Chapter 16: Questions & Answers
1 Theory of governance
Question 1: RTY company
(a) The RTY company has a board of eightdirectors. Ten senior managers are responsible for different departmentsin the company, including establishing appropriate internal controlsystems. Each senior manager provides a report to the board on aquarterly basis explaining the performance of their department. Aninternal audit department monitors the internal control systems andreviews the senior managers' reports. The chief internal auditor thenprovides a separate report to the board on the work carried out by theinternal audit department.
Using examples from the RTY company, explain the key concepts of agency theory.
(b) In a recent board meeting, the chairman ofRTY commented that too much attention was being given to satisfying theinterests of the community and the environment â€“ he reminded the boardmembers that the only aim of the RTY Company was to provide for theneeds of the shareholders. The other so called 'stakeholders' wereimportant to the company, but only insofar as RTY needed thosestakeholders, RTY could affect the stakeholders; they could not affector be allowed to affect RTY.
Explain the concept of 'stakeholder theory' and discuss whetherthe chairman's views are correct in the context of this theory. Includein your answer examples of stakeholders of the RTY Company.
(c)Explain the concept of transaction cost theory and the factors affecting the external costs.
(Total: 25 marks)
Question 2: OPC
Last year, Oddimental Petroleum Company (OPC) informed shareholdersthat the company intended to spend $50 million to build a museum inorder to house the art collection of OPC's billionaire founder, CEO andchairman Dr Arthur Clubman. Furthermore, $250,000 would be spent on hisbiography.
The company will construct the museum with a 30 year rent freeentitlement culminating in an option for the museum to buy the buildingoutright for cost price of $50 million. The board believes that thiswould cement the goodwill OPC gained through its continuing associationwith the Clubman Foundation (a charitable trust). Further favourable taxtreatment exists for charitable donations and shareholders wouldbenefit from increased brand recognition and perceptions of socialresponsibility.
As far as the biography was concerned, the company would receiveits money back from sales proceeds and any profits would be forwarded tothe museum's fund.
Since the announcement, critics have suggested that the real costof the museum is likely to be nearer $100 million, and that its contentis widely considered to be low quality art. Further, the State museumoriginally promised the art is resentful of Dr Clubman's decision torenege on the deal and create his own facility. Tax benefits are also inquestion since general advice is that, to be allowable, they should notexceed 10% of revenue (currently $300 million).
Although in poor health, Dr Clubman is still active as CEO. Theboard of directors were selected from those within and outside thecompany, all having close associations with the founder. The averageboard age is 73. Unusually, it would appear that any press releasesrelating to the deterioration of Dr Clubman's condition are met with asharp increase in share price.
Construction of the museum has already begun even though thespecial committee of non-executive directors drawn to consider theproposal (at the request of shareholders) have not formally approved it.
(a)With reference to OPC, explain the importance of corporate governance to both the company and the stakeholders.
(b)Explain what is meant by independence,fairness and accountability and assess their importance as underlyingprinciples of corporate governance. Refer to the case of OPC wherenecessary.
(Total: 20 marks)
2 Development of corporate governance
There are no questions for this chapter.
3 The board of directors
Question 3: NEDs
(a)Explain the purpose of a two-tier board and discuss the advantages and disadvantages of this type of board.
(b)Explain the purpose of non-executivedirectors and discuss the advantages and disadvantages of NEDs in alisted company based on the unitary board structure.
(Total: 20 marks)
Question 4: Mr Bacon
Charlie Bacon, the CEO, was satisfied he had beaten off the threatto his board of directors. A group of institutional investors had put uptheir own external candidate for election to the board at the next AGM.If successful they would have a voice on the inside at board meetings.
Board elections were staggered with one third being re-elected eachyear. In response to the threat, Mr Bacon simply shrunk the board bysacking three board members, reducing the total from nine to six. Allthose dismissed were up for re-election and so the crisis was averted.Next year may prove more difficult but with 25% of shares being owned byemployees, and the board refusing to cede to the shareholder requestfor confidential voting on board elections, he was sure no member ofstaff would dare to take anything other than the board's position.
The business was experiencing difficult times. It had failed todeliver its forecast returns to shareholders for the tenth yearstraight, its credit rating had been reduced and last month's Fortunemagazine ranked the firm 487 out of 500. These were tough times for thecountry's oldest and (now second) largest retailer.
The board of directors reflected the company's image, being steadyand reliable. In clothing retail this had helped the company survive forover 100 years, until low cost retailers and fast-moving fashionretailers had entered the market. Now the retail sector was making hugelosses, tied to main street real estate sites that were expensive tomaintain, inflexible and unpopular in relation to out of town malls(shopping centres). In order to avoid breaking up his empire, Mr Baconhad transferred profits from the successful financial services divisionthat provided credit and banking services to its retail customers.
Mr Bacon, along with the other board members, had long-standingpersonal and family relationships with the company. They all understoodthe need for change and a new direction but saw no need to move onanother shareholder request, that of regular board performanceevaluation.
(a)Identify and evaluate four governance issues raised in this scenario.
(b)Discuss the reasons why a board of directors should evaluate its own performance.
(Total: 25 marks)
4 Directors' remuneration
Question 5: BB Company
BB Company operates within the fashion industry. Pay is such acontentious issue within the organisation that the CEO and one otherdirector, both of whom are leading fashion designers and greatlyinfluential in the company's early successes, have resigned and gone tocompetitors. In his closing address the CEO made no mention of how hisnew company would double his personal compensation, but it is generallyrecognised by the remuneration committee that pay was at the heart ofhis reason for leaving.
The committee consists of five non-executive directors and ischaired by a fiercely independent (pro shareholder) chairman. He hasstated that recent corporate results do not warrant increases in basicsalary for directors (the sole element of their remuneration package).Further, he points to the outgoing CEO's decisions to award his topmanagers large rises that put them close to directorial salaries. Thechairman has commented that such awards must stop until performanceimproves.
The only group who do not appear to be concerned over this issueare the non-executive directors. In compliance with the chairman'swishes they have awarded themselves above market salary increases. Thechairman believes this is important to retain their expertise within thecompany, especially since the same directors sit with the chairman onthe nomination committee and form the majority on the board.
(a)In a report to the chairman, discuss thegovernance issues raised in the scenario, their likely impact on thecompany and recommendations for improvement.
(b)Consider the key components of a reward package and discuss how they would apply in this organisation.
(Total: 18 marks)
5 Relations with shareholders and disclosure
Question 6: DEF
Independence has just been granted to the South Pacific Island ofNew Thistle. Over a thousand miles away the CEO of DEF, a huge metalsand mining group is considering the impact. The group was sold off bythe national government 10 years ago, the government retaining a 55%share. Now, having granted the island independence, DEF's nationalgovernment has given away the company's ownership rights to a localnickel mine in order to appease the newly independent islanders.
The CEO and minority shareholders are unhappy with this action.Minority shareholders are drafting resolutions and appeals on a dailybasis.
DEF had, for many years, been dominated by the CEO, a legendaryfigure in the mining industry, who had worked for the company for mostof his life. The board of directors never queried, disagreed or votedagainst his wishes and were all handpicked by the CEO for their loyaltyto him.
The same minority shareholders, led by a powerful pension fund thatowned a considerable stake in the company, had recently voiced theirconcerns over the lack of truly independent non-executive directors(most were business associates of the CEO, none representingstakeholders such as environmental groups) and the lack of remuneration,nomination and audit committees in board operations.
When approached over these issues the CEO was dismissive. Hepointed out that he understood the company better than anyone else andtherefore he ultimately decided who worked within his organisation. Hisview was that non-executive directors beyond those already employed andthe use of committees seemed unnecessary 'window dressing' forshareholders. Further, the loss of the mine would mean a need torationalise costs, not incur additional overheads in such committees.
(a)Briefly describe what is meant by independence and evaluate the CEO's comments about independence at DEF.
(b)Discuss the objectives of a nomination committee should one be created at DEF.
(c)Describe the actions available to the minority shareholders in relation to their grievances against DEF.
(Total: 20 marks)
Question 7: Corky Candy
Corky Candy, a confectionary manufacturer, was founded by abenevolent man who started the company in order to keep the local town'spopulation in work during the depression of the 1930's. He practicedâ€œwelfare capitalismâ€, pioneering occupational safety, employeebenefits and many charitable community projects. One of these, the CorkyFoundation, an institution whose mission is to educate and supportorphans, was given a trust that today accounts for 58% of company sharesand is worth $5.9 billion.
The board of directors of the company and the trust managers havealways had a close relationship based on the highest principles ofintegrity and social responsibility. This is evidenced through theminimum disclosure requirement placed on the company for annualreporting and the informal nature of its AGM.
Recently, the trust has become concerned over its risk exposure.Nationally the sale of confectionary goods has dropped in line withincreased awareness of childhood obesity. In response the trust wishesto diversify its portfolio and sell off a large batch of shares into themarket place. This would mean that the firm would fall into the handsof outside shareholders for the first time in its history, since theyinevitably would hold the majority of shares.
The impact of such a move could have a disastrous effect on thelocal population, many of whom work for the company. In addition it hasroused the board of directors into frantic action to dissuade the trustfrom selling.
If the sale is successful, the CEO/chairman knows that the level ofdisclosure will have to increase even though he is unconvinced of themerits of increased voluntary disclosure. He is also concerned about hisown role in dealing with large shareholder groups and their potentialimpact on the organisation.
(a)Discuss the broad content of disclosure in the annual accounts according to general code principles.
(b)Describe other forms of dialogue that will support stakeholder communication.
(c)Advise the CEO/chairman as to the importance of extending disclosure beyond mandatory levels.
(d)Discuss forms of shareholder activism that may impact on this company.
(Total: 20 marks)
6 Corporate governance approaches
Question 8: Car manufacturers
The merger between Crystal Cars, the US auto giant, and Mannermenz,the German luxury car king showed sound industrial logic. The combinedbusiness could compete more effectively in an increasingly global marketplace. The challenge was in how to effectively blend the rigid,technically sophisticated German culture with the American mass marketorientation and flair.
Early indicators were not positive. The combined company wasincorporated under German law and therefore based in Germany. Onattending the first board meeting, Jim Black, the Crystal CEO, andlargest shareholder, noted the inclusion of employee representatives asboard members. He also found it difficult to understand why the threeboard members representing German banks (majority Mannermenzshareholders) discussed long-term, stable development and corporatecitizenship. Mr Black, an 80 year old billionaire, demanded the companyfocus on maximising immediate shareholder returns, since shareholderswould expect this in return for supporting the merger.
It became evident that the German banks were very influential andinvolved in business decision making, offering access to low costfinance in return. Mr Black was informed that this was common in theGerman model of capitalism.
Shortly after the first board meeting Crystal's domesticshareholders received the company's first annual report. Disclosure wasat an absolute minimum and far below that expected in the US. Amongstother missing items, there was no detail on directors' remuneration.Remuneration was itself a contentious issue with Crystal directorsreceiving 10 times more than their German counterparts. The bad news forthe US directors was that stock options are not recognised under Germanlaw. This issue has still to be resolved. US shareholders also missedthe opportunity to vote on company resolutions at the AGM sinceelectronic voting was not allowed.
When the merger was completed approximately 44% of the company wasin US hands. Six months later the US shareholding had fallen to below25%.
(a)Briefly describe the governance structure atMannermenz and the benefits accruing to the German organisation of thisform of governance.
(b)Briefly describe the governance structure of Crystal Cars and why shareholders may have left the merged organisation.
(Total: 16 marks)
Question 9: Osarus
Osarus is a TV cable company that currently enjoys serving 5.7million customers. It is also a relatively rare hybrid in the US marketbeing a publicly owned company whose economic interest is owned bythousands of shareholders, but whose management interests are controlledalmost entirely by the founding family. The corporation has a dualclass voting structure. The Reid family owns an 11% economic interestbut controls 56% of the votes.
John Reid is the founding father and chairman of the organisation.His son, Tom is the CFO and chairs all major board committees includingthe audit committee. Other family members hold 5 of the 11 boardpositions, with family friends and business associates taking up theremaining seats.
John Reid has always been known as a risk taker, and the company'scurrent debt (11 times market capitalisation) is significantly abovethat of its nearest competitor (0.5 times). Servicing this debt is amajor task not helped by sustained investor pressure to reduce thecompany's leverage burden. Calls from financial analysts querying theintegrity of recent accounts are routinely ignored or passed onto thefirm's longstanding local auditors. These auditors signed off thisyear's accounts without issue.
There are routine transfers of cash between the organisation andthe founding family. Osarus uses funds to help support other familybusinesses, one of which, run by Tom Reid, is in serious financialdifficulty. Other multimillion dollar transactions have financed thepurchase of a professional league hockey team and the creation of aprestigious golf club on family owned real estate.
The company's head office, which includes all strategic planningand accounting functions, is located next to the family ranch on theoutskirts of a small American town. The Reid family have substantialinterests throughout the local community and are very active in localcharity work such as using the company jet to carry sick children tohospital. Many of the firm's head office staff are drawn from the localpopulation.
(a)Evaluate the advantages and disadvantages ofa family owned governance structure and offer advice as to how thefamily may improve its governance position.
(b)Discuss four areas in which Osarus may have difficulty complying with SOX legislation.
(Total: 20 marks)
7 Corporate social responsibility and corporate governance
Question 10: Geko Oil
The share price at Geko Oil is generally considered to be half itstrue value, with no signs of improvement. The problems relate togovernance and social responsibility.
Geko is dominated by two major shareholders, both of whom own 25%of its shares and each of which has three non-executive directors on theboard. One of the shareholders is the US oil company, Armarda, who relyon Geko to support oil exploration activities within the CAX Sea.Returns from these fields have been poor in recent years.
The second partner is a national oil company operating in a countryunder military dictatorship. Summary arrest, forced labour and tortureare common in the country since the military ruler refused to accept theresults of a democratic election three years ago.
Minority shareholders, such as a prominent Trade Union PensionFund, are deeply concerned about Geko's involvement in this country andwish it to withdraw immediately. Both Armarda and the national oilcompany have refused, saying it is not in their best interests to loseGeko as a partner. Armarda has gone further and stated that itsinvestment in Geko should be considered as â€œring fencedâ€ outside ofthe human rights issue and that its directors on Geko's board do notparticipate in any decisions relating to exploration in the countryunder dictatorship.
In its defence, Geko has pointed to the good works carried out inthe country including building schools, assisting in AIDs awarenesscampaigns and environmental remediation. As an NGO, AmnestyInternational has denounced these measures and have campaigned outsidecorporate HQ and on news TV programmes for the company's immediatewithdrawal from the region.
Finally, another shareholder, a large US investment fund manager,has said that, outside of any moral issues, the company isunderperforming strategically since it is too large to be a â€œfleet offootâ€ exploration company and too small to challenge the world'slargest oil corporations.
(a)Examine reasons why Geko Oil should consider social responsibility as a key corporate issue.
(b)Describe how Geko Oil could use stakeholdermapping to define its strategy in meeting the needs of differingstakeholder groups identified in the scenario. Recommend two appropriatestrategies for change in response to the concerns that have beenraised.
(Total: 22 marks)
8 Internal control systems
Question 11: ILT
Innovative Life Technology (ILT) is a successful market leader inbiotechnology. Its mission is to facilitate scientific advancement andprotect the public through testing new chemicals and drugs prior totheir release into the market place. Its major customers arepharmaceutical companies and government sponsors. Much of its workinvolves the use of animals for testing programmes and this has led toviolent protests from animal rights activists, and a subsequent focus onsecurity and secrecy in company operations.
Last summer, an employee secretly filmed conditions within thecompany's testing facility. The harrowing documentary was released onnational television and showed cruelty and distress to ILT's animalcharges to a level unacceptable to the general population. Thegovernment threatened to revoke the company's licence if conditions didnot dramatically improve. Another response came from the pharmaceuticalcompanies who immediately suspended their contracts. Shareholders alsoleft in large numbers and share price dropped from 117p to 9p almostovernight. Three non-executive directors resigned stating that they feltthe company lacked integrity and an acceptable ethical stance.
These events have put enormous pressure on existing project teamsto complete their testing activities and deliver positive results forthe few clients that remain. Large team bonuses are awarded on thesuccessful final signing off of projects.
As a control activity project teams regularly review each other'sresults for accuracy and completeness. These review meetings are usuallydull affairs with auditing teams reluctant to criticise theircolleagues work, especially given the current tense climate in theorganisation. The board of directors are only involved in receivingfinal project results. They are too preoccupied with public relationsand finding replacement funding and contracts to consider results priorto this time.
