Practice question and answer bank p1

Bonus schemes                                                             49 mins

It has been suggested that optimal bonus schemes for profit centre managers promise significant rewards for the achievement of challenging targets in areas they can influence. These schemes balance short-term pressure with incentives to maintain a long-term focus and protect managers from the distorting effects of uncontrollable factors.

It has also been suggested that many bonus schemes have additional features with different motivational effects.

The following are possible features of bonus schemes.

  • Limiting the range of performance within which rewards are linked to results, in particular ignoring losses and limiting maximum payments
  • Linking incentive payments wholly or partly to the profit of the organisation as a whole Required
  • (i) Explain why bonus schemes might include these features.

(ii)         Discuss the benefits and drawbacks of incorporating these features into bonus schemes.

(16 marks)

Bonus schemes are normally designed to motivate full-time employees who have no other employment and are wholly dependent on the organisation for their income. Part-time employees and short-term employees might not be included.

  • Describe and advise on the possible features of bonus schemes which are designed to motivate non-executive directors who are part time, remunerated by fees under contracts for a fixed number of years and required by corporate governance codes to maintain independence. (9 marks)

(Total = 25 marks) 2 Cedric Coffee      49 mins

Cedric Coffee is a company that operates a chain of coffee shops. It is based in Europe and has been expanding over the last few years. Its managing director considers it to have reached its maximum growth potential in its own country and should expand into other European countries. It will need substantial finance to do this and is planning to obtain a listing on its local stock exchange.

The country in which Cedric Coffee is based is not part of the European Union and has not developed its own governance code. International investors who invest on the local stock exchange and whom the board of Cedric Coffee is hoping to attract tend to favour companies who follow national guidance from major countries such as Sarbanes-Oxley, or international codes such as the Organisation for Economic Cooperation and Development principles of corporate governance and the International Corporate Governance Network report on corporate governance. Cedric Coffee’s managing director wants to have a greater understanding of the reasons that have led to the development of the corporate governance codes and wants to see comparisons between different international guidance.

The managing director also believes that Cedric Coffee’s competitive position may be enhanced by adopting a corporate social responsibility code.

Required 

Prepare a memorandum for the managing director of Cedric Coffee that:

  • Discusses the main issues that led to the development of international corporate governance

codes.                                                                                                                        (7 marks)

  • Contrasts the requirements of the Sarbanes-Oxley legislation with the Organisation for Economic Co-operation and Development principles of corporate governance and the International Corporate

Governance Network report on corporate governance.                                      (13 marks)

  • Discusses the case for Cedric Coffee developing a corporate social responsibility policy. (5 marks)

                                                                                                                               (Total = 25 marks)

 

3 Peter Postgate                                                           49 mins

You have recently received a phone call from an uncle of a friend of yours, Peter Postgate. He is the managing director of a manufacturing firm that has been expanding over the last few years. Its success has been noticed in the press, and as a result he has been asked to become a non-executive director of a listed company based near to his own company’s headquarters.

Peter Postgate’s company does not have any non-executive directors on its board and he is somewhat uncertain about their role. In particular he has been told that the distinction between independent and nonindependent non-executive directors is important, but does not understand what it means and why it is significant. He recalls reading somewhere in a newspaper that non-executive directors are meant to ‘keep the peace’ between the executive directors and the shareholders. He doesn’t understand why there should be a conflict and is worried about what he’ll have to do.

Peter Postgate has also been asked whether he wants to be paid partly in shares or share options, in line with the way executive directors are paid in the listed company.

Required

Write a letter to Peter Postgate:

  • Explaining the distinction between independent and non-independent non-executive directors.

(5 marks)

  • Assessing the main areas for a potential conflict of interest between the shareholders of a listed company and its executive directors, and explaining how the use of non-executive directors should help to deal with this problem.            (13 marks)
  • Discussing the issues connected with paying NEDs in shares or share options of the company.

(7 marks)

(Total = 25 marks) 4 PKG High School         49 mins

PKG High School has 900 pupils, 40 teachers, 10 support staff and a budget of $3 million per annum, 85% of which represents salary and salary-related costs. PKG’s local authority allocates government funding for education to schools based on the number of pupils. It ensures that the government-approved curriculum is taught in all schools in its area with the aim of achieving government targets. All schools, including PKG, are subject to an independent financial audit as well as a scrutiny of their education provision by the local authority, and reports of both are presented to the school governing body.

The number of pupils determines the approximate number of teachers, based on class sizes of approximately 30 pupils. The salary costs for teachers are determined nationally and pay scales mean that more experienced teachers receive higher salaries. In addition, some teachers receive school-specific responsibility allowances.

PKG is managed on a day-to-day basis by the headteacher. The governance of each school is carried out by a governing body comprising the headteacher, elected representatives of parents of pupils, and members appointed by the local authority. The principles of good corporate governance apply to school governing bodies which are accountable to parents and the local authority for the performance of the school.

The governing body holds the headteacher accountable for day-to-day school management, but on certain matters such as building maintenance the headteacher will seek expert advice from the local authority.

The governing body meets quarterly and has as its main responsibilities budgetary management, appointment of staff and education standards. The main control mechanisms exercised by the governing body include scrutiny of a year-to-date financial report, a quarterly non-financial performance report, teacher recruitment and approval of all purchases over $1,000. The headteacher has expenditure authority below this level.

The financial report (which is updated monthly) is presented to each meeting of the governing body. It shows the local authority’s budget allocation to the school for the year, the expenditure incurred for each month and the year to date, and any unspent balances. Although there is no external financial reporting requirement for the school, the local authority will not allow any school to overspend its budget allocation in any financial year.

PKG’s budget allocation is only just sufficient to provide adequate educational facilities. Additional funds are always required for teaching resources, building maintenance, and to upgrade computer equipment. The only flexibility the school has in budget management is to limit responsibility allowances and delay teacher recruitment. This increases pupil-contact time for individual teachers, however, and forces teachers to undertake preparation, marking and administration after school hours.

Note. A local authority (or council) carries out services for the local community and levies local taxes (or council tax) to fund most of its operations.

Required

  • Explain why the review and audit of control systems is important for the governing body of a

school such as PKG.                                                                                                                (5 marks)

  • Evaluate the effectiveness of the governing body’s control over PKG High School and recommend

ways in which it might be improved.                                                                                   (20 marks)

               (Total = 25 marks) 5 Widmerpool        49 mins

You are a partner in an accountancy practice. One of your clients, Widmerpool, has expanded significantly over the last few years and is likely to seek a listing in a couple of years’ time. You have been contacted by the Chief Executive, Mr Kenneth, for advice on areas relating to the control and risk management systems.

Up until recently, the main board has dealt with all significant issues relating to the company. In view of the current plans to seek a listing, Widmerpool has recently appointed three non-executive directors, and has used them to staff the audit committee that has just been established. Mr Kenneth is also wondering whether to set up a separate risk committee. Ideally he would like the audit committee’s brief to be restricted to the accounting systems. There have recently been various incidents that appear to indicate problems with the ways Widmerpool’s employees deal with risk.

In one incident a worker was trapped in a machine. A fellow worker tried to help and both were seriously injured. A subsequent investigation found that safety instructions appeared to be adequate and there was sufficient safety equipment available. However, staff had not been using the right equipment, appeared ignorant of safety issues and seemed unwilling or unable to comply with instructions.

In another instance one of Widmerpool’s most significant suppliers, Stringham, with whom Widmerpool has been trying to develop much closer relations, supplied Widmerpool with confidential information concerning its operations. Two of Widmerpool’s managers discussed these details in a local restaurant, but left the documentation relating to Stringham behind when they left the restaurant. Another customer removed this information and offered to sell it to one of Stringham’s main competitors. The competitor declined the offer, and reported the situation to the police and Stringham. As a result Stringham has decided to terminate its relationship with Widmerpool. Widmerpool’s organisational handbook stresses the need to keep sensitive business information confidential, but does not provide detailed guidance.

Widmerpool recently carried out a staff satisfaction survey. One of the comments made was that as the company has grown bigger, the board has become more distant from operations and seems primarily concerned with ensuring that profits increase each year. As a result, staff have become laxer in following internal procedures, as they believe that they are being judged solely on whether their department fulfils its financial targets.

Required

  • Explain why Widmerpool’s internal guidance and control procedures have failed to ensure that

Widmerpool’s employees deal carefully with business risks.                                              (8 marks)

  • Explain the ways in which the board of directors can, by their own example, promote a better risk

culture than has recently been apparent at Widmerpool.                                                    (8 marks)

  • Evaluate the case for Widmerpool establishing a separate risk committee, staffed by non-executive directors.              (9 marks)              (Total = 25 marks)

6 Pacific Group                                                              39 mins

Pacific Group Ltd (PG) is a publisher of a monthly magazine ‘Sea Discovery’. Approximately 70% of the magazine’s revenue is derived from advertising, the remainder being subscription income.

Individual advertisements, which may be quarter, half or whole page, are priced at £750, £1,250 and £2,000 respectively. Discounts of 10% to 25% are given for repeat advertisements and to major advertising customers.

PG’s management has identified the following risks relating to its advertising revenues.

  • Loss of revenue through failure to invest in developments which keep the presentation of advertisements up to date with competitor publications (such as ‘The Deep’).
  • Due to unsuitable credit limits being set, business is accepted from a small proportion of advertising customers who are uncreditworthy.
  • Published advertisements may not be invoiced due to incomplete data transfer between the editorial and invoicing departments.
  • Individual advertisements are not charged for at approved rates – either in error or due to arrangements with the advertisers. In particular, the editorial department does not notify the invoicing department of reciprocal advertisement arrangements, whereby advertising customers provide PG with other forms of advertising (such as website banners).
  • Individual advertisers refuse to pay for the inaccurate production of their advertisement.
  • Cash received at a front desk, which is significant, may not be passed to cashiers, or be misappropriated.
  • The risk of error arising from unauthorised access to the editorial and invoicing systems.
  • The risk that the editorial and invoicing systems are not available.
  • The computerised transfer of accounting information from the invoicing system to the nominal ledger may be incomplete or inaccurate.
  • The risk that PG may be sued for advertisements which do not meet the British Standards Authority’s ‘Code of Advertising’.

Risks are to be screened out as ‘non-applicable’ if they meet any of the following criteria.

  • The effect of the risk can be quantified and is less than £5,000.
  • The risk is mitigated by an effective risk strategy eg insurance.
  • The risk is likely to be low or its effect insignificant.

