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Definition Concepts Agency Stakeholders Main issues1: Scope of corporate governance Page 3 Fairness Take into account all stakeholders with legitimate interests Transparency Openness, di

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Governance, Risk and Ethics

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Professional Paper P1 Governance, Risk and Ethics

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First edition 2007, Eighth edition June 2014

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e ISBN 9781 4727 1185 4

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Page iii

Contents

Preface

Welcome to BPP Learning Media’s ACCA Passcards for Professional Paper P1 Governance, Risk and Ethics.

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 They incorporate diagrams to kick start your memory.

 They follow the overall structure of the BPP Learning Media Study Texts, but BPP Learning Media’s ACCA

Passcards are not just a condensed book Each card has been separately designed for clear presentation.

Topics are self contained and can be grasped visually

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Run through the Passcards as often as you can during your final revision period The day before the exam, try to

go through the Passcards again! You will then be well on your way to passing your exams.

Good luck!

Preface

Page

1: Scope of corporate governance

Definition Concepts Agency Stakeholders Main issues

Corporate governance is the system by which organisations are directed and controlled It is a set of relationships between directors, shareholders and other stakeholders.

Risk management

and reduction

Appropriate controlsystems

Framework topursue strategy

Definition Concepts Agency Stakeholders Main issues

1: Scope of corporate governance

Page 3

Fairness Take into account all stakeholders with legitimate interests

Transparency Openness, disclosure in financial statements, press releases, websites

Independence Being free from constraints or influences that would prevent a correct course of

action being takenInnovation Recognise that the needs of businesses and stakeholders can change over timeScepticism NEDs, auditors and audit committees should adopt an air of scepticism and an

enquiring mindProbity Truth-telling/not misleading

Responsibility Management responsible for organisation, means of corrective action and

penalising mismanagementAccountability Directors and companies answerable for consequences of actions to shareholders,

professionals to values, public sector to stakeholders Reputation Jeopardised by poor risk management/corporate governance ethical behaviour,

may impact commerciallyJudgement Taking decisions that enhance organisation’s prosperity

Integrity Straightforward dealing, honesty and completeness, basis of trust

Definition Concepts Agency Stakeholders Main issues

Agency is acting on behalf of another (principal) in

dealing with others

Agency costs are the monies and resources

expended by principal in monitoring agent

 Share option plans

Transaction costs theory

Companies seek to keep business dealings in-house,managers act opportunistically in their own interests

Definition Concepts Agency Stakeholders Main issues

1: Scope of corporate governance

Page 5

Stakeholder theory

A broad range of stakeholders have claims on an

organisation Stockholder/Shareholder view that

company just responsible to shareholders is

wrong as modern corporations are very large and

social/political/legal impact is therefore great

 Instrumental view – mainly economic

responsibilities with aim of maximising profits

 Normative view – ethical/philanthropic

responsibilities as well as economic/legal

Stakeholders

Stakeholders are groups or individuals whose

interests can affect or are directly affected by the

activities of a firm or organisation

Stakeholder power mapping

Level of interest

DPower

LowHigh

C

BA

A: minimal effort B: keep informed, as can influence more powerful stakeholders C: keep satisfied

D: strategy must be acceptable

 Corporate governance accommodates views

 Repositioning of stakeholders

 Identify change blockers/facilitators

 Assess legitimacy/urgency

Results of mapping

Proximity to organisation

Internal – employees/management

Connected – shareholders, customers, suppliers,

lenders, trade unions, competitors

External – government, local government, public,

pressure groups, opinion leaders

Active and passive stakeholders

Active – seek to participate in organisation's

activities (managers, shareholders, regulators,pressure groups)

Passive – don’t seek to participate in policy-making

(shareholders, local communities, government)

Primary and secondary stakeholders

Narrow and wide stakeholders

Primary – need participation to continue as going

concern (customers, suppliers, government)

Secondary – their ceasing to participate won’t affect

continued existence (government, managers)

Narrow – most affected by organisation’s strategy

(shareholders, employees, suppliers, major customers)

Wide – less affected by organisation’s strategy

(government, less significant customers, community)

1: Scope of corporate governance

Page 7

Voluntary and involuntary stakeholders

Voluntary – those who of their own choice have

involvement with the organisation – employees,

customers, suppliers, shareholders

Involuntary – engage with the organisation without

choosing to do so – neighbours, wider public

Knowledge of stakeholders

Known – Existence known to organisation Unknown – Existence unknown to organisation

(wildlife, communities affected by suppliers)

Direct – stakeholders know effect/how affected by Indirect – unaware of claims or cannot express them

Who decides legitimacy? Basis?