Last week, a US drug company reported its recall of a recentlylaunched headache tablet that had unforeseen side effects when taken byolder citizens. During its development, ILT tested the drug and attestedto its compliance with all required health and safety standards.
(a)Describe the components of an effective system of internal control and identify the failings in internal control within ILT.
(b)Advise the board as to the objectives of internal control at ILT.
(Total: 25 marks)
Question 12: BJZ
The Arctic National Wildlife Refuge in Alaska extends across 19million acres, consisting of protected wilderness that prohibits evenroad building. It is the largest unexplored, potentially productive,on-shore petroleum producing basin in the world. Despite widespreadcondemnation from environmental protection groups, BJZ (an oil company)was given licence to drill there 15 years ago.
The costs of exploration are enormous. There are frequent budgetoverruns on developing the oil field and there have also been someinstances of loss of life among employees. There is also a need to relyheavily on specialist contractors drafted in from around the world whohave expertise in dealing with the harsh winter conditions. One suchcontractor is responsible for maintaining the ageing pipelines.
Recently disaster struck when a corroded pipeline erupted spilling4,000 gallons of crude oil onto the land, ravaging local caribou herds. Asubsequent investigation carried out at the insistence of the boardfound a number of operational weaknesses. Local site managers hadoverridden maintenance schedules in order to avoid placing employees atrisk during winter months, and there is evidence to suggest collusionbetween at least one manager and the contractor where maintenancerecords have been falsified.
At the next AGM the board's attempt at damage limitation incensed anumber of shareholders. Despite repeated requests for an apology to bemade to indigenous peoples and species, the board remained adamant thatresponsibility rested with the contractor. In a rare show of shareholderactivism, 13% voted for the company to cancel its Alaskan adventure andturn its attention to developing renewable energy sources.
Outside of the forum, environmental protection groups ran asuccessful campaign for customers to boycott the company's petrol pumpsas a sign of protest. Petrol station property has also been vandalisedand the board has been forced to convene an emergency meeting to discusswhat to do next.
(a)Discuss reasons why internal control may have failed at BJZ.
(b)Briefly consider the role of the board ofdirectors in relation to internal control and describe a process formanaging internal control at board level.
(Total: 20 marks)
9 Audit and compliance
Question 13: RSJ
RSJ is a 100 year old group of integrated and interdependentengineering, construction and consulting businesses. Its core businessis in building fossil fuel and nuclear power stations using acombination of in-house and contracted labour to carry out projectsaround the world. Ten years ago, a major nuclear reactor disaster wasattributed to one of its contractors forcing RSJ's internal auditors toreassess supplier selection policies.
Due to the decline in the use of its product, the company has beenforced to diversify into other fields of engineering such as stadiumconstruction, gas exploration and even corporate building management.These changes have strained its already depleted internal audit functionwhich, in line with all divisions, has reduced staff numbersdramatically in recent years. Overall, the company exists with less thanhalf the workforce that it had during its peak twenty years ago, due topoor performance and to the increased use of technology.
The upside of this reduction has been to free up the need tosupport a large pension fund for employees that was established andfully funded during happier times. The CFO has been using the reducedneed for funds to prop up trading results, transferring millions to theincome statement as â€œOther incomeâ€. The audit committee has justbeen made aware of this through an anonymous whistleblower in internalaudit. They will soon meet with the full board to discuss thisunacceptable accounting treatment.
The company continues to use its old policy of cost-plus accountingfor major governmental construction projects. This involves thecustomer paying the eventual costs in full plus a percentage for profit.Critics suggest this leads to a lack of control over costs, noincentive to innovate and improve construction processes and is onereason why the company continues to lose tenders for large projects. Theboard is unmoved. Most have been with the company for over 30 years andsee no need for change despite the sharp decline in share price. Boardmembers own very little, if any, of the company's stock.
The internal audit committee is currently considering the role of internal audit prior to its meeting with the board.
(a)Examine reasons for the increasing importance of internal audit at RSJ.
(b)Explain the differing types of work that internal audit could undertake within this company.
(c)Describe four objectives of internal audit.
(Total: 25 marks)
10 Risk and the risk management process
Question 14: DD Entertainment
DD Entertainment Inc is the largest casino operator in the world.Their assets include 48 gambling facilities spread across fourcontinents. The company's strategy has remained relatively constant overthe years, creating luxury venues in difficult terrain such as Indianlands and mountain resorts, as well as using river boats on majortributaries in the US and Europe.
Each new multimillion dollar construction project is financed from acombination of cash flow and external finance in an industry that isnotoriously highly geared (debt ridden). This creates instability due tothe fluctuating fortunes of casino operations, leading to operatingconditions coloured by periodic takeovers from competitors and privateequity firms/venture capitalists.
Today, amongst many other achievements, the company is proud of theextent to which technology has been used to extend and enhance theentertainment experience for its customers. Gambling (like the gamesconsole industry) needs to keep innovating through technology to offercustomers something new.
The board of directors at DD Entertainment recognise the importanceof diversification as a risk reduction technique and, for this reason,have invested heavily in other venues across the world. One issue raisedthrough this has been exposure to unfamiliar political systems, withvarying degrees of government interest in their operations. In additioncultural diversity is significant; where the brash showmanship of alarge US gambling corporation is not always fully appreciated outsidetheir customer base.
The board of directors is currently reviewing risk management aspart of the preparation of their 10K annual report (compulsory in the USunder SOX).
As a member of the management team, you have been asked to provide adiscussion paper to assist in their deliberations. You are required to:
(a)Identify the risks that DD Entertainment is exposed to, and explain how these risks can be assessed through examples.
(b)Discuss the importance of risk management to this organisation.
(Total: 20 marks)
Question 15: Mineco
Mineco employs 125,000 people in its global operation to extractvaluable minerals from the earth. It either owns or owns a share in over100 projects from South America to South Africa and the Arctic toAustralasia, mining for diamonds, gold and platinum as well as basemetals such as copper and ferrous metals such as iron ore.
Mining is a risky business. The current annual report pays tributeto the 50 people who lost their lives last year whilst in the company'semploy or working for contractors on site. Open- and deep-bore miningraises many technical difficulties which may mean that sites areeventually abandoned without any mineral extraction taking place. Events(weather, fire, explosions) are amongst a list of issues reported bydirectors alongside the company's $10 billion operating profit.
Extraction is only the first step in the process of bringing theproduct to the market. Most substantial mineral seams are in lessdeveloped countries. Often road infrastructures are poorly maintained bygovernments who themselves have a keen interest in the wealth beingtaken from their land. Royalty payments and other taxes both erodeavailable shareholder returns.
Pricing the product is also far from easy in the turbulent globalfinancial markets. Supply from the mines and demand from constructioncompanies and wealthy high street shoppers can fluctuate dramatically.In common with all companies of this size, Mineco's accounting functionattempt to deal with the implications of this threat to shareholderinvestment.
The global growth in sustainability and corporate socialresponsibility is something the company is acutely aware of. Mining is adirty business. Dust and noise pollution, communitydisplacement/removal, river contamination and decommissioning costs whenextraction is completed are all real concerns that must be addressed. Arecent advertising campaign for one of the company's products statedâ€œdiamonds are foreverâ€. Environmental campaigners have used this topoint out to the public that the world's stock of minerals is notlimitless and that mining involves the depletion of a non-replaceableresource for profit.
(a)Examine risk assessment as a process using four risks from the scenario to illustrate issues raised.
(b)Identify appropriate corporate strategies for each risk discussed in part A.
(Total: 20 marks)
11 Controlling risk
Question 16: WS
WS began life as a pipeline company linking natural gas and oilfields to power stations and refineries. It has now verticallyintegrated into owning all stages in the process with interestsspreading across Europe, Asia and North and South America. Its globalbase is in North America.
WS is driven by profits and share price growth. Senior managementremuneration is characterised by large stock options and the leadershipcontinually encourages all staff, whatever level they operate at, tosupport the company by buying shares. Many have invested their entirepensions in the unprecedented growth in share price, outperforming themarket many times over in the last few years.
This success has been largely fuelled by the company's move intoenergy trading where it buys and sells future contracts to stateauthorities guaranteeing the price of energy to light the streets andheat the hospitals and schools of their local population. WS'sinvestment in this area has outstripped all other concerns due to itsprofitability potential. The downside is in terms of its inherent risk.The market perceives this as a risky area of operation, where largelosses are easy to incur if trading conditions turn against the company.The market subsequently demands large returns in way of compensation.
The focus on share price can be evidenced by the existence of realtime trading information within the elevators at the Houston office sothat staff can watch the stock rise as they move around the building.Some analysts have questioned company's ability to continuallyoutperform all expectations, pointing to the lack of clarity of thecompany's accounts in detailing how this is being achieved. In responsethe audit committee and the chairman have collectively assured themarket that success is based on quality and focus and both exist inabundance at WS. This is despite of clear evidence of huge costwrite-offs resulting from failing power plants on the Indian subcontinent, blamed by the company on local governmental interference andmismanagement.
(a)Explain how the company defines risk and how dealing with risk is embedded into corporate culture.
(b)Discuss measures taken by the company to combat risk exposure.
(c)Evaluate the extent to which WS employs a comprehensive risk management programme.
(Total: 25 marks)
12 Ethical theories
Question 17: Internet services
Chinese journalist Shi Tao sent one of his last e-mails to acolleague in New York in 2004, attaching guidelines issued by theChinese government on how to cover the fifteenth anniversary of theTiananmen Square massacre. He had chosen DD as his internet serviceprovider because the company lists â€œcommitted to winning throughintegrityâ€ as one of its core values. He was arrested the followingday and began a process that would culminate in a 10 year labour campprison sentence.
The Chinese market for internet users is potentially as large asthat existing in the US. In order to gain access to this market allhardware and software providers must sign a cooperation agreement withthe government effectively signing over access to the personal recordsof their internet customers. These are then evaluated by appropriateauthorities and action taken as required.
Part of the cooperation agreement is to limit search enginecapabilities so that customers cannot access data deemed unacceptable bythe government. This includes searches relating to words such asâ€œfreedomâ€ and â€œdemocracyâ€.
Four global US giants in technology and internet services have beenassisting with a US government committee enquiry into their positionregarding trade with China. In a heated debate, both sides have veryclear views as to the ethical justification for their actions.
One of the four dismissed all responsibility for the outcome oftrade saying that it was not the company's responsibility to dictate tocustomers how their technology was to be used. In reply, one senatorremarked that no customer was unacceptable to US companies as long asthey were profitable, a harsh attack on their lack of ethics.
All of the four companies agreed that their business was to makemoney for their shareholders and not to operate as 'freedom fighters'for their government.
(a)Discuss cultural factors that colour ethical decision making in different countries.
(b)Evaluate the ethical position of the internet companies in their trade with China.
(Total: 20 marks)
13 Professional and corporate ethics
Question 18: Ethical code
(a)Explain the terms 'ethical threat' and 'ethical safeguard'.
(b)For each of the situations below,identify the ethical threat and recommend an ethical safeguard,explaining why that safeguard is appropriate.
The director of a listed company sells a substantial shareholdingprior to the announcement of worse than expected results for thecompany.
AB is CEO of Company X and is also a non-executive director ofCompany Y and sits on the remuneration committee of that company. CD isCEO of Company Y and is also a non-executive director of Company X andsits on the remuneration committee of that company. AB and CD are goodfriends and play golf together every Saturday.
The chairman of Company Z does not like conflict on the board.When a new director is appointed, the chairman always ensures that thedirector's family members obtain highly paid jobs in the company, and inthe case of children, that they are sponsored by Company Z throughcollege. Company Z is very profitable, although the board appears to beineffective in querying the actions of the chairman.
(Total: 14 marks)
Question 19: NM River Valley
Professor Hoi is carrying out a series of lectures on corporatesocial responsibility. He is currently appearing at the World WaterForum in The Hague. This international convention draws togethergovernment officials, scientists, corporate bodies, engineers andinterested campaign groups to discuss global warming and water supply,particularly national and local initiatives to manage water supply inareas where drought and shortages are common.
One such initiative is in the NM River Valley in the north-west ofIndia. It involves building a colossal dam at one end of the valley andthen diverting the river's waters so that they flood the valley andcreate a reservoir. These waters will then be used to create electricityand provide much needed water supply to over 40 million people in thesurrounding area.
The costs of the project will be large and work will be carried outthrough a private public partnership of corporations and localgovernment. The companies involved have carried out a full financialappraisal of the project and say that the investment required willpartly be recovered through charges for utility services to majorinternational organisations throughout the north of the country whoreceive water and electricity from the dam.
In order to build the dam the local population living in the valleywill need to be relocated. These people are an ancient indigenousIndian tribe that has lived on the land for at least 12 generations.Their homes, farmland and holy places are all within the valley and atthe moment they are refusing to leave. The local government has offeredthem money and housing in a variety of inner city housing developmentsacross the country. These offers have been rejected with many villagerssaying they will stay in their homes, even if the waters come.
Following Professor Hoi's presentation he is approached back stageby a young accountant who says that far from benefiting the localpopulation the dam is being built solely to provide local industry withpower. He also states that the number of people living in the valley hasbeen purposefully understated and that the real figure is likely to be250,000, far more than the local government will be able to re house orcompensate.
(a)Discuss a general approach that might be taken in ethical conflict resolution.
(b)Explain reasons why corporate reporting should extend into CSR.
(c)Explain how the attributes of the accountant can assist in extending CSR reporting.
(Total: 25 marks)
14 Ethical decision making
Question 20: Dirk Hausmann
Dirk Hausmann is a fund manager at a large institutional investor.Recent turbulent events in the market have led to increasing pressure onbanking sector stocks as the financial services industry attempts torestructure itself in the wake of a number of high profile cases wherespecific companies failed to adequately hedge against investment losses.Subsequently two have experienced catastrophic loss in share valueprior to being swiftly taken over by competitors.
Yesterday, it appeared that a similar fate was about to hit a thirdbank. Its share price was falling rapidly after rumours began to spreadthat it was suffering the same difficulties faced by its predecessors.In fact a number of rumours suggested the situation was far worse andthat the bank in question, NED Bank, was about to close its doors and goout of business unless a competitor rescued it.
Today, the Chairman of NED Bank has appeared on a television newschannel to deny that his bank is in trouble. He has accusedâ€œscaremongers of feeding the markets lies in order to make short termgainsâ€ by predicting the subsequent dive in share price. Indeed, heestimates the possible gains for instigating such as slide as to be inexcess of 1 billion dollars.
Dirk knows that the figure is actually 1.3 billion because he hasjust found out that his own trading team started the rumour and nowstand to gain substantial year-end bonuses for adding considerably tocompany profits. The actual sum made by his firm is however only a smallproportion of the billion dollar figure since he has been told by oneof the traders that at least ten other city-based trading teams boughtinto and perpetuated the story once they realised what was going on.
Mr Hausmann now needs to consider what he should do. Whilst hiscompany's shareholders will be pleased with the unexpected windfall hefeels uneasy about the ethical issues involved in either keeping silentabout the whole issue or raising the matter with the board of directors.
Advise on how the American Accounting Association (AAA) modelprovides an ethical framework through which Dirk Hausmann can considerhis course of action.
(Total: 14 marks)
15 Social and environmental issues
Question 21: C company
The C Company manufactures a wide range of construction machinerysuch as diggers, tractors and large lorries. Each type of equipment ismanufactured by one of seven different divisions, and each division islocated in a major city, meaning that there are hundreds of kilometresbetween each division.
C also has an administration headquarters. This has been movedrecently from an inner-city location to a new purpose built officebuilding on an out-of-town site. The move has enabled C to provideextensive employee facilities including a sports complex and restaurant.Flexible working hours have also been introduced to allow employees tostagger their journey times; there is no public transport so allemployees must travel in their own private cars.
The board of C are currently considering proposals for the use ofthe 'old' administration office site. The plan favoured by the financedirector is the building of a waste disposal site as this has thehighest return on investment. There is some disagreement over this moveas the site is in a residential area although the local council haveindicated agreement in principle to the proposal.
The finance director has also amended creditor payment terms from30 to 60 days in order to improve C's cash flow situation. This move waspart of a package of measures to improve cash flow. However, proposalsto hold divisional meeting by video-conference rather than visiting eachsite, and carrying out an energy audit were vetoed by the board.
(a)Explain the concept of the Triple BottomLine and from the information provided evaluate the extent to which the CCompany meets the TBL criteria. Briefly consider actions that the CCompany can take to implement TBL criteria.
(b)Explain the concept of, and the three perspectives of, 'sustainability', providing example in the context of C Company.