Those risks not screened out, called ‘applicable risks’, will require further consideration and are to be actively managed.

Required

For each of the above risks identified by management, evaluate, with a reason, whether it should be

considered an ‘applicable risk’.                                                                                                       (20 marks)

7 Azure Airline                                                              49 mins

Azure, a limited liability company, was incorporated in Sepiana on 1 April 20X6. In May, the company exercised an exclusive right granted by the government of Pewta to provide twice weekly direct flights between Lyme, the capital of Pewta, and Darke, the capital of Sepiana. The introduction of this service has been well advertised as ‘efficient and timely’ in national newspapers. The journey time between Sepiana and Pewta is expected to be significantly reduced, so encouraging tourism and business development opportunities in Sepiana.

Azure operates a refurbished 35 year old aircraft which is leased from an international airline and registered with the Pewtan Aviation Administration (the PAA). The PAA requires that engines be overhauled every two years, putting the aircraft out of commission for several weeks.

The aircraft is configured to carry 15 first class, 50 business class and 76 economy class passengers. The aircraft has a generous hold capacity for Sepiana’s numerous horticultural products (eg of cocoa, tea and fruit) and general cargo.

The six-hour journey offers an in-flight movie, a meal, hot and cold drinks and tax-free shopping. All meals are prepared in Lyme under a contract with an airport catering company. Passengers are invited to complete a ‘satisfaction’ questionnaire which is included with the in-flight entertainment and shopping guide. Responses received show that passengers are generally least satisfied with the quality of the food – especially on the Darke to Lyme flight.

Azure employs ten full-time cabin crew attendants who are trained in air stewardship including passenger safety in the event of accident and illness. Flight personnel (the captain and co-pilots) are provided under a contract with the international airline from which the aircraft is leased. At the end of each flight the captain completes a timesheet detailing the crew and actual flight time.

Ticket sales are made by Azure and travel agents in Sepiana and Pewta. On a number of occasions Economy seating has been overbooked. Customers who have been affected by this have been accommodated in business class, as there is much less demand for this, and even less for first class. Ticket prices for each class depend on many factors, for example, whether the tickets are refundable/nonrefundable, exchangeable/non-exchangeable, single or return, midweek or weekend.

Azure’s insurance cover includes passenger liability, freight/baggage and compensation insurance. Premiums for passenger liability insurance are determined on the basis of passenger miles flown.

Required

  • Explain the business risks facing Azure. (12 marks)
  • Recommend how the risks identified in (a) could be managed and maintained at an acceptable level by Azure. (13 marks)

Note. You should assume it is 5 December 20X6.                                                            (Total = 25 marks)

8 LMN                                                                             49 mins

LMN is a charity that provides low-cost housing for people on low incomes. The Government has privatised much of the home building, maintenance and management in this sector. The sector is heavily regulated and receives some government money but there are significant funds borrowed from banks to invest in new housing developments, on the security of future rent receipts. Government agencies subsidise much of the rental cost for low-income residents.

The board and senior management have identified the major risks to LMN as: having insufficient housing stock of a suitable type to meet the needs of local people on low incomes; making poor property investment decisions; having dissatisfied tenants due to inadequate property maintenance; failing to comply with the requirements of the regulator; having a poor credit rating with lenders; poor cost control; incurring bad debts for rental; and having vacant properties that are not earning income. LMN has produced a risk register as part of its risk management process. For each of more than 200 individual risks, the risk register identifies a description of the risk and the (high, medium or low) likelihood of the risk eventuating and the (high, medium or low) consequences for the organisation if the risk does eventuate.

The management of LMN is carried out by professionally qualified housing executives with wide experience in property development, housing management and maintenance, and financial management. The board of LMN is composed of volunteers with wide experience and an interest in social welfare. The board is representative of the community, tenants and the local authority, any of whom may be shareholders (shareholdings are nominal and the company pays no dividends). The local authority has overall responsibility for housing and social welfare in the area. The audit committee of the board of LMN, which has responsibility for risk management as well as internal control, wants to move towards a system of internal controls that are more closely related to risks identified in the risk register.

Required

For an organisation like LMN:

  • Discuss the purposes and importance of risk management and its relationship with the internal

control system.                                                                                                                        (8 marks)

  • Explain the importance of a management review of controls for the audit committee. (5 marks) (c) Discuss the principles of good corporate governance as they apply to the Board’s role:
    • In conducting a review of internal controls; and
    • Reporting on compliance. (12 marks)

Illustrate your answer with examples from the scenario.

(Total = 25 marks) 9 Pogles 49 mins

Pogles is a clothing manufacturer, based in an EU member state, with an international market for its designs. The company’s regular monthly board meeting will take place in a couple of days’ time. It seems likely that most of the meeting will be taken up with discussing two issues. 

Factory closure

The chief executive of Pogles has received an offer from a property developer for one of its factories in its home country. The proposal is to buy the freehold and to demolish the factory to build office units. The developer is offering €3 million for the site which presently employs 150 staff. The developer wishes to exchange contracts as soon as possible, but would not take possession of the site for another year. The chief executive believes that accepting the offer makes strategic and financial sense for Pogles. The developer is quite happy for the offer to be made public once contracts have been exchanged.

It will be possible to relocate all but one of the current manufacturing contracts currently being undertaken by this factory to Pogles’ remaining factories in other countries over time, without undue delay. However, the one exception is by far the largest contract Pogles currently has. The customer has imposed tight time limits on this contract and will terminate it if its requirements are not met. Production on this contract must continue uninterrupted for the next six months at this factory if the customer’s requirements are to be met.

The policy of Pogles is to offer either jobs elsewhere in the group or redundancy packages of 30% of current salary to staff who are affected by a factory closure. The redundancy packages are rather more generous than the statutory minimum in Pogles’ home country. However, only 20% of staff, mostly at managerial level, are likely to receive offers to transfer to other parts of the group. There are no similar jobs available locally.

The chief executive is concerned that rumours may possibly soon start circulating about the offer and staff may start demanding assurances from management that their jobs are safe. The chief executive fears that if staff knew or feared that the factory will close, there would be a fall-off in output and quality, and possibly industrial action. These would seriously jeopardise Pogles’ ability to fulfil the large contract.

Treatment of staff  

One of the company’s directors has recently returned from visiting a factory located in another European Union member state. Over the last few years this factory has performed better than any other in comparison with cost budgets, and has been particularly good at keeping its labour costs under control. However, on his return from his visit, the director reported some worrying facts to the chief executive.

The factory had suffered a significant number of losses of experienced part-time female staff. Although none had been dismissed, other employees still working at the factory made serious accusations that some had been ‘forced’ to resign by the actions of the factory manager. Among other accusations, it was suggested that they had been pressurised to take on work outside their contractual hours, or at times when they had never in the past had to work, such as during school holidays, weekends or on late shifts.

Some had taken on the extra work in fear of losing their jobs and in the knowledge that other clothing factories locally had closed down in recent months. However, many of the other staff had found the new working arrangements impossible to fit in with their domestic situations and had reluctantly handed in their notice. To replace the staff who had left, the factory manager recruited full-time staff on flexible contracts, which required them to accept shift changes provided two weeks’ notice was given to them.

Required

  • Analyse whether to disclose the decision to close the factory to the staff working in the factory,

using the American Accounting Association ethics model.                                                (15 marks)

  • Analyse whether the factory manager’s treatment of his staff is ethical using Tucker’s 5 question

criteria.     (10 marks)            (Total = 25 marks)

10 Zos                                                                             39 mins

Zos is a chain of coffee shops that operates 75 shops in its home country. A number of ethical problems have recently arisen at Zos, and an emergency meeting of its board has been convened to discuss their implications.

Thefts from stores 

Three employees in one shop have been dismissed for thefts of both produce and cash. These thefts were only identified because one of the employees was foolish enough to steal, and then sell, the bags of coffee beans on the premises of the Zos coffee shop in which they worked.  A customer reported the incident to the chief executive of Zos and an investigation of the shop revealed that two other employees had also been involved in the theft.

Drug dealing

One of the coffee shop managers was reported by a customer, and subsequently arrested, for selling illegal Class A substances in their Zos coffee shop and allowing drugs to be taken on the site. Police investigations showed that this had been taking place for at least ten months.

Fair trade 

A routine advertising campaign promoting Zos stated, ‘Zos is aiming to have all its coffee supplied by Fair Trade suppliers. However, a former Zos Head Office employee recently stated in the national press that only around 60% of Zos coffee was procured from Fair Trade suppliers. An investigation revealed that the figure was in fact around 80% but the percentage bought from Fair Trade suppliers had fallen by 5% over the past year.

Zos’s Chief Executive is very concerned about all these issues. They feel that they demonstrate that Zos has a poor ethical culture and could seriously damage the company’s reputation. They wish to introduce measures to improve Zos’s ethical culture and to use the company’s recently appointed internal auditors to ensure that the measures are effective.

Required 

  • Recommend the control mechanisms that should be implemented to reduce the problems

associated with the ethical risks.                                                                                         (12 marks)  

  • Discuss the extent of the responsibilities of internal audit for ensuring that the ethical problems do not recur.        (8 marks)

                                                                                                                                              (Total = 20 marks)

 

11 Loxwood                                                                   49 mins

You are the chief internal auditor of Loxwood, a company that manufactures pleasure boats. The board is currently considering improving the company’s corporate responsibility profile, particularly in relation to environmental issues. You have been asked to conduct an environmental audit to this end. You have also been asked for your views on a new idea that Loxwood’s development department has been considering. The directors are keen for you to indicate the range of opinions that they may need to consider in deciding whether to market this idea.

New idea

Recently the incidence of sea lion collisions with pleasure boats has been increasing off the local coast. Loxwood’s development department has recently come up with the idea of a sonic sea lion repellent, a sonic device emitting a sound frequency that would be extremely distressing for sea lions. In theory this sound would be sufficient to keep the sea lions at a safe distance from the boat.

Required

  • Explain how you would test for employee awareness, and how you would involve all employees in

the initiative.                                                                                                                            (6 marks)

  • Discuss the reasons why companies wish to disclose environmental information in their financial statements. Discuss whether the content of such disclosure should be at the company’s discretion.