Recognised – Managers consider interests and views

when deciding strategy

Unrecognised – Managers don't consider claims when

deciding strategy

Definition Concepts Agency Stakeholders Main issues

Concerned with impact of board upon position, supervise and co-ordinateimplementation of business strategy and risk management, provide data for boardCommitment, interest in pay and conditions, need to implement control systems, adoptculture and provide feedback

Pay and working conditions, concerned with poor board communication, lax risk andcontrol environment, can be used to harness employee support

Co-operation needed for just-in-time supply, poor payment record leads to creditrestriction and poor service

Increased expectations, power to shop elsewhere, ability to make views known, ethicalrequirements

Directors

Sub-board management

Trade unions

1: Scope of corporate governance

Page 9

Highlight governance and reporting issues, independence required to supplyconfidence in information, need for audit committee to reinforce positionEstablish rules and standards, carry out inspections May be enforcement costs orregulatory capture, domination of regulator by regulated

Establish overall climate, encourage private shareholdings, provide subsidies,nationalise poorly performing industries, run public sector organisationsCompanies raise money, investors transfer shares, supply data about companyvalue and provide regulatory framework for governance

Can influence prices, avoid speculative shares, want short-term profits, can influencecompanies through meetings and voting, able to take direct action if dissatisfiedHold small numbers of shares in companies, trusts and funds Likely to beundiversified and concerned with information asymmetry

Services from public sector, aid from charitiesProvide funds to charities, want them well-spent

Definition Concepts Agency Stakeholders Main issues

Duties of directors

Corporate governance guidelines reinforce legal and

fiduciary duties to act in company’s best interests,

use powers for proper purpose, avoid conflicts of

interest and exercise duty of care

Accounting and auditing

Greater transparency and reliability of accounts,

decreasing investor risks Tougher auditing standards

and requirements for auditors to avoid conflicts of

Need to avoid domination by single individual/small

group of executive directors

Builds on stakeholders' debate, what responsibilitiesshould organisation and board fulfil

Directors being paid undeserved and excessiveremuneration and bonuses Allegations that directorshave been rewarded for making losses

2: Approaches to corporate governance

Corporate social responsibility

Public sector governance

In this chapter we summarise the factors that haveinfluenced the ways corporate governance hasdeveloped, including the important rules v principlesdebate You may be asked about these in part (a) of aquestion before you consider specific corporategovernance arrangements later in the question We alsogive details of the major worldwide codes, particularlythose that have international impact

Corporate social responsibility is a major topic in thisexam, and the themes we cover here and in Chapter 11will occur in many questions

