A3. Ethical and governance issues

Question 1

Financial strategy and key stakeholder groups:

Answer 1

For financial strategy to be successful it needs to be communicated and supported by key stakeholder groups:
• Internal – managers, employees
• Connected - shareholders, banks, customers, suppliers
• External – government, pressure groups, local communities
Where a strategy creates a conflict between the interest of shareholders and those of other stakeholder groups then this can create ethical issues which need to be carefully managed.

Question 2

Ethical considerations in financial management (examples):

Answer 2

• Investment – fairness of wages, working conditions, impact on environment, bribery of officials
• Financing – bank with unethical profile, supressing bad news when finance is being raised
• Dividend – at the expense of product quality
• Risk management – neglect to hit profit targets, diversification then not in best interest.

Question 3

Ethics should and functional areas of the company

Answer 3

Ethics should govern the conduct of corporate policy in all functional areas of the company, such as a company’s treatment of its workers, suppliers and customers. The ethical stance of a company is concerned with the extent that an organisation will exceed its minimum obligations to its stakeholders.

Question 4

Examples of ethical issues in different business functions:

Answer 4

• Human resource management. Ethical problems arise when there is a conflict between the financial objectives of the firm and the rights of the employees:
o Minimum wage -if there are no minimum wage requirements, companies may take advantage and offer low wages. Business ethics would require that companies should not exploit workers.
o Discrimination – sexual orientation, race, gender, age – prohibited in most advanced economies through equal opportunity legislation.
• Marketing. Being one of the main ways of communication with customers, it should be truthful and sensitive to the social and cultural impact on society (no vulnerable groups, stereotypes or insecurity)
• Customers and suppliers. Companies should not take advantage of their dominant position in the market to exploit suppliers or customers.

Question 5

The 5 fundamental principles of the ACCA Code of Ethics

Answer 5

The 5 fundamental principles of the ACCA Code of Ethics must be followed:
• Integrity – Members shall be ‘straightforward and honest in all professional and business relationships. Integrity implies not merely honesty, but fair dealing and truthfulness.
• Objectivity – Members shall not allow bias, conflicts of interest or the undue influence of others to compromise their professional or business judgement.
• Professional competence and due care – Members have a continuing duty ‘to maintain professional knowledge and skill at a level required to ensure that clients or employers receive competent professional service’. Members shall ‘act diligently in accordance with applicable technical and professional standards when providing professional services’.
• Confidentiality – Members shall respect the confidentiality of information ‘acquired as a result of professional and business relationships’ and shall not disclose any such information to third parties ‘without proper and specific authority or unless there is a legal or professional right or duty to disclose’. Similarly, confidential information acquired as a result of professional and business relationships shall not be used to the personal advantage of members or third parties.
• Professional behaviour – Members shall comply with relevant laws and regulations and shall avoid any action that may discredit the profession.

Question 6

Ethical issues often arise from a conflict between the needs of different stakeholder groups. Examples:

Answer 6

• Directors and shareholders. Directors may be more risk averse, than shareholders, because greater proportion of their income and wealth is tied up in the company that employs them, whereas shareholders will hold a diversified portfolio of shares (agency theory).
• Between different shareholder groups. Some might have preference for short-term dividends, others for long-term capital gain (requiring more cash to be reinvested, and less to be paid as dividend)
• Between shareholders and debt holders. Debt holders may be more risk averse than shareholders, because it is only shareholders who will benefit if risky projects succeed.
• Shareholders and staff/customers/suppliers. Pursuit of short-term profits may lead to difficult relationships with other stakeholders (changes in terms, redundancies).
• Shareholders and external stakeholders. The impact of a company’s activities may impact adversely on its environment.

Question 7

The ACCA has developed a five-step framework to help you make ethical decisions.