(10 marks)

  • Compare and contrast Gray, Owen and Adams’ ‘expedient’, ‘social contractarian’ and ‘deep ecologist’ positions and explain how these positions could determine attitudes to the development

of the sonic sea lion repellent.                                                                                               (9 marks)

(Total = 25 marks)

 

 

1 Bonus schemes

Top tips. The biggest dangers in (a) are failing to read the question carefully and the temptation to overrun on the time allowed for the solution, given the marks available. Bonus schemes are a recurring feature of this exam and most candidates should be able to write about them both from theoretical and personal knowledge without too much difficulty.

(b) requires much more thought – think about the key issue of independence for NEDs. As long as the features you suggest do not compromise independence or suggest awarding too generous bonuses you will be earning marks.

(a)      Limiting the range of performance within which rewards are linked to results

Many schemes do indeed limit the range of performance within which rewards are linked to results, in particular ignoring losses and limiting maximum payments.

Ignoring losses

Unless the organisation in question was operating in an extremely stable and predictable environment, it would be unacceptable to the vast majority of managers to be asked to participate in a remuneration system that might require them to reimburse their employer in the event of losses being incurred. In general, managers want to receive their standard salary. They do not want the threat of some of it being taken away if their organisation reports losses. If the organisation were to impose penalties for poor performance, managers may well manipulate their targets to ensure that they did not suffer financiallyBenefits and drawbacks of ignoring losses

If losses are excluded from the range of performance, full participation in the scheme is likely as no financial penalty (or negative bonus) can be imposed on a manager if levels of performance are particularly poor. Salaries will be viewed as fair payment for duties performed, with any bonus being regarded as a genuine reward for effort.

Managers may take unnecessary risks, however, as they are under no financial risk themselves, and poor levels of performance may be deliberately further depressed to ensure easier future targets.

Capping maximum payments

Reasons for capping maximum payments include a desire by risk-averse managers to limit the organisation’s maximum liability and the prevention of payments which shareholders might regard as excessive.

Benefits and drawbacks of capping maximum payments

Capping maximum payments should ensure that managers concentrate on improvements which will be sustainable year on year. The financial incentive provided should be large enough to motivate without being excessive.

Managers might feel no incentive to improve performance beyond the cut-off level, however, and they could be forced into holding back for future periods profit-generating or cost-cutting strategies and ideas once the maximum limit has been reached. A limit on maximum payments could also cause managers to feel disempowered, the message being sent out by the bonus system indicating that no matter how good their performance, the most they would receive is £X.

Linking incentive payments to the profits of the organisation as a whole

This is a popular feature in many bonus schemes for a number of reasons.

  • Profit is a widely understood measure, and the maximisation of organisational profit is generally accepted to be congruent with the goals of shareholders.
  • As profit reporting forms part of most organisations’ standard reporting procedures, little additional work is required for profit to be used as the standard measure of performance (compared with more elaborate performance reward mechanisms which can generate substantial data collection costs).
  • It also provides a basis for participation in bonus schemes by service centre staff such as those of internal audit and IT departments, for whom the use of other measures can be much more problematic.
  • The profit reported by many profit centres will be significantly affected by head office policies on, for example, salary levels or stock valuation, and so overall organisational profit may be more objective.
  • Rather than arguing over scarce resources, the use of organisational profit may persuade profit centre managers to work together to further the aims of the organisation as a whole.
  • As agents of the organisation’s shareholders, managers’ rewards should be closely linked to the rewards of shareholders.

Benefits of linking payments to organisational profits

  • Inter-profit centre/-divisional conflicts should be minimised, with all parts of the organisation concentrating on group results.
  • Management attention should be focused on the need to cut unnecessary expenditure.
  • Management will not be diverted from performing their regular duties to agree on more elaborate performance-reward systems.

Drawbacks of linking payments to organisational profits

  • If the proportion of the bonus that is linked to overall organisational performance is significant and other profit centres do not perform well, managers will get a reduced bonus payment or even no payment at all. Managers who consistently perform well and achieve their individual targets are likely to become demotivated if they receive no bonus because of poor levels of performance in other parts of the organisation.
  • Managers could feel that their area of responsibility is too small to have a substantial impact on group profits and may become demotivated.
  • Managers may cut short-term, discretionary costs in order to achieve current profit targets at the expense of future profits.

(b)       Bonus schemes for non-executive directors (NEDs)

The design of bonus schemes for NEDs is problematic. If the bonus is too small the NEDs may not be motivated to do anything more than the minimum required to collect their fees. If the bonus is too generous they may stop acting in the best interests of shareholders for fear of incurring the displeasure of the executive directors and thereby jeopardising their bonus payments.

A bonus scheme for NEDs will therefore need to include the following features.

  • It should ensure that high quality and motivated NEDs are recruited, thereby ensuring that shareholders will benefit from the appointment of the NEDs.
  • The bonus should be paid either in cash or in the companies’ shares.
  • The bonus scheme could be linked to the long-term performance of the company, rather than simply to the financial performance of the current period. A balanced range of performance measures such as increase in market share or stock market valuation in relation to competitors over a certain period of time (depending on the NEDs’ length of contract) and so on should encourage NEDs to take a broader view of corporate governance.
  • It is important that good corporate governance is seen to be maintained. Shareholders’ prior approval of any bonus scheme should be obtained to avoid any impression that NEDs’ bonuses are being offered as a quid pro quo for the executive directors’ remuneration.
  • Any bonus scheme should be designed to provide an incentive for the NED to achieve specific objectives or complete specific tasks outside their normal duties as a NED.

Bonuses are justified for such tasks as carrying out competitor reviews or designing staff remuneration schemes, which will enhance the NED’s understanding of the business without compromising their independence.

  • Any goal-orientated bonuses should be paid immediately following the work to which they relate. Rolling up of bonus payments may silence any criticism from the NED as the payment date approaches.

2 Cedric Coffee

Top tips. (a) emphasises that pressures to improve financial reporting and auditing practices have not been the only influences on corporate governance development. There has been emphasis as well on various aspects of directors’ conduct that would be considered unacceptable even if there were no problems with the financial statements and audit. Don’t forget the role of globalisation, as this has led to the development of international codes.

(b) illustrates how you should approach a comparison question. Your answer should be a point by point comparison rather than the first half of the answer dealing with the Sarbanes-Oxley Act, the second half with the OECD/ICGN principles. Although the answer does include some detail on the requirements, it also brings out the comparison by exploring what the legislation and guidelines aimed to achieve.

Note in (c) the links between corporate responsibility and stakeholder interests.

Memo

To:                  Managing Director, Cedric Coffee

From:             Consultant

Date:              30 May 20X8

Subject:        Corporate governance and corporate social responsibility

You asked me to provide you with guidance on why corporate governance codes have developed, points of comparison between different international governance codes and the advantages of developing a corporate social responsibility code.

(a)     Several different issues triggered moves towards systematised corporate governance.

Global investment

The trend towards global investment has meant that large investment institutions in the US in particular, but also in other countries such as the UK, have been seeking to invest large amounts of capital in companies in other countries. US investors, expecting similar treatment from foreign companies that they received from US companies, expressed concern about the inadequacy of corporate governance in many countries. Many of their concerns focused on the lack of shareholder rights, or the disregard for minority shareholder rights shown by major shareholders or the boards of foreign companies.

The move towards systematised corporate governance still has a long way to go in many countries. However, in issuing its principles of corporate governance, the OECD recognised that the demands and expectations of global investors would have to be met if the trend towards global investment (and efficient capital allocation) is to continue.

Financial reporting and auditing

There were serious concerns about the standards of financial reporting. In the late 1980s, there were a number of well-publicised corporate failures, which were unexpected because the financial statements of those companies had not given any indication of their financial problems. This also raised questions about the quality of external auditing and the effectiveness of professional auditing standards.

Executive directors

There were also concerns that many large companies were being run for the benefit of their executive directors and senior managers, and not in the interests of shareholders. For example, there were concerns that acquisitions were sometimes made to increase the size of a company and the power of its chief executive, rather than as a means of adding shareholder value. These concerns raised the question of the conflict of interest between the directors and shareholders.

A particular concern was the powerful position of individuals holding the positions of both chairman and chief executive officer in their company, and the lack of ‘balance’ in boards.

Directors’ remuneration

Directors’ remuneration also became an issue. There is a widely held view that executive directors are paid excessive amounts, in terms of basic salary, ‘perks’ and incentives. Some directors appeared to receive high rewards even when the company performed badly or no differently from the ‘average’ of other companies. Although investment institutions did not object to high pay for talented executives, they believed that incentive schemes were often badly conceived, and that executives were being rewarded for performance that was not necessarily linked to the benefits provided to shareholders, for example in terms of a higher share price.

Insider dealings

Although convictions for insider dealing have been rare, there was a suspicion that some directors might be using their inside knowledge about their company to make a personal gain by dealing in shares in the company. For example, directors might sell a large number of shares just ahead of a profits warning by their company, or buy shares just ahead of a public announcement that might be expected to boost the share price.

Risks and controls

Again poor controls have been a symptom of poor corporate governance with, for example, inadequate management control of individuals such as Nick Leeson at Barings. In addition, the development of risk management frameworks, such as the COSO guidance, has impacted on regulations.

Internationalisation

More investors, in particular institutional investors, have begun to invest outside their home countries. In order to limit the risks of their investments, they seek to promote a common international governance framework.

(b)       Purpose

The main purpose of the Sarbanes-Oxley Act was to tackle various problems that had been brought to light by Enron and other corporate scandals. These included poor internal controls, misleading financial statements and ineffectiveness of non-executive directors and auditor monitoring of companies. They relate to the situation in America, although foreign companies with a listing on the US stock market have to comply as well.

The OECD principles have been designed to establish an credible international framework that promotes global investment. Investors who are investing in different countries can have confidence in the corporate governance of companies that adopt the OECD principles or regimes that base their own governance codes on the OECD. The ICGN report is designed to enhance the OECD principles by providing practical guidance for boards wishing to enhance their reputation for good corporate governance and to establish better dialogue with their investors.

Board roles

Sarbanes-Oxley aims to reinforce the monitoring role of the board and the responsibility of the

board for producing true and fair financial statements. It lays stress on the role of the audit committee, which is compulsory for all listed companies. The audit committee should oversee the role of external auditors and establish mechanisms for dealing with complaints. Board responsibility is enforced by the chief executive officer and the chief financial officer being required to certify the financial statements, and having to forfeit their bonuses if the financial statements subsequently have to be restated.