Corporate social responsibility

Development of

guidance

Public sector governance Sarbanes-Oxley

Major governance codes

Basis of guidance

Corporate scandals

Corporate social responsibility

Development of

guidance

Public sector governance Sarbanes-Oxley

Major governance codes

2: Approaches to corporate governance

Page 13

Basis of guidance

Principles-based approach

Most corporate governance codes use a

principles-based approach with broad guidelines supplemented by

limited specific requirements Encourage companies to

comply or explain

Rules-based approach

Rules-based approach focuses on regulations and

targets that must be met without any leeway It should be

easy to ascertain compliance, but in practice there may

be questionable situations which are not fully covered by

the rules

 Fulfil strategic objectives

 Reinforce governance regulation

 Minimise risk

 Promote ethical behaviour

 Underpin investor confidence

 Fulfil stakeholder responsibilities

 Establish management accountability

 Maintain NED/auditor independence

 Provide accurate reporting

 Encourage owner involvement

 Direct behaviour

Key Principles

Corporate social responsibility

Development of

guidance

Public sector governance Sarbanes-Oxley

Major governance codes

Basis of guidance

Insider systems

Most companies listed on stock exchange are controlled

by a few individuals, for example family companies

 Avoids inflexible rules

 Confusion over what is compulsory

 Companies treat as non-binding

 Markets don't understand disclosures

Problems with principles

Corporate social responsibility

Development of

guidance

Public sector governance Sarbanes-Oxley

Basis of guidance

2: Approaches to corporate governance

Page 15

Major governance codes

OECD principles

 Shareholder/stakeholder rights

 Equitable treatment of all shareholders

 Stakeholders rights protected

 Timely/accurate disclosure of material matters

 Board responsible for strategy and monitoring

Principles

ICGN report

International Corporate Governance Network has

provided practical guidance for boards to operate

efficiently and compete for scarce capital

Organisation for Economic Co-operation andDevelopment produced non-binding principles toaddress the interests of global investors Companiesshould work towards achieving principles, andprinciples are guidelines for individual countries todevelop own codes

UK Corporate Governance Code

Code derived originally from Cadbury, Greenbury and

Hampel reports, supplemented by:

 Turnbull report – risk and internal control

 Smith report – audit committees

 Higgs report – non-executive directors

Corporate social responsibility

Development of

guidance

Public sector governance

Sarbanes-Oxley

Major governance codes

Basis of guidance

The non-audit services auditors can provide are

significantly restricted and auditors are subject to

various other rules:

 Compulsory partner rotation

 Retention of audit papers

 Quality control standards

 Review internal control systems

Sarbanes-Oxley

The Sarbanes-Oxley Act was a response to the

collapse of Enron, one of America's biggest companies

The Act is more prescriptive than codes in other

jurisdictions, impacting on review of controls,

disclosures, audits, ethics and directors’ share trading

 Lack of transparency in accounts

 Non-executive directors weak

 Lack of external audit scrutiny

 Directors’ use of inside information

 Dishonesty and law-breaking

2: Approaches to corporate governance

Page 17

Audit committees

Every listed company should have an audit

committee consisting of independent directors, with

member(s) with financial expertise Audit committee

should be responsible for:

 Appointment, compensation and oversight of

auditors

 Discussing key accounting policies with auditors

 Setting up complaints mechanisms

Internal control reports (s404)

Annual accounts must contain internal control reportsthat:

 State management responsibility for controlstructure/financial reporting procedures

 Assess effectiveness of control structure/financialreporting procedures (with audit report)

 State whether code of conduct for senior financialofficers has been adopted

Employees/auditors will be granted whistleblowing

protection if they disclose private employer

information to parties involved in a fraud claim

There should be appropriate disclosure of material balance sheet transactions

off-Corporate social responsibility

Development of

guidance

Public sector governance Sarbanes-Oxley

Major governance codes

Basis of guidance

Carroll's model

Four levels of responsibilities:

 Economic – shareholders/employees/customers

 Legal – comply with laws

 Ethical – act in fair and just way

 Philanthropic – generosity to employees/

community

 Collaboration time-consuming and expensive

 Culture clashes with certain stakeholders

 Collaboration on some issues, conflict onothers

 Lack of consensus between differentstakeholders

Problems with stakeholder view

CSR and stakeholders

Businesses benefit from goodwill and other aspects

of society and therefore owe those particularlyaffected by their activities certain duties in return

Significance of responsibility

Large businesses in particular face expectations that

they will act in a socially responsible fashion

2: Approaches to corporate governance

Page 19

Ownership responsibilities

By buying shares, shareholders buy a responsibility to

ensure that company is managed efficiently and in ways

consistent with public welfare Responsibilities of

institu-tional shareholders have been stressed, instituinstitu-tional

shareholders' large % shareholdings meaning they

should be actively involved and pressure managers

 Shareholders with small % holdings aren’t

influential

 Shareholders can easily dispose of shares and

this loosens feelings of obligation

Ownership view problems

 Objectives

 Mission statements

 Ethical codes

 Governance codes

 Stakeholder board representation

 Corporate social reporting

Impact of CSR

Corporate social responsibility

Development of

guidance

Public sector governance

Sarbanes-Oxley Major

governance codes

Basis of guidance

Public sector Private sector Charitable status NGOs/quasi NGOs

Purposes and objectives Public service Profit Relief of poverty,

research, etc

As defined by owners

Performance Central regulation Financial reporting

standards

shareholders

Stakeholders

(including lobby groups)