Answer 7

These are:
• Step 1 - Establishing the issues. A business needs to be aware of the ethical issues that it faces.
• Step 2 - Are there threats to compliance with fundamental principles? A company’s fundamental ethical principles need to be clearly understood.
• Step 3 - Are the threats significant? If an employee is unsure about this, they should use the mirror test. If felt to be significant, it needs to be reported to the ethics department to deal with it.
• Step 4 - Are there safeguards to reduce threats to an acceptable level? Safeguards in place in the work environment such as policies and procedures to monitor the quality of work, or to encourage communication of ethical concerns.
• Step 5 – Can you face yourself in the mirror? Sometimes called the mirror test. Whether or not you choose to perform the action, it’s useful to look in the mirror and ask yourself:
o Is it legal?
o What will others think? – How would you feel explaining what you did to a friend, a parent, a spouse, a child, a manager, or the media?
o Is it right? – What does your conscience or your instinct tell you?

Question 8

Framework for developing ethical policies

Answer 8

Framework for developing ethical policies
• Establish stakeholder concerns:
o Assess impact of activities (eg investment) on stakeholders and ensure that solutions are researched to try to meet their needs where possible.
o Ethical concerns should then be reported to an ethics committee to ensure that the Board is aware and can take action
• Ensure that the company’s fundamental ethical principles are understood by everyone
o Issue code of conduct outlining key ethical values
o Shows commitment from senior management
o Provides guidance for staff
• Introduce safeguards to reduce threats to an acceptable level
o Policies and procedures
o Executive bonus scheme to include ethical measures?
o Greater powers to the risk management function
o Whistle-blowers hotline

Question 9

Agency relationships

Answer 9

Agency relationships occur when one party, the principal, employs another party, the agent, to perform a task on their behalf. In the case of corporate governance, the principal is a shareholder and the agents are the directors. The directors are accountable to the principals. For example, managers can be seen as the agents of shareholders, employees as the agents of managers, managers and shareholders as the agents of long and short-term creditors, etc. The problem lies in the fact that once the agent has been appointed, he is able to act in his own selfish interests rather than pursuing the objectives of the principal.

Question 10

Agency Costs.

Answer 10

• A cost to the shareholder through having to monitor the directors
• Over and above normal analysis costs
• A result of comprised trust in directors

Question 11

The goal of agency theory

Answer 11

The goal of agency theory is to find governance structures and control mechanisms (incentives) that minimise the problem caused by the separation of ownership and control.

Question 12

Goal congruence

Answer 12

Goal congruence is accordance between the objectives of agents acting within an organization and the objectives of the organisation as a whole. It may be better achieved and the ‘agency problem ‘better dealt with by giving managers some profit-related pay, or providing incentives which are related to profits or share price, such as:
• Profit-related/economic value-added pay – bonus or pay related to size of profits or EVA
• Rewarding managers with shares – this might be done when private company goes public and managers are invited to subscribe to shares at attractive offer price.
• Executive share option plans – selected employees are given a number of shae options, each of which gives the holder the right after a certain date to subscribe for shares in the company at fixed price. The value of option will increase if the companu is successful and share price goes up.

Question 13

Transaction cost theory.

Answer 13

Transaction costs occur when dealing with another party.
• Search and information costs: to find the supplier.
• Bargaining and decision costs: to purchase the component.
• Policing and enforcement costs: to monitor quality

If items are made within the company itself, therefore, there are no transaction costs. Company will try to keep as many transactions as possible in-house in order to:
• Reduce uncertainties about dealing with suppliers
• Avoid high purchase prices
• Manage quality

Question 14

Analysing transaction costs can be difficult because of:

Answer 14

• Bounded rationality: our limited capacity to understand business situations, which limits the factors we consider in the decision.
• Opportunism: actions taken in an individual’s best interests, which can create uncertainty in dealings and mistrust between parties.

Question 15

The 3 factors to take into account as to whether the transaction costs are worthwhile are:

Answer 15

• Uncertainty. Do we trust the other party enough? The more certain we are, the lower the transaction / agency cost.
• Frequency. How often will this be needed? The less often, the lower the transaction/agency cost.
• Asset specificity. How unique is the item? The more unique the item, the more worthwhile the transaction / agency cost is.

Question 16

The 3 factors to take into account as to whether the transaction costs are worthwhile are(applied to agency theory).

Answer 16

This can be applied to directors who may take decisions in their own interests:
• Uncertainty - Will they get away with it?
• Frequency - how often will they try it?
• Asset specificity - How much is to gain?

