ACCA P1 Governance, Risk and Ethics - 2011 - Study text

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Paper P1: Governance, risk and ethics

374 © Emile Woolf Publishing Limited

48 Principles and rules

What is the main difference between a rules-based and a principles-based code of

professional ethics for accountants?

49 Imported meat

Ben Meakin is a senior accountant with Venal Foods, a company that imports and

sells a range of meat products. A large quantity of meat was delivered from a

supplier in Eastern Europe. This was checked by the company’s hygiene and safety

inspectors, who reported that some of the meat was contaminated with a virus that

could be very harmful to anyone eating it.

Ben was at a meeting where the senior management decided that the risk to human

health was probably low, and that the company should sell the meat to its

customers in the normal way. However, Ben did not hear any convincing

explanation about why the risk was low.

When Ben mentioned the hazards to public health, he was told that as an accountant

he did not properly appreciate the risks and that he should leave the decisions to

operational management. He should ignore the problem, as this was his duty as an

employee of the company.

Required

(a) Explain the ethical responsibilities of a professional accountant to his

employer.

(b) Explain the ethical responsibilities of a professional accountant as a

‘professional.

reasons for your advice.

50 Footprint

Explain the meaning of the term ‘environmental footprint’ and suggest how a

company might provide a report to shareholders and the public in general on its

‘environmental footprint’.

51 Sustainability

(a) Describe the nature and features of a sustainability report.

(b) Explain why sustainability reports should be verified and suggest a way in

which verification can be provided.

environmental risk reporting.

375

Paper P1

Governance,riskandethics

Q&A

Answers to

practice questions

Contents

Page

The scope of governance

1 Transparencyandindependence378

2 Principlesofpubliclife 378

Agency relationships and theories

3 Agency 379

4 Transactioncosts 381

5 Stakeholdertheory 381

The board of directors

6 Compositionoftheboard 382

7 JohnSmith 382

8 Balanceofpower 384

9 Chairman 385

10 Two‐tierboardsandunitaryboards 385

11 RoleofNEDs 386

12 Induction,CPDandperformance

review

387

Board committees

13 Nominationscommittee 389

Paper P1: Governance, risk and ethics

376 © Emile Woolf Publishing Limited

14 Remunerationcommittee 390

15 Riskcommittee 391

Directors’ remuneration

16 Shareschemes 392

Different approaches to corporate

governance

17 Rules‐basedandprinciples‐based 393

18 Family‐runcompany 394

19 OECDandICGN 395

Governance: reporting and disclosure

20 Activism 396

21 Corporatesocialresponsibility 397

Internal control systems

22 Internalcontrolsystem 397

23 TheBlackOilCorporation 398

Internal control, audit and compliance

24 Auditorindependence 399

25 Internalauditandriskmanagement 400

26 Theneedforaninternalauditfunction 401

27 Auditcommittee 402

Identifying and assessing risk

28 Reputationrisk 403

29 Technologyrisk 404

30 Liquidityrisk 405

31 Marketriskandderivativesrisk 406

32 Charity 407

33 Riskappetiteandotherterms 407

34 Riskmapandriskdashboard 408

Answers to practice questions

Controlling risk

35 Approachestoriskmanagement 409

36 Riskmanagementreview 410

37 Riskmodel 410

38 Embedded 411

Ethical theories

39 Consequentialist 412

40 Kohlberg 413

Ethics and social responsibility

41 Socialresponsibility 414

Professional practice and codes of ethics



42 Integrity 415

43 Publicinterest 416

44 Businessandprofessionalethics 416

Conflicts of interest and ethical conflict

resolution

45 Twoclients 417

46 Errorsinthenumbers 418

47 Discount 420

48 Principlesandrules 420

49 Importedmeat 421

Social and environmental issues in ethics

and business

50 Footprint 422

51 Sustainability 422

Paper P1: Governance, risk and ethics

378 © Emile Woolf Publishing Limited

1 Transparency and independence

(a) Transparency means making something clear to see and understand, without

hiding or obscuring anything from view. Companies that are well governed

should make transparent to shareholders and other stakeholder groups

information relating to their financial and operating results, the company’s

objectives, major shareholdings in the company, the directors and senior

executives (and their remuneration), significant foreseeable risks facing the

company, other issues of significance to employees and other stakeholder

groups, and governance structures and policies.