The public, centralgovernment,service users

Shareholders,regulators, taxationauthorities

Service users Government,

lobbying groups

3: Corporate governance practice and reporting

relationships

Directors' remuneration

Non-executive directors

Board membership

Scope of board's role

The board should have a formal schedule of matters

reserved to it for decisions Board is also responsible

for overseeing strategy, monitoring risk, control

systems and management, and ensuring effective

communication

 Maximise talent pool

 Broader range of knowledge

 Access stakeholder constituencies

 Greater independence

 Corporate citizen

Advantages of diversity

 Legal responsibilities

 Avoidance of conflict of interest

 Time limits on appointments

 Limits on service contracts

 Retirement by rotation

 Insider dealing

Legal and regulatory frameworks

Nomination of directors

Nomination committee should oversee appointments

and make recommendations to the board Needs to

consider:

 Executives/non-executives

 Gaps in current board's skills

 Expanding board diversity (age, gender, race,

ethnicity, education, background)

 Continuity and succession planning

3: Corporate governance practice and reporting

Page 23

CPD and appraisals

All board members should have training covering

strategy, management, legal responsibilities and

company related issues

There should be annual appraisals of the performance

of the whole board and of individual directors

 Performance against objectives

Deters management fraud

Better links with stakeholders

Better use of non-executive time

Disadvantages of multi-tier boards

Lack of accountabilityDon't receive information from managersSupervisory board decision-making restrictedLess effective at questioning managers

Companies in some countries are run by two or more

boards, often with supervisory/management role split

Multi-tier boards

relationships

Directors' remuneration

Non-executive directors

Board membership

Board membership

Companies need to consider optimum

size, balance of executive and

non-executive directors, and diversity of

membership

Division of responsibilities

No one individual should have unfettered control Ideally chairman andchief executive should be different people; if not there should be a strongindependent element on the board with a recognised senior member

Board committees

Board committees supervise specific

areas, doesn't absolve main board

from overall responsibilities Key

committees:

 Nomination (this chapter)

 Remuneration (this chapter)

 Risk management (Chapter 5)

 Strategic development

 Investment analysis

 Risk management

 Recommendations toboard committees

 Control systemsenforcement

Responsibilities of CEO

 Running board

 Accurate board information

 Shareholder communication(Chairman's Statement)

 New director induction

 Board appraisal

 Board development

 Signing off accounts

Responsibilities of chairman

3: Corporate governance practice and reporting

Non-executive directors

Board membership

 Appointment for specified term

 Ability to take independent advice

Non-executive directors (NEDs)

NEDs have no executive (managerial) responsibilities

They should provide balance and help to reduce

conflict between executive directors and shareholders

Majority of NEDs should be independent

Role:

 Strategy

 Scrutiny  Risk management Board personnel

relationships

Directors' remuneration

Non-executive directors

Board membership

Service contracts

If service contracts are too long, premature terminationmay mean significant payments Service contractsshouldn't be >12 months normally

UK's Greenbury committee suggests:

 Directors' remuneration set by independent board

members

 Bonuses related to measurable performance/enhanced

long-term shareholder value

 Full transparency in annual accounts

3: Corporate governance practice and reporting

Page 27

Elements of remuneration package

Basic salary – in contract of employment

Performance-related bonuses – limited possibly

to maximum % of pay, shouldn't be given for

transactions, or if excessive risks taken?

