fretch, which have the status of
nationally recognized statistical rating organisations (NRSROs).

The US crisis of investor confidence about financial reporting in the mid-2002

brought the role of the credit rating agencies into question. The agencies defended
themselves publicly against allegation that they failed to identify financial
problems in companies such as Enron, when they should have been much more
alert, and in a position to forewarn investors about companies that were getting
financial difficulties.

When a company proposes to issue new bonds, a rating agency carries out an
investigation and then gives a rating to the bonds. The interest rate the company
has to offer on the bonds will depend on the rating awarded. After the bonds have
been issued, the rating agency review the rating continually and adjust it if the
financial condition of the company either improves or worsens.

Bond investors therefore use the rating agencies as ‘gatekeepers to the financial
markets’. Their decisions whether or not to invest in bonds, and the rate of interest
they require for doing so, depend on the judgement of the agencies.

However, the rating agencies themselves rely on honest financial reporting from
the companies they monitor. They are not experts in identifying fraud or dubious
53
accounting practices. The chairman of Moody’s has commended (Financial Times,
23 July, 2002) that in spite of the need to review their rating methods in the wake
of the Enron collapse: ‘We still do not believe that we are going to be in a position
of systematically to detect fraud. Full and fair financial disclosure is critical to us
to do our jobs, just as it is critical for many others in the market to do their jobs.’
Standard & Poor’s similarly defended the credit rating it gave to Parmalat bonds
before the company’s collapse in December, 2003, on the grounds that, it had
relied on relied on audited financial statements for much of its information.

The point to note about credit rating agencies is that the reliability of financial
reporting has consequences for bond markets as well as equity markets, i.e. for the
capital market as a whole.

4.3 Key Issues in Financial Reporting and Auditing

There are several corporate governance issues to consider:

 Why should the management of a company want to prevent the financial

statements from giving a true and fair view of the company’s financial
position and performance?
 What are the consequences of financial statements lacking credibility?
 What should be the role of the company’s external auditors in ensuring that
the financial statements give a true and fair view?
 In what ways might the independence of the external auditors be
compromised?

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  What measures should be taken to ensure that published financial statements
are reliable?
 How can investors obtain some reassurance from the report and accounts of
a company that the company is not going to go into liquidation suddenly and
unexpectedly?
4.4 Misleading Financial Statements

There are three ways in which published financial statements could be misleading:

1) There could be fraudulent misrepresentation of the affairs of the company,

where the company’s management deliberately presents a false picture of the
financial position and performance.
2) The company might use accounting policies whereby it presents its reported
positions and profits more favourable than would be the case it more
conservative accounting policies were used.
3) The financial statements could be complex and difficult for investors to
understand. It is relatively easy matter for accountants, particularly in
companies whose business is itself quite complex, to present financial
statements in a way that readers will find difficulty to comprehend properly.
It is recognized that some companies on occasion might want to report strong
growth in revenues and profits, or even to improve the look of its balance sheet by
‘hiding’ debts or other liabilities. A company can probably succeed in presenting
an excessive favourable picture of its performance for a number of years,
particularly when the economy is strong and business is growing. Eventually,
however, it will become impossible to ‘massage’ the figures any further. Unless
the business can sustain a strong ‘real’ growth in its operations, it cannot achieve
strong profits growth indefinitely. Eventually, a company that uses ‘creative
accounting’ methods will have to report declining profits.

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Improving the reported financial position, at least in the short term, shows the
board of directors in a favourable light, and helps to boost the share price.
Individual directors could therefore stand to benefit from higher annual bonuses
and more valuable share options.

The worldwide falls in stock markets, particularly in 2002, were prompted to a

large extend not simply by concerns about the financial collapse of companies such
as Enron and WorldCom. A number of other major US corporations reported
serious financial problems, and the investment community, not surprisingly,
wanted to know why some of the largest companies in the world faced financial
collapse without any hint of problems being evident in their published financial
statements. Having lost confident in the reliability of financial statements,
investors lost faith in equities as an investment, and share prices tumbled.

4.5 Ways of Improving Financial Reports

There are several ways in which a company might improve its reported financial
position or reported performance. The methods used might sometimes be
deliberately incorrect. More often, a company might use accounting policies that
are acceptable to the auditors, but succeed in giving a more flattering of picture of
the company’s position.

 A company might claim to earn revenue and profit earlier than it probably
should. For example, a company that enters into a three-year contract that
will earn £12 million in total might try to claim all the revenue of £12

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 million in the first year instead of spreading the revenue over the three-year
life of the contract.
 A company might try to take debts off its balance sheet. This can sometimes
be achieved means of setting up separate companies, sometimes referred to
as ‘special purpose vehicles’.
 A company might try to disguise money from loans as operating income, to
increase its reported cash flow from operating activities.
It is probably useful to look at a selection of reported examples of investor
concerns about financial statements and company announcements. All are from the
period of stock market turmoil during mid-2002. In each of these examples,
concerns about the accuracy of financial reporting helped to undermine investor
confidence in companies, because the financial report and accounts remains the
principal method of communication between a public company and the investment
community. If the report and accounts can’t be trusted, what can?

Case Example 1
In July 2002, five former executives of Adelphia Communication, a bankrupt US
cable operator, were arrested and charged with fraud. The accused included the
company’s founder and his two sons. The indictment alleged that they ‘looted
Adelphia on a massive scale, using the company as the … family piggy bank’.
The charges included:
 Using loans from the company to buy shares in the company;
 Self-dealing between the company and companies controlled by members
of the family;
 Misleading statements to investors about the financial position of the
company;

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  Use of corporate funds by family members for their personal benefits.

Case Example 2
In July 2002, a group of US investors filed a securities fraud lawsuits against
Vivendi Universal and its former chairman, M. Jean-Marie Messier, alleging that
the company inflated the value of its shares by concealing a financial crisis.
Between mid-January 2002 and early July 2002, when M. Messier was ousted
from his position in the company, the share price fell from $48 to less than$14.
Having issued press releases stating that the company did not face a cash crisis, it
was revealed in July that a debt of $1.8 billion had to be repaid by the end of the
month, and the company barely had that amount in cash and unused credit lines.

The Irish pharmaceuticals group Elan, which has a New York Exchange listing,
suffered a fall of over 95 per cent in its share price between July 2001 and July
2002. (The company publishes its annual report and account in July.) the loss of
investor confidence was reported to have begun with concerns about the use of
special purpose vehicle by the company. In February 2002, The Securities and
Exchange Commission started an investigation into the company’s accounting
policies. Investors were further concern about the rumours of a cash crisis in the
company were also mounting.

4.6 The Blame for Poor Corporate Financial Reporting

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Not surprisingly perhaps, when allegations are made of misleading financial
reporting, there is a tendency to pass the blame on to someone else. The company
might blame its auditors, on the grounds that the accounting practices must be
acceptable if the auditors do not challenged them. The auditors in turn might argue
that the choice of accounting methods is a matter for the company itself, if not the
auditors.

When WorldCom announced its $3.8 billion accounting fraud, its auditors
Andersen tried to lay the blame squarely on the company’s chief financial officer,
who had, Andersen claimed, withheld important information from them,
preventing them from carrying out their audit properly. The fraud had been
discovered by an internal auditor of the company in a routine audit check, and not
one of the external audit team. The Financial Times commented in an editorial (27
June 2002) that the practice of expenses manipulation is well known to
accountants, and found it ‘astonishing’ that Andersen should try to pass all the
blame to the chief financial officer. ‘What is the purpose of an audit if it is not to
ask about hefty transfers in the accounts?

Another interesting example emerged from the collapse of energy company Enron.
US senate investigators into the company’s collapse obtained evidence that some
banks had entered into complex financial transactions with Enron, which made the
transactions seem like energy trades rather than loans. This gave an impression that
the company was earning money from business activities rather than from
borrowing. This improved the look of its cash flow from operations, and almost
certainly helped the company to maintain a high credit rating that its actual
financial situation did not justify. The banks concerned therefore came under close
scrutiny from the committee. They justified their position by saying that the

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transactions themselves and the accounting treatment given to them were approved
by solicitors and accountants.

The concerns about financial reporting, particularly in the US, have drawn
attention to:

 The role of the external auditors and their responsibilities;

 The responsibilities of the directors for financial reporting;
 The relationship between the auditors and the directors of their client
company.
4.7 The Role of the External Auditors: The Audit Report

Investors, creditors and other stakeholders in a company rely on the information

contained in the annual report and accounts, which are audited each year by a firm
of independent auditors. The purpose of an independent audit is to make sure, as
far as reasonably possible, that the financial statements are objective and can be
reliable on.

After completing their annual audit, the auditors are required to prepare a report to
the shareholders of the company. (This is included in the published report and
accounts of public companies.) The audit report has two main purposes:

1) To give expert and independent opinion about whether the financial

statements give a true and fair view of the financial position of the company
as at the end of the financial year covered by the report, and of its financial
performance during the year;
2) To give an expert and independent opinion on whether the financial
statements comply with the relevant laws.
In the UK, auditors of listed companies are also required to review the company’s
compliance with the Combined Code, and to obtain evidence to support the
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company’s statement (in the annual report and accounts) of its compliance with the
Code.

The role of the auditors is an important issue for corporate governance.

Shareholders might suppose that they can rely on the auditors to ensure that the
financial statements are ‘correct’. If published accounts are subsequently found to
be inaccurate, perhaps due to fraud, an immediate question is whether the problem
should have been uncovered and exposed by the auditors. Similarly, if the
management of a company use questionable accounting practices in order to
improve the company’s reported performance, it might be supposed that the
auditors should either insist that more conservative accounting policies must be
used, or should report their concerns to the shareholders if management do not
follow their advice. Three issues relating to auditors need to be considered:

1) What is the purpose of annual audits? To what extend can the auditor detect
fraud or error in the client company’s preparation of financial statements?
2) Independence from management, and how it might be protected.
3) Control over the audit profession.
4.8 The Purpose of the External Audit

The purpose of the audit report is to give users of a company’s financial statements
some reassurance that the information in the statements is believable. Users of
accounts want reassurance that there has not been any fraud or error. ‘Fraud’ is
intentional; ‘error’ is unintentional and results in:

 Incorrect use of accounting policies;

 Omission of facts; or
 Misinterpretation of facts.
4.9 Responsibility for detecting Fraud and Error

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There is a popular misconception that the auditor is responsible for detecting fraud
or error in a company’s financial statements. This is not the case.

 The management of the company has the responsibility for preventing and
detecting fraud and error. This is achieved by implementing an adequate
system of accounting and ‘internal control’.
 The auditor has no responsibility for detecting fraud or error. However, the
auditor will assess the risk or possibility that fraud or error might have
caused the financial statements to be materially misleading. The auditor
should therefore design audit procedure that will provide reasonable
reassurance that material fraud or error has not occurred, and that the
financial statements give a true and fair view of the company’s financial
position and performance.