The OECD/ICGN guidelines provide rather more general guidance on the role and responsibilities of the board. They aim to promote board effectiveness. The OECD principles do this by stressing the board’s overall role in strategic development, that board members should exercise care and good faith as well as independent judgement, and assigning non-executive directors to appropriate roles. The ICGN code gives some specific guidelines on how to achieve the OECD guidelines. These include listing strategic matters that would normally be considered by the board, recommending that certain board committees (nomination, remuneration and audit) be established, suggesting that the chairman and chief executive should be different people and stating that scrutiny of director performance would be enhanced by yearly appraisal and regular re-election.

Accounts 

A major aim of the Sarbanes-Oxley legislation is to tighten up accounting rules that were perceived as too lax, allowing Enron to produce accounts that may have complied with existing standards but were misleading. Hence the Act targets the kinds of off-balance sheet arrangements that Enron employed. Sarbanes-Oxley also seeks to promote effective internal controls by requiring disclosure of management responsibility for control system maintenance, and an audited assessment of the effectiveness of the internal control structure and the procedures for financial reporting.

The OECD/ICGN guidelines contain various recommendations for disclosure based on good practice in major jurisdictions. The disclosures reflect the important areas highlighted in the guidelines including governance structures and policies, and relationships with shareholders and stakeholders. They aim to promote disclosure that aids investors by recommending the provision of analysis or advice that is relevant to investors. The guidelines also stress the importance of the company excelling in the returns it achieves in comparison with its equity-sector peer group.

Audit

Sarbanes-Oxley responded to concerns about external auditing practice by stiffening the requirements relating to auditor independence. The enhanced role of the audit committee was part of this, but the Act also includes provisions limiting the non-audit services auditors can provide and requiring the regular rotation of lead audit partners. The Act also includes a number of provisions relating to the conduct of audits and audit firm procedures, including retention of working papers and quality control requirements, and the requirement for auditors to review internal control systems.

The OECD/ICGN guidelines place less stress than Sarbanes-Oxley on the role of the auditor, although they do stress the importance of the auditor providing external and objective assurance and audit committee-auditor links. The issue of non-audit services affecting independence is raised, the guidance noting the various methods different regimes have used to deal with this potential problem.

Shareholders

Sarbanes-Oxley does not contain significant provisions enhancing the role of shareholders. The OECD and ICGN guidelines do contain provisions promoting shareholder interests, in line with their key objective of enhancing investor confidence. The OECD principles stress the importance of treating all shareholders equitably and eliminating cross-border impediments to shareholding. The ICGN report seeks to reinforce these general aims with some specific guidance on how shareholder voting rights can be protected and also promoting the role of institutional shareholders, with the idea that their active involvement can encourage better corporate governance.

Stakeholders and ethics 

The provisions relating to ethics in Sarbanes-Oxley were mainly inspired by the examples of unacceptable behaviour at Enron. They are designed to reduce the chances of poor ethical behaviour occurring and remaining undetected. Hence companies are required to state whether they have adopted a code of conduct for senior financial officers and the contents of that code. The Act also contains strong provisions protecting the position of auditors, employees and lawyers who whistleblow on unethical behaviour.

The OECD/ICGN guidance also stresses the importance of companies establishing an ethical code and protecting whistleblowers. However, these requirements are set in the rather wider context of encouraging companies to act in an economically, socially and environmentally friendly manner and the board promoting a culture of integrity. The guidance also emphasises the importance of successful and productive relationships with stakeholders, particularly employees, and suggests various methods of enhancing employee participation.

Enforcement

Sarbanes-Oxley has passed into US law and thus companies listed on the US Stock Exchange have to comply with its provisions. The OECD/ICGN principles have no legislative power. However, countries are using the OECD principles as a basis for developing or judging their own regimes.

(c)        Benefits of a CSR policy

Marketing advantage

CSR offers marketing advantages and is a differentiator, appealing to certain types of customer. It produces a ‘feel good’ factor.

Publicity

CSR neutralises poor publicity from high interest, low power stakeholders such as pressure groups. For example using Fair Trade suppliers would mean that Cedric Coffee cannot be criticised for exploiting coffee growers. In other words, CSR can provide some assistance in managing reputation risk.

Staff turnover 

If CSR extends to the management of employees, and Cedric Coffee is known as a good employer, the costs of staff turnover might be contained. High staff turnover means high recruitment costs, high training costs and, perhaps, an adverse impact on customer service. However, a high level of staff turnover is perhaps inevitable in a business such as this.

Impact on other stakeholders  

CSR makes a good impression on other stakeholders eg the Government or local community. CSR can influence a company’s reputation. Being known to be a good corporate citizen may help the company if it has business dealings with other significant stakeholders.

Drawbacks of a CSR policy

Failure to maximise shareholder value 

Managers in charge of corporations are responsible to the owners of the business. CSR may be a distraction from maximising shareholder wealth. If Cedric Coffee has a statutory duty to maximise shareholder wealth, the scope of CSR may be restricted.

Costs of compliance 

There may be costs in complying. This could include direct costs (eg paying premium prices or higher salaries) and indirect costs, such as management time.

3 Peter Postgate

Top tips. The introduction to the letter picks up that there has been previous contact, but the relationship is still reasonably formal, hence Mr Postgate and yours sincerely.

(a) is a good example of selective use of information. You don’t need to disclose all the circumstances given in corporate governance codes that mean that an non-executive director would not be independent. A few illustrative examples would do fine. Note in (b) how each of the committees addresses a leading area of conflict of interest.

The wording in the question requirements in (c) is fairly neutral, indicating that you have to cover the advantages of these methods of remuneration as well as the (more obvious) drawbacks.

Anystreet

Anytown

1 May 20X8

Mr P Postgate

Anyroad

Anytown

Dear Mr Postgate

I enjoyed our conversation the other day and am pleased to provide the further guidance and information you requested about non-executive directors.

  • Independent NEDs

The definition of independent NEDs in corporate governance guidance is quite strict. An independent NED is a person who has no connection with the company other than as a NED. Because they are independent, a NED should be able to give an independent opinion on the affairs of the company without influence from any other director or shareholder.

Non-independent NEDs

  • NED is not independent if they are representing the interests of specific shareholders. If a director is on the board to represent the interests of a major shareholder, then they will not be regarded as independent, because the views given by the director will be seen as influenced by the best interests of that shareholder. The same applies to directors who could be seen as representing other stakeholders. If the company appointed as a NED a director of one of its suppliers, then that director would be seen as representing that supplier. NEDs with close personal relationships to executive directors would also not be independent. This would mean, for example, that a former chief executive of the company who was given a non-executive role after retirement would not be independent.
  • Conflicts of interest
    • potential conflict of interest can occur when the executive directors of a company take decisions that would not be in the interests of the company’s shareholders. Although there are several areas where a conflict of interest could arise, the most difficult areas are remuneration of the directors and senior managers, financial reporting and nominations of new board members.

Remuneration

If executive directors decide their own remuneration, they could pay themselves as much as possible, without having to hold themselves to account or justify their high pay. If executive directors are allowed to devise incentive schemes for themselves, these may be linked to achieving performance targets that are not necessarily in the shareholders’ interests. For example rewarding directors with a bonus for achieving profit growth is of no value to shareholders if the result is higher business risk and a lower share price.

Remuneration committee

Corporate governance in many countries, such as the UK Corporate Governance Code, calls for a remuneration committee of the board to be established to decide on directors’ pay, including incentive schemes. The committee’s members should all be independent non-executive directors.

The remuneration committee should have delegated responsibility for setting remuneration packages for all executive directors and the chairman, including pension rights and any compensation payments. The committee should also recommend and monitor the level and structure of remuneration for senior management. The NEDs should be able to devise fair remuneration packages, which include an incentive element where the performance targets align the objectives of the executive directors with those of the shareholders.

Financial reporting

A second problem area is financial reporting. The executive directors might be tempted to distort the financial results of the company in order to present them in a way that reflects better on themselves and their achievements.

Audit committee

The board should establish an audit committee, consisting of non-executive directors, whose task should be to consider issues relating to financial reporting and financial control systems. This committee should be responsible for liaising regularly with the external and internal auditors. The board should satisfy itself that at least one member of the audit committee has recent and relevant financial experience.

Nominations to the board

A third potential area for conflict is nominations of new board members. A powerful chairman or chief executive could be tempted to appoint their supporters or ‘yes’ men to the board, and so strengthen their position on the board.

Nomination committee 

The UK Corporate Governance Code recommends that the board should establish a nomination committee of the board, manned by NEDs. The committee should oversee recruitment, keep the balance of the board under review and consider longer-term succession planning.

Other areas

Other areas of potential conflict of interest include the board’s decisions on making acquisitions or in preparing defences against a takeover bid. In each of these areas NEDs should be able to provide a counterbalance to self-interested views of executive directors.

(c)       Share payments

In many companies, NEDs receive a fixed cash payment for their services, without any incentives.

However, some companies pay their NEDs in shares. They would argue that the more equity the NEDs hold, the more likely they will be to look at issues from the point of view of the shareholders.

A NED holding shares could however be more concerned with short-term movements in the share price and the opportunity of making a short-term profit from selling their shares than the long-term interests of the company and its other shareholders. However, a suitable precaution against this could be to obtain the agreement of a NED not to sell their shares until after leaving the board.

Share options

The view that NEDs should be rewarded with share options to align their interests with other shareholders is more contentious. However, it has been widely practised in the UK and is even more common in the US.

The argument against rewarding NEDs with share options is that it could align the interests of the NEDs more closely with the executive directors, who also hold share options. NEDs should give independent advice, and it can be argued that it is not appropriate to incentivise them in the same way as the executives.

The UK Corporate Governance Code points out that holding share options could be relevant to the determination of a non-executive director’s independence. It states that remuneration for nonexecutive directors should not include share options. If, exceptionally, options are granted, shareholder approval should be sought in advance. Any share acquired by exercise of the options should be held until at least one year after the non-executive director leaves the board.

I hope this letter has been helpful. Please do get in touch if you want to discuss anything further.

Yours sincerely

A N Accountant

4 PKG High School

Top tips. This is a tough question at this stage but it should get you thinking about the controls all organisations should have.

In (a) the stakeholders are different to those of a company, but they still need the assurance provided by an objective review. Benchmarking is likely to be a particularly important aspect of the audit, given that the governing body is responsible for educational standards.

It is very easy in (b) to stray from the subject and talk too generally about controls – the question asks you to evaluate (often as here concentrating on the deficiencies), and recommend what the governing body should be doing. Our answer is based around the structure of:

•                  How the governing body is constituted and how it operates

•                  The data it gets (financial/non-financial, internal-external)   The decisions it takes and the monitoring it carries out

This is a useful way of analysing how any governing body works.