(Total: 21 marks)
Test your understanding answers
Question 1: RTY company
(a) Agency theory
Agency refers to the relationship between a principal and theiragent. In the RTY company, the directors are the principals and thesenior managers are the agents. The relationship is defined within thecompany hierarchy, (senior managers report to directors) and may becontractual (explained in the senior managers terms of employment).
An agent is employed by a principal to carry out a task on theirbehalf. In the RTY company, the senior managers are employed by theboard to run their departments, including establishing the internalcontrol systems and providing reports on the performance of theirdepartments.
Agency costs are incurred by principals in monitoring agencybehaviour because of a lack of trust in the good faith of agents. Thedirectors of RTY need to have confidence that the senior managers arerunning their departments correctly and that the reports produced areaccurate. The internal audit department, therefore, checks the controlsystems and the reports. In effect, internal audit monitors the seniormanagers and is therefore an agency cost.
By accepting to undertake a task on their behalf, an agentbecomes accountable to the principal by whom they are employed. Theagent is accountable to that principal. In RTY, the senior managers areaccountable to the directors for the running of their departments. Themanagers have been entrusted with running their departments correctly.The quarterly reports provide an account from the agent to the principalshowing how well the senior managers have run their departments.
(b) Stakeholder theory
Stakeholder theory identifies and models the groups which arestakeholders of a company, and both describes and recommends methods bywhich management can give due regard to the interests of those groups.In a corporate context a stakeholder is, therefore, a party who affectsor can be affected by the company's actions. In this context, thecomment by the chairman is incorrect; not only does RTY affectstakeholders, it can be affected by those stakeholders.
All of the following are stakeholders in the RTY Company becausethey are affected by the company and can also affect the company in someway.
- Shareholders â€“ expect dividends but also affect the company by voting on director appointment etc.
- Employees â€“ expect salary, good working conditions etc, but also provide the company with their services in terms of knowledge or manpower.
- Customers â€“ expect quality goods but also affect the company by requesting product changes/improvements.
- Suppliers â€“ expect to be paid on time, but also affect the company either by denying goods (if not being paid) or by providing product enhancements which the company can use (e.g. faster processing chips for computers).
- Communities â€“ expect the company to act ethically within the community (not produce too much noise or pollution for example) and can affect the company in terms of being a pressure group.
- Environment â€“ if taken in the context of a 'person', then expects the company to be aware of and attempt to decrease its environmental footprint â€“ that is the impact of the company on the environment. Can also affect the company in terms of provision of raw materials â€“ either in terms of finite supply or the quality of those materials.
The comment by the Chairman that the RTY Company aims to satisfythe needs of its shareholders only is potentially incorrect; there aremany other stakeholder groups to consider.
(c) Transaction cost theory
Transaction cost theory relates to the decision being made withina company to obtain resources either internally or from third parties.The theory states that market prices are not the sole factor in makingthis decision. There are also significant transaction costs, searchcosts, contracting costs and co-ordination costs which will affect thedecision. In effect, this is the essence of the 'make or buy' decision.
There are two human and three environmental factors that lead totransactions costs arising. The two human factors are as follows.
(1) Bounded rationality: Humans are unlikely to have theabilities or resources to consider every state-contingent outcomeassociated with a transaction that might arise. In other words, it isimpossible to obtain all the information on every possible method ofobtaining the resource either because it would cost too much or simplybecause that information is not available to the company. For example,detailed costs of production from another manufacturer are unlikely tobe available.
(2) Opportunism: Humans will act to further their ownself-interest. This means that cost analysis may be imperfect orincomplete because a decision maker may not, for example, want to spendtoo much time or energy making a full investigation of alternative costsâ€“ it is too much like hard work. Alternatively, people tend to retaininformation because it gives them perceived power over others.
The three environmental factors are as follows.
(1) Uncertainty: makes the problems that arise because ofbounded rationality and opportunism worse. For example, lack of trustin agency situations implies that the agent is acting with opportunism.Also, the more time a contract runs into the future, then the lesscertainty there is concerning its outcome.
(2) Small numbers trading â€“ e.g. number of suppliers.If only a small number of suppliers exist in a market-place, a customerwill find the transaction more difficult to complete because thepossibility of withdrawal and use of alternative players in themarketplace cannot be used. In other words, the external cost will begreater as the threat of changing suppliers cannot be used â€“ thesupplier therefore has more power.
(3) Asset specificity or how much the specific asset isneeded by the company. There is therefore the possibility (or threat) ofa supplier acting opportunistically â€“ that is increasing the price ofthe asset or denying access to it which leads to a 'hold-up' problem.
Internalising operations eliminates the transaction costs.However, where external supply must be used, in terms of governance, asuncertainty and asset specificity increase, then there is greater scopeof opportunism to be used. This means that the company will attempt tohave very formal relationships with suppliers using hierarchicalstructures so that uncertainty is decreased.
As the number of suppliers increases, the small numbers factorbecomes less important â€“ there is less scope for opportunism asalternative suppliers are available.
Question 2: OPC
(a) Importance of governance
Governance is concerned with ensuring management are meaningfullyaccountable to the owners of the organisation. This accountability canbe considered through examination of the objectives of governance from acorporate and stakeholder perspective.
The purpose of a corporation is to create wealth or profitsthrough its operation within boundaries set by external parties (legaland compliance standards). Good governance is important in pursuit ofthis goal.
Internally, governance standards ensure that an appropriatemanagement team exists to provide the best opportunity for wealthcreation. The average age of board members and, more importantly, theirlack of objectivity being close associates of the CEO, may call thisinto question.
Good governance should reduce risks in organisational activity,through using good managers and providing rules or guidance throughwhich risks are adequately considered. The special committee would haveprovided a mechanism to assist in risk reduction although here itsfunction seems to have become redundant given the CEO's action inbeginning construction of the museum.
Governance is also important as a way of improving the control ofthe corporation, and through improved control higher profits can beachieved. This control may be through improved counter balances in powersuch as the separation of the chairman and CEO role. In this case, thecompany is too tightly controlled by the individual who operates in bothcapacities and this may be detrimental.
Corporations exist for the benefit of their owners, theshareholders. Governance has a key role to play in ensuring their needsare met above all other considerations.
Stakeholders also include the needs of a wider society andensuring corporations do not abuse their position and impact negativelyon the wider needs of the public at large.
Governance codes and the law should ensure shareholders'interests are always the key decision criteria employed by management.The museum proposal seems unlikely to provide a suitable return toshareholders, especially the sale of the asset after 30 years at today'smarket price. Property prices are almost certain to increaseconsiderably over such a period.
Governance, through management, should also reduce the risks toshareholders. It is difficult to see how such an investment will enhancethe stability or likelihood of future revenue streams, even given theenhancement to reputation, which seems questionable.
Wider stakeholder needs may have been better concerned had theCEO gifted the art to the existing local museum. The negative publicitythat surrounds this issue makes the question over positive impact of theproposal a greater concern.
In a general sense, the abuse of power suggested in the scenariowill not enhance corporate reputation or the attractiveness of investingin stock markets. The governing body of such a market may look veryunfavourably on corporations that operate as private empires for givenindividuals.
(b) Importance as principles of governance
Independence is a key underlying concept in governance. Itrelates to the need for separation of roles and subsequent freedom ofthought or action between those charged with running the organisationfor the benefit of shareholders.
A lack of independence can be seen in the lack of separationbetween the CEO and the organisation. In effect, the organisation seemsto be being run in the interests of the CEO. There seems littlejustification in building the museum on financial grounds (even the taxbreak is unlikely to materialise) and the goodwill extended to the CEO'sFoundation has little proven commercial merit.
This lack of separation is created through an ineffectual boardof directors and their lack of separation from the CEO. This in turncomes about through the director selection process which seems to relatepurely his selection. When someone is selected (and thereforepresumably fired) at the behest of one individual, freedom of thoughtand action must be questioned.
As mentioned previously, one firewall to ensure independence maybe the separation of the CEO and chairman roles, with the formerrepresenting management and the latter shareholder viewpoint. Combiningthe role creates a conflict of interest as to whose interests toprimarily serve.
Fairness relates to the need to appear to be even handed, openand honest in business dealings. These ethical issues are vital to theefficient functioning of the markets in terms of attracting investors,as well as to the corporation's image and the subsequent effect on salesand share price.
Fairness must necessarily extend to fair dealings with the ownersof the company and it is in this last area where OPC is open tocriticism. It seems unfair to ask the company to take on the risk of thebook failing in the market when the billionaire CEO is quite capable ofaffording to launch the book himself. Apart from repaying the loanthere seems no return for taking this risk.
It seems unfair and underhand to start the construction of themuseum without the consent of the special committee. This may extend to abreach of fiduciary duty to shareholders under governance codes of bestpractice although there is nothing in the scenario to indicate whetherthis is the case.
In general it seems unfair to ask shareholders to use their moneyto fund projects for the personal benefit of the CEO. This is theunderlying issue throughout the case study.
Accountability relates to the need to account for one's actions.This means accepting responsibility for and reporting of, issues underthe control of the entity. In this case there seems littleaccountability to shareholders. In particular, the cost of the museumhas been misstated and this may be symptomatic of other deficiencies incommunication.
Finally, it would seem that since share price improves when theCEO's health is questioned, that in order to act in the best interestsof shareholders, the CEO might consider retirement in order to allow forthe creation of an improved governance structure.
Question 3: NEDs
(a) Two-tier boards
In a two-tier board structure the company has a supervisory board and a management board.
The management board is responsible for the general day-to-day running of the company and is controlled by the CEO.
The supervisory board is responsible for:
- appointments to, supervision of and removal of members of the management board
- overseeing the activities of the management board and ensuring that it complies with relevant legislation and governance requirements
- general oversight of the company and its business strategies.
The supervisory board is led by the chairman.
Advantages of a two-tier board
There is a clear separation between those who manage the companyand those who own it or must control it for the benefit of shareholders.The supervisory board can act in the interests of shareholders whilethe management board literally manages the company.
The structure provides implicit shareholder involvement in mostcases since these structures are used in countries where insider controlis prevalent. This means that the shareholders effectively form thesupervisory board and oversee their investment by reviewing the work ofthe management board. This structure is only of benefit whereshareholders want to be involved in direct supervision of 'their'company.
The use of a supervisory board allows wider stakeholderinvolvement implicit through the use of worker representation andpossibly representation from other stakeholder groups such asinstitutional investors.
There can be independence of thought, discussion and decision since supervisory and management board meetings are separate.
The members of the supervisory board have direct power overmanagement through the right to appoint members of the management board.Where the supervisory board is made up of major shareholders this helpsto ensure the managers they want are appointed rather than relying onthe appointments committee or limited annual participation at the AGM.
Problems with two-tier boards
There can be dilution of power through stakeholder involvement.In effect, too much time is spent on discussing conflicting stakeholderinterests rather than focusing on the strategy for the company.
There is isolation of the supervisory board because they do notparticipate in management meetings. It is possible that the supervisoryboard would like to make more detailed recommendations or assist themanagement board in implementing decisions; however, the board structureprecludes this.
There are agency problems between the two boards. It may not beclear which board is the agent of the other, and therefore whereresponsibility to make decisions actually lies. Clear guidelines areneeded so that the work of each board is clearly defined.
Having two boards provides added bureaucracy and slower decisionmaking. There is obviously the need for communication channels betweenthe two boards â€“ which is not necessary with a unitary structure. Theneed for additional communication does slow down decision making.
A non-executive director (NED) is a member of the board ofdirectors of a company, although not part of the executive management. ANED is therefore not involved in the day-to-day decision making for thecompany. The main purpose of a NED is therefore monitoring executiveactivity and the overall strategic development of the company. From thepoint-of-view of corporate governance, the NED provides an independentreview of board activity. Not being involved in the running of thecompany apart from by virtue of being on the board, the NED can commentobjectively on the actions of the executive directors.
Advantages of having NEDs
They offer a clear monitoring role, checking that the company isfollowing appropriate codes of governance. For example, on remunerationcommittees NEDs can help to ensure that executives are paid anappropriate salary and provided with benefits commensurate with theircontribution to the success of the company.
NEDs can offer specific expertise to the company, particularly inregard to checking of financial information. It is a requirement ofmost codes of governance for at least one NED to have recent andrelevant financial experience. NEDs can also provide an external view onthe activities of the company and suggest courses of action based ontheir wider industry experience.
As mentioned above, NEDs provide an independent check on whetherthe company is meeting corporate governance requirements. The overallperception and image of the company is enhanced because of the presenceof NEDs. The company is seen to be following appropriate codes ofcorporate governance.
There should be an improvement in the amount of and the qualityof communication between shareholders and the company itself. Forexample, NEDs check communications such as annual reports forcompleteness and accuracy.
Disadvantages of NEDs
NEDs are only appointed for a limited number of years. It willtake time for the board to build trust in the decision making ability ofNEDs. There is also the risk that NED input is not always helpful andthis can have a negative effect on board operations.
There may be a limited number of people available to act as NEDs,especially with the experience necessary for the role. Many potentialNEDs will already be directors of other companies, limiting timeavailable to take on other roles. The quality of some NEDs may thereforebe below what is actually desired.
NEDs share equal liability in law for company operations with theexecutive directors of a company. Limited remuneration packages and thelack of ability to affect the company on a day-to-day basis might leadsome potential NEDs to question whether they want the job or not.
Question 4: Mr Bacon
(a) Governance issues
There are a number of governance concerns within the companydescribed. They all go to the heart of the governance issue, asking thequestion as to whose interests the organisation exists to serve. It isclear that, in the view of the board, the company exists to perpetuatetheir employment whilst in reality it should serve shareholders andshareholders alone.
In appears that there are no independent directors on the board.All of the directors have associations with the organisation thatstretch back a number of years and so cannot be deemed to beindependent. It is likely that they are all also executives at thecompany. This raises a conflict of interest exemplified by the inabilityto make hard decisions that, whilst negatively impacting on thehistorical size and structure of the organisation, should, if carriedout, be in shareholders' best interests.
The defensive action taken to stop the election of anon-executive to the board is unlikely to be in shareholders' bestinterests. The reaction to the possibility that outsiders may have avoice on the board is a separate but related issue since it suggests alack of meaningful dialogue exists at present between the board and theowners of the company. The UK Corporate Governance Code (2010)recommends the need to formalise this dialogue in order to ensure majorshareholders are kept well informed.
Restructuring of the board should be a matter for shareholderresolution and it is likely that this is part of the Articles ofAssociation of the company. Since the resolution (should it be required)is retrospective and since it is very unlikely that the majority ofshareholders would vote against its board, the CEO is likely to besuccessful in this strategy.
The governance issue is really about whether the reduction indirectors is in the shareholders' best interests. It seems difficult tobuild a case for reducing the level of expertise on a board simply toavoid a situation where increased expertise through NED involvementwould emerge.
It is common for boards to be re-elected in rotation. The needfor re-election arises due to the short-term nature of contracts fordirectors. This focuses the director on the need to perform and reducesthe shareholders liability for paying off long contracts should theywish to replace directors.
The re-election also provides a regular opportunity forshareholders to review the quality of their management team. Staggeredre-election is a mechanism to promote stability of board membership sothat only a small proportion could possibly change at any given time.This helps to ensure continuity although critics would suggest that thefewer the opportunities to re-elect, the more entrenched directorsbecome.
The governance issue, beyond the fact that re-election did nottake place, could relate to the three year rotation and, given the poorperformance of the company, whether annual re-election of the entireboard should be used. It is unlikely that the current board of directorswould support such a proposal even though it is probably in theshareholders' best interests.
The lack of confidential voting is a major governance concern.This basic right does not exist for shareholders and it is verydifficult to gauge the benefit that shareholders get from not havingthis right. The board will use it to apply pressure to staff to not voteagainst them and so it is certainly in the board's interest to maintainthe status quo.
Shareholders could vote in order to make voting confidential butit is likely that this specific vote will need to be open under currentrules. This means that the board will be able to exact retribution onthose that vote against them. The board must honestly and wholeheartedly support confidential voting for it to be implementedsuccessfully. As suggested this is a moral issue as well as a governanceissue.
(b) Board evaluation
The UK Corporate Governance Code (2010) recommends that boardsemploy a formal process of annual review and that the results of thisreview be communicated via the annual accounts. The key benefit is oneof transparency in board operations so that the owners of the companyknow the extent to which their board is successful and making honestattempts to improve itself.
The natural outcome of a review will be performance improvementin board operation. This should be reflected in the quality of decisionsmade, the increase in control or the reduction in risk within corporateoperations. All of these results should feed through to improvedreturns to shareholders.