4.10 The Audit Report

The audit report itself provides only limited information to shareholders, even
though shareholders often assume that an unqualified audit report means that the
financial statements of the company are accurate and reliable.

Unqualified Opinion

An unqualified audit report is given when the auditor believes that the accounts
give a true and fair view of the company’s financial position and performance. The
wording of an unqualified audit report is usually fairly standard, although reports
are longer for public companies (where the auditor might also report on some

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corporate governance statements) and differ between countries. The framework of
an audit report for a company might be as follows:

To the shareholder of ABC Company

We have audited the accompanying balance sheet of ABC Company as of 31
December, 20XX and the related statements of income and cash flows for the
year then ended.
Respective Responsibilities of Directors and Auditors
The financial statements are the responsibility of the company’s management.
Our responsibility is to express an opinion on these financial statements based on
our audit.
Basis of Opinion
We conducted our audit in accordance with International Standards on Auditing
(or the report might refer to the relevant national auditing standard). Those
Standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
Opinion
In our opinion, the financial statements give a true and fair view of (or ‘present
fairly in all material respects’) the financial position of the Company as of 31
December, 20XX, and of the results of its operations and its cash flows for the
year then ended in accordance with [the international accounting standards or

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 relevant national accounting standards] and comply with [relevant national
statures or regulations].
Auditor signature and name (and address)
Date

An audit report is occasionally not unqualified, but ‘modified’ by a qualified

opinion, a disclaimer or an adverse opinion.

Qualified Opinion

A qualified opinion is an opinion in which the auditor believes the financial

statements give a true and fair view, except for a particular matter. However, the
disagreement of the auditors with the company’s management is not so great as to
justify a disclaimer or an adverse opinion.

For example, the auditors might state that they have been unable to check by a
physical count the inventory quantities at a particular location, and have accepted
the company’s inventory records as being sufficiently accurate. If the amount of
inventory involved is unlikely to be large, a qualified audit opinion should be
sufficient.

Disclaimer

A disclaimer of opinion is a refusal by the auditor to give an opinion on a

particular item in the financial statements. A disclaimer is appropriate where the
auditor has been unable to obtain sufficient evidence, and the amount involved
could be material. A disclaimer of opinion might state:

‘Because of the possible effect of the limitation in the evidence available to us, we
are unable to form an opinion as to whether the financial statements give a true and

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fair view… and whether the statements have been prepared in accordance with [the
relevant legislature].’

Adverse Opinion

An adverse opinion is the most negative type of modified audit report. This is
given when there is a disagreement between the auditors and the company’s
management, and the auditors believe that the financial statements are misleading
or incomplete in a material or pervasive way. An adverse audit opinion will make a
statement such as:

‘In our opinion, because of the effects of the matter discussed in the preceding
paragraph, the financial statements do not give a true and fair view of the financial
position of the company as at 31 December, 20XX, and of the results of its
operations and its cash flows for the year then ended…’

Modified audit opinions are fairly uncommon, and adverse opinions are the least
common form of modified opinion. In practice, public companies will normally
expect to have unqualified audit report. As a result, investors might assume that the
company’s financial statements are trustworthy. If the financial statements turn out
to be misleading, investors may suppose that either:

 The auditors failed to do their job properly, because they should have
spotted the problem and provided a modified audit opinion; or
 The auditors are too close to management and have lost their independence,
so that they were unwilling to provide a modified audit opinion.
4.11 Audit Independence

The external auditor should be independent of the client company, so that the audit
opinion will not be influenced by the relationship between the auditor and the

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company. The auditors are expected to give an unbiased and honest professional
opinion to the shareholders about the financial statements. An unqualified audit
report is often seen by investors as a ‘clean bill of health’ for the company.
However, doubts have been expressed about the independence of external auditors.
It might be argued that unless suitable corporate governance measures are in place,
a firm of auditors might reach opinions and judgements that are heavily influenced
by their wish to maintain good relations with the management of a client company.

4.12 Financial Reporting: Directors’ Duties and Responsibilities

It is important to remember that the company’s directors are responsible for the
preparation and content of the financial statements. The directors of a company
have certain legal duties with regard to financial reporting. The duties set out
below relate to UK law:

 They have a duty to prepare annual company accounts and, in a case of a

parent company, consolidated accounts for the group (section 226-7
Companies Act 1987). The annual accounts must be approved by the board
and signed by a director on behalf of the board.
 They have a duty to prepare a director’s report, which must be approved by
the board and signed in its behalf by a director or the company secretary
(section 234 and 234 A).
 The directors of a quoted company have a duty to prepare a director’s
remuneration report, which, must be approved by the board and signed in its
behalf by a director or the company secretary (234B and 234C).
 These accounts and reports must be laid before the shareholders in general
meeting (section 241) and the shareholders must be invited to approve the
director’s remuneration report (section 241A).

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  In respect of each financial year the directors must file with the Registrar of
Companies a copy of the annual accounts, the directors’ report, and auditors’
report and, in the case of quoted companies, the director’s remuneration
report (section 242).
The Combined Code places additional requirements and responsibilities on the
directors with regard to financial reporting, and states that the financial reports
should be balanced and understandable.

 The board should present a balanced and understandable assessment of the

company’s position and prospects. This requirement applies not only to the
statutory financial reports, but also to interim reports, other price-sensitive
reports and reports to the regulators.
 The director should explain in the annual report their responsibility for
preparing the accounts.
 The auditors must provide a statement about their reporting responsibilities.
 The directors should also report that the business is a going concern. This
requirement is also included in the UK Listing Rules, which requires listed
companies incorporated in the UK to include in their annual report and
accounts a statement by the directors that the business is a going concern,
‘with supporting assumptions or qualifications as necessary’. This statement
must be reviewed by the auditors before publication.
A typical statement of director’s responsibilities for a UK listed company might be
as follows:

‘The directors are required by company law to prepare financial statements for
each accounting period that give a true and fair view of the company and group as
at the end of the period and the profit or loss of the group for that period.

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 The directors confirm that appropriate accounting policies have been used
and applied consistently, and reasonable and prudent judgements and estimates
have been made in the preparations of the accounts for the year ended [date]. The
directors also confirm that applicable company standards have been followed, any
material departures being disclosed and explained in the notes to the financial
statements, and that the financial statements have been prepared on the going
concern basis.

The directors are responsible for ensuing proper accounting records are kept
which disclose with reasonable accuracy at any time the financial position of the
company and the group and to enable them to comply with the Company Act 1985.
They are also responsible for taking steps to safeguard the assets of the company
and the group and to prevent and detect fraud and other irregularities.’

Having made such a statement of responsibilities, the directors must also accept
liabilities arising out of a failure to carry them on.

Going Concern Statement

In the context of corporate governance, an important part of the corporate

governance report of UK listed companies is the going concern statement. This is
a statement by the directors that the company is a going concern, and will be for
the next 12 months. If, for any reason, the company subsequently suffers financial
collapse, each director could be liable to anyone suffering a loss (e.g. shareholders,
bondholders lending banks) having relied on that statement.

A typical going concern statement within a corporate report might be as follows:

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‘The directors, on the basis of current financial projections and facilities available,
have a reasonable expectation that the company and group have adequate resources
to continue in operational existence for the foreseeable future. The directors
accordingly continue to adopt the going concern basis in the preparation of the
group’s financial statements’.

4.13 The Audit Committee

As stated above, the Combined Code requires a board of directors to present a

balanced and understandable assessment of the company’s position and prospects.
The Code also requires the board to maintain a sound system of internal control. A
further principle (C.3) is that the board should establish formal and transparent
arrangement for:

 Considering how they should apply the financial reporting and internal
control principles, and
 Maintain an appropriate relationship with the company’s auditors.
It should do this by setting up an audit committee, which should be a committee of
the board of directors. It is now a well-established principle of good corporate
governance in the US and UK that companies extensive responsibilities should be
delegated to this committee. In the UK, following the recommendation of the
Smith Report in 2003, the role of the audit committee was set out in the revised
Combined Code.

According to the Combined Code, the main roles of this committee should be:

 To monitor the integrity of the company’s financial statements and any

formal announcements relating to the company’s financial performance. In
doing so, it should review ‘significant judgements’ that these statements and
announcements contain;
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  To review the company’s internal financial controls;
 Unless the role is assigned to a separate board risk committee, or taken on by
the full board, to review the company’s internal control and risk
management systems;
 To monitor and review the effectiveness of the company’s internal audit
functions;
 To make recommendations to the board in relation to the appointment, re-
appointment or removal of the company’s external auditors, for putting to
the shareholders for approval in general meeting of the company;
 To approve the remuneration and terms of engagement of the external
auditors;
 To review and monitor the independence and objectivity of the external
auditors, and also the effectiveness of the audit process, taking into account
relevant UK professional and regulatory requirements;
 To develop and implement the company’s policy on using the external
auditors to provide non-audit services. This should take into account any
relevant external ethical guidance on the subject. The committee should
report to the board, identifying actions or improvements that are needed and
recommending the steps to be taken.
A separate section of the annual report should describe the work of the audit
committee. This ‘puts the spotlight on the audit committee and gives it an authority
that it might otherwise lack’ (Smith Guidance).

Other provisions in the Combined Code elaborate on the responsibilities of the

audit committee. In addition, further guidance on the audit committee is provided
in The Smith Guidance, which is annexed to the Combined Code and based on the
recommendations of the Smith Report. The Smith Report was published in January

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2003 (at the same time as the Higgs Report) by a committee set up by the FRC to
consider the roles of audit committees.

The ‘Smith Guidance’ makes the following comments about the role and
responsibilities of the of the audit committee:

 The audit committee arrangements within each company need to be

proportionate to the task, and will differ according to size, complexity and
risk profile of the company.
 All the board directors have a duty to act in the best interests of the
company, but the audit committee has a particular role, ‘acting
independently from the executive, to ensure that the interests of shareholders
are properly protected in relation to financial reporting and internal control.’
 The principle of the unitary board is not affected by the creation of the audit
committee. All directors are equally responsible in law for the company’s
affairs. The audit committee is a committee of the board, and any
disagreement within the board, including the disagreement within the audit
committee members, should be resolved at board level.
 Where there are disagreements between the audit committee and the rest of
the board that cannot be resolved, the audit committee should have the right
to report the issue to the shareholders as part of the report to shareholder on
its activities.
 The company’s management is under an obligation to make sure that the
audit committee is kept properly informed and should take the initiative in
providing the committee with information, instead of waiting to be asked.
The executive directors should have regard to their common law duty to
provide all directors, including the audit committee members, with all the
information they need to discharge their duties as directors of the company.