You may have felt that the question could have given more detail about what the governing body is doing and the information it receives. It is valid to assume that if you’re not told anything about key aspects of governance such as a committee system, then they aren’t being operated when they should be.

It’s also easy in (b) to fail to consider whether financial and other resources are being used to maximum efficiency. Spending limits often mean that expenditure is made to the limits set down, with little consideration of whether value for money has been obtained.

(a)      Independent and objective assurance

Having an external review carried out should provide an unbiased view of how the school is performing. In particular this provides reassurance to stakeholders such as parents and the local authority that the school is providing education of sufficient quality and expenditure is being properly controlled.

Aid to monitoring

Like the board of directors in a listed company, the governors are responsible for establishing and maintaining a sound system of internal control and risk management. The review should provide feedback to the headteacher and governing body to enable them to set priorities for systems improvements, based on the areas of greatest risk. It should also highlight where the headteacher and governors should focus their own monitoring activity.  

Expert opinion

The external reviewers can make recommendations based on their knowledge of best practice in other schools. This can provide the school with benchmarks that it can incorporate into financial and non-financial performance indicators.

(b)       (i)       Structure and workings of governing body

           Membership

The governing body includes representatives of the key stakeholder group of parents and the local authority.

However, it may be a more effective monitor if it includes representation from key internal stakeholders. Certainly it should include staff representatives and might include pupil representatives as well.

Committee system

Having the full governing body consider all relevant items at every meeting may not be the most efficient way of operating, and it may mean that some key risk areas receive insufficient attention.

Although committees may be difficult to staff, a committee system with each committee concentrating on certain key aspects of running the school may be the best way to conduct decision-making, with committees reporting into the main governing body. Certainly it may provide a good mechanism for parent representatives to use their particular expertise.

  • Audit committee

An audit committee, including members with financial expertise, could be responsible for detailed scrutiny of expenditure and liaising with auditors. Its remit could also cover compliance with legislation and the operation of internal controls. This would leave the main governing body to concentrate on the split of expenditure and the overall review of control systems.

  • Staff recruitment committee

Because of the significance of staffing the board should establish a separate recruitment committee. The committee should be involved in specific recruitment decisions, and should also proactively consider staffing needs. For example, are there sufficient experienced members of staff and does the staff body as a whole have an appropriate range of skills in key areas such as IT? The committee must consider how staffing headcount needs can be reconciled with planned staff expenditure.

The committee should also consider the balance between teachers and other support staff, whether support staff, with specific skills, need to be recruited or whether their numbers could be reduced and more teachers recruited. It should also be involved in internal promotion decisions and consider the effectiveness of the system of responsibility allowances.

Induction of governing body members

There appear to be no induction procedures for new governing body members that would enhance their knowledge of what the school does and the requirements the governing body has to meet.

Certainly parent governors will need this understanding if they are to be effective governors (hopefully the local authority will have selected suitably qualified and knowledgeable members).

(ii)      Information received by governing body

Financial information

It is unclear whether the financial information is sufficiently detailed. The governing body needs to ensure that it receives sufficient information about expenditure, particularly because of the wide discretion the headteacher has and the lack of segregation of duties.

Expenditure should be classified into different categories depending on its materiality and the ways it is controlled. The information should include what has been spent, expenditure commitments and phasing of expenditure during the year; not all expenditure will be made in even amounts over the year. The governing body also needs to ensure that the reliability of the monthly financial report is reviewed because of its importance for decision-making. As the external auditors may not spend time on this, this review should perhaps be carried out by members of the audit committee.

Financial variances

Although the governors receive information about variances from budgeted expenditure, there is nothing mentioned about how they are, as they should be, informed of action planned if an overspend appears likely.

They should have input into what should be done.

Non-financial information

There appears to be a lack of non-financial information that the governors need in order to ensure that educational standards are being maintained. An annual inspection by the local education authority would not be frequent enough.

Governors should be supplied with the results of internal methods of assessing the effectiveness of teaching such as termly exams and internal quality reviews of teaching programmes. Since staffing is both a major element of expenditure and vital in ensuring standards, governors should be receiving details about staff such as results of appraisals and staff development programmes. Having parent, staff and pupil representatives on the governing body will help measure the satisfaction levels of these key stakeholder groups; the governors ought to consider other methods such as regular staff and parent surveys.

External information  

No mention of whether the governing body is receiving the external information which it will need for longer-term decision-making.

The governing body should be receiving details of population trends in the area and the impact of changes in schools provision. It should also be considering specific information about other schools in the area that it can use for benchmarking purposes, such as pupil numbers, disposition of staff, facilities and exam results.

(iii)      Actions taken by governing body

Strategic decision-making

The governing body’s time horizon appears to be limited to a year, and it does not appear to be considering longer-term issues; there seems to be no strategic plan.

Better information should help it modify its strategy in response to local issues such as changes in pupil numbers, the opening of new schools, particularly specialist schools or government-promoted schools (such as UK academies) and changes in educational practice (such as increased use of information technology).

Flexibility of decision-making 

The governing body needs to consider whether its decision-making is too constricted; the governors may have the flexibility to take decisions that ensure better use of resources and better risk management.

For example it may consider whether class sizes can be increased in the lower age ranges to allow smaller class sizes and greater preparation time for more advanced teaching. It should also consider whether to include a contingency fund for urgent items of additional expenditure on staff, buildings and IT.  

Review of small items of expenditure

The governing body does not appear to take any interest in expenditure under $1,000. There may be scope for the headteacher to abuse this by spreading significant expenditure out so that individual items are below $1,000, but the total sum is quite substantial.

The governors should review all expenditure below $1,000 even if they don’t approve it in advance. There may be scope for raising the limit on certain types of expenditure, so that the governing body does not spend time considering what is essentially non-discretionary expenditure.

Communication 

The governing body needs to consider how its work should be communicated; there is no evidence of how this is happening at present.

Clearly the headteacher will have prime responsibility for communicating and what the governing body publishes should be consistent with what the headteacher is saying. However, communication of what the governing body is doing and the issues it is considering should prove to staff, pupils and current and prospective parents that the school is well run. It should also aid future recruitment onto the governing body.

5 Widmerpool

Top tips. (a) is a good example of why you need to read scenarios carefully and highlight all relevant data. Every point our answer makes is supported by relevant information from the scenario.

You need to read the requirement to (b) quite carefully. The key words are ‘by their own example’ so that your discussion should be confined to what the board should be doing (and seen to be doing).

In (c) remember that the requirement evaluate means that you should consider the strength of the arguments for and against. The risk committee need not be staffed by non-executive directors, although in many instances it would be (this would be consistent with the audit committee which we’ll look at in Chapter 8).

(a)        Lack of detail in guidance

The problems over the suppliers’ data may indicate that some of the organisational guidance is written too much in terms of general principles, without enough examples of detailed application. It would appear that the guidance needs to spell out that confidential information should not be removed from the office, and staff should not talk about business matters outside work.

Lack of awareness of risks  

The accident with the machine indicates that staff did not understand the risks involved, despite the health and safety documentation. This could be because they failed to read the documentation or they read it but failed to understand it. This also suggests that training, on the job or in formal courses, was non-existent or ineffective.

Poor culture 

The problems over Stringham’s information and the difficulties over the machine indicate that a culture of carelessness is prevalent at Widmerpool. Managers, in positions of responsibility, should naturally be careful with confidential information. The comments in the staff survey also seem to suggest the culture is poor, that the board is seen as not caring about internal controls and procedures.

Lack of enforcement 

The staff comments underline what happened over the machine, that the company’s internal procedures are not being enforced by managers. The survey comments suggest that, while the board is receiving sufficient financial information about the profitability of operations, it is not getting the non-financial data it needs to obtain assurance that control systems are operating effectively.

(b)       Personal example

The board’s day-to-day behaviour can help set the right tone in Widmerpool. This includes being seen to comply fully with health and safety requirements, for example wearing the right clothing in the factory. More importantly perhaps, it means avoiding the sort of careless behaviour of which the managers were guilty, taking confidential information outside the workplace.

Adherence to code 

The board needs to order all staff to demonstrate full commitment to Widmerpool’s control procedures. Directors and staff should acknowledge in writing their responsibilities, including adherence to internal codes. Directors should reinforce this by communicating, through internal newsletters, what is expected of staff.  

Participation in training

Directors should fully and enthusiastically participate in training in areas such as health and safety. Excusing themselves on the grounds that they are ‘too busy’ significantly increases the risk that staff will not take the training seriously.

Internal meetings

Directors should set up a system of meetings to discuss risk and compliance issues. They should meet with senior managers, the senior managers should meet with the staff who work for them, and so on.

Taking disciplinary action  

If necessary, the directors should show that poor behaviour will not be tolerated by being personally involved in disciplinary action against staff.

(c)       Benefits of risk committee

Independent viewpoint

If the risk committee consists of non-executive directors, they can take a detached view of Widmerpool’s risk exposure, using their own experience from other organisations. Delegation of duties from the main board to the committee will allow the executive directors to concentrate more on matters connected with obtaining a listing.

Determining acceptable exposure

Widmerpool has expanded significantly over the last few years, and it is likely that the company’s risk profile has also changed significantly. The committee needs to press the board to consider regularly what constitutes acceptable levels of risk, bearing in mind the likelihood of the risks materialising and the board’s ability to reduce the incidence and impact on the business.

Monitoring acceptable exposure 

Once the board has defined acceptable risk levels, the committee should monitor whether Widmerpool is remaining within those levels, and whether earnings are sufficient given the levels of risks that are being borne.

Reviewing reports 

There should be a regular system of reports to the risk committee covering areas known to be of high risk, as well as one-off reports covering conditions and events likely to arise in the near future. This should facilitate the monitoring of risk.

Monitoring risk management systems      

The committee should consider whether the risk management systems are operating effectively. For Widmerpool this will mean obtaining evidence that procedures are being followed, through evidence from internal audit and reports by line managers. The committee will also ascertain whether measures taken to correct problems in risk management have been effective. For example it will find out whether all staff have received the health and safety training that they need, and seek to obtain evidence that the training has resulted in safer working practices.

Sign of board action 

Setting up a risk committee would demonstrate to managers and staff that the board was taking risk management seriously. The risk committee could also be a point of contact if staff had concerns, for example about safety procedures not being followed.