It is also a question of investor confidence. The very fact thatthe process occurs suggests a greater level of professionalism from theboard of directors and enhances investor confidence in them.
It is unlikely, given the poor results over such a long period,that the creation of such a process will have the desired effect here.The problems are too deep rooted and there is a clear lack of trustbetween some shareholders and the management team they employ to runtheir affairs. A synthetic attempt to demonstrate interest in their owneffectiveness is unlikely to generate anything other than cynicism fromshareholders.
A board evaluation process also signals that the board is notcomplacent about its position and role. If honestly tackled the boardwill seek to redefine what it does, extending or contracting asappropriate. At its simplest the process helps the board to understandwhat it is and its role. This is a fundamental requirement for allboards of directors and yet one that is achieved by only a few.
In an operational sense the performance evaluation process willimprove corporate culture demonstrating that the board itself is notimmune from processes it carries out on all those below the board level.This again suggests good management and should pay a dividend inmanagement employee relationships as long as it is real and seen to bereal.
Performance evaluation ensures the board is aware and able toadapt to new business challenges, possibly identifying the need for newskills, membership, training or development. All managers should welcomethis as part of their professional development.
Finally, and ultimately board appraisal is in the best interestsof shareholders through many of the points mentioned. Working in theinterests of shareholders is the basic function or requirement of theboard and so it is natural to adopt this process as part of boardoperations. Clearly, in this scenario, the board does not believe thatoperating in shareholders' best interests is necessarily how theyoperate within the organisation and so this kind of change has lesslikelihood of being successful.
There are however many other ways of dealing with this commonscenario. The most obvious will probably be in the form of a takeover.If management are performing poorly over such a long period then thisattracts the attention of others better able to make a success of theventure in the market place.
Question 5: BB Company
(a) Chairman's Report
To: The Chairman, BB Company
Subject: Remuneration issues and their impact on BB Company
Terms of reference
I have been asked to report on governance issues relating toremuneration, their likely impact and recommendations for improvement. Ihave pleasure in submitting the following and remain available todiscuss these matters should you believe this necessary.
The present situation within BB Company raises a number of keygovernance issues that have serious consequences for the company, andlead to the company falling outside of generally accepted goodgovernance practice.
The most important of these is that the non-executive directorsappear to decide on their own pay as members of the remunerationcommittee. Although unclear, if this is the case it will raise seriousquestions over potential conflict of interest. There is also uncertaintyover the degree of effective committee operation. It has been suggestedthat decisions are made in order to comply with your best wishes ratherthan on the basis of collective, expert decision making. Whilst it isnot for me to comment on the correct approach to such decisions from acompany point of view, in governance terms this suggests the committeeforms no useful function and should therefore be disbanded.
Another critical issue is the operation of the nominationcommittee. It would appear that the same non-executives form the basisfor nomination committee membership. I would hope that executives areinvolved in this committee's operation since their expertise isabsolutely essential in selecting new directors. It is inconceivablethat non-executives would be more aware of the worthiness of seniormanagers to join the board than those individuals' line managers.
The central governance issue is that the remuneration committeeis not performing its job. The role of the committee is to ensure theappointment, retention and motivation of board members. In at least twoof these areas the board is clearly failing, the resignations of CEO andone other being evidence of this. Finally, the nature of remunerationitself, as a detailed policy issue, is also inappropriate. Goodgovernance suggests a range of rewards primarily linked to performance.These simply do not exist in this company.
The likely impact of the poor remuneration structure can be seenas a continuance of events that have already occurred in terms of boardlevel resignation. This deeply affects the company. It leads to a lossof key creative expertise and leadership at the top of the organisation.This in turn is likely to feed through to lower level staff, impactingon culture and performance. Negative shareholder returns will follow.
The impact on top management is an interesting outcome of thecurrent approach. These managers will not see further promotion withinthe organisation as a realistic career move. Although pleased withsalary increases received, they will see this as a ceiling on prospectsand have no incentive to seek further promotion.
Incentivisation is at the heart of remuneration policy. The lackof linking pay to performance will mean that productivity and motivationof directors will suffer. This deterioration in the agency relationshipwill have a direct negative impact on shareholders who, as we bothknow, are the key stakeholders in whose interests we operate.
Within the remuneration committee individual and collective selfinterest is likely to increase if not controlled. This could lead todomineering behaviour over executive directors and inflated wages. Thissends out an inappropriate signal to other directors and lead to aâ€œthem and usâ€ culture on the board that is not conducive to gooddecision making.
Finally, there appears to be an implicit imbalance in boardoperations with executive relegated to powerless, suppressed managers.These people run the company and if not given the appropriate authorityto do so, will simply follow the CEO to the detriment of shareholderreturns and company prospects.
The recommendations arise from the previous discussion. Firstly,and most importantly, an appropriate remuneration package must becreated for directors. This will return motivation and assist inrecruitment and retention. Secondly, no non-executive director must beallowed to determine their own pay and the chairman must be seen tooperate a fair, independent committee working in executive andnon-executive interests for the benefit of shareholders.
Executive directors must be involved in the work of thenomination committee, particularly in the recruitment of the new CEO.The company should at least consider the possibility of recruiting fromwithin in order to improve morale within the firm.
Finally, I strongly recommend that you consider your own role andapproach to governance and whether any changes in delegating authoritycan be made so as to improve company performance.
(b) Reward Package
A reward package has a number of elements that build into acomprehensive compensation scheme. Above all, this should ensure abalance exists between risk and reward, pay and performance. This is adifficult task and one that requires balance between the size of therole, competitive and comparable reward systems and elements that rewardthe past whilst motivating to achieve in the future.
Basic pay and conditions will tend to be market driven.Conditions might include a raft of rewards such as company car, pension,insurance and other benefits. The extent to which each is seen asrelating to the company and performance may be important since excess inthis area and misuse is always a potential problem.
Bonuses must relate to performance. These may be annual, threeyear or even bi-annual depending on the company. They should relate to atangible measure such as profits or increases in shareholder wealth andshould be reviewed regularly and adjusted as necessary for changingconditions.
Share options are also very popular. These involve commitments toallow the director to purchase shares at a discounted rate sometime inthe future. The incentive is to attempt to raise share price well abovethe purchase price in order to maximise returns gained.
Application to BB Co
Basic pay, as suggested, must be market driven. There is evidencethat current levels are well below those experienced in other companiesin the industry (the CEO doubling his rewards) and so this needs to beaddressed quickly. Other incentives may include the use of companyvehicles, travel arrangements to fashion shows (Rome etc), generalexpenses associated with this and usual health and pension benefits. Thelast issue must be very carefully considered since it will lead to thecompany making payments for retrospective, not current services in thefuture.
Bonuses may relate to increases in sales to retailers, thesuccessful launch of new ranges, the number of new ranges orfinancial/shareholder related issues such as EPS increases. Shareoptions are so common that they are likely to feature in directors'returns but not non-executive pay. This assists in ensuring theindependence of non-executives.
Finally, a golden hello may be used to entice a high quality CEOinto the company ranks should this be considered appropriate by theremuneration committee.
Question 6: DEF
Independence means separation from a source. In this case, thesource is the CEO. The form of separation is in the thought processesand decision making criteria used to form judgements about companyoperations.
Agency theory identifies the separation between the needs ofowners and those charged with running the company. Although alldirectors should act in shareholders' best interests, the moreindependent non-executive directors are, the more likely they are toseparate themselves from the views and needs of executive managementsuch as the CEO.
The CEO believes that independent non-executive directors are notnecessary in the organisation. He suggests the importance of expertisein making decisions in the best interests of the company and that he isexpert and so is most likely to know what is best.
The counter to this argument would be the benefit of expertise inother areas such as environmental reform that additional non-executivesare likely to bring ensuring wider expertise is deployed in theinterest of shareholders rather than the company.
This wider stakeholder involvement can be emphasised sinceshareholders may feel social responsibility in ensuring miningoperations do not adversely affect the planet. This need is more likelyto be understood and voiced by a non-executive director rather than theCEO.
The central issue however is one of self-interest. Thenon-executives, if truly independent, are likely to balance theself-interests of the CEO and ensure shareholder interests are putfirst. The CEO's interest may relate to power and maintaining the sizeof operations rather than profits and short-term gain. Whatever theneeds of shareholders are, they are more likely to be met by those whowish to serve those needs and this suggests the non-executive directors.
In support of the CEO's viewpoint, non-executive directors willbe recommended to the board and the board will vote for their inclusion.Since the CEO dominates the board, and at present will almost certainlymake the recommendation in the first place, anyone selected is selectedat his behest. There is therefore an assumed loyalty to the CEO sincehe employed the person.
The CEO fully appreciates that the reality of this is that anyoneemployed is unlikely to operate truly independently since in as much asthey are employed they are also open to being dismissed by the CEO.
The counter of this argument might rest with the shareholders whoratify such decisions by voting on them. If necessary they can stop theremoval of a director. This however is more in theory than practicesince it is very rare that a majority of shareholders would go againstthe board's wishes.
There are also specific benefits of committees that the CEO may not appreciate, these are discussed below.
(b) Nomination committee
The nomination committee is a board structure used to identifyand recommend new directors for appointment to the board. In pursuit ofthis goal there are a number of objectives in committee operation.
The committee must first ensure the succession of appointments tothe board function. This relates to continuity and ensuring that postsare not vacated for long periods or that the company is not harmedthrough a lack of leadership in senior posts. The role is thereforecentral to continuance in operations and a fundamental requirement ofall boards, whether a committee exists or not.
The task of ensuring roles are filled will require the committeeto be in continual contact with senior management, aware of the talentthat exists and involved in planning career development of top flightstaff in preparation from their evolution to full board membership.
When a position is vacated for whatever reason, the committeeshould carefully consider the profile of the replacement and thecharacteristics they think are suitable for the individual filling thepost. This may require consideration of a specific skill set orleadership personality that will fit into or drive future boardoperations.
Instigating searches for successful replacements usingconsultants or agencies may form a part of the committee function asshould the evaluation of names put forward as a result of thosesearches.
The final stages or objectives will relate to the need torecommend and report. The recommendation will be relayed to the fullboard for their deliberation and decision. Reporting relates to thecompliance need to report their work as part of the annual accounts ofthe organisation.
This final point leads to the suggestion that an objective of thecommittee is to ensure compliance to best practice such as the UKCorporate Governance Code (2010) since the existence of such a structureis recommended within the code.
Overall, the role is to support the board. This can be donethrough offloading this important function onto a specific and separatebody whilst the main board considers other pressing issues.
(c) Shareholder actions
The variety of actions available to shareholders will depend on anumber of issues including the legal framework of the country in whichthe corporation operates and the quality of communication between thecompany and its owners.
There may be some legal protection in Company Law to ensureminority shareholders are not disadvantaged through the actions ofmajority shareholders (in this case the government). Although this isoften the case it seems unlikely that the government would have takensuch action if they had known it was against the laws of their owncountry.
Shareholders can lobby the company individually or collectively.Most compliance or governance codes call for companies to maintain acommunication channel to major shareholders and it is through thisdialogue that pressure can be brought to bear. This is probably alreadythe case since the chairman would have talked to such shareholders priorto discussing the independence issue with the CEO.
This communication extends to shareholders at the AGM and theability of shareholders to raise resolutions for general voting. Thiscan be a powerful weapon for change if enough support can be garneredamong existing shareholders. The pension fund has a large shareholdingand so may be able to have some impact in this area.
Shareholder voting rights allow shareholders to vote againstboard proposals. This might be in relation to the recommendation toincrease the number of friendly directors on the board or in favour ofrecruiting more non-executive directors that are truly independent.
A final course of action available is to divest shareholding. Thethreat of doing so may be enough to change management's viewpoint sinceit could have a profoundly negative impact on share price.
Question 7: Corky Candy
(a) Annual accounts
The structure and content of annual accounts arises fromcorporate law, Generally Accepted Accounting Principles and governancecodes issued for consideration by all organisations.
- Chairman and CEO statement
UK Corporate Governance Code (2010) asks the chairman/CEO to provide a balanced and understandable assessment of the company's position. The opening statement is an attempt to start this process. Other elements will be mention of board structure, detailing executive and non-executive positions and, in a 'comply or explain' environment, why CEO / chairman positions are not separated as in this case.
- The Business Review
This continues and expands on the assessment of company position with particular reference to strategy success and future strategic opportunities. Committee operations at board level will be an important element of the review. Codes of best practice such as the UK Corporate Governance Code (2010) discuss the need to report on audit, nomination and remuneration committees as board structures.
The formal financial accounts will be the heart of corporate reporting including details of directors' remuneration, cash flow, income statements and the statement of financial position. This is the dominant section of the annual report and will have always been present adhering to accounting standards and company law as applicable. In the US senior management must attest to the integrity of this information in writing as part of reporting requirements.
The Business Review may defer some issues such as committee operation to this section. In addition compliance issues will include an evaluation of the quality of internal control systems and details of how the board evaluates its own performance and the results of that evaluation.
- Any Other Business (AOB)
This will include details of AGM, dividend history and taxation positions of shareholders. The AGM will subsequently become an important forum for discussion of the annual accounts presented to shareholders.
(b) Other forms of dialogue
Beyond the annual accounts, changing shareholder membership will increase the need to consider the following:
- Press releases
This may relate to changing board composition, sales of strategic assets, major changes in workforce or implementation of new marketing strategy. Information is the lifeblood of the markets and helps assess the true worth of an investment.
- Management forecasts
These may be quarterly to identify progress towards bi-annual targets in order to reassure investors or pre warn them concerning imminent failure to achieve predicted goals.
- Analysts' presentations
The UK Corporate Governance Code (2010) states that the organisation should ensure dialogue exists between itself and major institutional investors. This dialogue may include regular analyst presentations to reassure the markets or explain anomalies in the accounts or strategy being pursued.
The AGM and EGM are important communication channels that the UK Corporate Governance Code (2010) requests all directors to attend. It includes an open forum for questions although these may need to be submitted in advance and be supported by institutional investors before being accepted for discussion.
- Web site
The corporate web site provides a simple communication vehicle for the latest company news although access by shareholders is not guaranteed. The informality allows for the inclusion of opinion and operational issues that will not warrant consideration in the formal accounts.
(c) Extending disclosure
Extending disclosure helps to strengthen mandatory disclosure byproviding greater depth in support of corporate actions. Moreinformation is better information since it provides the opportunity forclarification of the company's position.
In agency terms information leads to improved accountability andreduces the need for other measures such as meetings in order to cementthe agency relationship. Improvements in information reduce asymmetrybetween the owners' position outside of the corporate structure andthose with access to information within.
Better information attracts investors who appreciate transparencyin operations and the implied improvement in quality of the firm. Italso reduces risk through information and in this way supports shareprice and possibly reduces dividend requirement.
Information provides investors with assurance regardingmanagement and ensures compliance to applicable codes of best practice.The UK Corporate Governance Code (2010) stipulates the nature of avariety of reporting needs such as the work of committees and aninability to comply with this requirement leaves the company open to theneed to explain its position. This in turn leads to suspicion and, ifnot fully explained, possible sanctions from regulatory bodies.
(d) Shareholder activism
Shareholder activism relates to positive action taken byshareholders in order to influence company behaviour. This mightinclude:
The UK Corporate Governance Code (2010) requires institutional investors to consider carefully the use of their vote taking into account all relevant issues put before them. This is an attempt to reduce arbitrary voting in support of the board or simply ignoring the right and responsibility to vote that attaches to share ownership.
Technology has led to increased use of proxy voting with third party vendors organising collective voting for shareholders unable to attend the AGM. This increased activism may be a new revelation for the directors and they should be aware that poor performance may not be tolerated by shareholders who have a voice regardless of physical location.
The UK Corporate Governance Code (2010) also requires organisations to organise formal channels of communication or dialogue with institutional investors. As already described, this dialogue may in the form of analysts meetings to discuss corporate performance, strategy and ethics policy.
- Ethical investment
Social responsibility is a growing area of shareholder activism. This relates to shareholders refusing to place their money with companies that show a poor track record in ethical matters. This may be the case in relation to the company's perceived partial responsibility for childhood obesity. Strong public relations and an increased focus on disclosure in relation to the organisations other charitable works should assist in deflecting this criticism.
Question 8: Car manufacturers
The German company's governance structure can best be describedas an insider dominated structure. This means that the listed company iscontrolled by a small group of shareholders who exhibit power overexecutive decision making within the organisation.