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  The core functions of the audit committee are concern with ‘oversight’,
‘assessment’ and ‘review’ of other functions and systems in the company. It
is not the committee’s duty to carry out those functions; for example,
management remains responsible for preparing financial statements and the
auditors remain responsible for preparing the audit plan and carry out the
audit.
 However, the high-level oversight function can sometimes lead to more
detailed work. The Smith Guidance gives an example of a situation where
the audit committee are unhappy with the explanations of management and
the auditors about a particular financial reporting decision, ‘there may be no
alternatives but to grapple with the detail and perhaps seeking independence
advice.’
 For groups, the audit committee of the parent company will usually have to
review activities related to subsidiaries within the group. The board of the
parent company must ensure that there is adequate co-operation within the
group to allow the audit committee of the parent company to do its job
properly.
 The board should decide just what the role of the audit committee should be,
and the terms of reference should be tailored to the company’s particular
circumstances. However, the audit committee should review its terms of
references and effectiveness annually, and recommend any necessary
changes to the board. The board should also review the effectiveness of the
audit committee annually.
Composition of the Audit Committee

The Combined Code states that an audit committee should consist of at least three
members (or at least two members in the case of small companies, outside the

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FTSE) all its members should be independent non-executive directors. The Smith
Guidance adds that:

 The chairman of the company should not be a member of the committee, and
 Appointments to the committee should be made to the board on the
recommendation of the nomination committee (if there is one), in
consultation with the audit committee chairman;
 Appointments should be for a period of up to three years, extendable by no
more than two additional three-year periods, and provided that the
committee member remain independent during that time.
The Code also states that the board should satisfy itself that at least one member of
the committee has recent and relevant financial experience. The Smith Guidance
adds that it is desirable that this person should have a professional qualification
from one of the professional accountancy bodies. The degree of financial literacy
required from the committee members will vary according to the nature of the
company.

Financial Reporting and the Role of the Audit Committee

The Combined Code emphasizes that it is the responsibility of management, not

the audit committee, to prepare complete and accurate financial statements. It is the
responsibility of the audit committee to review the significant financial reporting
issues and judgements that are made in connection with these statements:

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  The audit committee should consider significant accounting policies used to
prepare the statements, and any changes to them, and any significant
estimates or judgements on which the statements have been based.
 Management should inform the committee about the methods they have used
to account for significant or unusual transactions, where the accounting
treatment is open to different approaches.
 Taking the external auditor’s views into consideration, the committee should
consider whether the company has adopted appropriate accounting policies
and made appropriate estimates and judgements.
 The committee should also consider the clarity and completeness of the
disclosures in the financial statements.
If the committee is not satisfied with any aspect of the proposed financial reporting
by the company, it should report its views to the board (Smith Guidance). The
committee should also review related information presented with the financial
statements, including the operating and financial review (OFR) and the corporate
governance statements relating to audit and risk management.

Unit Five

Control and Compliance

Companies need to be entrepreneurial to succeed over the long term, but many
different events might occur or changing circumstances might arise that throw

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plans off course. Unnecessary risks should be avoided, and unavoidable risks
should be managed in a way that the company’s exposures to risk are justified by
the expected benefits and returns. In other words, businesses should seek a suitable
balance between risks and returns. Risk management is a key element of corporate
governance. In the UK, the overall responsibility for identifying and monitoring
risks, and ensuring that adequate control mechanism are in place, rests with the
board of directors.

5.1 The Nature of Risk

Risk refer to the possibility that something unexpected or not planned for will
happen. In many cases, risk is seen as the possibility that something bad might
happen. In everyday life, there is a risk for individuals of becoming seriously ill,
being involved in a road accident, having a house burgled or flooded, having a
motor car breakdown, and so on. This type of risk can be described as ‘downside
risk’, because it is a risk that something will happen that would not normally
expected.

There is ‘upside risk’ too. This is the possibility that actual events might turn out
better than expected. In a business context, an example of upside risk is the
possibility that sales volumes will be higher than planned or that workdays lost
through industrial action will be lower than anticipated.

Individuals can take measures to deal with downside risk. For example, suppose
that you are considering what to about the risk of your car breaking down. You
would have choice of several options:

 You could accept the risk. If your breakdown, you will pay to have the car
recovered and taken to a garage to be mended.

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  You could avoid the risk entirely by deciding to sell your car and give up
driving.
 You could take measures to reduce or mitigate consequences of the risk, by
obtaining accident recovery insurance, or even by purchasing a newer car
that is less likely to breakdown.
Businesses should also manage their risks, but risk management involves making
decisions about upside risks as well as downside risks:

 Just as individuals make decisions about accepting risks, avoiding risks or

mitigating risks through insurance and other measures, businesses do the
same. Risk insurance is an important aspect of risk management, and a large
organisation might employ specialist risk managers. In some companies, the
responsibility for risk management is given to the company secretary.
 Businesses are exposed to the risk of losses through errors and omissions by
its employees of by fraud and dishonest. Many of the errors and omissions
relate to the activities of the account department, such as failing to send out
invoices to customers, or failing to carry out sufficient credit checks on a
new customer asking for credit. Fraud is often related to the accounts
department too, because it deals with payments and receipts of money for
the business.
 Businesses also make investment decisions. Every investment is risky.
Actual returns could be either lower or higher than expected. In deciding
whether or not to undertake an investment, the risks as well as the potential
returns should be taken into consideration. Shareholders would like to see
their company earning high returns, but might be willing to see the
management taking excessive investment risks in trying to achieve those
returns.

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5.2 Internal Control System

An internal control system consists of a ‘control environment’ and control

procedures.

A control environment describes the awareness of (and attitude to) internal controls
in the organisation, shown by the directors, management and employees generally.
It therefore encompasses corporate culture, management style and employee
attitude to corporate procedures.

The control procedures and policies within an internal control system are known as
internal control. Internal controls are devised and enforced to ensure, as far as
practicable in the given circumstances, the orderly and efficient conduct of the
business. They include measures to safeguard the assets of the business, prevent
and detect fraud and error, ensure the accuracy and completeness of the accounting
records and ensure the timely preparation of reliable financial information.

There are several types of internal control, and each organisation will use some or
all types of controls, to a greater or lesser extent. Some organisations have more
extensive and more effective controls than others. A useful method of categorizing
internal control was used in an old guideline of the UK Auditing Practices Board,
and remembered by the mnemonic SPAMSOAP. Internal controls can be
categorized as:

S Segregation of duties. Where possible, duties should be split between two

or more people, so that the work done by one person acts as a check on the
work done by another. With segregation of duties, it is more difficult for
fraud to take place, because several individuals would have to collude in
the fraud. It is also more difficult for accidental errors to occur, because
when several people are involved in a task, they act as a check on each
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 other.
P Physical controls. Physical controls are measures to ensure the physical
safety of assets, such as putting cash in a safe, banking cash receipts
immediately, and preventing unauthorized access to computer systems
through the use of password and internet firewalls.
A Authorization and approval. All financial transaction should require the
authorization or approval of an appropriate responsible person, and there
should be an authorization limit to how much spending each responsible
person should approve.
M Management control. Management should exercise control over financial
systems, for example by preparing a budget and then monitoring actual
performance by comparing it with the budget. Management controls can
also be exercised by reviewing other financial statements, such as a balance
sheet, profit and loss account and cash flow accounts.
S Supervision. The day-to-day work of employees should be properly
supervised. Good supervision will reduce the likelihood of error or fraud.
O Organisation. Everyone should be fully aware of his or her
responsibilities, and lines of authority, lines of reporting, and levels of
responsibility should be clear. Errors and fraud are much more likely where
it is uncertain who is responsible for what and who should be reporting to
whom.
A Arithmetic and accounts control. These are procedures in an accounts
office to check the accuracy of the records and the numbers. They include
the use of control totals and reconciliations.
P Personnel. The quality of internal controls is dependent on the quality of
the individuals working in the organisation, and personnel selected to do a
job should have the right personal qualities and be properly trained and/or

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 qualified.

5.3 Compliance

Compliance refers to the company’s ability and duty to operate in accordance with
the internal and external environmental conditions. Every public company has a
duty to establish a Compliance Committee that should oversee the company’s
compliance to the following issues:

 Statutes
 Accounting and Auditing Standards
 Legal frameworks
 Social responsibilities
 Employee’s rights
 Company policies and procedure
 Company regulations
 Tax obligations
 Transparency in information and financial statements
 Company’s adherence to its goals and objectives.

Unit Six

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 Codes of Corporate Governance
A code of corporate governance best practices is a set of principles and
recommendations aimed at improving and guiding the governance practices of
companies within a country.

The goals of the Codes of Corporate Governance are to identify and articulate
“good” or “best” governance practices and provide specific benchmarks against
which these can be monitored. These Codes contains a number of key principles of
effective corporate governance: accountability, transparency, responsibility and
fairness. The code is intended to lead to improvements in governance behaviour,
practices and standards beyond the legal threshold requirements. In particular
improvements in corporate governance are associated with: optimalisation of
operational and financial efficiency; improvements in access to capital; increases
in valuation; lowering cost of capital and improvements in a company’s reputation
and trust levels. This increase in investor confidence supports a better investment
climate based upon greater transparency and disclosure.

The Codes of Good Governance in headed by the following heading:

1) The Principles:
2) Boards and Directors
3) Board committees
4) Role and functions of board members and the company secretary
5) Risk Management, Internal Control and Internal Audit
6) The board shall be responsible for the information governance system
7) Accounting, Reporting and Auditing
8) Relations with Shareholders and Other Key Stakeholders
1.1 Boards and Directors

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1.1.1: The Role of the Board

1.1.1 All companies shall be headed by an effective board which can both lead and
control the company and which is collectively responsible for the long-term
success of the organisation.

1.1.2 The board shall report to shareholders and other appropritate stakeholders on
how the board operates.

1.1.2: The Composition of the Board

1.2.1 Every board shall determine its optimal size for effective execution of its
responsibilities.

1.2.2 All members of the board shall be individuals of integrity who bring a blend
of knowledge, skills, objectivity, experience and commitment to the board.

1.1.3: Appointments to the Board

1.3.1 There shall be a formal, rigorous and transparent procedure for the
appointment and induction of new directors to the board.

1.3.2 All directors shall receive induction on joining the board and should regularly
update and refresh their skills and knowledge.

1.1.4 Director duties

1.4.1 Directors must diligently carry out their responsibilities and duties to the
company.

1.4.2 All directors shall be able to allocate sufficient time to the company to
discharge their responsibilities effectively.

1.1.5: Director Remuneration

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1.5.1 Companies shall disclose their remuneration philosophy to shareholders and
other appropriate stakeholders.

1.5.2 Companies shall disclose the remuneration paid to each director on an

individual basis to shareholders and other appropriate stakeholders.

1.1.6: Board Development

1.6.1 The board should undertake a formal and rigorous annual evaluation of its
own performance and that of its committees and individual directors and produce
an annual development plan.

1.1.7: Re-election

1.7.1 All directors shall be submitted for re-election every year at the meeting of
shareholders, subject to continued satisfactory performance.

1.1.8: Information and Support

1.8.1 The board shall be supplied in a timely manner with information in a form
and of a quality appropriate to enable it to discharge its duties.