Drawbacks of risk committee

Over-commitment of non-executive directors 

Non-executive directors already have to attend full board meetings and audit committee meetings. The board will have to set up a nomination committee, consisting of non-executive directors, if Widmerpool achieves a listing. Non-executive directors may not have enough time to fulfil all their responsibilities. One result may be that the risk committee does not meet frequently enough to monitor risks effectively.

Confusion with responsibilities of audit committee

If different directors staffed the risk committee and the audit committee, there could be confusion over the responsibilities of each. Clear terms of reference will be required to determine, for example, the laws and regulations for which each committee is responsible for monitoring compliance.

Need for active involvement in strategy

The members of the risk committee need to be clear of Widmerpool’s strategies in all major areas, as they should be concentrating on the risks arising out of those strategies.

6 Pacific Group

Top tips. This question might seem overwhelming, but bear in mind that the examiner has done the hard part already. The risks have been identified, you simply have to assess how serious they are. Make sure that you read the question properly and understand the criteria that the examiner gives you to judge whether risks are applicable or not, then apply those criteria to each risk in the question. If you are not sure, decide whether you can say more in support of classifying it as applicable or non-applicable. You gain marks for your explanations.

Applicable risks

(a)       Failure to invest in new developments

Applicable risk

The majority of PG’s income comes from advertising revenue and therefore it is crucial that they keep up to the cutting edge of advertising developments, particularly when their competitors do. This could have a substantial adverse financial impact if advertisers decide to cut advertising in PG in favour of more up to date advertising techniques in competitor publications such as The Deep. (b)     Unsuitable credit limits

Non-applicable risk

As credit limits (albeit unsuitable) are set, and the majority of customers are likely to be creditworthy, the effect of a small number of advertisers being uncreditworthy is not likely to be substantial.

  • Incomplete data transfer (editorial – invoicing departments)

Applicable risk

It is crucial to cash flow and business operations that published adverts are invoiced. Only two full page adverts and a half page advert would have to be omitted from invoicing before the effect of this risk would be greater than £5,000. If the system is failing to transfer data, there is no reason to assume that the problem should be limited to so few adverts.

  • Rates charged

Applicable risk

As seen above, given the prices of adverts, a problem with a small number of adverts can have a significant (>£5,000) impact. So, for example, if two full page and three half page adverts were given a 50% discount and the same number were given ‘free’ for reciprocal advertising, this could have a significant financial impact.

  • Individual errors

Non-applicable risk

PG is likely to have reasonable controls over production to ensure that errors in production such as typos and colour problems are likely to be isolated and no individual advertisement has a significant financial effect on PG.

  • Cash misappropriation

Applicable risk

Cash received at front desk is significant and there appear to be no controls to ensure that it is secure and passed on to cashiers. This is a big risk to PG, as they may simply lose a large amount of income this way. Again, it only requires payment for three full page adverts to be misappropriated to have a significant impact.

  • Errors due to unauthorised access

Non-applicable risk

It is likely that PG has basic computer system controls making this risk a low risk.

  • Availability of systems

Applicable risk

This risk is applicable because if PG does not have contingency plans against systems failure, and many companies with computerised systems do not, then the financial and operational risk of delay in invoicing and processing advertising orders could be significant in terms of customer dissatisfaction and delayed payments.

  • Incomplete transfer of information to nominal ledgers

Non-applicable risk

This is potentially significant to the reported results of the company but should not affect their operational or financial strength.

  • Risk of litigation for inappropriate advertising

Applicable risk

As PG carries a large amount of advertising in its publication this risk is significant. Although PG is likely to have insurance for the financial impact of such litigation, the cost in terms of loss of reputation and/or customers could be significant.

7 Azure Airline

Top tips. When asked to identify, you should aim to be brief and not copy out chunks of the scenario. Instead concentrate on explaining the risks well. In (a) you would probably need to identify and explain half a dozen risks to gain full marks. The answer below contains more than this for illustration. Most of the risks identified below are signalled in the question. However, it is acceptable to use your general knowledge to identify a risk not signposted in the question, such as the fact that the price of fuel can escalate, and Azure needs fuel to operate. You can easily spend too much time on competition risk and on (a) in general, though. It’s easy to overrun on this part and lose the chance of gaining marks elsewhere.

In (b) you are asked for controls for the risks, and you must think widely about how the risks could be managed. For example, think about the lease contract. It must have contingencies and protections for Azure’s operation in it. It’s also important to make realistic suggestions. For example, saying that the company should buy a new plane or employ its own captain and co-pilot would be irrelevant, as it is only operating two days a week.

(a)        Business risks

  • Leasing of equipment and specialist staff

As Azure leases its equipment and the most specialised of its staff from another airline, there is a risk that its equipment and/or pilots could be withdrawn leaving it unable to operate.

  • Conditions of exclusive right

The PAA requires Azure’s aircraft engines be overhauled biannually. There is a risk that Azure will be unable to meet this condition, if the lessor company does not agree to regular overhaul, or if it will be too expensive for Azure to meet this requirement. It could then lose the right to operate, or its exclusivity, opening it up to competition. There may be other conditions which Azure has to meet, such as the two weekly flights being a minimum.

  • Necessary service suspension

As Azure is required to overhaul its engines every two years, there will be a significant period every two years where Azure will either have to incur the cost of leasing other planes (assuming this is possible) or will have to suspend services. The cost of leasing other planes might be prohibitively expensive or the disruption to service might mean that conditions relating to the right to operate might not be met. As Azure only has one plane, service would also be interrupted if there was an emergency relating to the plane, such as fire or a crash.

  • Age of aircraft

The aircraft being leased is old. This raises operational risks (it may not always be able to fly due to necessary maintenance), finance risks (it may require regular repair) and compliance risks (it may not meet environmental or safety standards, now or in the future).

  • High proportion of expensive seats

The plane leased by Azure has a high proportion of empty expensive seats and therefore insufficient (overbooked) cheaper seats. Although Azure can appease customers by upgrading them, this means the airline is operating well below capacity.

  • Cargo

The flight route results in the airline carrying a large amount of horticultural produce. This raises various risks. Azure might be liable to passengers if their cargo deteriorates in transit. The airline might be liable for any breaches of law by its passengers (for example, if prohibited items are transferred into Pewta or Sepiana. Many countries prohibit the importation of animals or meat products or plants).

  • On-board services

Customers are currently dissatisfied with the food provision on the flight and there is a risk that food prepared in Lyme may become less appealing and even dangerous when served on a Darke to Lyme flight (when it has been prepared a substantial time earlier, given a six hour flight, at least an hour’s turn around time, and time for getting to the airline in the first place). If the food makes customers ill, Azure might be faced with compensation claims.

  • Pricing

There is a complex system of pricing and a large number of sales agents, and Azure is at risk of operating at a sales value less than required to cover costs (for example, if too many of the cheapest tickets are sold).

  • Safety

The airline industry has stringent safety conditions and Azure may face customer boycotts or difficulty in recruiting staff if safety requirements are not met, as well as the threat of not being allowed to fly.

  • Fuel

The aircraft cannot fly without fuel, which can be a scarce or high-cost resource. If fuel prices escalate due to world conditions, the company might not be able to meet the costs of operating. (b)       Managing risks

  • Leasing of equipment and specialist staff

Azure must ensure that the terms of the contract with the international airline ensure that aircraft and staff cannot be withdrawn without reasonable notice, and, that in the event of withdrawal, substitutes will be provided.

  • Conditions of exclusive rights

Azure must ensure that all staff are aware of any conditions and the importance of meeting them. However, this risk must simply be accepted. as there is little Azure can do about conditions imposed on them by the governing body of their industry.

  • Necessary service suspension

Azure must have contingency plans for service suspension, such as ensuring its contract with the international airline ensures alternative aircraft will be made available in the event of maintenance or damage to the aircraft, or by making arrangements to lease from a different airline in the event of emergency. As a minimum, Azure must ensure that the airline it leases from would give it financial compensation in the event of aircraft or staff not being available, so that Azure’s customers could be compensated.

  • Age of aircraft

Azure should have plans in place to be able to lease/afford newer planes if required to by law. Again, this could be written into its contract with the airline. Azure should manage cash flow and borrowing facilities so as to be able to afford ongoing maintenance when required.

  • High proportion of expensive seats

Azure should negotiate a reconfiguration of the plane with the lessor so that business and first class seating could be reduced and more economy seats made available. If this is not possible with the current lessor, Azure should investigate leasing differently configured planes from a different company. If it is not feasible to adjust the plane seating, Azure should consider its pricing and on-board facilities policies to make business and first class seats more attractive to customers. As the seats are not being sold anyway, it is probable that a reduction in prices would increase overall revenue.

  • Cargo

Azure should publish a cargo policy to ensure that customers are aware of their legal obligations. They should ensure that staff are sufficiently trained to discuss the contents of baggage with customers and are aware what items Azure should not carry. They should insure against lost and damaged cargo.

  • On-board services

Azure should consider entering into a contract with a company in Darke to provide food for the Darke to Lyme journey. Obviously they must not breach any existing contract with the Lyme company and so in the meantime should review the type of food provided. For example, it might be safer to only offer cold food like sandwiches and cakes until a Darke contract can be set up. Even if a new contract is set up, it might still be best to offer cold food, as there is less chance of health problems arising as a result of serving cold food rather than hot food.

  • Pricing

As discussed above, Azure should review the pricing policy. It should also establish limits on how many of certain types of tickets (non-refundable/single etc) can be issued for one flight and it should institute a centralised system to ensure that each agent is aware when limits have been reached. As the agents must be linked to a similar system already (to be aware of whether tickets are available for sale) this should not be too difficult to achieve.

  • Safety

The company should appoint a member of staff to be specifically responsible for safety operations (such as training, updating for legal requirements, educating passengers) and should ensure that staff are regularly appraised about safety issues.

  • Fuel

The company could take out hedging contracts against the cost of fuel. Other than this, there is little it can do about this matter, and it is another risk that has to be accepted.

8 LMN

Top tips. This question illustrates that questions won’t always be about companies.

In (a) the link between controls and risk management is highlighted in the question details. The discussion in the first part of (a) should be assisted by examples from the scenario, and in the risks-controls you need to include some examples of appropriate controls for LMN. Your answer needs to differentiate clearly, as ours has done by using headers, between purposes and importance to maximise your marks.