Question 17

UK corporate governance.

Answer 17

In the UK there are 3 main reports recommending best practice in Corporate Governance:
• The Cadbury report
• The Greenbury report
• Hampel report

Question 18

The corporate reports recommend:

Answer 18

• Separate MD (chief executive) & chairman
• Minimum 50% non-executive directors (NEDs)
• Independent chairperson
• Maximum one-year notice period
• Independent NEDs (three-year contract, no share options)
• Executive remuneration should be subject to the recommendations of a remuneration committee (entirely or mainly NEDs).
• An Audit committee to review financial statements, comprising of at least 3 NEDs.
• Governance should be viewed as an opportunity to enhance long term shareholder value.
• The Board is responsible for maintaining a sound system of internal control.

Question 19

US corporate governance.

Answer 19

In the US, statutory requirements for publicly-traded companies are set out in the Sarbanes-Oxley Act. These requirements include:
• The certification of published financial statements by the CEO and the chief financial officer (CFO)
• Faster public disclosures by companies
• Legal protection for whistle-blowers
• A requirement for an annual report on internal controls
• Requirements relating to the audit committee, auditor conduct and avoiding ‘improper’ influence of auditors.
The Act also requires the Securities and Exchange Commission (SEC) and the main stock exchanges to introduce further rules relating to matters such as the disclosure of critical accounting policies, the composition of the Board and the number of independent directors.

Question 20

European corporate governance.

Answer 20

In Europe most large companies are not listed on a Stock Market and are often dominated by a single shareholder with more than 25% of the shares (often a corporate investor or the founding family). Banks are powerful shareholders and generally have a seat on the boards of large companies. A major difference that exists in the board structure for companies is that the UK has a unitary board (consisting of both executive and non-executive directors). It is common in Europe to have a two-tier board structure consisting of a supervisory board (elected by shareholders normally) and an executive board.
The Supervisory Board does not have full access to financial information, is meant to take an unbiased overview of the company and is the main body responsible for safeguarding the external stakeholders’ interests. The presence on the Supervisory Board of representatives from banks and employees (trade unions) may introduce perspectives that are not present in some UK boards. In particular, many members of the Supervisory Board would not meet the criteria under UK Corporate Governance Code for their independence.

Question 21

Social and environmental issues in the conduct of business and of ethical behaviour.

Answer 21

Economic activity is only sustainable where its impact on society and the environment is also sustainable. Sustainability can be measured empirically or subjectively.

Question 22

Environmental Footprint

Answer 22

• Measures a company’s resource consumption of inputs such as energy, feedstock, water, land use, etc.
• Measures any harm to the environment brought about by pollution emissions.
• Measures resource consumption and pollution emissions in either qualitative, quantitative or replacement terms.
Together, these comprise the organisation’s environmental footprint. A target may be set to reduce the footprint and a variance shown. Not all do this and so this makes voluntary adoption controversial.

Question 23

Sustainable development.

Answer 23

The development that meets the needs of the present without compromising the ability of future generations to meet their own needs. Energy, land use, natural resources and waste emissions etc should be consumed at the same rate they can be renewed. Sustainability affects every level of organisation, from the local neighbourhood to the entire planet. It is the long term maintenance of systems according to environmental, economic and social considerations.

Question 24

Full cost accounting.

Answer 24

This means calculating the total cost of company activities, including environmental, economic and social costs.

Question 25

TBL (Triple bottom line) accounting.

Answer 25

The triple bottom approach to reporting on corporate social responsibility involves the consideration of social, economic and environmental factors. The concept is also explained using the triple ‘P’ headings of ‘People, Planet and Profit’. The principle of TBL reporting is that true performance should be measured in terms of a balance between economic (profits), environmental (planet) and social (people) factors; with no one factor growing at the expense of the others.

Question 26

Advantages of TBL

Answer 26

• Better risk management and higher ethical standards through:
o Identifying stakeholder concerns
o Employee involvement
o Good governance 
o Performance monitoring
• Improved decision making through
o Stakeholder consultation
o Better information gathering
o Better reporting process
• Attracting and retaining higher calibre employees through practicing sustainability and ethical values

Question 27

TBL measures:

Answer 27

• Economic impact – gross operating surplus, dependence on imports, stimulus to the domestic economy by purchasing local goods
• Social impact – tax contributions, employment
• Environmental impact – pollution, water and energy use
The contention is that a corporation that accommodates the pressures of all the three factors in its strategic investment decisions will enhance shareholder value, as long as the benefits that accrue from producing such a report exceeds the costs of producing it.