1.8.2 The company shall arrange appropriate insurance cover in respect of legal
action against its directors.

1.1.9: Conflicts of Interest

1.9.1 Transactions between the company and its managers, directors or

large/dominant shareholders are sources of conflicts of interest. The personal
interests of a director, or persons closely associated with the director, must not take
precedence over those of the company and its shareholders, including minority
shareholders.

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1.9.2 A director should make a best effort to avoid conflicts of interest or situations
where others might reasonably perceive there to be a conflict of interest. Any
director must treat confidential matters relating to the company, learned in his/her
capacity as director, as strictly confidential and must not divulge them to anyone
without the authority of the board.

1.2 Board committees

1.2.1 Terms of reference

2.1.1 The terms of reference of the Board committees should be formally laid
down and approved by the board, published on the organization’s website and in
the annual report.

2.1.2 There should be transparency and full disclosure from the board committee to
the board. However, time should not be wasted on repeating a committee’s
deliberations at board level.

2.1.3 All companies should have, at a minimum, an audit committee and a

corporate governance committee.

1.3 Role and functions of board members and the company secretary

1.3.1: Division of Responsibilities

3.1.1 No one individual should have unfettered powers of decision.

3.1.2 There should be a clear division of responsibilities at the head of the

company between the running of the board and the executive responsibility for the
running of the company’s business.

1.3.2: The Role of the Chairman

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3.2.1. The chairman is responsible for leadership of the board and ensuring its
effectiveness on all aspects of its role.

1.3.3: The Role of the Chief Executive Officer

3.3.1 Every company shall have a Chief Executive Officer.

1.3.4: The Role of Non-Executive Directors

3.4.1 Every company shall have an appropriate number of non-executive directors.

1.3.5: The Role of Independent Directors

3.5.1 Every company shall have a minimum of two independent directors.

1.3.6: The Role of the Company Secretary

3.6.1 Every company shall have a company secretary.

1.4 Risk Management, Internal Control and Internal Audit

1.4.1: Risk Management

Principles

4.1.1 The board shall possess a reasonable knowledge of risks specific to the entire
spectrum of the institution’s activities.

4.1.2 The board is responsible for the total process of risk management and should
ensure that the company develops and executes a comprehensive and robust system
of risk management.)

4.1.3 The board is responsible for determining the nature and extent of the
principal risks it is willing to take in achieving its strategic objectives.

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4.1.4 The board shall determine and articulate the levels of risk appetite and
tolerance for the organisation.

4.1.5 The board shall ensure that there are processes in place enabling complete,
timely, relevant, accurate and accessible risk disclosure to stakeholders.

4.1.6 The board shall monitor the company’s risk management system and, at least
annually, carry out a review of their effectiveness, and report on that review in the
annual report.

1.4.2: Internal Control

4.2.1 The board shall maintain a sound internal control system.

4.2.2 The board shall report on the effectiveness of the company’s system of
internal controls.

1.4.3: Internal Audit

4.3.1 Companies shall have an effective internal audit function that has the respect,
confidence and co-operation of both the board and management.

1.4.3: Information Governance

4.3.1 The board shall be responsible for the information governance system.

1.5 Accounting, Reporting and Auditing

1.5.1: Accounting

5.1.1. Directors are responsible for adequate accounting records. Directors are
responsible for the preparation of accounts which fairly present the state of affairs
of the company and the results of its operations and which comply with
International Financial Reporting Standards (IFRS).
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5.1.2 The directors are responsible for selection of appropriate accounting policies
supported by reasonable and prudent judgements.

1.5.2: Reporting

5.2.1 The board shall present a fair, balanced and understandable assessment of the
company’s position and prospects.

5.2.2 The board shall ensure that any report delivered as an annual report under the
Companies Act (20XX) contains a corporate governance report with appropriate
sections.

1.5.3 Audit

5.3.1 The board should establish formal and transparent arrangements for
considering how they maintain an appropriate relationship with the company’s
auditors.

5.3.2 The audit committee should submit a recommendation to the board for
consideration and acceptance by shareholders for the appointment and, if
necessary, the removal of the external auditors and non-audit services.

1.6 Relations with Shareholders and Other Key Stakeholders

6.1 The board has responsibility for ensuring that a satisfactory dialogue with
shareholders and other key stakeholders takes place.

6.2 The board should use general meetings to communicate with investors and to
encourage their participation.

THE COMBINED CODE

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PRINCIPLES OF GOOD GOVERNANCE AND CODE OF BEST
PRACTICE

Derived by the Committee on Corporate Governance from the Committee’s Final

Report and from the Cadbury and Greenbury Reports, it has the following as its
content and format:

SECTION 1: COMPANIES
A. DIRECTORS
A.1 The Board
Principle Every listed company should be headed by an effective board which
should lead and control the company.
Code Provisions
A.1.1 The board should meet regularly.
A.1.2 The board should have a formal schedule of matters specifically reserved to
it for decision.
A.1.3 There should be a procedure agreed by the board for directors in the
furtherance of their duties to take independent professional advice if necessary, at
the company’s expense.
A.1.4 All directors should have access to the advice and services of the company
secretary, who is responsible to the board for ensuring that board procedures are
followed and that applicable rules and regulations are complied with. Any question
of the removal of the company secretary should be a matter for the board as a
whole.
A.1.5 All directors should bring an independent judgement to bear on issues of
strategy, performance, resources, including key appointments, and standards of
conduct.

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A.1.6 Every director should receive appropriate training on the first occasion that
he or she is appointed to the board of a listed company, and subsequently as
necessary.
A.2 Chairman and CEO
Principle There are two key tasks at the top of every public company - the
running of the board and the executive responsibility for the running of the
company’s business. There should be a clear division of responsibilities at the
head of the company which will ensure a balance of power and authority, such
that no one individual has unfettered powers of decision.
Code Provision
A.2.1 A decision to combine the posts of chairman and chief executive officer in
one person should be publicly justified. Whether the posts are held by different
people or by the same person, there should be a strong and independent non-
executive element on the board, with a recognized senior member other than the
chairman to whom concerns can be conveyed. The chairman, chief executive and
senior independent director should be identified in the annual report.
A.3 Board Balance
Principle The board should include a balance of executive and non-executive
directors (including independent non-executives) such that no individual or
small group of individuals can dominate the board’s decision taking.

Code Provisions

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A.3.1 The board should include non-executive directors of sufficient calibre and
number for their views to carry significant weight in the board’s decisions. Non-
executive directors should comprise not less than one third of the board.
A.3.2 The majority of non-executive directors should be independent of
management and free from any business or other relationship which could
materially interfere with the exercise of their independent judgement. Non-
executive directors considered by the board to be independent in this sense should
be identified in the annual report.
A.4 Supply of Information
Principle The board should be supplied in a timely manner with information
in a form and of a quality appropriate to enable it to discharge its duties.
Code Provision
A.4.1 Management has an obligation to provide the board with appropriate and
timely information, but information volunteered by management is unlikely to be
enough in all circumstances and directors should make further enquiries where
necessary. The chairman should ensure that all directors are properly briefed on
issues arising at board meetings.
A.5 Appointments to the Board
Principle There should be a formal and transparent procedure for the
appointment of new directors to the board.
Code Provision
A.5.1 Unless the board is small, a nomination committee should be established to
make recommendations to the board on all new board appointments. A majority of
the members of this committee should be non-executive directors, and the
chairman should be either the chairman of the board or a non-executive director.
The chairman and members of the nomination committee should be identified in
the annual report.
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A.6 Re-election
Principle All directors should be required to submit themselves for re-election
at regular intervals and at least every three years.
Code Provisions
A.6.1 Non-executive directors should be appointed for specified terms subject to
re-election and to Companies Act provisions relating to the removal of a director,
and reappointment should not be automatic.
A.6.2 All directors should be subject to election by shareholders at the first
opportunity after their appointment, and to re-election thereafter at intervals of no
more than three years. The names of directors submitted for election or re-election
should be accompanied by sufficient biographical details to enable shareholders to
take an informed decision on their election.
B. DIRECTORS’ REMUNERATION
B.1 The Level and Make-up of Remuneration
Principle Levels of remuneration should be sufficient to attract and retain the
directors needed to run the company successfully, but companies should avoid
paying more than is necessary for this purpose. A proportion of executive
directors’ remuneration should be structured so as to link rewards to
corporate and individual performance.
Code Provisions
Remuneration policy
B.1.1 The remuneration committee should provide the packages needed to attract,
retain and motivate executive directors of the quality required but should avoid
paying more than is necessary for this purpose.
B.1.2 Remuneration committees should judge where to position their company
relative to other companies. They should be aware what comparable companies are
paying and should take account of relative performance. But they should use such
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comparisons with caution, in view of the risk that they can result in an upward
ratchet of remuneration levels with no corresponding improvement in performance.
B.1.3 Remuneration committees should be sensitive to the wider scene, including
pay and employment conditions elsewhere in the group, especially when
determining annual salary increases.
B.1.4 The performance-related elements of remuneration should form a significant
proportion of the total remuneration package of executive directors and should be
designed to align their interests with those of shareholders and to give these
directors keen incentives to perform at the highest levels.
B.1.5 Executive share options should not be offered at a discount save as permitted
by paragraphs 13.30 and 13.31 of the Listing Rules.
B.1.6 In designing schemes of performance related remuneration, remuneration
committees should follow the provisions in Schedule A to this code.
Service Contracts and Compensation
B.1.7 There is a strong case for setting notice or contract periods at, or reducing
them to, one year or less. Boards should set this as an objective; but they should
recognize that it may not be possible to achieve it immediately.
B.1.8 If it is necessary to offer longer notice or contract periods to new directors
recruited from outside, such periods should reduce after the initial period.
B.1.9 Remuneration committees should consider what compensation commitments
(including pension contributions) their directors’ contracts of service, if any, would
entail in the event of early termination. They should in particular consider the
advantages of providing explicitly in the initial contract for such compensation
commitments except in the case of removal for misconduct.
B.1.10 Where the initial contract does not explicitly provide for compensation
commitments, remuneration committees should, within legal constraints, tailor
their approach in individual early termination cases to the wide variety of
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circumstances. The broad aim should be to avoid rewarding poor performance
while dealing fairly with cases where departure is not due to poor performance and
to take a robust line on reducing compensation to reflect departing directors’
obligations to mitigate loss.
B.2 Procedure
Principle Companies should establish a formal and transparent procedure for
developing policy on executive remuneration and for fixing the remuneration
packages of individual directors. No director should be involved in deciding
his or her own remuneration.
Code Provisions
B.2.1 To avoid potential conflicts of interest, boards of directors should set up
remuneration committees of independent non-executive directors to make
recommendations to the board, within agreed terms of reference, on the company’s
framework of executive remuneration and its cost; and to determine on their behalf
specific remuneration packages for each of the executive directors, including
pension rights and any compensation payments.
B.2.2 Remuneration committees should consist exclusively of non-executive
directors who are independent of management and free from any business or other
relationship which could materially interfere with the exercise of their independent
judgement.
B.2.3 The members of the remuneration committee should be listed each year in
the board’s remuneration report to shareholders (B.3.1 below).
B.2.4 The board itself or, where required by the Articles of Association, the
shareholders should determine the remuneration of the non-executive directors,
including members of the remuneration committee, within the limits set in the
Articles of Association. Where permitted by the Articles, the board may however