It’s necessary to read (b) quite carefully to see what the question wants – an assessment of how much a review by the professional managers contributes to the work of the audit committee, and therefore why the review should be carried out. You should start off by defining what the work of the audit committee is, then consider how much managers’ review contributes compared with other sources of information that they can use.

In (c) again you can’t be too theoretical. Any discussion of principles has to be related to how they impact on the audit committee and board’s reviews. Selected examples from the scenario information are also needed here to boost the discussion. If you can remember that the board needs to carry out a regular and annual review and the main elements you would have scored well in (c) and gone a long way towards passing this question.

(a)       Purposes of risk management 

Alignment of risk appetite and strategy

LMN’s board should consider what risks it is prepared to tolerate in the light of the organisation’s strategy. Risk management comprises the systems and processes for dealing with the risks that the board is prepared to tolerate in order for LMN to fulfil its strategic objectives, including its social goals.

Develop a consistent framework for dealing with risk

A coherent risk management framework can help LMN compare risks with obvious financial consequences (poor cost control, loss of income due to bad debts) with risks whose financial consequences are less obvious (dissatisfied tenants). It also should provide guidelines that can be applied by staff operating across all areas of LMN’s activities.

Develop risk response strategies    

The risk management process should identify and evaluate risks (for example by the highmedium-low method described) and therefore provide the information necessary for management to decide what the best response to risk should be – acceptance, control, avoidance or transfer.

Importance of risk management

Improve financial position   

The risk management framework can provide a means of judging the costs of treating the risks measured against the benefits. It can also help LMN’s directors judge whether to take advantage of opportunities, for example property investment.

Minimise surprises and losses  

By identifying risks in the risk register, the risk management process should reduce the occurrence of unexpected shocks. For example, identifying property maintenance as a risk issue should encourage a programme of regular maintenance designed to deal with the risks associated with the types and ages of property.

Maintain reputation

As LMN is a charity, its reputation as a good corporate citizen is very important. Risk management should help it avoid risks to its reputation such as poor treatment of tenants or failing to comply with regulatory requirements.

Risk management and the internal control system

Internal control is action taken by management to achieve organisational objectives and goals. Internal control is thus bound up with the organisation’s strategies, and is therefore also bound up with risk management that is dependent on the organisation’s strategies. Internal control is made up of two elements.

  • Control environment, the framework within which controls operate and within which attitudes towards risk are an important element. Communication between directors and employees is a key element of the control environment.
  • Internal controls, which should be operated when their benefits outweigh costs; controls focused on dealing with the most significant risks will have obvious benefits. Given the risks LMN faces, key controls will include debtor management, maintenance inspections and

logs, financial appraisal of new investments and tenant satisfaction questionnaires, as well as accounting, compliance and cost limitation controls.

(b)      Audit committee’s role in internal control

Under corporate governance guidelines audit committees are responsible for creating a climate of discipline and control. To do this, they have to obtain assurance that internal control is working effectively and providing an adequate response to the risks faced; in particular for LMN, controls over expenditure.

Importance of management review   

The management review provides the audit committee with evidence of whether the control systems appear to be effectively managing the most significant risks. It also gives the audit committee an indication of the scope and quality of management’s monitoring of risk and internal control; whether it appears to be adequate given the risks faced. In the circumstances of LMN, the board of volunteers will wish to gain assurance that the professional managers are carrying out their duties effectively and are worth the salaries LMN is paying them. The review should provide feedback on weaknesses and should lead to improvements in the control systems.

Other sources of evidence 

However, management’s review of internal control is only one source of evidence that the audit committee should use to gain assurance. LMN’s committee should also receive reports from staff undertaking important and high-risk activities, such as property investment, and from control functions, such as human resources or internal audit (if any). Feedback from external sources such as external audit or regulatory visits will also provide information.

(c)        (i)        Review of internal controls

The UK’s Turnbull committee emphasises the importance of a regular review and an annual review of internal control as part of an organisation’s strategy for minimising risk, ensuring adherence to strategic objectives, fulfilling responsibilities to stakeholders and establishing accountability at its senior levels.       

Regular review

Regular review is an essential part of the strategy for minimising risks. The audit committee is likely to have responsibility for this review, and as best practice recommends at least three audit committee meetings a year; this is therefore how often the review should take place. Its findings should be communicated to the board.

The review should cover the following areas.

  • Risk evaluation

Whether LMN is identifying and evaluating all key risks, financial and non-financial. This is a very significant task given the variety of risks faced and also the need to devote limited resources to the most important risks.

  • Risk responses

Whether responses and management of risks are appropriate.

  • Effectiveness of internal controls

The effectiveness of internal controls in countering the risks. The board should consider to what extent controls could be expected to reduce the incidence of risks, any evidence that controls have not been operating effectively and how weaknesses are being resolved. The board would consider such evidence as incidence of bad debts, records of property occupation and complaints from tenants.

Annual review

The annual review of internal control should be more wide ranging, taking into account the strategic objectives of the charity and undertaken by the whole board rather than just the audit committee. It should examine controls and risk management systems in all major areas.   

  • Changes in risks

The changes since the last assessment in risks faced, and the charity’s ability to respond to changes in its environment. For example, the board would consider any changes in LMN’s credit ratings andlonger-term trends such as changes in the incidence of low-income earners.

  • Monitoring

The scope and quality of management’s monitoring of risk and control, also whether internal audit is required. In particular the review should consider whether the scope and frequency of the regular review should be increased.

  • Reports

The review should consider the extent and frequency of reports to the board; whether reports on high incidence, high likelihood risks should be made more regularly.

  • Impact on accounts

Significant controls, failings and weaknesses that may materially impact on the financial statements, for example problems over its property portfolio management should be looked at.

(ii)       Disclosures in the annual report

The report on compliance is a key part of the annual report by which LMN demonstrates its compliance with regulations and how it has fulfilled the differing requirements of its stakeholders, including tenants, donors, banks and local government.

Responsibility

The board should also acknowledge its accountability for LMN’s system of control and reviewing its effectiveness.

Risk management

The Turnbull report recommends that as a minimum the board should disclose what has been done to manage risk and how the board has reviewed the effectiveness of the risk management process. The board should explain the limits of the process (it aims at risk management rather than risk elimination) and disclose any material problems or weaknesses that have been found. It should communicate risks, objectives, targets and measures to counter risks.

9 Pogles

Top tips. In (a) two sentences is about the right length for the summary of the facts. It is legitimate in this exam to raise the issue of whether the factory should be closed at all – the examiner expects you not to prioritise automatically the interests of shareholders over other stakeholders. Key wording in the scenario was that it was not certain that rumours would start circulating, and so you needed to consider separately what the directors should do if they weren’t pressurised to tell the truth and what they should do if they were.

In (b) it’s possible to extend the concept of sustainability as we have done. Note that the concept of right can be seen as meaning what is profitable – this is the pristine capitalist view we shall discuss in Chapter 11. However, you do need to consider other definitions of right as well.

It would be possible (and a good exercise for you to attempt) to apply Tucker to the situation in (a) and the AAA model to the situation in (b).

(a)       What are the facts

Pogles has received an offer for one of its factories and it appears to be in the interests of shareholders that the board should accept the offer. However, if staff learn of the acceptance of the offer, they are likely to take industrial action and jeopardise Pogles’ biggest contract.

What are the ethical issues

The first issue is whether the factory should be closed at all. The staff in the factory are clearly adding value. They are after all working on Pogles’ biggest contract. One viewpoint is that staff are key stakeholders, and the decision to close the factory wrongly prioritises shareholder interests over staff interests.

If the board decides the factory should be sold:

  • Whether to disclose the sale of the factory to the staff in the absence of any pressure to do so
  • If rumours start circulating and staff ask whether the factory will be closing, whether to tell staff the truth or deny the rumours

What are the norms, principles and values that relate to the case

In most jurisdictions, companies have a general duty to act in the interests of their shareholders. Closing the factory would be in line with this responsibility. Pogles would be acknowledging it had some responsibility towards its employees by giving them a generous pay-off package.

If the offer was accepted, and the board did not come under pressure to disclose it, the situation is finely balanced. The board would generally be regarded as having a right to keep some information confidential for commercial reasons. The question is whether the need of staff to have this information as soon as possible so that they can start making alternative employment arrangements overrides the board’s right to keep the information confidential. It could also be argued that failing to tell staff is itself a distortion of the truth.

If staff do start asking questions, the ethical issue then becomes not only whether the board can keep the information confidential but also whether to do so it has the right to give staff incorrect information.

What are the alternative courses of action

One course would be to decline the developer’s offer.

If the offer is accepted and the board does not come under any pressure to disclose the information, it could nevertheless:

  • Tell staff as soon as the deal is finalised
  • Or wait six months and tell staff once the work on the large contract is finished

If the board comes under pressure from staff because rumours are circulating, it can either:

  • Maintain that the rumours are misguided or state that an offer has been received but rejected
  • Tell staff the truth

What is the best course of action that is consistent with the norms, principles and values that relate to the case

The best course of action would appear to sell the site and tell staff the truth only when the board is pressurised to do so. This would certainly be in shareholders’ best interests, as the factory sale would go ahead and the board would be making every effort not to jeopardise the large contract. However, if the board is pressed on the issue, it would seem most ethical for the truth to be told then.

What are the consequences of each course of action

If the developer’s offer is declined, and it becomes public knowledge that it has been declined, the board may come under pressure from shareholders for failing to take decisions in their best interests.

Assuming no pressure is applied, telling the employees now is most likely to jeopardise the large contract. The board may be able to mitigate the unrest by providing more generous redundancy packages, giving assistance in job hunting and possibly giving staff a consultation period to come up with an alternative business plan.

Not telling employees until after the contract is completed would mean that production was not disrupted. However, although staff in other factories may not wish to take industrial action, there may be a loss of trust in senior management and hence worsening industrial relations.

Telling staff the truth when pressure is applied would also jeopardise the contract, but is less likely to do so the later in the six months the disclosure is made. Again the board may be able to mitigate the unrest, although the factory’s staff may be less inclined to co-operate if they are angry that the board has kept the news from them.

Denying the news until after the contract is completed may lead to legal repercussions and certainly a loss of trust in the board by other employees.

What is the decision

The recommendation is that the board accept the offer and to tell the employees immediately. If it is in shareholders’ interest for the factory to be closed, then loss of the contract would be a necessary cost. The board would appear to be acting in good faith and doing its best to mitigate the hardship faced by its employees.