In this case, the three German banks are described as majorshareholders who have great influence over the strategic direction and,more importantly, the agency relationship between the corporation andits shareholders. This agency relationship leads to a number ofpotential benefits and drawbacks, the benefits are discussed below.
Firstly, there are fewer agency costs in such an arrangement. Thecloseness of the relationship means that major shareholders are moreaware of company operations reducing the need for communication,reporting and monitoring of the company executive. These cost savingscan be extended through access to lower cost of finance and greaterlevels of finance since the banks are more willing to lend at lowinterest rates due to the perceived lower level of risk.
Secondly, the managerial input of these major shareholdersprovides the organisation with greater levels of financial or industrialexpertise. Mannermenz not only has access to the banks representativesbut also expertise within the bank. This can be of assistance incorporate decision making. The stability of the relationship extends theperiod of availability of such expertise.
Thirdly, the stability of the relationship and the presumedlong-term nature of shareholder involvement means that shareholderreturns will probably be less, the company being able to plough morefunds back into its growth, taking a long-term view of companyoperations. This ability to avoid the cost of short-termism is a majorbenefit of insider structures.
Fourthly, although not necessarily inherent within the insiderstructure, the governance arrangements identified suggest widerstakeholder involvement in decision making. This is more to do with thenational culture and political decision making but is still worthy ofmention. In this scenario it manifests itself through employeerepresentation on the board suggesting greater social responsibility toemployee and wider stakeholder welfare.
(b) Crystal Cars
The governance structure of Crystal Cars is best described as anoutsider dominated structure. This means that shareholding is wide anddiverse with no single party dominating the agency relationship. It isassociated with access to a vibrant stock market where shares are openlyand easily sold between individuals.
In this case, Crystal Cars shareholders are mainly drawn from theUS domestic population although mention is made of Jim Black's largestake holding in the venture. This clouds the issue slightly suggestingthat Crystal, whilst essentially an outsider company, has traits ofinsider domination in the guise of the CEO.
Mr Black cites the reason for shareholders leaving theorganisation when he refers to the need to focus on shareholder value.This relates to the need to offer shareholders adequate returns in termsof dividend and share price growth in order to retain their support.The agency relationship is much more arms length and driven by financialrewards, hence his insistence that this should be recognised. Simplyput, without retaining shareholders by paying them they will leave.
The opaque reporting identified in the scenario does not help toelicit support from these shareholders. The distanced relationship (interms of involvement if not geographically) requires appropriate flowsof information to ensure shareholders are kept informed as to how theirmoney is being used. Without this information it is difficult forshareholders to make informed decisions and risks are perceived ashigher. When this is not compensated through improved returns they willsimply invest elsewhere.
An interesting side issue may rest in the disincentivising ofdirectors, assuming shareholders are aware of this. Part of the agencyrelationship is in terms of ensuring directors are encouraged to makemoney for themselves as well as shareholders. Some shareholders mayconsider this lack of incentive could lead to poorer managementperformance and poorer future returns.
Coupled with the lack of focus on shareholder value, USshareholders will be concerned over the dominance of the German banksand the subsequent reduction in their (minority) interests beingadequately protected. They may view the lack of electronic voting to besymptomatic of disenfranchisement. Without a strong voice they willsimply walk away from the company. Finally, cultural differences andgeographical distance cannot be ignored. Ignorance and hostility towardsforeign companies in general will have some, hopefully minimal,influence on shareholder decision making.
Question 9: Osarus
(a) Family owned structures
Osarus is a family owned structure even though many of its sharesare owned by outside investors. The dual class voting system used meansthat the family vote with the majority of shares and so are able topass decisions without major recourse to other parties. This dominationcan have benefits but ultimately highlights potential risks that willneed to be dealt with in order to ensure compliance with SOXlegislation.
Lower agency costs are often suggested as being a key advantagefor family owned corporations due to the active involvement ofshareholders in decision making. This is true when considered from theReid family perspective, and their lack of interest in external analystssupports the view that they are not concerned with increasing externalshareholder engagement or the costs associated with it. It is also amajor problem for external investors and suggests a lack of transparencyin company operations. This must be considered as a disadvantage.
Personal reputation is closely associated with family ownedcorporate structure and this may suggest a heightened ethical position.This may be seen in relation to the level of charity work mentioned andis seen in the employment of the local population. The risk is that thetemptation that arises through power may lead to an unethical stancesuch as the questionable use of company funds for personal causes.
Since the founder is still an active member of the managementteam this supports the idea that a long-term perspective rather than afocus on short-term shareholder wealth accumulation is associated withfamily structures. This benefits the company in retaining fundsnecessary for growth (and paying off debt) and assists in providing alegacy for the family to enjoy over time. The problem is that it is notonly their company to enjoy and their needs must be balanced against theneeds of other shareholders whose financial need for short-term gainsmay be significantly different. This in itself may be a reason why thecompany is so debt heavy. Other investors simply will not purchase stock(at a reasonable price) because of the longer term perspective andfamily interest.
Personal aspirations rather than independent corporate goalsoften infringe on family company management. This can be seen in thehockey team purchase, and this is detrimental to general shareholderwealth if these investments are not considered at arms length withstrict decision making criteria.
Over time, the quality of management may also suffer since thegene pool for business expertise is so narrow. This might be the casewith Tom Reid and his failing business venture, although a moreimportant concern would be how this interest impacts on his managementcommitments within the company. In general successive generations drawnfrom the same family are unlikely to have the same level of businessacumen as the founding father.
This in turn can create a succession crisis when the foundingfather retires. In this scenario it is likely that Tom Reid is beinggroomed to take over as chairman. This is certainly not against the bestinterest of the majority of the voting shareholders (the family) and sois perfectly acceptable to the majority. It is the minority interestthat could be damaged through potential mismanagement although, as ever,shareholders can simply sell their interest if this occurs.
Osarus may have a number of concerns regarding SOX compliance.The following are all possibilities; a formal investigation intooperations will be required in order to substantiate the level of threator risk that exists and the appropriate actions to take.
Perhaps the most striking issue in SOX legislation is thepersonal criminal liability of senior managers for theauthenticity/integrity of financial statements released by the company.The scenario makes reference to financial difficulties which in turnoften lead to an increase in the risk of false accounting andunscrupulous earnings management. It is impossible to gauge any level ofguilt in relation to this area but senior management would be wellinformed to take the matter seriously and investigate appropriately.
Loans to senior management are expressly forbidden by thelegislation. The transactions involving the purchase of the hockey team,golf club and assistance with the associate company must be arms lengthand carefully structured so as not to fall into this category.Transactions may be considered loans even though they are not expresslyreferred to as such.
The CFO's chairmanship on the audit committee is specificallyoutlawed by SOX. There are controls on the role of the audit committeeas being independent from the management of the company. This is clearlyan area where immediate and relatively simple changes can be made inorder to ensure full compliance with the legislation.
Control and audit
SOX calls for companies to review their systems of internalcontrol in order to reduce risks of financial impropriety. Theindependence of the audit committee is one such area of control thatrequires attention. Rotation of audit partners is another element inimproving independence and external control. The close relationshipbetween the family and the audit firm does nothing to quell allegationsof mismanagement by outside investors. Further, the employment of largenumbers of the local population may also call into question personalallegiance to the powerful local landowner above professionalism andeven legal compliance to SOX and company law in general.
Question 10: Geko Oil
(a) Social responsibility
A corporation is run in the interests of shareholders and thisinterest is deemed to be primarily financial. The most potent argumentsfor social responsibility should therefore be discussed in terms of howan active interest in social responsibility can have a positive effecton the financial rewards due to the owners.
The company is currently undervalued due, presumably, to therejection of its involvement in the country under dictatorship, its poorstrategic thrust in terms of market positioning and the dominance oftwo major shareholders on the board. This last issue weakens theposition of minority shareholders and makes change unlikely.
Improvements in social responsibility should reduce the number ofinvestors who feel unable to invest in the organisation on ethicalgrounds. This greater liquidity in shares should subsequently increaseshare price and so returns to shareholders. Whilst this is true forminority shareholders, the overall return for the dominant partners mustconsider the impact of company involvement in support of their currentbusiness operations and whether any changes will have an overallnegative impact.
Concentrating on the minority shareholders, a reduction inadverse publicity through socially responsible actions leads to greatercustomer support for the company and less likelihood of the organisationbeing boycotted for corporate tenders or customer purchases. Improvedrevenue flow improves shareholder wealth.
Rewards gained by shareholders must relate to the risk ininvestments. These are very high in this scenario with the risk ofnationalisation in the dictatorship cutting off wealth transfer abroadand the risk of governmental action to boycott all trade with theregime. These risks will be a major feature in suppressing current shareprice.
Some shareholders demand a return beyond the financial. Thisincludes the Trade Union Pension Fund whose moral position on labourrelations and human rights demands a return from the company in terms ofa level of ethical behaviour to retain the Fund's investment. Actionregarding social responsibility meets this need.
Beyond the financial issue, many would regard Geko as a corporatecitizen, granted the same rights as any other citizen. With theserights attach responsibilities to operate in a way that does not impingeon the rights of others. At this ethical level, social responsibilityis a prerequisite to having a place in this world, a place that can betaken away by those who grant it in the first place.
Geko must determine its own unique way of dealing with thevariety of stakeholder interests that impact on its operation. This willneed to be a blended approach determined through a rigorous process ofanalysis and evaluation. Information and inclusion will be key factorsas well as seeking expert advice and consultation.
Stakeholder mapping, possibly using the Mendelow model, canassist. This plots the level of interest of stakeholder groups againsttheir level of power to affect the organisation. The outcome of theassessment identifies key stakeholder groups and a variety of possibleresponses. Those with power generally require greater action.
Key interest groups such as the dominant shareholders have beenthe most important to pacify. This has led to the continued support ofthe regime. More powerful, yet less interested, will be local governmentand international interest (possibly UN interest). Such structures mustbe kept informed and satisfied with the company's response. The goodcharitable works carried out in the region cannot be ignored. Theselocal stakeholders benefit from the company's involvement and any lossof patronage will sorely affect local groups.
Minority shareholders are less powerful but collectively stillhave a potentially damaging impact on current business strategy andmanagement. They still account collectively for 50% of shareholding andmay alert regulatory bodies to mismanagement should this be found. Onekey issue here is the fact that non-executives are not reallyindependent. This goes against many codes of best practice and may be ofinterest to regulatory groups.
The Mendelow model is a framework for external analysis.Internally the board of directors must decide on its ethical stance.This, at present, rises slightly higher than Carroll's economic andlegal levels with a slight interest in ethical issues. Ethical stancemust be fully explored by management on a corporate and personal levelto try to make tangible what the company believes in and whether theyfeel complicit in human rights abuse or whether corporate concerns donot stretch into these political and civil areas.
Emerging from this analysis will be a corporate stance inrelation to ethical decision making. At present it would appear that thecorporation is reactionary, denying any responsibility for its poorsocial record. This could easily move into a defensive stance whetherthe company accepts some responsibility and decides to take minimumaction in order to pacify stakeholder groups.
This might include promises to open direct dialogue with themilitary dictatorship over labour rights or facilitating meetingsbetween the target government and NGO's such as Amnesty International.
An accommodating approach would improve on this matter stillfurther and probably amount to a withdrawal from the region. This wouldbe difficult given the high voting power of interested parties among theboard and the shareholder base. A final level is one of proactivelymoving beyond what stakeholders have requested. This will not occurwhilst the dominating partners are in control of the company.
Stance leads to the definition of action through determination ofpolicies and programmes for change. Environmentalism is not mentionedin the scenario although this is a key area for oil companies. Thisorganisation could make improvements in this area in order to distractinterest from its collusion in the military regime.
All such programmes must be implemented and reviewed asappropriate to ensure the company is responding to the changinginterests and needs of both shareholders and stakeholders.
The current situation is untenable and the unavoidable issue isinvolvement in the military regime. Since the issues in the case relateto governance and social responsibility these should form the twostrands of a strategy (or strategies) for change.
First, the organisation should sell its interest in bothcountries where its dominant shareholders are operating. The sale may beto the shareholders themselves. These revenues can then be used to buyout the dominant shareholders, returning the shares to Geko's control.
The removal of these shareholders' interests on the board allowsappropriate non-executive directors with independent expertise to beemployed so reinforcing quality at the board level.
The strategy also reduces the size of the company, making it morefleet of foot and returns power to the minority and the market soraising liquidity and through this share price. Any residual gains, andthe value from increasing share price, can be reinvested in new venturesin exploration in more suitable commercial environments around theworld.
Question 11: ILT
(a) Effective systems of internal control
The committee of Sponsoring Organisations (COSO) identifies thecomponents of an effective system of internal control as being a controlenvironment within which all operations occur, a risk assessmentprocess to ensure all risks and considered, control activities to ensureoperations occur in an acceptable way, information and communication tointegrate and facilitate effective operations and finally the existenceof monitoring services to evaluate the effectiveness of control.
- Control environment
The control environment sets the tone of an organisation, influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure. Factors include the integrity, ethical values and competence of the entity's people; management's philosophy and operating style; the way management assigns authority and responsibility, and organises and develops its people; and the attention and direction provided by the board of directors.
- Risk assessment
This process will ensure that all risks are captured and maintained in a risk register for the organisation. The risks will subsequently be assessed, considering both impact and probability, and an attempt will be made to distinguish between controllable and uncontrollable risks.
- Control activities
Control activities are the policies and procedures that help ensure management directives are carried out. They help ensure that necessary actions are taken to address risks to achievement of the entity's objectives. Control activities occur throughout the organisation, at all levels and in all functions. They include a range of activities such as authorisations, reviews of operating performance and segregation of duties.
- Information and communication
Pertinent information must be identified, captured and communicated in a form and timeframe that enables people to carry out their responsibilities. Information systems produce reports, containing operational, financial and compliance-related information that makes it possible to run and control the business. Communication is the process through which information is received and passed on through the corporate structure.
Internal control systems need to be monitored. This is accomplished through ongoing monitoring activities, separate evaluations or a combination of the two. Ongoing monitoring occurs in the course of operations. It includes regular management and supervisory activities, and other actions personnel take in performing their duties.
The more significant issue is to question how these controlelements are failing within ILT. Such an assessment should identifyroads to improvement.
- Control environment
The company has a noble mission and this should be communicated and reinforced from board level downwards through the hierarchy of the company. The current situation at ILT suggests that the board is failing to do this. A positive self image has been replaced with negative culture of secrecy and a lack of trust.
Increased secrecy has arisen in part through a failure in internal control over the treatment of animals and, perhaps more damaging, there may be a lack of trust between work colleagues as each feels the other is a potential whistleblower. This lack of openness, endemic in operations, will manifest itself in a lack of internal control in other areas.
- Risk assessment
There is no evidence of a formal risk assessment activity being undertaken. However, it is clear that the concept of risk exists amongst management who have decided to implement the controls over the current projects. This process still needs to be formalised, since at present it is very likely that significant risks could remain undetected, on unacknowledged by the management of ILT.
- Control activities
The only control mentioned is the work of project review teams. In its operation there is clearly pressure to collude in order to protect each other's projects and ensure criticism of one's own work does not arise. Board level pressure for results and a bunker mentality do not suggest objectivity and openness in discussions. In effect there is no review or control mechanism over project results and this leads to a risk of fabricated positive results in order to secure bonuses.
- Information and communication
The inherent secrecy over operations will not support open communication. A lack of communication can lead to errors, a lack of coordination in projects and isolation of groups, especially the board. The reluctance of the board to carry out its monitoring function in receiving information regarding projects throughout their operation leads to a delay in negative results being brought to the board's attention. This seriously jeopardises the ability of the board to evaluate and respond to risks.
There is no mention of a review process to ensure internal controls are operating effectively. Details of current board focus suggest they are not actively involved in this area. Without a formal evaluation of the quality of internal controls, failings in internal controls are almost certain to continue.
The objectives of internal control are to improve the opportunityfor successful company operations. This can be viewed in a variety ofways.
Firstly, internal control seeks to ensure objectives are beingmet. These are stated as being to advance scientific knowledge andprotect the general public. One aspect of this will be the ability ofinternal control measures such as the project review to identify faultsin research and correct them prior to poor products entering the market.
Internal control creates an environment for efficient andeffective operations. This can be seen in the ability to constantlycorrect problems and allow for new ideas or adaptation to occur as aresult of problems coming to light. Control over animal conditionsthrough the use of clear procedures for care and the auditing ofprocedure use by managers may have saved this company from poorpublicity.