92
delegate this responsibility to a small sub-committee, which might include the
chief executive officer.
B.2.5 Remuneration committees should consult the chairman and/or chief
executive officer about their proposals relating to the remuneration of other
executive directors and have access to professional advice inside and outside the
company.
B.2.6 The chairman of the board should ensure that the company maintains contact
as required with its principal shareholders about remuneration in the same way as
for other matters.
B.3 Disclosure
Principle The Company’s annual report should contain a statement of
remuneration policy and details of the remuneration of each director.
Code Provisions
B.3.1 The board should report to the shareholders each year on remuneration. The
report should form part of, or be annexed to, the company’s annual report and
accounts. It should be the main vehicle through which the company reports to
shareholders on directors’ remuneration.
B.3.2 The report should set out the company’s policy on executive directors’
remuneration. It should draw attention to factors specific to the company.
B.3.3 In preparing the remuneration report, the board should follow the provisions
in Schedule B to this code.
B.3.4 Shareholders should be invited specifically to approve all new long term
incentive schemes (as defined in the Listing Rules) save in the circumstances
permitted by paragraph 13.13A of the Listing Rules.
B.3.5 The board’s annual remuneration report to shareholders need not be a
standard item of agenda for AGMs. But the board should consider each year

93
whether the circumstances are such that the AGM should be invited to approve the
policy set out in the report and should minute their conclusions.

B.2 Procedure
Principle Companies should establish a formal and transparent procedure for
developing policy on executive remuneration and for fixing the remuneration
packages of individual directors. No director should be involved in deciding
his or her own remuneration.
Code Provisions
B.2.1 To avoid potential conflicts of interest, boards of directors should set up
remuneration committees of independent non-executive directors to make
recommendations to the board, within agreed terms of reference, on the company’s
framework of executive remuneration and its cost; and to determine on their behalf
specific remuneration packages for each of the executive directors, including
pension rights and any compensation payments.
B.2.2 Remuneration committees should consist exclusively of non-executive
directors who are independent of management and free from any business or other
relationship which could materially interfere with the exercise of their independent
judgement.
B.2.3 The members of the remuneration committee should be listed each year in
the board’s remuneration report to shareholders (B.3.1 below).
B.2.4 The board itself or, where required by the Articles of Association, the
shareholders should determine the remuneration of the non-executive directors,
including members of the remuneration committee, within the limits set in the
Articles of Association. Where permitted by the Articles, the board may however

94
delegate this responsibility to a small sub-committee, which might include the
chief executive officer.
B.2.5 Remuneration committees should consult the chairman and/or chief
executive officer about their proposals relating to the remuneration of other
executive directors and have access to professional advice inside and outside the
company.
B.2.6 The chairman of the board should ensure that the company maintains contact
as required with its principal shareholders about remuneration in the same way as
for other matters.
B.3 Disclosure
Principle The Company’s annual report should contain a statement of
remuneration policy and details of the remuneration of each director.
Code Provisions
B.3.1 The board should report to the shareholders each year on remuneration. The
report should form part of, or be annexed to, the company’s annual report and
accounts. It should be the main vehicle through which the company reports to
shareholders on directors’ remuneration.
B.3.2 The report should set out the company’s policy on executive directors’
remuneration. It should draw attention to factors specific to the company.
B.3.3 In preparing the remuneration report, the board should follow the provisions
in Schedule B to this code.
B.3.4 Shareholders should be invited specifically to approve all new long term
incentive schemes (as defined in the Listing Rules) save in the circumstances
permitted by paragraph 13.13A of the Listing Rules.
B.3.5 The board’s annual remuneration report to shareholders need not be a
standard item of agenda for AGMs. But the board should consider each year

95
whether the circumstances are such that the AGM should be invited to approve the
policy set out in the report and should minute their conclusions.
C. RELATIONS WITH SHAREHOLDERS
C.1 Dialogue with Institutional Shareholders:
Principle Companies should be ready, where practicable, to enter into a
dialogue with institutional shareholders based on the mutual understanding of
objectives.
C.2 Constructive Use of the AGM:
Principle Boards should use the AGM to communicate with private investors
and encourage their participation.
Code Provisions
C.2.1 Companies should count all proxy votes and, except where a poll is called,
should indicate the level of proxies lodged on each resolution, and the balance for
and against the resolution, after it has been dealt with on a show of hands.
C.2.2 Companies should propose a separate resolution at the AGM on each
substantially separate issue, and should in particular propose a resolution at the
AGM relating to the report and accounts.
C.2.3 The chairman of the board should arrange for the chairmen of the audit,
remuneration and nomination committees to be available to answer questions at the
AGM.
C.2.4 Companies should arrange for the Notice of the AGM and related papers to
be sent to shareholders at least 20 working days before the meeting.
D. ACCOUNTABILITY AND AUDIT
D.1 Financial Reporting
Principle The board should present a balanced and understandable
assessment of the company’s position and prospects.
Code Provisions
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D.1.1 The directors should explain their responsibility for preparing the accounts,
and there should be a statement by the auditors about their reporting
responsibilities.
D.1.2 The board’s responsibility to present a balanced and understandable
assessment extends to interim and other price-sensitive public reports and reports
to regulators as well as to information required to be presented by statutory
requirements.
D.1.3 The directors should report that the business is a going concern, with
supporting assumptions or qualifications as necessary.

D.2 Internal Control

Principle The board should maintain a sound system of internal control to
safeguard shareholders’ investment and the company’s assets.
Code Provisions
D.2.1 The directors should, at least annually, conduct a review of the effectiveness
of the group’s system of internal control and should report to shareholders that they
have done so. The review should cover all controls, including financial, operational
and compliance controls and risk management.
D.2.2 Companies which do not have an internal audit function should from time to
time review the need for one.
D.3 Audit Committee and Auditors
Principle The board should establish formal and transparent arrangements
for considering how they should apply the financial reporting and internal
control principles and for maintaining an appropriate relationship with the
company’s auditors.

Code Provisions
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D.3.1 The board should establish an audit committee of at least three directors, all
nonexecutive, with written terms of reference which deal clearly with its authority
and duties. The members of the committee, a majority of whom should be
independent non-executive directors, should be named in the report and accounts.
D.3.2 The duties of the audit committee should include keeping under review the
scope and results of the audit and its cost effectiveness and the independence and
objectivity of the auditors. Where the auditors also supply a substantial volume of
non-audit services to the company, the committee should keep the nature and
extent of such services under review, seeking to balance the maintenance of
objectivity and value for money.

SECTION 2 INSTITUTIONAL SHAREHOLDERS

E. INSTITUTIONAL INVESTORS
E.1 Shareholder Voting
Principle Institutional shareholders have a responsibility to make considered
use of their votes.
Code Provisions
E.1.1 Institutional shareholders should endeavour to eliminate unnecessary
variations in the criteria which each applies to the corporate governance
arrangements and performance of the companies in which they invest.
E.1.2 Institutional shareholders should, on request, make available to their clients
information on the proportion of resolutions on which votes were cast and non-
discretionary proxies lodged.
E.1.3 Institutional shareholders should take steps to ensure that their voting
intentions are being translated into practice.

E.2 Dialogue with Companies

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Principle Institutional shareholders should be ready, where practicable, to
enter into a dialogue with companies based on the mutual understanding of
objectives.

E.3 Evaluation of Governance Disclosures

Principle When evaluating companies’ governance arrangements, particularly
those relating to board structure and composition, institutional investors
should give due weight to all relevant factors drawn to their attention.

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 Unit Seven

Professional Ethics in Accounting and Business

This chapter starts with the general definition of “ethics”; its field of study,
including metaethics, normative ethics, and applied ethics; and proceeds with
business ethics. Ethics are broadly described in the literature as moral principles
about right and wrong, honourable behaviour reflecting values, or standards of
conduct. Honest, openness, responsiveness, accountability, due diligence, and
fairness are ethical principles. An online poll conducted in 2005 by the Dallas
chapter of the International Association of Business Communicators
(Dallas/IABC) reveals that:
1) About 30 percent of respondents indicate that they have been asked to
compromise their integrity often, very often, or extremely often.
2) Of these, more than 10 percent responded they have been asked to
compromise their integrity extremely often; and
3) The remaining 69 percent said they have never or not often being asked by
management to compromise their integrity.
Those results suggest that employees and even executives are still under pressure
to compromise their integrity despite the requirement of corporate governance

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reforms (SOX, listing standards) for the establishment of a code of business ethics
for senior executives and employees that promotes ethical conduct by setting a
“right tone at the top”. Organisations should ensure an ethical work environment
free of pressure or incentives for senior executives and other employees to
compromise their integrity and professional responsibility.

7.1 Ethical Theories

There are several broadly accepted ethical theories. The consequentialist theory
advocates that ethical behaviour or the moral rightness of one’s actions are
determined by the results of the act and its impact on either the individual (egoism)
or all involved (utilitarianism). Non-consequentialists, in contrast, assess the nature
of the act as being either ethical or unethical regardless of its results. The
individualist dimension of ethical decision making asserts that individual are only
concerned with the impact of their decisions on their own and their immediate
family’s well-being and interests. Collectivism postulates that individuals tend to
belong to groups and thus focus on the group’s interest when making ethical
decisions.

Metaethics focus on ethical theories, their evolution, and the social, religious,
spiritual, and cultural influences shaping those theories. Normative ethics
emphasize practical aspects by providing principles of appropriate behaviour and
guidance for what is right or wrong, good or bad in behaviour (e.g., principles of
justice, honest, social benefits, and lawfulness). Applied ethics deal the application
of moral principles and reasoning as well as codes of conduct for a particular

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profession or segment of the society (e.g., business ethics, environmental ethics,
and medical ethics).

Business ethics, the focus of this chapter, are a subset of applied ethics that deal
with ethical issues, conflicts of interest, and the moralist of business decisions.
Business ethics are defined as the moral principles and ethical standards that guide
business behaviour. An appropriate code of ethics that sets the appropriate tone at
the top of promoting ethical and professional conduct is the backbone of effective
corporate governance and establishes the moral structure for the entire
organisation. Integrity and ethical conduct are key components of an organization’s
control environment as set forth in both reports of the Committee of Sponsoring
Organisations of the Treadway Commission (COSO): “Internal Control-Integrated
Framework” and “Enterprise Risk Management-Integrated Framework”.