(b)       Profitable

At present the decision appears to be profitable. The factory is performing well against budget and the changes in the employment terms offered to new staff should mean the factory is more flexible in meeting customer demands. However, if the factory manager’s treatment of staff is challenged successfully in the courts, Pogles may have to pay fines and compensation.

Legal 

It certainly seems that some of the factory manager’s actions could be held to contravene the law, particularly as Pogles is located in an EU State. EU law does not look kindly on employers who are unwilling to allow their staff to work part time as long as this is reasonably practicable for their business, as always seems to have been the case for Pogles. Pogles will also probably have contravened local employment laws if the allegations of bullying are held to be justified.

Fair

From the point of view of the longstanding employees, the treatment is clearly unfair, if they are viewed as significant stakeholders because of the commitment they have shown to Pogles over the years. The factory managers’ actions are also not fair to the new employees in the sense that they are working under different terms to longstanding employees. However, arguably they are being given employment opportunities that they are willing to take up, so the terms do not appear to be a significant issue for them.

Right 

If right is judged solely in terms of maximising profits, then the manager’s treatment of staff can be justified. However, most societies would regard bullying in the workplace as wrong. The board would need to consider the threat to Pogles’ reputation if the behaviour became public knowledge.

Sustainable 

If the idea of sustainability is confined to the natural environment, then this criterion is not relevant. It can however be extended. If labour is treated in the same way as a natural resource, then the factory manager’s exploitation of the labour market may have its limits. Eventually they may find that people are not prepared to be employed on those terms. If the concept of sustainability is extended to social sustainability, then the factory manager’s treatment of staff is not sustainable in the sense that they are ignoring their need for decent working conditions that do not cause them stress.

10 Zos

Top tips. The answer to (a) illustrates that ethical non-compliance can be prevented by a number of aspects of the control environment and strong controls over human resources and information reporting and review.

The point at the start of (b) is very important – that internal auditors have no statutory responsibilities and it’s up to the directors to define what they should be. Assuming they are responsible for investigating ethical non-compliance, the answer looks at the direct and indirect links between audit work and ethical compliance, and also considers different ways auditors can approach the audit. However, the point in the last paragraph is also vital – internal auditors should not be responsible for implementing procedures to prevent non-compliance.

(a)       Board example

The board should make clear when communicating with staff that they are committed to ethical behaviour and they expect staff to be committed as well. Appointing a board member as ethics champion emphasises board commitment as well as being a contact point for whistleblowing (discussed further below).

Code of conduct 

A code of conduct could be used to remind staff of Zos’s objectives of being an ethical business.

Staff should be required to commit to the code when they join Zos. This would strengthen the basis for disciplinary action if they transgress.        

Communication with employees

The board needs to ensure that specific ethical objectives are communicated unambiguously to staff. With Zos, although coffee was ideally meant to be sourced 100% from Fair Trade suppliers, it has been impossible recently to attain this target. There may therefore have been confusion, and local managers may have regarded it as acceptable to source from non Fair Trade suppliers if there were significant cost advantages in doing so.

Central policies 

One way of preventing problems with the use of non Fair Trade suppliers would be to insist that shops only used suppliers on a centrally approved list. Alternatively, a central purchasing function could be responsible for making purchases for all shops.    

Recruitment 

One way of reducing the risk of dishonest acts by staff is to ensure that staff who are recruited do not have records of bad behaviour. References should be required and confirmed for all staff.

Appraisal

Staff should also be regularly appraised and the results of appraisals communicated to senior management. If appraisals indicate staff unhappiness, this may suggest that problems are more likely to occur.

Disciplinary procedures  

There should be clear disciplinary sanctions against staff who are found guilty of dishonesty or unethical behaviour, including dismissal from employment. If necessary, staff accused of dishonesty should be suspended until the accusation is resolved.

Manager rotation

Staff may not have reported problems because of misplaced loyalty to, or fear of, management or colleagues. One way of preventing this would be to rotate managers between shops on a regular basis, to prevent a situation where managers allow problems to persist over a long time.       

Whistleblowing 

Both the drug dealing and the coffee beans sales were reported by customers and not staff. This suggests a lack of channels for staff to report problems confidentially, and therefore the board needs to make clear who staff should contact if they have concerns.      

Monitoring procedures 

Lastly the board should review evidence available from information systems and internal audit work and investigate signs of problems. The shops where there were ethical problems may have been underperforming in other areas.

(b)       Extent of responsibilities

The extent of internal auditors’ responsibilities are defined by the board. They can be given wide-ranging duties in relation to fraud, unlike external auditors whose responsibilities are concentrated on frauds that have a material impact on the financial statements.

Specific tests 

Audit tests could be used as a matter of course to pick up certain problems. Here for example reviewing shop purchase records and checking whether suppliers used were, or could have been, Fair Trade would have identified that problem.

Consideration of other evidence 

Internal audit should be alert for evidence that does not directly indicate fraud, but indicates the general possibility of problems at the shops. These include accounting results that are very

much better or worse than other shops and high staff turnover. Inadequate records or unwillingness to respond to auditor enquiries should also put the auditors on alert. These are signs that the shop may be high risk and thus require greater audit work.      

Recommendations for improvements  

Internal audit will be responsible for making recommendations to management for improvements in systems that could prevent problems occurring, or make it easier for management to detect them. These include shortcomings in human resource procedures, such as failure to check references properly. They could also include improvements in the reports provided by the information systems. Internal audit feedback could be a very useful source of information when changes in the information systems are being considered.

Audit approach 

Conducting audits solely by preannounced visits may limit the assurance the audit gives, since staff at the shops may behave while the auditors are there and cover their tracks beforehand. Surprise visits may identify issues such as shortages of cash or inventory.

Lack of evidence 

However, internal audit can only reasonably be expected to detect frauds that impact in some way on the business’s systems. It appears that the drug dealing manager took care to ensure that they covered their tracks, and did not leave any information for the internal auditors to detect. Internal auditors can also only be expected to work within their own areas of expertise. They are not trained members of the Police Drug Squad.

Prevention of problems 

Internal audit should always have a monitoring and detection role. To preserve internal audit independence, it should not be responsible for implementing systems that prevent problems occurring. If these are fully effective, then there will be nothing for internal audit to detect.

11 Loxwood

Top tips. In (a) observation is likely to be the most useful audit technique, although if staff are being observed, they may behave differently. You may have come up with other means for informing staff.

(b) is good revision of issues that we have discussed throughout this text; the impact of stakeholder views and voluntary principles-based disclosure versus compulsory rules-based disclosure.

Interestingly in (c) taking the expedient view may lead to Loxwood being more cautious about developing the product than if it took the social contractarian view, if the local community was strongly in favour of action being taken about the sea lions.

  • Testing for employee awareness

Employee awareness could be measured by observation, questionnaire and interview. In a large organisation a sampling approach could be taken. Observation could be largely unobtrusive and might provide a useful control on the results of interview, since some staff might make exaggerated claims about their environmental awareness.

Involvement of employees

The techniques of internal marketing could be used to involve employees. Internal marketing is the use of marketing techniques that are normally associated with communications flowing out from the organisation, for internal purposes. It is a concept associated with change management and therefore may be appropriate here.

A concerted campaign could be created. This could include messages in salary advices, posters, presentations, the formation of discussion groups, and the creation of a suggestion scheme specifically aimed at environmental issues. If there are any existing empowerment schemes, such as quality circles, it may be possible to introduce an environmental dimension into them.

  • Stakeholder interest

Public interest in corporate social responsibility is steadily increasing. Although financial statements are primarily intended for investors and their advisers, there is growing recognition that companies actually have a number of different stakeholders. These include customers, employees and the general public, all of whom are potentially interested in the way in which a company’s operations affect the natural environment and the wider community. These stakeholders can have a considerable effect on a company’s performance. As a result many companies now deliberately attempt to build a reputation for social and environmental responsibility. Therefore the disclosure of environmental and social information is essential.

Regulatory and professional interest

Another factor is growing interest by governments and professional bodies. Although there are no IFRSs that specifically require environmental and social reporting, it may be required by company legislation. There are now a number of awards for environmental and social reports and high quality disclosure in financial statements. These provide further encouragement to disclose information. 

Performance impact

There is also growing recognition that corporate social responsibility is actually an important part of an entity’s overall performance. Responsible practice in areas such as reduction of damage to the environment and recruitment increases shareholder value. Companies that act responsibly and make social and environmental disclosures are perceived as better investments than those that do not.

Compulsory or voluntary disclosure

At present companies are normally able to disclose as much or as little information as they wish in whatever manner that they wish. This causes a number of problems. Companies tend to disclose information selectively and it is difficult for users of the financial statements to compare the performance of different companies. However, there are good arguments for continuing to allow companies a certain amount of freedom to determine the information that they disclose. If detailed rules are imposed, companies are likely to adopt a ‘checklist’ approach and will present information in a very general and standardised way, so that it is of very little use to stakeholders. (c) Expedients

The expedient’s view would be that Loxwood should primarily pursue profit maximisation. However, the board has to realise that Loxwood’s activities generate, or are seen as generating, some excesses. The board therefore needs to accept CSR legislation and moral requirements, if it is broadly in line with Loxwood’s economic interests.

The board has decided that having a more enlightened corporate social responsibility position is in line with Loxwood’s interests. It may therefore be cautious about developing the sea lion repellent further, even if it is a profitable opportunity. Doing so may undermine Loxwood’s CSR policy, and cause Loxwood more problems than if it did not have its current focus on CSR. Loxwood could be accused of hypocrisy, which could carry a serious reputation risk.

Social contractarian

The social contractarian would see Loxwood’s duty as to deliver benefits to the local community from which it derives its power. Loxwood effectively has an agreement with the local community as it uses labour from it, and sells boats that impact on the local environment. It therefore should act in accordance with the ethical norms of the community.

However, this viewpoint may not be a very helpful guide for Loxwood, if the local community’s view is split. Local boat owners may be very happy for the company to develop its sea lion repellent and reduce the risks of their boats being damaged. Other members of the community may think it unethical for Loxwood to develop a product that causes animals distress.

Deep ecologist           

The deep ecologist position would be that human interests, either as individuals or collectively as a community, should not be prioritised over the interests of other species.

Even if the community felt that its pleasure was disrupted by having to be careful around sea lions, this is not relevant to the decision. The view of the deep ecologists would be that the device should not be developed because of the pain caused to the sea lions. The fact that the sea lions would suffer distress must be regarded as more important than the leisure activities of the community.

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