Internal control leads to financial propriety. This isspecifically mentioned by COSO. The reason relates to the purpose oforganisations (to make profits) and that anything that helps inachieving this is worthy of consideration. It is also mentioned becauseof the need to ensure quality in financial reporting to shareholders(true and fair view). At ILT, contract costs and revenues, reduction inlegal claims against the company for faulty results and awarding bonusesonly on merit are all financial concerns that will improve throughinternal control.
Assured compliance is a linked point mentioned in the COSOframework. Here compliance initially relates to the ability to complywith codes of practice such as the UK Corporate Governance Code (2010)or, perhaps more importantly, SOX and the legal implications of afailure to comply. However, internal control can extend to the abilityto comply with health and safety regulations at ILT and generalmethodologies for testing used in the industry.
The issue of assurance is a part of the compliance objective. Theboard will gain an assurance that operations are occurring as theyshould through focusing on internal control. This assurance reducesrisks and therefore the likelihood of a repeat whistleblower event asdescribed, or the possible investigation into their activities followingthe US drug recall.
Question 12: BJZ
(a) Reasons for failure in internal control
Internal control, no matter how sophisticated, cannot provide anabsolute assurance that disaster will not strike. This is true for anycompany. However, in the case of BJZ, a number of weaknesses haveexacerbated a difficult situation and heightened the risk of failure.These are dealt with below.
Control is a financial investment in risk reduction. This benefitmust be weighed against the size of investment the company is willingto commit to the cause. It will always be a balancing act in terms ofinvesting enough to reduce risks to an acceptable level against thecosts arising should the threat materialise. In this instance, it islikely that the huge costs involved in the project have curtailed someefforts to reduce risk. This might relate to over reliance on outsidecontractors or costs in relation to the type of pipe used in the oilfield.
There is no doubt that managers were well intentioned in overriding maintenance schedules in order to protect human life. The failurein internal control is twofold. Firstly, adequate internal control overemployee safety should exist through other policies and practices sothat their health is not threatened in the harsh operating conditions.Secondly, managers should not sacrifice one control in order to protectanother asset. Policies and procedures are high level concerns, whererisks and measures are best assessed. Managers should instead havecommunicated the problem and provided information to senior linemanagers to assist them in determining a solution.
The collusion between the manager and the contractor is anotherreason for internal control failure. It is difficult to protect againstthis kind of problem since operations are human processes and thereforeopen to corruption and misplaced loyalties. Professionalism, culture,training and supervision as well as independent verification ofmaintenance work carried out may have reduced the impact of thisfailure.
At a strategic and operational level, poor professional judgementhas led to failure. At the strategic level poor judgement may relate tothe board's position regarding admission of responsibility and itssubsequent inability to gain shareholder support. It could be said thatthe decision to drill in such an inhospitable and challengingenvironment was poor judgement or a lack of adequate consideration ofrisk.
In the end internal control can fail simply due to bad luck. Itis impossible to identify everything that may happen and to protect allassets, particularly when they include thousands of miles of pipeline.Risks and outcomes can be assessed and control determined andimplemented but there are always natural occurrences such as the weatherthat remain unpredictable. The problem for BJZ is the extent to whichthis problem could have been predicted and the perception of companyculpability in orchestrating the environmental disaster.
(b) Role and process
Role of the board of directors
The primary role of the board of directors, according to the UK Corporate Governance Code (2010),COSO and SOX, is to accept responsibility for internal control withinthe organisation. The board are the strategic leaders making executivedecisions and it is ultimately their responsibility to protect theorganisation and its stakeholders against the risks that arise throughoperations. The board's position at the AGM seems indefensible in thismatter and this should be addressed through formal communication to allstakeholders through the media.
Once acceptance of this responsibility is instilled in boardoperation, they should then determine appropriate policies to deal withthe risks ranged against the company. The process for dealing with thisrole is described below. An important consideration is the depth ofpolicies that emerge. Clearly the board is not in a position to detailprocedures in every area of operation and so policy may be more targetor objective orientation, stating KPIs for others to achieve.
The UK Corporate Governance Code (2010) makes specific referenceto the need to gain an assurance of the quality of internal controlsused in the organisation. This is an annual review or evaluation processcarried out through the internal audit function and responsible to theaudit committee which itself is a working party formed from boardmembership. The role of the board in this instance should be detailedthrough the annual report.
Finally, and ultimately, through the above, the role of the boardis to manage risk. Managing risk does not mean risk elimination. It is arelative process and the degree to which risks are managed is a primeconsideration for board debate. In this instance it would appear thatthe failures in internal control have led to an inability tosuccessfully manage risk. This failure is therefore a failure of theboard itself as well as specific individuals below this level.
A process for managing internal control at board level will tendto reflect a standard change process used in all decision making. Thespecifics will, of course, relate to this area.
- Risk identification
Risks must be identified and assessed in order to determine those that are acceptable and those that require action. Risks may then be prioritised for immediate or later consideration and in order to assist in internal control investment determination. There are many risks in this scenario. The risk of loss to human life and the risk of environmental disaster are two prominent issues. Other risks include the reputational risk that such failures bring with its resulting outcome both at the shareholder meeting and the petrol stations. There are also financial risks such as the risk of project budget over runs and natural risks such as the risk of a prolonged winter and its effect on production. Operational failure and the risk of raising or lowering oil prices due to events in this field and others around the globe must also be considered.
- Strategy determination
As already discussed, the extent to which the board of directors will consider any issue is limited by time, expertise and necessity. However, there must be guidance and policy determination. Various strategies will be considered and a few selected after deliberation of costs and benefits. There must be a clear policy or even mission statement regarding the extent to which the company will develop renewable energy sources or remain focussed on these traditional, high risk non renewable sources such as oil. KPIs should include targets for reduction in accidents and loss of life, targets for elimination of oil spills, targets for R&D into new forms of energy and statements of ethical intent. Policies over the use of contractors should be reviewed as soon as possible.
- Review and report
Regular review is a separate process that ensures control systems are working effectively and updated as required. This review should be hierarchical and independent of operations, carried out by internal audit teams. The review builds from the bottom up and culminates with evaluation/consideration by the audit committee.
The committee itself should be dominated by non-executive directors with appropriate expertise in areas such as environmental protection and exploration in difficult terrain. The committee report directly to the board with recommendations as appropriate. This report becomes the basis for information included in the annual report delivered to shareholders.
Question 13: RSJ
(a) Reasons for increasing importance
Most companies would describe themselves as going through aperpetual process of change. RSJ is no exception. However, the move froma long-term traditional base into new businesses is a particularlydifficult and risky process with an increased need for risk assessmentand appropriate management and control.
Under these circumstances internal audit has an increasinglyimportant role to play in monitoring the level of control built into newbusinesses, how these integrate into the company as a whole and theeffectiveness of operations in achieving company goals.
Scale and diversity of operations suggest a need for increases inthe volume and diversity of internal audit functions. Whilst there hasbeen a reduction in the overall size of the firm, with accompanyingappropriate reduction in the numbers involved in internal control, thisdoes not remove the need to consider these issues. The company isobviously very large and so needs an internal control function tomonitor its scale effectively. It is also diverse, to an extent, andthis diversity seems to be increasing with the move away fromtraditional markets. Internal control is increasingly important inunderstanding and dealing with this diversity.
Two specific operational issues are identified, technology andoutsourcing. It could be argued that the greater the level of automationthe increased opportunities that exist for fraud and error. Thecomplexity of technology suggests an increased need for expertise tomonitor that complexity. Externalities such as outsourcing are difficultto control and although externalising suggests less need for directcontrol there is an increasing need to develop different approaches tocoordinate and control these separate entities, hence an increasing orat least differing role for internal audit.
The failure of one outsourcing contract and the risk to humanlife and corporate continuance is a major concern for RSJ. The costs offailure heighten the need for internal control in this industry asopposed to other less risky venture.
Finally, the unacceptable accounting treatment is itself a causefor concern. In terms of increasing importance of internal audit thisrelates to desperation arising from poor trading performance. The needfor internal audit is inverse to the performance of the company in thisrespect with its role increasing as results decrease.
(b) Differing types of work of internal audit
The reasons for increasing importance of internal audit provide abackdrop to considering the differing roles such as function may take.These can be viewed in relation to the various different forms of auditassociated with the internal audit function.
This investigates the extent to which management are complyingwith internal controls set by the organisation. These could relate tooperational controls over project management such as the need to signoff stages in construction or health and safety controls on site. Theyalso relate to the need to consider compliance in relation to governanceand accounting.
The CFO's accounting treatment would point to a failure in thisarea. The reporting of the matter to the audit committee is a relatedrole for all audits or work carried out by the internal audit function.The anonymity associated with reporting this issue shows the seriousnessof the concern and the difficulty internal audit has in operatingwithin and yet outside of the management structure.
This relates to assessment of current operations in terms of theextent to which they are effective in supporting company objectives.Real issues raised include the policy towards outsourcing and itsattached risks and the management accounting policies used for pricingprojects and the extent to which these are effective. It would seem thatchanges are required in this area.
This considers productivity and the use of company resources.Critics of the costing policy suggest that its use has led to areduction in innovation and improving construction processes. These areproductivity issues. Benchmarking against competitors may offer asolution and is worthy of investigation by management or internal audit.
Value for money (VFM)/Economy audit
This relates to cost reduction exercises and may be viewedthrough the lens of outsourcing and staff reduction. These are resourceissues and costs associated with relocation, staff transfer, redundancyare all worthy of assessment in order to verify management policy inthis area.
This relates to the need to review the quality of managementwithin the organisation and to recommend change as necessary. There islittle evidence in the scenario to support this need althoughrecommendation to the board on the importance of a rigorous review oftheir performance as part of governance reform is a related point. Thereseem to be serious strategic failings in the management of the companyand this should be the subject of a frank and open review.
(c) Objectives of internal audit
Internal audit is a function designed to improve the level ofinternal control within an organisation. This improvement might manifestitself in increasing VFM as described above or in a reduction in errorand misjudgement. The increasing need for internal audit and thereforeinternal control has already been described. Ensuring the entity iscontrolled effectively is the first step to changing direction andrecovery. This should be communicated to the board for theirconsideration.
Risk management may mean risk reduction and with the high pricefor failure detailed in the nuclear disaster, risk reduction is a worthygoal in itself. Risk management is actually a wider issue suggestingthe development of a formal process for identifying and dealing withrisks. Internal audit becomes a part of risk management through itsoperation and therefore this is part of its purpose.
External audit support
Much of the work of the internal audit function has a directimpact on the need for and nature of external audit work carried out. Itwill lead to support for the independent review of the company'sfinancial position and should mean lower audit costs for organisations.These are important issues for the board, especially in relation togovernance in the interests of shareholders.
Through reporting to the audit committee the internal auditfunction provides a level of assurance as to the good management of thecompany. This assurance feeds through to board operation in anatmosphere of good governance and provides shareholders with theassurance they require in terms of the use of their money within theentity. The fact that directors do not seem to own shares in the companymay question the extent to which they are aligned with shareholderneeds.
Question 14: DD Entertainment
(a) Risks and risk assessment
To: The board of directors
From: XXX (management team)
Subject: Risk assessment in company operations
The following offers a broad view as to the nature of risks andthe importance of risk management as a tool in assessing exposure andstrategy in dealing with risks.
The competitive success of the company depends on its ability todeal with the variety of risks to which it is exposed. These includeproject based, financial market, technology and political risk, each ofwhich is examined below.
- Project based
Casino construction is exposed to a variety of risks that are exacerbated through location decisions such as country, region and terrain. The site chosen is a critical decision in terms of its ability to attract clientele. For this reason it may be preferable to follow competitors who have a proven track record in certain location chosen for historic, economical and cultural reasons. Within the construction project risk exposure is inherent in terms of design difficulties, labour relations, political interference and supplier relationships.
Risk assessment in terms of monitoring the extent to which difficulties may arise can be viewed through cost projection, lengthening forecasts on project completion and architectural commentary on potential problems. During the project itself these same issues may be used as a strong indicator of increasing exposure and the need for control action.
- Financial risk
The corporate strategy to diversify geographically has been used as a risk reduction technique. However, inherent within this move is exposure to finance risk through exchange rate volatility affecting earnings and cash flow. This can be coupled with varying taxation levels in different companies and potential problems in the ability to transfer funds from overseas venues.
Risk assessment involves monitoring the changing impact of these issues on finance available for both shareholders and retention for ongoing expansion. Levels of gearing are also an increasingly important performance indicator given the potential for takeover within the industry. The level of gearing has a direct relationship to cash flow problems and, possibly, difficulties in raising cash from shareholders due to their perception of risk within the industry. An improvement in risk management may affect this perception and through this corporate finance raising prospects.
- Market risk
Market risk could relate to this takeover issue and the potential for competitors or equity firms to make a bid for control of the organisation. In a general sense, market risk relates to the level of risk within the industry itself, which is considerable. Gambling, for many, is a leisure pursuit available through the existence of high levels of disposable income. Economic cycles dictate the extent to which this income is available and leisure industries are often the first to suffer during periods of economic downturn.
Risk assessment can be viewed through an historic analysis of returns and cycles over the company's long history. It could also be assessed through readily available economic data. In terms of competition, the existence of takeover bids, increased shareholder dissatisfaction and activism or simply bad analyst publicity could assess the extent to which a threat exists.
- Technology risk
Direct reference is made to technology as a risk issue. The speed of change in technology continues to accelerate and will do so for the foreseeable future. It is an important element in marketing and attracting customers to our facilities and provides the potential to achieve competitive advantage. Risk relates to failure to keep up with competitors in this area and the costs that arise through use of technologies that do not enhance the experience in line with customers' needs.
Risk assessment investigates the extent of exposure to these kinds of threats. Customer and competitor surveys may assist in the task. Size of information technology (IT) budget and turnover of IT projects indicate the extent to which the company is reliant on this resource or exposed to it.
- Political risk
There are many political risks such as changing governmental policy on the issue of licenses, refusal of planning permission and even, in extreme circumstances, regime change. Risk exposure or assessment may involve expert opinion or monitoring the changing levels of taxation and negotiating difficulties in license approval. Media reports or even instances of direct action from the local population are strong indicators of the need to increase public relations effort in this area.
(b) Importance of risk management
The importance of risk management can be seen through a number ofissues raised in the previous discussion regarding risks and riskassessment. Risk management relates to the development and monitoring ofa formal process for reducing the company's exposure to the threatsranged against it. The positive aspects of doing this centre on animproved ability to deal with these risks reducing their instance andcost and so enabling the company to perform more effectively. Thiseffectiveness can be viewed in terms of the ability to generate profitsand the ability to increase the certainty in operations, the assurancethat the company will perform adequately. Assurance is beneficial initself since the sense of certainty provides management with strengthand focus away from the uncertainty and firefighting prevalent in lesssuccessful organisations.
At a strategic level, risk management is a tool through whichstrategic opportunity can be identified and managed. The importance ofthis can be seen in current corporate strategy and the ability toidentify appropriate global site locations for casinos. This is anincredibly difficult task and one upon which the success of multimillion dollar investment hangs. A single wrong decision could markcorporate failure or at least the likely takeover by a competitor.
As a process risk management has a coordinating and percolatingeffect. Beginning with strategic management's improved focus on threatsand ability to deal with these issues, tactical and operational staffactions are coordinated efficiently and focused towards what needs to bedone. The percolating effect is cultural in terms of highlighting theimportance of risk management, raising awareness of the need to be awareof risks and capable of reporting or dealing with them. This has aparticular resonance down to the gambling tables and identifyingfraudsters and cheats at work in the casino.
Compliance is a final benefit of improved risk management thathighlights its importance to the company. Managing risks is an activity,like all others, carried out on behalf of the company owners.Compliance can be viewed in terms of how the process ensures the companycomplies with their wishes in terms of assuring adequate returns ontheir investment. Risk management also enables the company to complywith the terms of its license agreement with governments and evenelements of the local population by complying with age restrictions andtime restrictions on the availability of the service.
In a governance sense, risk management or risk awareness is apart of required reporting as evidenced by the 10K report and so is notan optional consideration.
Question 15: Mineco
(a) Risk assessment process
Risk assessment is a process through which an organisationidentifies and assesses the importance of threats facing its operation.It is the first stage in a wider risk management process that determinesstrategies to deal with these threats and then monitors and adapts asnecessary in order to reduce risks and hazard occurrences as much aspossible.
Mineco operates in a high risk environment. The scenarioidentifies a number of categories of risk and specific examples. Allwould need to be addressed in a comprehensive process. The outcomes ofrisk management will need to be identified to shareholders through theannual accounts in sufficient detail to allow them to assess the extentto which the organisation has been successful in dealing with risks, andthrough this the security of their stake in the company.