A corporate code of ethics has been defined in several authoritative guides and in
the business literature. The SEC’s definition of code of ethics focuses on ethical
conduct of the company’s specified officers involved in financial reporting. Public
companies are encouraged to define codes of ethics broadly to address the ethical
conduct of all personnel within the company, with broad coverage of both financial
and nonfinancial activities. The SEC rules describe the term code of ethics as
written standards designed to deter wrongdoing and to promote:

1) Full, fair, accurate, timely, and transparent disclosures in reports and

documents filed or submitted to the SEC and in other public
communications.
2) Honest and ethical conduct throughout the company, including the ethical
handling of apparent or actual conflicts of interest between personal and
professional activities and relationships.

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 3) Accountability for compliance with the established code of ethics.
4) Compliance with applicable regulations and professional standards.
5) The timely and effective internal reporting of noncompliance and any
violations of the established code of ethics to an appropriate person or
persons designated in the code.
Ethical crisis have occurred throughout the history of mankind and will continue to
occur particularly when there is a conflict of interest. Many tragedies and scandals
can be traced back to the ethical behaviour of individuals involved and their
activities. For example, reported financial scandals might have been prevented had
executives, directors and auditors behaved more ethically. Code of business ethics
and conduct are intended to govern behaviour, but they cannot substitute for moral
principles, culture, and character. There are some who believe that moral principles
and ethics are part of family values that cannot be taught. Although we are not
taking any position on this issue, we believe that business ethics can be promoted
and taught to improve professional reputation, accountability, integrity, judgement,
and other qualities of the business decision-making process. Setting the appropriate
“tone at the top” promoting ethical organisation, culture, and policies can
effectively influence individual’s behaviour. Teaching business ethics should
provide incentives, opportunities, and rationalization for individuals, particularly
professionals, to uphold their personal integrity and professional accountability.

7.2 Business Ethics

Ethics are a branch of philosophy with no clear-cut definition of what behaviours

are ethical and which are unethical when judging one’s behaviour. There is no
general or global consensus for defining ethical behaviour for individuals because
it may change from time to time and from one place to another. There is no
universal measure or standard as to what constitutes ethical behaviour. The

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problem of defining business ethics is more severe because a business is a
collection of individuals, often with conflicting interests, who make decisions on
behalf of the organisation. Business ethics are most simply described as a process
of promoting more principles and standards that guide business behaviour. Four
different levels of business ethics have been identified based on what type of
business and how their actions are evaluated. These levels are:

1) The society level, which define ethical behaviour and assesses the effect of
business on society.
2) The industry level, which suggests that different industries have their own
set of ethical standards (e.g., chemical industries vs pharmaceutical
industries).
3) The company level, under which different companies have their own set of
ethical standards.
4) The individual manager level, at which each manager and other corporate
participants are responsible for their own ethical behaviour.
Companies need to have ethics and business programmes to address:

1) Their diversity of personnel services;

2) Their expectations of the public and their stakeholders;
3) Their legal, professional and regulatory environments;
4) Compliance with applicable regulations including SOX, FSG, SEC rules and
listing standards of national stock exchanges; and
5) Integration of ethics and business conduct programmes into their corporate
governance.
Thus, one feasible way to judge ethical behaviour is to focus on determinants of
business ethics and behaviour such as corporate culture, incentives, opportunities,
and choices.

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Corporate Culture

A corporate culture of setting an appropriate tone at the top of promoting ethical

and honourable behaviour can play an important role in establishing ethical
behaviour throughout the company. Corporate is influenced by the delegation of
authority, assignment of responsibilities, and the process of accountability. Proper
communication of corporate culture such as code of conduct and job descriptions
throughout the company are essential in promoting and enforcing ethical
behaviour.

Ethics in business have an important underlying postulate that the majority of

business leaders, managers, and other personnel are honest and ethical in
conducting their business, and the minority who engage in unethical conduct will
not prevail in the long term. Thus, corporate culture and compliance rules should
provide incentives and opportunities for the majority of ethical individuals to
maintain their honesty and integrity and provide measures for the minority of
unethical individuals to be monitored, punished, and corrected for their unethical
conduct. Companies should promote a spirit of integrity that goes beyond
compliance with the established code of business ethics or compliance to the letter
of the law by creating culture of doing what is right.

Incentives

Incentives are perhaps the most essential determinants of business ethics.

Individuals within the company (managers, employees) tend to act according to
incentives provided to them in terms of rewards and the performance evaluation
process. The company’s incentive plans can be structured to direct managers’ and
employees’ behaviour in the desired manner. The diversity of people, existence of
various value systems, and sensitivity of moral issues make it difficult to achieve a

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consensus and central theme for ethics. Thus, “situation ethic theory” is used in
this chapter to build a consensus as to appropriate ethical practices, professional
responsibilities, and honourable behaviour through the promotion, establishment,
and compliance with business and professional codes of conduct. Situation ethics
are “a moral pattern allowing circumstances to overrule principle and allegiance.
Principle here is interpreted as definable moral, criminal, or civil law. Allegiance
refers to group loyalty.” This suggests that individuals should do what is right
rather than comply with specific principles when facing ethical challenges.

Opportunity

Corporate culture and incentives can encourage individuals to behave in the

desired ethical manner. However, if opportunities exist, wrongdoers will take
advantage and behave in an opportunistic manner. Thus, effective corporate
governance, internal control, enterprise risk management can reduce the
opportunity for unethical conduct. Attributes of an ethical integrity-based corporate
culture are sense of employee responsibility, freedom to raise concerns without
fear of retaliation, managers modelling ethical behaviour and expressing the
importance of integrity, an understanding by leadership of the pressure points that
drive unethical behaviour, and processes to find and fix these areas of pressure.

Dark Reading’s 2006 “security scruples” survey reveals that entities operate
differently in private than they say they do in public. A survey of 648 IT and

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security professionals was conducted to determine their beliefs and behaviour in
both real and hypothetical security situations. The results indicate that:

1) A large majority agreed on how to “do the right thing”;

2) More than 27 percent have accessed unauthorized data;
3) Only 53 percent said they would report a colleague who was abusing
security privileges; and
4) Although many entities maintain codes of ethics and related policies to
protect their ethical and legal positions, their actual enforcement of these
policies varies with the situation.
These results suggests that situational ethics where the ends justify the means
prevail more in the workplace than the codes of ethics focusing on good versus bad
or acceptable behaviour versus unacceptable conduct.

Choices

Individuals, in general, are given the freedom to make choices and usually choose
those that will maximize their well-being. Managers and employees make
decisions, take actions, and exercise their choices on behalf of the company as
agents of their company. Nevertheless, their choices are often influenced by
corporate culture, incentives, opportunities, and actions because other individuals
in the organisation do not work in isolation. Although there is not a single
commonly accepted definition of ethics, there are numerous examples of possible
violation of ethics in business ranging from backdating practices of executive stock
options grants to spying on outside directors. Ethical violations include the
behaviour of the convicted executive of the high-profile company Enron,
WorldCom, Adelphia, and Tyco. The trend in business shows a decline in business

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ethics in recent years. The actual decline or the perception of such is not good for
business and modern society for the following reasons. This trend of dealing in
business ethics should be reversed through:

1) More education of business ethics;

2) Establishment of business codes of ethical conduct;
3) Enforcement of ethical conduct; and
4) Increased promotion of ethical behaviour in the business culture.
7.3 Professional Ethics

Characteristics of a profession are:

1) Existence of a common body of knowledge consisting of an intellectual skill

obtained through education, training, certification, and continuing
professional education;
2) Adoption and adherence to a common code of conduct guiding professional
behaviour and action and holding members accountable for their actions;
and
3) Acceptance of a duty to society, the profession, and its members.
Thus, the acceptance of ethical duties or responsibilities is the cornerstone of a
profession. The accounting professional is characterized by:

1) Serving the public interest;

2) Performing responsibly with integrity, competency, objectivity, and
transparency;
3) Exercising due diligence in maintain independence and improving the
quality of services provided; and
4) Protecting investors from receiving misleading audited financial reports.
In addressing an auditor’s bias in judgement, one should realize that:

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 1) Accountants do not work in isolation, but rather as team players, where their
work ethics and behaviours are influenced by the ethics and conducts of
coworkers, superiors, and even subordinates within the company; and
2) Like other human, they can be pressured and motivated when the
opportunity is given and thus be tempted to engage in unethical behaviour
(e.g., manipulation of financial reports).
In June 2005, the International Ethics Standards Board of Accountants (IESBA),
part of the International Federation of Accountants (IFAC), issued its revised Code
of Ethics for use by professional accountants worldwide. The key principles of the
IESBA’s code of ethics are:

1) Integrity;
2) Objectivity;
3) Professional competence and due care;
4) Confidentiality; and
5) Professional behaviour.
Standard 2130, Assurance Engagement of the ETA’s International Standards for
the Professional Practice of Internal Auditing, require internal auditors to “evaluate
the design, implementation, and effectiveness of the organisation’s ethics-related
objectives, programmes, and activities.” The audit committee should ask internal
auditors to evaluate the company and the extent of compliance of its major
functions (key units) with its established code of business conduct. The purpose of
this evaluation is to reinforce the company’s commitment to ethical values and
integrity. Many states have started to require mandatory ethics education and
training as part of their continuing professional education (CPE) requirements to
maintain a CPA license in good standing. For example, New York requires four

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hours of ethics CPE for a triennial license period, while the state if Virginia
requires two hours of ethics CPE reporting each year.

7.4 Financial Reporting Integrity

Financial reporting integrity is vital in rebuilding investor confidence in corporate

America, its financial reports, and the capital markets. Integrity is also important to
individuals and society in providing a basis for:

1) Establishing trust;
2) Relying on information;
3) Developing markets;
4) Achieving desired outcomes; and
5) Inspiring public policy.
The five key aspects of integrity are moral, values, motives, communication,
qualities, and achievement.

The integrity of the financial reporting process can create investor confidence in
financial information required for the efficiency functioning of the capital markets.
The integrity of the process is a function of trustworthiness of all individuals
involved including the board of directors, particularly the audit committee,
management, both internal and external auditors, legal counsel, investment banks,
and financial analysts. Specifically, the integrity and competence of those engaged
directly in the financial reporting process, such as management, the audit
committee, and external auditors, greatly influence the quality and reliability of
financial reports. The table below presents a framework for reporting with integrity
consisting of (1) five key aspects of moral values, motives, commitments, qualities,
and achievement; (2) five organisational drivers of leadership, strategy, policies,

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information, and culture; and (3) six reporting processes of honesty, fairness,
compliance, public interest, transparency, remediation, and consistency.

Table 7.1 Framework for Reporting with Integrity

Key aspects Organisational drivers Reporting process attributes

1. Moral values 1. Leadership 1. Honest and
2. Motives 2. Strategy truthfulness
3. Commitment 3. Policies 2. Fairness
4. Qualities 4. Information 3. Compliance
5. Achievements 5. Culture 4. Public interests
5. Remediations
6. Consistency

The five key aspects of integrity in reporting are:

1. Moral values – all financial reporting participants should embrace honesty,

trustworthiness, and fairness, and observe moral values in fulfilling their
reporting responsibilities with a keen focus on substance over form reporting
attributes.
2. Motives – reporting should be motivated by a desire to provide relevant,
useful, reliable, and transparent information to enable users of reports to
make informed decisions rather than a preference for self-interested goals of
focusing on maximizing personal wealth through bonuses, stock options
backdating, or saving face.