A requirement for companies to disclose information and be transparent is

one of the OECD’s principles of good corporate governance.

(b) Independence means reaching opinions and making decisions that are not

subject to influence from other people. Independence is often linked to

objectivity; an objective person reaches views rationally and without bias or

prejudice.

The concept of independence is important for corporate governance because a

company should be managed by independent-minded and objective leaders,

who will reach opinions on the basis of objective judgement, and without

influence from other people or other groups.

A well-governed company should have a substantial number of independent

people on the board of directors. In the UK for example, a requirement of the

Combined Code on corporate governance is that (except for smaller

companies) at least one half of the members of the board of directors should

be independent non-executive directors. In this way, the board will be more

likely to reach decisions that are in the (objective) best interests of the

shareholders, and will not be dominated by the opinions of other individuals

or interest groups.

2 Principles of public life

(Tutorial note: You should be able to explain most of the seven principles of public

life, by applying the qualities of good governance to people holding a public office.

However, some concepts are not so easily identified from their ‘name’. In particular

‘integrity’ and ‘honesty’ can mean in the same thing, and in corporate governance

integrity means honest and ‘straight dealing’. The Nolan Committee gave integrity

and honesty different meanings, although both are related to ‘straight dealing’.)

(1) Selflessness. Holders of public office should take decisions that they consider

to be in the public interest, and should not make their decisions in order to

benefit their own self-interest.

(2) Integrity. Holders of public office should not place themselves in a position

where they are under any financial or other obligation to outside individuals

that might influence them in the performance of their duties.

(3) Objectivity. When making appointments and awarding contracts, holders of

public office should make their choices on merit.

Answers to practice questions

(4) Accountability. Holders of public office should be accountable for their

decisions to the public. They should therefore be prepared to submit

themselves to public scrutiny, in whatever form is appropriate.

(5) Openness. Holders of public office should be as open as possible about the

decisions they have taken and the reasons for their decisions, and should only

restrict the information they give when this is clearly in the public interest.

(6) Honesty. In their dealings and transactions, holders of public office should

avoid conflicts of interest between the public interest and their own self-

interest.

(7) Leadership. Holders of public office should promote and support the other

principles through leadership and by setting an example to others.

3 Agency

(a) Agency theory is a theory of the relationship between a principal and an

agent. In limited companies, the directors and senior management act as

agents of the shareholders, who own the company. Agency theory is based on

the view that when an agent represents a principal, the self-interests of the

agent are different from the interests of the principal. Without suitable

controls and incentives, the agent will take decisions and actions that are in

his own interests rather than those of the principal.

Agency theory is relevant to corporate governance because many of the

measures recommended for good corporate governance are concerned with

controls and incentives that will persuade agents to act in the shareholders’

best interests. For example, controls are applied though accountability and

incentives are given in remuneration packages.

(b) A fiduciary duty is a duty to act in good faith, in the best interests of someone

else. A person with a fiduciary duty is in a position of trust. In the laws of

some countries, company directors have a fiduciary duty to their company

(rather than to the shareholders), which means that they must act in good faith

in the interests of the company and should not be in breach of that duty.

The existence of a fiduciary duty is not sufficient, however, to ensure good

corporate governance.

a combination of controls and incentives. Accountability is a form of control.

The agent should be required to account to the principal for their decisions

and actions, and for how they have performed their duties. In companies, the

directors are accountable to the shareholders and are required to submit an

annual report and accounts. Accountability is more expensive in several

countries, with statutory requirements for narrative reporting (such as the

requirement in the EU for companies to provide an annual business review)

and additional voluntary reporting (such as sustainability reports).

(d) Agency conflicts are differences in the interests of a company’s owners and

the self-interests of its managers. They arise in several ways.