This could incorporate the risk of failure in mining operations,the risk of cost escalation through technical difficulties arisingthrough mining operations and the specific event risk mentioned such asthe risk of loss of human life. The final issue would tend to be giventhe highest priority in strategy definition and reporting due to itsnature.
Risk assessment should firstly detail the scope of this issue andwhether it needs to be subcategorised under health and safety andtechnical issues and site selection risks. Sufficient information shouldthen be introduced to provide a clearer picture of the nature of theproblem.
Appropriate health and safety legislation, recommendations andstatistics benchmarked to competitors may be used in relation to thethreat to human life. Geographical and seismic surveys followed by onsite investigations will form part of assessing the risk of failure inpotential drilling operations. Regular progress reports to seniormanagement and information sharing across all sites will assist inforecasting the extent to which technical problems are likely as well aspossible solutions.
Market risk can relate to the competitive market or financialmarket risk. In this scenario the latter is given attention. There are anumber of risks to consider. Exchange rate volatility will be importantsince operations are truly global. Fluctuations in exchange ratesaffect the value of contracts with customers as well as the cost ofoperations and the value of the product.
This will be readily understood at the strategic level and dealtwith through the accounting function described. Related financial risksinclude problems with liquidity to support the huge cost of extraction,customer credit risk when dealing with governments and companies aroundthe world and commodity price risk as identified.
Risk assessment will use macro economic data and forecastingtools, a wealth of historic commodity statistics and, importantly, theneed for senior management to assess future trading conditions and set astrategy accordingly. There is no doubt price and rates will move, itis the likely severity of change and its impact on the bottom line thatmust be assessed.
The global nature of the company leads to the need to considertrading conditions within a variety of countries. These conditionsinclude the nature of interactions with government / regime authorityand its potential impact. Mines operate in some of the least politicallystable regions of the world and risks must be assessed accordingly.
Risk assessment will necessarily be on a region and countryspecific basis. It will call upon the use of expert opinion and contactswithin governments to assess the extent and nature to which the companycan work with the authority. Outcomes include a forecast of likely taxand royalty payments as well as the possibility of incentives to aiddevelopment of given regions.
This is an increasingly important concern due to the nature ofcompany operations. A number of areas of environmental and socialconcern are detailed in the scenario; risk assessment must evaluatetheir importance individually. This again will call upon the need forexpert opinion, possibly involvement of environmental groups such and areflection on competitor action and governance standards. ISO 14001 is astandard against which environmental performance can be assessed. Theextent to which the company is unable to comply is an assessment ofnegative impact.
Environmental risk is not the same as environmental impact. Thecompany will impact on the environment due to its nature. The risk isthe threat of negative impact beyond that which is expected. This couldrelate to local communities or the natural world. Risk assessment shouldcall upon information from the 100 sites in current operation, thetrade / industry knowledge database and the company's own historicalexperience to identify the scope of issues raised. Their severity andlikelihood should then be determined prior to appropriate strategydefinition.
Mineco will have a number of strategies, policies and proceduresin place to deal with the risks ranged against it. The determination ofstrategy and its implementation moves the company from risk assessmentto risk management, concluding with the need for review and adaptation.
Since this risk category is broad, strategies will be numerous.Since the loss of human life is the greatest threat facing any company,this will be discussed here. There will already be stringent safetyprocedures in place at mines; these must be enforced through goodquality management and sanctions for non adherence. Regular, compulsorytraining of staff will also assist in ensuring safety is given a highpriority. All industries have specific safety equipment and technologiesand these should be used company wide. These are all operationalissues. At the strategic level the board should communicate its intentthrough giving this risk the highest priority in its corporatedisclosures and should been seen to reward loss accident levels wherethese exist.
Standard financial management instruments can be used to assistin reducing market risk. These include the use of derivatives in orderto hedge against future price fluctuation through futures contracts.This is a way of reducing risk although it may also lead to a reductionin possible profits depending on market movement. Currency swaps mayassist in dealing with the negative impact of exchange rate fluctuation.Credit rating agencies will be used to reduce the problems of potentialbad debts from customers and cash flow management will include the needto use reserves that can be liquidated at short notice in order to dealwith liquidity problems.
One strategy mentioned in the scenario was to use partnerships onlarge projects rather than take on the entire project as a singlecompany. This seems a reasonable strategy to reduce risk; it will alsohave an impact on profits through the need to distribute profits throughall partners.
Strategies will call for the development of a full corporatesocial responsibility programme using some of the large profits thecompany makes to invest in community projects including housing andschooling. Possibly the biggest issue is the amount invested in coveringthe scars left when mines are finally decommissioned. This is animportant issue for those left behind when the company leaves.
Question 16: WS
(a) Risk and corporate culture
WS is a very successful company with performance outstripping themarket many times. This is due to its limited objective focus and itsinvestment in this area.
WS defines risk in terms of the potential threat to its shareprice or continued growth and subsequent inability to meet marketexpectations. The hazard would become a reality if it failed to achieveforecasts levels of profitability or if the market perceived that itwould be unable to meet such forecasts in the future. Another scenariowould be perception of misstatement of accounting performance as alludedto at the end of the case.
Embedding risk into corporate culture is the transference ofbelief systems between those who define that belief and all otherstakeholders/staff operating within the structure. This process beginswith the definition of risk as detailed above and the determination ofobjectives in relation to risk. This definition would relate to theforecast in earnings/growth/share price over a given period as definedby the CEO.
The communication process and absorption of belief by staffbegins with senior management pronouncements as to what is important tothe company. This can be seen in the actions of management inencouraging staff to buy stock and the evidence of price screens in theelevators.
The financial interest created by staff buying stock and bysenior management's remuneration relating to stock price creates anincentive to work in the interest of improving stock performance. Thisis common to most organisations of size and entirely appropriate sinceit is a way of dealing with the agency relationship and aligning theneeds of management with the needs of shareholders.
Belief must be supported through action. Management investment inenergy trading signals this as being the pathway to success in raisingprofits and share price. The financial nature of the trading activity isa subtle and unintentional reinforcement of the importance of themarkets and trading in general and can be linked to the need to performin the stock market.
It may be the case that focus on profitable areas has led to alack of control over other projects that do not offer the same rapidrewards such as the power station construction project. This evidence ofa lack of control or rather a refocus of interest and managementcontrol on profitable areas reinforces the importance of rapid growthand instant returns rather than steady development over time.
(b) Combating risk exposure
Risk exposure relates to the likelihood of something going wrong.In this instance the â€œsomethingâ€ would relate to a downturn inprofits or an inability to meet market expectation. There are a numberof ways of dealing with this.
The first reference is to the need to diversify risk through avariety of business interests. This can be seen in the verticalintegration strategy developed by the company during its early years.Being involved in a number of areas reduces the impact of failure in anygiven area. The greater the diversification the greater the riskreduction as long as enough expertise exists to service different marketdemands. This is probably why the company moves into financial markettrading through energy trading, because it already has expertise in thisarea, although it is a different business and, as stated, risks arehigh.
Combating risk exposure is not necessarily the same as reducingrisk exposure. It may also involve raising the level of rewards requiredin order to compensate for the added risk that exists. The companyraises the expectation of profits to compensate the market for increasedrisk. This ensures share price remains supported and high. The problemis in the ability to service this higher expectation over a long period.
The combating of risk through higher rewards can also be seen inthe compensation of staff and, more importantly, senior management.Their belief and enthusiasm is maintained through the level of rewardthe market is willing to pay them through their remuneration packages inorder to retain them within the firm and presumably compensate them forworking in a risky venture.
Externalising problems is a way of dealing with risk. The companyuses this in terms of dealing with the negative publicity from thefailed venture on the Indian sub continent. Blaming others externalisesresponsibility and if successful leads to a negligible or non existentimpact of the problem on the company, except of course for the lossesthat are incurred through the project.
The lack of transparency in accounting works in the interests ofthe firm in that it makes it difficult to determine whether the shareprice is or is not justified. The outcome of this is that shareholdersare willing to believe in the integrity of the company and keepsupporting it by buying shares. It may be the case that they are whollyjustified in this belief although it is risky for the organisation torely on a strategy that may be misinterpreted. If there is nothing tohide then there seems no useful purpose in deliberately making accountsdifficult for the owners of the company to understand and use.
(c) Comprehensive risk management programme
It could be argued that the company does provide a comprehensiverisk management programme. It defines risk in a simple way, embeds thatrisk into the belief systems of all staff down to the screens in theelevators, and then manages that risk through its investments andcommunication to the shareholders. It is difficult to argue against riskmanagement from this perspective.
The issue is in the interpretation of the word comprehensive. Thecurrent approach is comprehensive if the definition of risk is limitedbut entirely lacking if the scope of risk is extended.
An improved risk management programme would appreciate the fullscope of risks and act accordingly. It could be argued that all otherrisks, except possibly the loss of human life, fall beneath theoverriding demand for profit, after all this is the purpose of theorganisation operating in accordance with the wishes of shareholders;even if this is accepted it should also be appreciated that lower tierrisks, if not adequately dealt with, will impact on the overridingobjective as much as a direct failure to focus on cost reduction andrevenue growth.
Direct problems that are not being appropriately managed are thefailure of the power plant projects and the lack of transparency in theaccounts. The power plant write-offs must impact in some way onoperating statements and this affects share price. Local projectmanagement on difficult investments such as this should be given ahigher priority or the investment decision process should bere-evaluated so that projects such as this are not considered in thefirst place.
The risk of a lack of transparency has already been discussed.There is as much a possibility of misunderstanding as support and thereseems little reason for the company to expose itself to this given thatit has nothing to hide.
The most important issue in risk management for this company isoverexposure. In the pursuit of profits short-term share price growthhas led to the sacrifice of lower risk growth through traditionalmarkets and steady returns to shareholders. It is a truth that nocompany can continue to outperform the market forever and when thedownturn happens the company must manage it well or the repercussionsmay be severe. It is of particular interest that so much of the personalwealth of employees is tied up in stock. This may lead to unethical,unprofessional and even illegal actions by them in pursuit ofmaintaining the share price.
The audit committee must be aware of this and should act to slowdown the acceleration since the outcome may be corporate and personaldisaster.
Question 17: Internet services
(a) Cultural factors
There are many cultural factors that impact on the mindset andprocess through which ethical justification is reached. Culture itselfhas many facets and definitions, here it is considered in terms ofcharacteristics common to the national or ethnic psyche. Throughnecessity, this simplification of a complex, idiosyncratic profile lendsitself to stereotypical conclusions that should in general be avoidedin understanding ethical approaches.
One such facet is the regional / religious or local climateunique to a given country or people. This can be considered in terms ofwhat is acceptable given the history and cultural norm of thepopulation. In the scenario it refers to the difference between amindset that holds democracy and freedom of individual thought asparamount as opposed to a different perspective based in part on Marxistdoctrines in China.
An associated point is in terms of the collective belief in apredominant egotistic or utilitarian view of society. The former wouldbe more associated with the US whilst the latter believes that actionsshould be taken in the common good and that the individual's needs mustbe sacrificed to meet the needs of the many. Such a view would justifythe imprisonment of the journalist on the grounds that freedom of speechleads to dissenting views and this in turn threatens the perpetuationof a structure designed to meet the needs of the many (the Communiststate).
Other deep psychological beliefs include the degree to whichcultures differ in terms of their need to avoid uncertainty in societalfunctioning. Strict religious states, or tighter control by thegoverning body as associated with China, has a positive outcome in thatit removes some decision making power from the individual and replacesit with a degree of certainty over how state controlled functions willoperate. This can be seen, loosely, in the limitations placed on the useof the internet and the scope of search engine capability. Oneinterpretation of this is that by removing access to some informationthis reduces the scope for thought concerning alternatives and createsgreater certainty through the ability to only consider limited options.
The general acceptance of power distribution is another culturaldifference. The stereotypical view of the US model is one of abhorrencetowards government interference in life whilst the Chinese model isbased on a generational acceptance of the need for power to be placed atthe centre and used to guide/control individuals. It is never aconsideration of right or wrong since, in the ethical decision makingprocess, every decision is right, at least for the individual making thedecision.
A cultural factor that impacts on most countries is the extent towhich national culture is willing to accept the western cultural modelas appropriate. This becomes a dominant issue in the expansion ofglobalisation with its accompanying use of these cultural beliefs andsymbols at its heart.
This is very important in this case since the internet is itself aglobal phenomenon that generally embraces western cultural norms. Thereluctance of the Chinese government to accept the uncontrolled use ofthis resource could be viewed as an attempt to stop the infiltration ofwestern cultural beliefs into its population. Whether this is consideredto be good or bad is a purely individual ethical view since it requiresthe individual to first perceive what they mean by good or bad and thisis a deeply personal issue.
In a positive sense technology and the internet, deliveredthrough the four major players identified in the question, could beviewed as a mechanism through which national borders and cultures aretranscended and the global population is brought together to exchangeideas and influences. The journalists' communication to New York couldbe seen as an example of this. Viewed in this way, the internet becomes amelting pot used to reduce national or ethnic cultural dependence anddifference. The differences in culture become less pronounced and peoplebegin to transform their ethical view into more of a collective,singular, global viewpoint.
If this is accepted as a change process that the globalpopulation is exposed to the question that arises is as to thecharacteristic of that global cultural norm. Whose ideas/beliefs becomethe predominant belief system that others adopt? Whose colours willdefine the one country that replaces the different countries of today?
There is, of course, no agreement that this will take place or iswanted by different countries. The information restrictions withinChina can be viewed as an attempt to reduce this colourisation andpreserve "better" cultural characteristics more attuned to the uniqueneeds of its population.
(b) Ethical position of internet companies
The US committee discussion exposes deep divisions between theethical standpoints of different stakeholders. It would appear that thegovernment is highly critical of US companies trading with a regime thatit deems to be unfriendly and undemocratic. The view of the internetcompanies is that they do not perceive any ethical flaws to exist intheir position and wish to continue and possibly extend the tradingrelationship with China over time.
It would appear that the major argument is the ethical beliefthat the company is run for the benefit of shareholders and that theirneeds are for financial returns. This is also a legal standpoint and assuch the government could be considered culpable in creating andsupporting it. A business is an artificial legal entity whose onlypurpose is the creation of wealth, as such it has no need or ability toconsider moral issues since it is not a human being.
The argument against is that this is a facile position sincebusinesses consist of people and one cannot hide behind a corporate logowhen there are perceived infringements to human liberty as defined bythe US model on what liberty is.
A second justification for trade is that the companies would beunfairly penalised if they were forced not to trade with the country. Ifthey retire from the commercial arena, others who are not restrictedwill simply take their place. This will do nothing for the Chinesepopulation (assuming they feel disadvantaged in life) yet will affectthe ability of the companies to compete globally and through thissustain domestic employment and tax payments.
This is a powerful argument although those against would statethat moral justification based on others actions is an amoral stance(having no moral standpoint and being led by whoever leads). This isunacceptable since one would hope that a company would not decide tomurder a population just because others have done so in the past.
A counter claim made in the case study relates to not being heldresponsible for the clients actions suggesting the company'sresponsibility ends at the point of sale. There is justification in thissince no company, no matter how big, can police its customers andanyway, to do so is an infringement of their right to freedom of action.Why should a customer listen or adhere to what a large US corporationwants if it doesn't want to?
This seems a dubious defence since in this instance the company'sknow exactly how their technology will be used through the cooperationagreement. The plurality of their moral position is hard to understandsince on the one hand they exist in a society that demands basicfreedoms for its citizens (the company benefiting from that society inits own wealth creation), and yet it purposefully seeks to limit thesame freedoms for others. The issue here may be the ambiguous nature ofthe position rather than the position itself.
Finally, the reference to fighting the governments' battles seemsreasonable since governments are probably best placed to influenceother governments.
Question 18: Ethical code
(a) Ethical codes and ethical dilemmas
Ethical codes may assist in resolving ethical dilemmas for the following reasons.
Provision of a framework
Ethical codes provide a framework within which ethical dilemmascan be resolved. The codes set the basic standards of ethics as well asthe structures that can be applied. For example, most codes provide ageneral sequence of steps to be taken to resolve dilemmas. That sequencecan then be applied to any specific dilemma.
Interpretation of code
As a code, it is subject to interpretation. This means that twodifferent people could form two entirely different but potentiallycorrect views on the same element of the code. For example, terms suchas 'incorrect' will mean that an action should not be attempted at allby some people, while others will interpret this as a warning that theaction may be attempted, as long as good reasons are given for theattempt.