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 3. Commitments – all participants in the financial reporting process should be
committed to and accountable for creating shareholder value while
protecting the interests of other stakeholders.
4. Qualities – all participants in the financial reporting process should be
competent, possess the knowledge and experience needed to discharge their
reporting responsibilities, be courageous enough to resist pressure and report
both good and bad news, and be capable of exercising independent
judgement.
5. Achievement – all participants in the financial reporting process should strive
to achieve the stated financial reporting goals.
Organisational Drivers of Integrity in Reporting

The five organisational drivers of integrity in reporting are:

1. Leadership – an appropriate tone at the top set by senior executives in

promoting ethical behaviour and commitment to high-quality financial
reporting is vital in ensuring the integrity of financial reports.
2. Strategy – a proper strategy should be established for achieving the stated
financial reporting goals of providing high-quality financial information
with a keen focus on assisting the users to make informed decisions. This
this strategy should identify users’ information needs and financial reporting
goals as well as recruit competent and ethical senior executives and other
professionals (e.g., accountants, auditors) to achieve these goals.
3. Policies – proper policies should be established to support the stated
strategy, and these policies should be reviewed periodically and on an
ongoing basis for their adequacy, appropriateness, and effectiveness.
Reporting policies and procedures are normally concerned with accounting
policies, internal control procedures, and risk assessments policies and

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 procedures. Effective implementation of these policies substantially reduces
the risks of misleading financial information.
4. Information – an organisation’s policies and procedures should ensure the
product og relevant, useful, reliable, and high-quality financial information
to assist users in making informed decisions.
5. Culture – a culture of ethical behaviour and financial reporting integrity
should be promoted throughout the organisation by linking rewards systems
to high-quality reporting and sustainable performance rather than short-term
performance or pressure to make the numbers.
The integrity reporting process promotes the attributes of honesty, fairness, and
compliance with applicable regulations; ensures public interests are subject to
proper remediation; and should be applied consistently.

A well-established and effectively enforced code of conduct provides ethical

standards and guidelines on resolutions of conflicts of interest; compliance with
applicable regulations, confidentiality and proprietary of information; and fair
dealing with investors, customers, suppliers, employees, and other interested
parties. The emerging corporate governance reforms require public companies to
establish a code of conduct for their executives and other key personnel and
publicly disclosure their business code of conduct.

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 Unit Eight

Ethics and Social Responsibility

Most of those who write about ethics do not make a clear distinction between
ethics and morality. The question of what is “right” or “morally correct” or
“ethically correct” or “morally desirable” in any situation is variously phrased, but
all of the words and phrases are after the same thing: what act is “better” in a moral
or ethical sense than some other act? People sometimes speak of morality as
something personal but view ethics as having wider social implications. Others see
morality as the subject of a field of study, that field being ethics. Ethics would be
morality as applied to any number of subjects, including journalistic ethics,
business ethics, or the ethics of professionals such as doctors, attorneys, and

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accountants. We will venture a definition of ethics, but for our purposes, ethics and
morality will be used as equivalent terms.

People often speak about the ethics or morality of individuals and also about the
morality or ethics of corporations and nations. There are clearly differences in the
kind of moral responsibility that we can fairly ascribe to corporations and nations;
we tend to see individuals as having a soul, or at least a conscience, but there is no
general agreement that nations or corporations have either. Still, our ordinary use
of language does point to something significant: if we say that some nations are
“evil” and others are “corrupt,” then we make moral judgments about the quality of
actions undertaken by the governments or people of that nation. For example, if
North Korea is characterized by the US president as part of an “axis of evil,” or if
we conclude that WorldCom or Enron acted “unethically” in certain respects, then
we are making judgments that their collective actions are morally deficient.

In talking about morality, we often use the word good; but that word can be
confusing. If we say that Microsoft is a “good company,” we may be making a
statement about the investment potential of Microsoft stock, or their preeminence
in the market, or their ability to win lawsuits or appeals or to influence
administrative agencies. Less likely, though possibly, we may be making a
statement about the civic virtue and corporate social responsibility of Microsoft. In
the first set of judgments, we use the word good but mean something other than
ethical or moral; only in the second instance are we using the word good in its
ethical or moral sense.

The aim of ethics is to identify both the rules that should govern people’s behavior
and the “goods” that are worth seeking. Ethical decisions are guided by the
underlying values of the individual. Values are principles of conduct such as

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caring, being honest, keeping promises, pursuing excellence, showing loyalty,
being fair, acting with integrity, respecting others, and being a responsible citizen.
Most people would agree that all of these values are admirable guidelines for
behavior. However, ethics becomes a more complicated issue when a situation
dictates that one value overrules others. An ethical issue is a situation, problem, or
opportunity in which an individual must choose among several actions that must be
evaluated as morally right or wrong. Ethical issues arise in every facet of life; we
concern ourselves here with business ethics in particular. Business ethics
comprises the moral principles and standards that guide behavior in the world of
business.

CORPORATE SOCIAL RESPONSIBILITY

Should business be responsible for social concerns beyond its own economic well-
being? Do social concerns affect a corporation’s financial performance? The extent
of business’s responsibility for noneconomic concerns has been hotly debated for
years. In the 1960s and 1970s, the political and social environment became more
important to U.S. corporations as society focused on issues like equal opportunity,
pollution control, energy and natural resource conservation, and consumer and
worker protection. Public debate addressed these issues and the ways business
should respond. This controversy focused on the concept of corporate
socialresponsibility —the obligation toward society assumed by business. A
socially responsible business maximizes its positive effects on society and
minimizes its negative effects.

Social responsibilities can be categorized more specifically. The economic

responsibilities of business are to produce goods and services that society wants at
a price that perpetuates the business and satisfies its obligations to investors. For
Smithfield Foods, the largest pork producer in the United States, this means selling

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bacon, ham, and other products to customers at prices that maximize Smithfield’s
profits and keep the company growing over the long term. Economic responsibility
may also extend to offering certain products to needy consumers at a reduced
price. Legal responsibilities are to obey local, state, federal, and relevant
international laws. Laws affecting Smithfield cover a wide range of requirements,
from filing tax returns to meeting worker safety standards. Ethical responsibilities
include meeting other societal expectations, not written as law. Smithfield took on
this level of responsibility when it responded to requests by major customers,
including McDonald’s and Walmart, that it discontinues the practice of using
gestation crates to house its sows. The customers were reacting to pressure from
animal rights advocates who consider it cruel for sows to live in the two-foot by
seven-foot crates during their entire gestation period, which means they cannot
walk, turn around, or stretch their legs for months at a time. The practice had been
to move the sows to a farrowing crate to give birth and then return them to the
gestation crate soon after, when they became pregnant again. Smithfield plans to
exchange the crates for “group housing,” which allows the animals to socialize,
even though group housing costs more. 73 Smithfield is not legally required to
make the change (except in two states), and the arrangement may not maximize
profits, but the company’s actions help it maintain good customer relationships and
a positive public image. Finally, philanthropic responsibilities are additional
behaviors and activities that society finds desirable and that the values of the
business support. Examples include supporting community projects and making
charitable contributions. Philanthropic activities can be more than mere altruism;
managed properly, “strategic philanthropy” can become not an oxymoron but a
way to build goodwill in a variety of stakeholders and even add to shareholder
wealth. Robert Giacalone, who teaches business ethics at Temple University,
believes that a 21st-century education must help students think beyond self-interest
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and profitability. A real education, he says, teaches students to leave a legacy that
extends beyond the bottom line—a transcendent education. A
transcendenteducation has five higher goals that balance self-interest with
responsibility to others:
1. Empathy —feeling your decisions as potential victims might feel them, to
gain wisdom.
2. Generativity —learning how to give as well as take, to others in the present
as well as to future generations.
3. Mutuality —viewing success not merely as personal gain, but a common
victory.
4. Civil aspiration —thinking not just in terms of “don’ts” (lie, cheat, steal,
kill), but also in terms of positive contributions.
5. Intolerance of ineffective humanity —speaking out against unethical actions
Do businesses really have a Social Responsibility?
Two basic and contrasting views describe principles that should guide managerial
responsibility. The first holds that managers act as agents for shareholders and, as
such, are obligated to maximize the present value of the firm. This tenet of
capitalism is widely associated with the early writings of Adam Smith in The
Wealth of Nations, and more recently with Milton Friedman, the Nobel Prize–
winning economist of the University of Chicago. With his now-famous dictum
“The social responsibility of business is to increase profits,” Friedman contended
that organizations may help improve the quality of life as long as such actions are
directed at increasing profits. Some considered Friedman to be “the enemy of
business ethics,” but his position was ethical: he believed it is unethical for
unelected business leaders to decide what is best for society, and unethical for
them to spend shareholders’ money on projects unconnected to key business
interests. In addition, the context of Friedman’s famous statement includes the
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qualifier that business should increase its profits while conforming to society’s
laws and ethical customs.

The alternative view is that managers should be motivated by principled moral

reasoning. Followers of Friedman and TheWealth of Nations might sneer at such
soft-headed propaganda. But Adam Smith wrote about a world different from the
one we are in now, driven in the 18th century by the self-interest of small owner-
operated farms and craft shops trying to generate a living income for themselves
and their families. This self-interest was quite different from that of top executives
of modern corporations. It is noteworthy that Adam Smith also wrote A Theory of
Moral Sentiments, in which he argued that “sympathy,” defined as a proper regard
for others, is the basis of a civilized society. Advocates of corporate social
responsibility argue that, as members of society, organizations have a wider range
of responsibilities beyond profitability. As members of society, organizations
should actively and responsibly participate in the community and in the larger
environment. From this perspective, many people criticized insurance companies
after Hurricanes Katrina and Rita devastated homes and businesses along the Gulf
Coast. From a social responsibility perspective, it was wrong for companies to
watch out for their bottom line and avoid paying claims where they could make a
case that the damage wasn’t covered; the insurers should have been more
concerned about their devastated customers. Or consider how companies have
responded to public criticism that products manufactured in low-wage countries
are produced in “sweatshops,” where employees work in conditions widely viewed
as unacceptable in developed nations such as the United States. Do U.S. companies
have a social responsibility to insist on better working conditions? Walmart and
other companies that buy products made in China have written codes of conduct
and conducted onsite audits. Unfortunately, some enterprising Chinese consultants

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have set up services that help factories hide violations instead of correcting them.
Still, as demand for Chinese-made products and pressure from multinational
corporations have both intensified, observers say pay and working conditions in
China have generally improved.
You can do good and do well
Profit maximization and corporate social responsibility used to be regarded as
leading to opposing policies. But in today’s business climate, which emphasizes
both doing good and doing well, the two views can converge. 80 The Coca-Cola
Company has set up about 70 charitable projects to provide clean water in 40
countries. These projects are helping some of the 1.2 billion people without access
to safe drinking water. The company is building structures to “harvest” rainwater
in India, expanding the municipal water supply in Mali, and delivering water
purification systems and storage urns to Kenya. These projects are aimed at
burnishing the company’s image and targeting complaints that the company is
using too much of the world’s water supply to manufacture its beverages. From a
practical perspective, Coca-Cola’s strategic planners have identified water
shortages as a strategic risk; from a values perspective, water is, in the words of
executive Neville Isdell, “at the very core of our ethos,” so “responsible use of that
resource is very important to us.” Earlier attention to corporate social responsibility
focused on alleged wrongdoing and how to control it.