Paper P1: Governance, risk and ethics

380 © Emile Woolf Publishing Limited

 Moral hazard. A manager has an interest in receiving benefits from his

or her position as a manager, including all the benefits that come from

status. Larger benefits mean lower profits, and so are not consistent with

shareholders’ interests.

 Effort level. Managers may put less effort and care into their work than

they would if they were the owners of the company. The effect of this

could be lower profits and a lower share price.

 Earnings retention. The remuneration of directors and senior managers

is often related to the size of the company, rather than its annual profits.

The size of a company depends on the scale of its operations and

volume of sales. Management might prefer to re-invest profits to make

the company bigger, rather than pay out the profits as dividends – even

if the investments provide a poor return.

 Risk aversion. Executive directors and senior managers are often more

risk-averse than their shareholders. They do not like taking risks that

could threaten the stability of the company, and their jobs and careers.

Shareholders often invest in a portfolio of different companies; and risk-

taking by individual companies in the portfolio is of less concern to

them.

 Time horizon. Shareholders are concerned about the long-term financial

prospects of their company, because the value of their shares depends

on expectations for the long-term future. Managers might only be

interested in the short-term, especially when the payment of bonuses is

linked to achieving annual performance targets.

(e) Agency costs are the costs of having an agent to make decisions on behalf of a

principal. Applying this to corporate governance, agency costs are the costs

that the shareholders incur by having managers to run the company instead of

running the company themselves.

There are three aspects to agency costs:

 Costs of monitoring. The owners of a company can establish systems

for monitoring the actions and performance of management, to try to

ensure that management are acting in their best interests. This includes

financial reporting and auditing, which are expensive activities.

 Bonding costs. These costs might be incurred to provide incentives to

managers to act in the best interests of the shareholders, and so reduce

the size of the agency problem. The incentives are given in the director’s

remuneration package.

 Residual loss. Costs to the shareholder of management decisions that

are not in the best interests of the shareholders (but are in the interests of

the managers themselves).

Agency costs = Monitoring costs + Bonding costs + Residual loss

Answers to practice questions

4 Transaction costs

Transaction cost theory, as developed by Coase and Williamson, is an economic

theory. It is concerned with how companies develop and take on their form and

structure. The form a company takes depends on what activities it chooses to carry

on ‘in-house’ and which goods and services it chooses to buy from external

suppliers and leave to other entities. However, it also attempts to provide an

explanation of the actions and decisions of managers that are not consistent with

rationality and profit maximisation.

Williamson argued that the actions and decisions of managers are based on a

combination of bounded rationality and opportunism. Opportunism will often

mean that managers take decisions that are in their own personal interests.

A conclusion from this analysis is that the actions of managers should be controlled,

to prevent them from acting in their own interests rather than in the best interests of

shareholders. In this respect, transaction cost theory is consistent with agency

theory, and provides a theoretical justification for the need for rules or principles of

good corporate governance, that companies and their managers should apply.

5 Stakeholder theory

(a) Stakeholder theory is based on the view that companies, especially large

companies, have an enormous effect society and the environment. In addition

to providing wealth for their shareholders, they provide jobs to a large

number of employees, and contribute to national economies and the

economies of local communities. They also affect the quality of living of

customers and society as a whole.

Companies are ‘corporate citizens’ and like other citizens they should have

responsibilities to society.

In addition to providing returns to their shareholders, companies should

therefore consider the interests of its other stakeholders – employees,

customers, governments, communities, suppliers, lenders and the general

public. Directors and managers should manage their company in a way that

serves the interests of all stakeholder groups.

There is a close link between stakeholder theory and the concept of corporate

social responsibility (CSR).

(b) Accountability is an important aspect of responsibility. The managers of

companies should be accountable to all stakeholder groups for which they

have responsibility.

If the objective of management is to maximise the wealth of shareholders,

without regard for any other stakeholders, it might be sufficient for companies

to restrict their reporting to the annual report and accounts. This is a

document prepared for and directed towards shareholders, and its main

concern is with financial performance and financial position.