Lack of enforcement provisions
Many codes have limited or inadequate penalties and/orenforcement provisions. Breach of the code may result in fines, orsimply a warning not to breach the code again. Again, a code is subjectto interpretation making a 'breach' of the code difficult to identifyanyway.
(i) Ethical threats and safeguards
An ethical threat is a situation where a person or corporation is tempted not to follow their code of ethics.
An ethical safeguard provides guidance or a course of action which attempts to remove the ethical threat.
(ii) Situation A
The ethical threat is basically one of self-interest. Thedirector is using price sensitive information to ensure that a loss isprevented by selling shares now rather than after the announcement ofpoor results for the company.
An ethical safeguard is the professional code of conduct whichrequires directors to carry out their duties with integrity andtherefore in the best interests of the shareholders. The director wouldrecognise that selling the shares would start the share price fallingalready and this would not benefit the shareholders. As a code it maynot be effective â€“ the director could argue that selling shares priorto the results was designed to warn shareholders of the imminent fall inshare price and was, therefore, in their best interests.
An alternative course of action is to ban trading in shares agiven number of weeks prior to the announcement of company results (ashappens in the USA where directors are not allowed to sell shares during'blackout periods'). This would be effective as share sales can beidentified and the directors could incur a penalty for breach oflegislation.
Provision of example methods of resolution
Ethical codes also provide examples of ethical situations andhow those example situations were expected to be resolved. Specificethical dilemmas can be compared to those situations for guidance on howto resolve them.
Ethical codes provide boundaries which, ethically, it will beincorrect to cross. For example, many accountants prepare personaltaxation returns for their clients. However, it is also known that,ethically, it is incorrect to suggest illegal methods of saving tax orto knowingly prepare incorrect tax returns. Maintenance of ethicalconduct in this situation ensures that the accountant continues to betrusted by both his clients and by the taxation authorities.
Ethical codes do not always assist in resolving ethical dilemmas for the following reasons.
Ethical codes are literally what they say â€“ they are 'only' acode. As a general code it may not fit the precise ethical dilemma and,therefore, the code will be limited in use.
The ethical threat appears to be a lack of independence andself-interest regarding the setting of remuneration for these directors.Not only do they have common directorships, but they are also goodfriends. They could easily vote for higher than normal remunerationpackages for each other on the remuneration committees knowing that theother director will reciprocate on the other remuneration committee.
In corporate governance terms, one ethical safeguard is to banthese cross-directorships. The ban would be enforceable as the directorsof companies must be stated in annual accounts, hence it would be easyto identify cross-directorships. The ban would also be effective as theconflict of interest would be removed.
In professional terms, the directors clearly have a conflict ofinterest. While their professional code of ethics may mention thisprecisely as an ethical threat, AB and CD should follow the spirit ofthe code and resign their non-executive directorships. This again wouldremove the threat.
There is a clear ethical threat to the directors of Company Z.They appear to be being bribed so that they do not query the managementstyle of the chairman. The threat is that the directors will simplyaccept the benefits given to them rather than try to run Company Z inthe interests of the shareholders. It is clearly easy to accept thatoption.
Ethical safeguards are difficult to identify and theirapplication depends primarily on the desire of the directors to takeethical actions. In overall terms, the chairman does not appear to bedirectly breaching ethical or governance codes. The main safeguard istherefore for the directors not to accept appointment as director toCompany Z or resign from the board if already a director.
The director could attempt to get the matter discussed at boardlevel, although it is unlikely the chairman would allow this. Takingany other action is in effect 'whistle blowing' on all the directors andhas the negative impact that the director would also have to admit toreceiving 'benefits' from the company.
Question 19: NM River Valley
(a) An approach to ethical conflict resolution
As with any decision, a structured framework probably providesthe best approach to making the decision. The IFAC provides such aframework for ethical conflict resolution and this could be used in thiscase.
The first step is to gain as many relevant facts concerning thecase as possible. In this scenario these will relate to identificationof who the real beneficiaries of the project are. Even if it is the casethat they are solely corporations this will have social implicationssince such companies bring employment and prosperity to the region. Thenumber of people displaced through the project must also be determinedmore accurately as well as environmental costs of the project. Thesewill enhance the financial investment appraisal that has already takenplace.
Ethical issues involved
One of the ethical issues involved will be a utilitarian decisionwhere the needs of the few are sacrificed for the needs of the many.The price of a quarter of a million people compared to benefit to 40million must be considered. Compensation for their sacrifice is anotherethical dilemma as is the extent to which the corporations should payfor that compensation rather than the local government which wouldamount to the people simply paying themselves for their sacrifice sincethey originally paid the taxes of the local government.
Fundamental principles related to the matter in question
The decision making process should draw together all relevantinformation and this includes the need to consider fundamentalprinciples relating to the matter in question. These would include theneed for the accountant to act professionally since he is representingthe company in these matters. It also raises the question of whether theaccountant is operating in the public good since the public do not seemto support the project. This latter issue highlights the importance ofdetermining the volume of people involved and the actual public benefitsof the project should it take place.
Established internal procedures
There will be established internal procedures for the accountantto follow rather than the need to resort to Professor Hoi. These wouldinclude a whistleblower communication channel with direct access to theaudit committee and non-executive directors should the seriousmisstatement of the business case prove to be well founded throughexamination of the above. All internal procedures must be exhaustedprior to any direct action outside of the organisation.
Alternative courses of action
There are many alternative courses of action depending on theoutcome to the investigation. These may include the need toindependently report findings to the forum or media. They might alsoinvolve resigning from the project on ethical grounds. They mightinclude doing nothing and simply accepting the sacrifice of the few asbeing necessary for the wider good. It is important for the accountantto accept the need to at least consider these issues as part of aprofessional ethical approach to decision making.
(b) Extending corporate reporting into CSR
The reasons why corporate reporting should extend into CSR can beviewed from a number of standpoints. In a purely commercial sensecorporations are able to more fully meet the needs of shareholders andwider stakeholders and in meeting this need their reputations andreturns may be enhanced.
From a stakeholder perspective there are a number of deep issuesrelating to the structure and distribution of power. CSR could embracefull disclosure of the impact of organisational activity on society suchas the negative impact on the local population and environment. Thisillumination leads to a wider appreciation of the costs and benefits ofprojects such as the dam and this in turn leads to a more frank, openand honest discussion of the real issues at events such as the WorldWater Forum. It would also improve the quality or appropriateness ofpresentations given such as that of Professor Hoi.
The illumination leads to increased visibility of corporateoperations. This is a goal worth pursuing in itself since it attempts todemystify or make transparent that which is obscured from stakeholders,most importantly shareholders. The need for transparency arises throughthe agency relationship between management and the owners of thecorporation. A lack of transparency makes it difficult for shareholdersto make correct decisions on ethical issues simply because they do notknow the issues involved in such decisions.
Transparency in turn leads to accountability. Accountability is areckoning for actions taken by corporations. The immense power givenand wielded by corporations must be balanced through a responsibility touse that power in a way that society deems appropriate. The dam projectis a very visible example of the power to change lives and the naturalworld in which all citizens must live. A lack of accountability meansthat power can be used to the detriment of these citizens without payingan appropriate price for those actions.
Better information through CSR should lead to better decisionsand more appropriate solutions to problems. The scientists, engineers,governments and corporations can then share their knowledge in order tocreate solutions that are most appropriate. Simply widening the scope ofknowledge in the decision should increase the likelihood of a bestsolution being found.
This collective decision making process, extending on a globalbasis through forums such as that identified in the question graduallyreconstructs the power that exists in society away from single corporatedecision making to a more inclusive world view. This reconstruction isboth political and commercial, developing the organisation away from apurely pristine capitalist structure as defined by Gray, to one that hasa greater social responsibility at its heart.
This should be considered as a positive development and one that accountants should ethically consider appropriate.
(c) Attributes of the accountant
Accountants are perhaps uniquely capable of developing increasedCSR in the public interest. The professional skills of the accountant inreporting, disclosure and audit, adapted as part of their work to anygiven industry or sector enables them to collect and disseminateinformation to stakeholders regarding CSR issues.
Accounting also involves an essentially systems-based approach tobusiness where staged frameworks are applied in order to achieverequired goals. These system skills assist in the development ofenvironmental management systems through which reporting and monitoringis achieved. This view requires the accountant to use project basedskills to implement systems where auditing techniques can be used.
Investment appraisal is mentioned in the question as a purelyfinancial decision. Skills in this area enable the accountant to use afoundation skills base and extend it to include CSR related information.
As a profession including millions of professional, accounting isa body large enough to take on the task. Its formalisation throughaccounting bodies means that accountants have the infrastructure to takeon the challenge on a global scale.
Finally, an attribute of the accountant as a profession is tooperate in the public interest. This scenario identifies the public inthe widest context to include the very poor and disadvantaged. To meettheir purpose accountants should consider who the public are and actaccordingly.
Question 20: Dirk Hausmann
The AAA model is sanctioned by the IFAC and provides a rigorousstructure to evaluate the wide ranging issues involved in making anethical decision or coming to a conclusion in terms of what is right inthe narrow or wider context for the individual or the organisation as awhole. It suggests a logical, seven-step process for decision makingwhich takes ethical issues into account.
Step 1: Establish the facts of the case
The first step is to gather the facts relating to the situation.This means that when the decision-making process starts there is noambiguity about what is under consideration.
Much of the discussion in this situation revolves around rumour andopinion and so it is important for Dirk to gain actual writtentestimony or a clear picture of how events unfolded and who were the keyplayers in the events of the previous day.
Step 2: Ethical issues of the case.
The second step is to consider the ethical issues involved. Theestablishment of these ethical principles will offer a guide as to whatto do in a given situation. The principles may be understood through thecompany's code of ethics or with reference to the IFAC model. The modelstates that integrity professionalism and confidentiality are among alimited range of key ethical principles that must not be sacrificed inthe ethical decision deliberation.
Dirk is faced with the decision as to whether to keep the information of this false rumour to himself.
Step 3: Norms, principles and values related to the case
This involves placing the decision in its social, ethical, and, in some cases, professional behaviour context.
A corporate code should include procedures for individuals tofollow such as the appropriate hierarchical structure through whichconcerns can be raised with those on the board of directors or below.
The standard whistleblower clause should not be ignored in thisinstance as it may offer a way of passing the onerous requirement toactually make a decision to a higher level.
A core principle of integrity would suggest that the rumour shouldnot have been spread and Dirk should be honest about his findings.
Step 4: Identify alternative courses of action
In this step each alternative course of action open to Dirk isidentified. This involves stating each one, without consideration of thenorms, principles, and values identified in Step 3, in order to ensurethat each outcome is considered, however appropriate or inappropriatethat outcome might be.
Dirks' alternatives include:
(1) keep silent about the rumours that have been spread
(2) notify the board of directors
(3) seek another internal route to escalate the problem.
Step 5: Best course of action
Then the norms, principles, and values identified in Step 3 areoverlaid on to the options identified in Step 4. When this is done, itshould be possible to see which options accord with the norms and whichdo not.
Dirk should evaluate the variety of possible actions he could take.Raising the matter with someone internally, possible a senior manager,would be in line with the principles of integrity, as would notifyingthe board of directors.
Step 6: Consequences of each possible course of action
This step requires clear consideration of the consequences of eachcourse of action. The purpose of the model is to make the implicationsof each outcome unambiguous so that the final decision is made in fullknowledge and recognition of each one.
- Alternative (1): keeping silent would ensure that the shareholders remained pleased with the favourable trading results. However, Dirk may feel uncomfortable with this approach.
- Alternative (2): Notifying the board of directors may have adverse repercussions on Dirk's trading team colleagues and even his whole department. The board would then have to decide if they communicated this matter outside the company.
- Alternative (3): If Dirk chooses to talk to another manager with the organisation he may feel that he has passed on the burden of the decision with regards to this matter, hence easing his own concerns. However, it may be the case that this approach is not successful and no further action is taken.
Step 7: Decision
Finally, in the last step a decision can be taken based on weighing up the consequences with the values and ethical beliefs.
Alternatives (2) or (3) appear to be the ethical options. If nosolution can be found then advice should be sought from governing bodiesand even lawyers. In the end a decision simply must be reached or theDirk should distance himself from the situation by resigning.
Question 21: C company
(a) Triple bottom line
Triple bottom line (TBL) accounting means expanding the normalfinancial reporting framework of a company to include environmental andsocial performance. The concept is also explained using the triple 'P'headings of 'People, Planet and Profit'.
The people element of the TBL expands the concept of stakeholderinterests from simply shareholders (as in financial reporting) to othergroups including employees and the community where the company carriesout its business. Actions of the company are therefore considered inlight of the different groups, not simply from the point of view ofshareholders.
The C Company appears to be meeting this objective of the TBL forits own staff. The provision of flexible working hours, staffrestaurant and sports facilities all indicate a caring attitude towardsstaff.
However, the ability of C Company to take into account otherstakeholder interests is unclear. Specific areas where C is not meetingthe TBL include:
- Delaying payment for raw materials will adversely affect the cash flow of C's suppliers. Some discussion or negotiation of terms may have been helpful rather than simply amending terms without consultation.
- Moving the administration headquarters 'out-of-town' does not necessarily help the community. For example, there will be increased pollution as C's employees drive out to the administration building (note that there is no public transport). Also, while flexible working time is allowed, this may mean travel time has increased. This may place pressure on workers regarding collection of children on 'school runs' and mean more cars on the road increasing the risk of accidents. Provision of company buses out to the new headquarters would help decrease pollution but would not necessarily assist with the working hours issue.
- Finally, the proposal for the re-development of the old administration headquarters into a waste disposal centre is unlikely to benefit the community. There will be additional heavy lorries travelling through residential areas while the burning of rubbish provides the risk of fumes and smoke blowing over residential properties. Finding an alternative use, even if this was less profitable, would benefit the community overall.
The planet element of TBL refers to the environmental practicesof the company to determine whether they are sustainable or not. The TBLcompany attempts to reduce the 'ecological footprint' by managingresource consumption and energy usage. The company therefore attempts tolimit environmental damage.
It is not clear that the C company is meeting this section of the TBL. Specific areas of concern include the following.
- Lack of an energy audit. A review of energy consumption could identify areas for energy saving, even if this was only the use of low wattage light bulbs.
- The relocation of the administration office to a out-of-town district may enhance working conditions for staff, but it also means that public transport cannot be used to reach the offices. This increases fuel use as employees must use their own transport.
- Finally, the insistence of the chairman in holding all divisional review meetings in person rather than using newer technology such as video-conferencing means increased use of air travel and therefore carbon dioxide emissions.
Profit is the 'normal' bottom line measured in most businesses.As noted above, a non-TBL company will seek to maximise this measure toimprove shareholder return. A TBL company on the other hand will balancethe profit objective with the other two elements of the TBL.
At present, the C Company appears to be placing a lot ofimportance on the profit motive. Two specific decisions to increaseprofits are:
- delaying payment to creditors to provide additional cash within C and therefore decrease the need for bank overdrafts, which in turn decreases interest payments
- the proposal for the redevelopment of the old administration headquarters into a waste disposal site, which appears to be focused entirely on the amount of profit that can be made.
As noted above, involving creditors in the discussions andfinding alternative uses for the old administration site (even at alower profit) would show C's commitment to the TBL.
Sustainable development can be defined as development that meetsthe needs of the present without compromising the ability of futuregenerations to meet their own needs (World Commission on Environment andDevelopment 1987).
Sustainability is an attempt to provide the best outcomes for thehuman and natural environments both now and into the indefinite futurewith reference to the continuity of economic, social, institutional andenvironmental aspects of human society, as well as the non-humanenvironment.
The three perspectives of sustainability are economic, social and environmental.
The economic perspective recognises that the earth's resourcesare finite and so economic development must be limited. Sustainabilitymeans that the organisation must plan for long term growth and beneutral in its use of resources. There is no evidence that the C Companyhas considered this perspective apart from the fact it is profitmotivated and wants, therefore, to survive as a company.
The social perspective recognises that organisations have animpact on their communities and may also change the social mix of acommunity. By moving the administrative headquarters out of town, the CCompany has had an impact on the community â€“ in effect C is denyingjobs in its headquarters to those members of the community who do nothave access to private transport.
The environmental perspective recognises that organisations havean impact on the environment and that lack of environmental concernmeans an overall decrease in earth's resource base. The lack ofvideo-conferencing for example, means that C's executives use air travelun-necessarily, decreasing the amount of fossil fuels and increasingcarbon dioxide emissions.
Created at 5/24/2012 12:39 PM by System Account
(GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 5/25/2012 12:55 PM by System Account
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