More recently, attention has also been centered on the possible competitive
advantage of socially responsible actions. DuPont has been incorporating care for
the environment into its business in two ways it hopes will put it ahead of the
competition. First, the company has been reducing its pollution, including a 72
percent cut in greenhouse gas emissions since 1990. It hopes these efforts will give
it an advantage in a future where the government regulates emissions, requiring

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competitors to play catch-up. In addition, reducing emissions goes hand in hand
with reducing waste and unnecessary use of energy, saving the company money
and directly benefiting the bottom line. Second, DuPont has been developing
products that are sustainable, meaning they don’t use up the earth’s resources.
Examples include corn-based fabrics and new applications of its Tyvek material to
make buildings more energy-efficient. DuPont expects these innovations to give
the company profitable access to the growing market for environmentally friendly
products.

The real relationship between corporate social performance and corporate financial
performance is highly complex; socially responsible organizations do not
necessarily become more or less successful in financial terms. Some advantages
are clear, however. For example, socially responsible actions can have long-term
benefits. Companies can avoid unnecessary and costly regulation if they are
socially responsible. Honesty and fairness may pay great dividends to the
conscience, to the personal reputation, and to the public image of the company as
well as in the market response. 84 In addition, society’s problems can offer
business opportunities, and profits can be made from systematic and vigorous
efforts to solve these problems. Firms can perform a cost-benefit analysis to
identify actions that will maximize profits while satisfying the demand for
corporate social responsibility from multiple stakeholders. 85 In other words,
managers can treat corporate social responsibility as they would treat all
investment decisions. This has been the case as firms attempt to reconcile their
business practices with their effect on the natural environment.

The Natural Environment

Most large corporations developed in an era of abundant raw materials, cheap
energy, and unconstrained waste disposal. But many of the technologies developed

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during that era are contributing to the destruction of ecosystems. Industrial-age
systems follow a linear flow of extract, produce, sell, use, and discard— what
some call a “take-make-waste” approach. 90 But perhaps no time in history has
offered greater possibilities for a change in business thinking than the 21st century.
Business used to look at environmental issues as a no-win situation: either you help
the environment and hurt your business, or else you help your business at a cost to
the environment. But now a shift is taking place as companies deliberately and into
the design and manufacturing of products. Why? In addition to philosophical
reasons, companies “go green” to satisfy consumer demand, react to a competitor’s
actions, meet requests from customers or suppliers, comply with guidelines, and
create a competitive advantage. General Electric CEO Jeff Immelt used to view
environmental rules as a burden and a cost. Now he sees environmentally friendly
technologies as one of the global economy’s most significant business
opportunities. Under a business initiative called Ecomagination, GE is looking for
business opportunities from solving environmental problems. Ecomagination
solutions already include wind turbines, materials for solar energy cells, and
energy-efficient home appliances. Over a five-year period, GE’s revenues from
renewable-energy products have risen from $5 million to $7 billion.

Economic activity has Environmental Consequences

We live in a risk society. That is, the creation and distribution of wealth generate
by-products that can cause injury, loss, or danger to people and the environment.
The fundamental sources of risk in modern society are the excessive production of
hazards and ecologically unsustainable consumption of natural resources. Risk has

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proliferated through population explosion, industrial pollution, and environmental
degradation. Industrial pollution risks include air pollution, smog, global warming,
ozone depletion, acid rain, toxic waste sites, nuclear hazards, obsolete weapons
arsenals, industrial accidents, and hazardous products. More than 30,000
uncontrolled toxic waste sites have been documented in the United States alone,
and the number is increasing by perhaps 2,500 per year. The situation is far worse
in other parts of the world. The pattern, for toxic waste and many other risks, is one
of accumulating risks and inadequate remedies. The institutions that create
environmental and technological risk (corporations and government agencies) also
are responsible for controlling and managing the risks. Lockheed Martin
Corporation had to contain the spread of a chemical used in industrial degreasers
when it leaked from a broken sump pump at an old facility in Florida. Even though
Lockheed had sold the facility to another company, it had owned the property
when the contamination was first discovered, so it was responsible. Lockheed’s
efforts included sealing off an old contaminated well at a cattle operation and
providing a new well with clean water for the cattle.
Development can be Sustainable
Ecocentric management has as its goal the creation of sustainable economic
development and improvement of quality of life worldwide for all organizational
stakeholders. Sustainablegrowth is economic growth and development that meets
the organization’s present needs without harming the ability of future generations
to meet their needs. 99 Sustainability is fully compatible with the natural
ecosystems that generate and preserve life. Some believe that the concept of
sustainable growth can be applied in several ways:
 As a framework for organizations to use in communicating to all
stakeholders.
 As a planning and strategy guide.
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  As a tool for evaluating and improving the ability to compete. 100
The principle can begin at the highest organizational levels and be made explicit in
performance appraisals and reward systems. Increasingly, firms are paying
attention to the total environmental impact throughout the life cycle of their
products. Life-cycle analysis (LCA) is a process of analyzing all inputs and
outputs, through the entire “cradle-to-grave” life of a product, to determine the
total environmental impact of its production and use. LCA quantifies the total use
of resources and the releases into the air, water, and land. LCA considers the
extraction of raw materials, product packaging, transportation, and disposal.
Consider packaging alone. Goods make the journey from manufacturer to
wholesaler to retailer to customer; then they are recycled back to the manufacturer.
They may be packaged and repackaged several times, from bulk transport, to large
crates, to cardboard boxes, to individual consumer sizes. Repackaging not only
creates waste but also costs time. The design of initial packaging in sizes and
formats adaptable to the final customer can minimize the need for repackaging, cut
waste, and realize financial benefits. Profitability need not suffer and may be
increased by ecocentric philosophies and practices. Some, but not all, research has
shown a positive relationship between corporate environmental performance and
profitability. Of course, whether the relationship is positive, negative, or neutral
depends on the strategies chosen and the effectiveness of implementation. And
managers of profitable companies may feel more comfortable turning their
attention to the environment than are managers of companies in financial
difficulty.

Some Organizations set Environmental Agendas

In the past, most companies were oblivious to their negative environmental impact.
More recently, many began striving for low impact. Now, some strive for positive

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impact, eager to sell solutions to the world’s problems. IBM has three decades of
experience in lowering its environmental impact through efforts such as reducing
waste in packaging and measuring carbon emissions. It has begun to use that
experience as a strength, a basis for expertise it can sell to other organizations,
along with its computing power and other consulting services.

Thus, one application might be to help clients measure and forecast the carbon
emissions of their entire supply chain. By running calculations on its
supercomputers, IBM consultants could help the clients find ways to lower their
energy use. You don’t have to be a manufacturer or a utility to jump on the green
bandwagon. Web search giant Google is applying a three pronged strategy aimed
at reducing its “carbon footprint,” that is, its output of carbon dioxide and other
greenhouse gases. At Google, most greenhouse gas emissions are related to
electricity consumption by its buildings and computers. So Google is first seeking
ways to make buildings and computers more energy efficient, such as by using
high-efficiency lighting and installing power management software in its
computers. Second, the company is developing ways to get more of its power from
renewable sources, such as the solar power system at its facility in Mountain View,
California. Finally, recognizing that its other efforts cannot yet eliminate Google’s
release of greenhouse gases, the company is purchasing “offsets”—funding
projects that reduce greenhouse gas emissions elsewhere. Webs of companies with
a common ecological vision can combine their efforts into high-leverage, impactful
action. In Kalundborg, Denmark, such a collaborative alliance exists among an
electric power generating plant, an oil refiner, a biotech production plant, a
plasterboard factory, cement producers, heating utilities, a sulfuric acid producer,
and local agriculture and horticulture. Chemicals, energy (for heating and cooling),
water, and organic materials flow among companies. Resources are conserved,

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“waste” materials generate revenues, and water, air, and ground pollution all are
reduced. Companies not only have the ability to solve environmental problems;
they are coming to see and acquire the motivation as well. Some now believe that
solving environmental problems is one of the biggest opportunities in the history of
commerce.

Prescribed Reading

Tricker, R (2012) Corporate Governance: Principles, Policies and Practices, 2nd edition, Oxford
University Press.

Thomsen, S., &Conyon, M. (2012). Corporate governance: Mechanisms and systems.

McGraw Hill.

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Solomon, J. (2013). Corporate Goverance and Accountability, 4th edition, Wiley.

Corporate Governance by Monks, Robert A.G. and Nell Minow New

York: John Wiley & Sons, 2011, 5th edition.

Recommeded readings

Corporate Governance by Kenneth Kim, John R. Nofsinger, Derek J

Mohr, 2010 3/E, Prentice Hal

Ten Bos, René & Dunne, Stephen (2011) Corporate Social Responsibility. In: Business Ethics
and Continental Philosophy, Mollie Painter-Morland and René Ten Bos (Eds.), Cambridge:
Cambridge University Press, 220-241.
Painter-Morland, M. and T. Ten Bos (2011). Introduction: Critical Crossings. In: Business
Ethics and Continental Philosophy, M. Painter-Morland and R. Ten Bos (Eds.), Cambridge:
Cambridge University Press, 15-36.
Painter-Morland, M. (2011). Agency in corporations. In: M. Painter-Morland and R. Ten Bos
(Eds.), Business Ethics and Continental Philosophy, Cambridge: Cambridge University Press,
15-36.
Abeler et al. (2010), Gift Exchange and Workers' Fairness Concerns: When Equality is
Unfair, Journal of the European Economic Association, 2010, 8:6, pp. 1299-1324

Carroll, Archie B. (1979) A Three-Dimensional Conceptual Model of Corporate

Performance, Academy of Management Review 4, 497-505.
Frederick, William C. (1994) From CSR1 to CSR2 - The Maturing of Business-and Society
Thought, Business and Society 33(2), 150-164.
Tirole, Jean and Bénabou, Roland (2010) Individual and Corporate Social Responsibility,
Economia Issue 305 (77), 1-19.
Painter-Morland, M. (2011). Rethinking Responsible Agency in Corporations: Perspectives
from Deleuze and Guattari. In: Journal of Business Ethics 101, 83-95.

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