Question 28

The aim of integrated reporting

Answer 28

The aim of integrated reporting is to explain how an organisation creates value over time and the nature and quality of an organisation’s relationships with its stakeholders. Integrated reporting will involve reporting on sustainability/environmental issues, and this may help to enhance the importance with which these issues are treated. Integrated reporting is designed to make visible the capitals (resources and relationships used and affected by the organization) on which the organization depends, and how the organization uses those capitals to create value in the short, medium and long term.

Question 29

IR capitals

Answer 29

The capitals.
• Financial capital –funds available to an entity, obtained through financing or generated through operations
• Manufactured capital – the equipment and tools used in an entity’s production process. Manufactured capital is man-made and does not include natural resources.
• Intellectual capital – intangibles providing competitive advantage (patents, copyrights etc)
• Human capital – refers to an entity’s management and its employees and the skills they have developed through education, training and experience
• Social and relationship capital – refers to the relationships in place within an entity and between and entity and its external stakeholders such as suppliers, customers, governments and the community in which the entity operates.
• Natural capital - all renewable and non-renewable environmental resources and processes

Question 30

IR Guiding principles.

Answer 30

Guiding principles. Provides the foundations for what an integrated report should be focused on:
• Strategic focus and future orientation. An integrated report should provide insight into the organization’s overall strategy and plans for the future.
• Connectivity of information. The capitals are interrelated (increase in one = decrease in another). An integrated report should show a holistic picture of the combination, interrelatedness and dependencies between the factors that affect the organization’s ability to create value over time.
• Stakeholder relationships. An integrated report should provide insight into the nature and quality of the organization’s relationships with its key stakeholders and how and to what extent the organisation understands, takes into account and responds to their legitimate needs and interests.
• Materiality. The IR framework provides guidance for organisations as to how to determine materiality in terms of the purpose and scope of the report and its intended audience. Integrated report should disclose information about matters that substantively affect the organization’s ability to create value.
• Conciseness. An integrated report should include sufficient context to understand the organization’s strategy, governance, performance and prospects without being burdened with less relevant information
• Reliability and completeness. An integrated report should give a balanced view of the entity and should not report only positive matters. It should include all material matters, both positive and negative, without material error.
• Consistency and comparability. Information should be presented in an integrated report on a basis that is consistent over time and in a way that enables comparison with other organizations to the extent it is material to the organization’s own ability to create value over time.

Question 31

Content elements of integrated reports.

Answer 31

• Organisational overview and external environment. What does the organisation do and what are the circumstances under which it operates?
• Governance. How does an organisation’s governance structure support its ability to create value in the short, medium and long term?
• Business model. What is the organisation’s business model?
• Risks and opportunities. What are the specific risk and opportunities that affect the organisation’s ability to create value over the short, medium and long term, and how is the organisation dealing with them?
• Strategy and resource allocation. Where does the organisation want to go and how does it intend to get there?
• Performance. To what extent has the organisation achieved its strategic objectives for the period and what are its outcomes in terms of effects on the capitals?
• Outlook. What challenges and uncertainties is the organisation likely to encounter in pursuing its strategy, and what are the potential implications for its business model and future performance?

Question 32

IR Communicating with stakeholders.

Answer 32

Integrated reporting aims to emphasize the importance of value creation, with the aim of producing guidance that will assist investor’s decision. It provides a higher quality information for investors, which should enable them to make more informed decision and ensure a better allocation of capital across the whole economy, towards sustainable businesses that focus on longer-term value creation within natural limits and the expectations of society. Above all, integrated reporting should promote engagement with stakeholders that goes beyond the provision of information. It should encourage businesses to focus on enhancing the mechanisms for stakeholder feedback, which may identify issues that have not been considered as important previously, but are concerns that should have an impact on strategy.