Shares – granted on condition can't be sold

Share options – purchased at specified exercise

price, encouragement to improve company's

performance and hence share prices, options

(and shares) to be held for certain length of time

Benefits-in-kind – is cost excessive and how

comparable are they with what employees are

Factors affecting remuneration levels

 Variety of financial/non-financial measures

 Focus on current not historic performance

 Avoid short-termism

 Reward individual effort

Performance measures

relationships

Directors' remuneration

Non-executive directors

Board membership

Relationships with stakeholders

OECD stresses role of:

 Protected by law

 Enhanced by participation (eg employees shareownership, profit-sharing arrangements, seat onboard)

Relationships with shareholders

Directors should be required to submit to regular

re-election (every year/every three years) Boards should

consider relationships with all shareholders, particularly

institutional shareholders Annual general meetings

nor-mal part of calendar, other general meetings discuss

issues of immediate/serious concern

Proxy voting

Myners report recommends:

 Clear agreements between beneficial owners

and investment managers

 Stock lending shouldn't happen

 Electronic voting

 Poll (including proxies) for all resolutions

3: Corporate governance practice and reporting

Question andanswer sessions

Shareholders vote on

substantially

separate issues

Shareholders vote onreport and accounts

relationships

Directors' remuneration

Non-executive directors

Board membership

 Board composition, directors, NEDs, evaluation

of board performance

 Committee reports

 Relations with auditors and shareholders

 Review of internal controls

London Stock Exchange requires:

 Narrative statement of how principles in UK

Corporate Governance Code have been applied

 Statement of compliance/details of reasons for

non-compliance

Voluntary disclosures

Disclosures above statutory/best practice minimum

Disclosures should follow certain principles:

 Planned process

 Transparency in disclosures made

 Consultation with users

 All relevant information considered

 Disclosures subject to review

 Wider information provision

 Different forms of information

 Greater assurance about management

 Reflect investor interests

Benefits

4: Internal control systems

systems

Enterprise risk management

Assessment of systems

Control limitations

Control framework

Nature of risks

Internal management control

Cybernetic control system

Management planning, organising and directing so

that organisational objectives are achieved

Turnbull report listed key aims:

 Facilitate effective and efficient operation

 Ensure quality of reporting

 Ensure compliance with laws and regulations

Process of control within system

 Identification of system objectives

 Setting targets for system objectives

 Measuring system achievements/outputs

 Comparing achievements with targets

 Identifying corrective action

 Implementing corrective action

 Embedded in operations

 Form part of culture

 Capable of quick response

Characteristics of control systems

 Ease of targetachievement

 Qualitative/

quantitativemeasures

 Short/long-termmeasures

 Consistency ofmeasures

 Managementintervention

 Automatic controlmechanisms

 Reliance on socialrelationships

Features of control systems

systems

Enterprise risk management

Assessment of systems

Control limitations

Control framework

Nature of risks

4: Internal control systems

Page 33

Risk classification

Risks can be classified in various ways:

Fundamental – affects society in general

Particular – individual in control

Speculative – good or bad consequences

Pure – only outcomes harmful

Risk and uncertainty

Uncertainty means possible outcomes and/or chances

of each occurring are unknown

Risk and corporate governance

Corporate governance reports aim to addressshareholder concerns that directors are notachieving adequate returns for risks incurred andprovide mechanisms for controlling directors whoare taking excessive risks Directors' responsibilityfor monitoring and disclosing risk management isstressed

 Predictability of cash flows

 Limitation of effects of bad events

 Increased shareholder confidence

 Weigh costs

Benefits of risk management

Risk and return

Businesses have to take some risks to trade

(entrepreneurship) Businesses may tolerate higher

risk levels provided they receive higher returns.

systems

Enterprise risk management

Assessment of systems

Control limitations

Control framework

Nature of risks

CONTROL FRAMEWORK

Control activities Control environment

 Orderly conduct of business

 Adherence to internal policies and laws

 Safeguarding assets

 Prevention/detection of fraud

 Accuracy/completeness of accounting records

 Quality of information and reporting

Purposes

 Objectives

 Nature/extent ofrisks

 Acceptable risks

 Likelihood risksmaterialise

 Ability to reducerisks

 Costs/benefits ofcontrols

 Changes in riskconditions

Control systems and risks

systems

Enterprise risk management

Assessment of systems

Control limitations

Control framework

Nature of risks

4: Internal control systems