Paper P1: Governance, risk and ethics

When a stakeholder theory of corporate governance is applied, companies

should be expected to report to all the relevant stakeholder groups.

Companies should therefore either produce more reports for other

stakeholders, or should include more information in their annual report and

accounts and publish the report and accounts for the benefit of all major

stakeholders, not just the shareholders.

This might explain the publication by some companies of an annual

sustainability report (for circulation to interested readers, not necessarily

shareholders) and employee reports for the benefit of the company’s

employees.

6 Composition of the board

(a) The composition of the board of directors fails to comply with the provisions

of the Combined Code in two ways.

(i) The same individual, Ken Potter, is both the company chairman and the

CEO. The Combined Code states that the same individual should not

hold both these positions.

(ii) The Combined Code states that (except for small companies) at least one

half of the board members should be independent non-executive

directors. In FS plc, at least three of the NEDs are not independent, and

on a board with 8 members, one at most is an independent NED.

- An NED cannot usually be independent if he or she (like Wendy

Potter) has a close family tie with another director.

- An NED cannot usually be considered independent if he or she

(like Jasper Back) was an employee of the company within the

previous five years.

- An NED cannot usually be considered independent if he or she

(like Nancy O’Brien) holds a cross-directorship with a member of

the board. Nancy O’Brien has a cross-directorship with Ken Potter.

- The independence of an NED is also questionable if he or she has

been a member of the board for over nine years. Alan Todd has

been a NED for seven years. There is no other evidence suggesting

that Alan Todd might not be considered independent.

(b) The composition of the board of directors should be changed.

Ken Potter should be persuaded to give up the position of chairman, so that

he is only the CEO. An independent chairman should then be found for the

company.

The size of the board should not be too large for the company, and it is

doubtful whether a suitable solution is to appoint about six extra independent

NEDs so that they make up at least 50% of the board. This would make the

board too big.

The appropriate solution is to ask some directors to retire. It might be difficult

to ask one or two of the executive directors to retire from the board, because

Answers to practice questions

the individuals affected might regard this as a ‘demotion’. A more appropriate

solution would be to ask the three NEDs who are not independent to retire.

If there is a new independent chairman, there would be four executive

directors (including Ken Potter as CEO) and one independent NED (Alan

Todd). Assuming that Alan Todd is a suitable individual to remain as NED, at

least three independent NEDs should be appointed. This would mean that

independent NEDs made up exactly one half of the board, excluding the

chairman.

The individuals appointed as NEDs should have a suitable range of skills and

experience, so that they can contribute effectively to the work of the board of

FS plc.

7 John Smith

(a) Codes of corporate governance vary between countries. However in the UK,

the Combined Code states that a former CEO of a company should not move

on to become the company chairman. This is to avoid the risk that a chairman

who has been the CEO will have a strong and undesirable influence on the

new CEO. For example a new CEO might want to make changes to the way

the company is run, which the chairman (former CEO) might take as a

criticism of the way he used to run the company. The chairman might

therefore challenge the changes that the new CEO proposes to make.

A new CEO has not yet been appointed. The current CEO plans to become the

chairman in three months’ time, and it is not clear whether there will be time

to find a successor. If the nominations committee has not already discussed

succession planning and a replacement for the CEO, it has been failing in its

responsibilities.

If a new CEO is not appointed in the next three months, and the former CEO

becomes the chairman, he might also retain temporarily the role of CEO. The

UK Combined Code argues that the powers of chairman and CEO should not

be held by one individual, because it gives too much power on the board to

that individual. A situation in which an individual is both CEO and chairman

should normally be temporary and should not continue for longer than is

necessary.

(b) When a former CEO moves on to become the company chairman, the

responsibility of the non-executive directors for maintaining a balance of

power on the board becomes even more important than usual. The non-

executive directors, possibly with the senior independent director acting as

their spokesman, should be able to challenge attempts by the

chairman/former CEO to exert undue influence over decision-making by the

board.

ACCA P1 Governance, Risk and Ethics - 2011 - Study text - Emile Woolf Publishing

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