P1 ACCA Workbook

75 Pages·2012·0.35 MB·English

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ACCA P1 - Governance,
Risk & Ethics
Workbook
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Lecture 1 - Governance
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Illustration 1
In the country of Laland, aid organisations registered as charities are not subject to the
same financial reporting requirements as limited companies (this is not the case in many
other countries where they are treated equally in law). One person to take advantage of
this is Horace Hoi who has led his vigorous campaign in favour of animal protection for the
past 25 years. As a highly competent self-publicist for his charity and an engaging media
performer, he has raised the public profile of his charity substantially. He can and does
raise large amounts of money for his charity through his personal charm and passionate
appeals on television and in large meetings of supporters. His charity is called the ‘Horace
Hoi Organisation’ (HHO) and its stated aim is to ‘stop animals suffering’.
Mr Hoi has recently become the subject of criticism by the media because of allegations
that he lived a lavish lifestyle and personally owned a large mansion and a number of
classic cars. The HHO recently bought a private jet to support Mr Hoi in his travels around
the world for speaking engagements and for his work for the HHO charity. One journalist
reported that most of the donors to HHO are well-meaning individuals, mainly of modest
means, that care greatly about animal suffering and who would be ‘horrified’ if they knew
of the luxury in which Mr Hoi lived.
Despite the fact that Mr Hoi had claimed that he personally takes only a modest salary
from the organisation for his work, a journalist recently estimated Mr Hoi’s personal wealth,
thought to be gained from the HHO, to be around $10 million. When challenged to disclose
the financial details of the HHO and Mr Hoi’s own personal earnings, a HHO spokesman
simply replied that this was not required under the law in Laland and that the HHO was
therefore fully compliant with the law. The HHO has refused to join a group of other
charities that have undertaken to make full financial disclosures despite it not being
mandatory in law. The HHO says that although it does produce financial information for the
charity and tax authorities, it has no intention of making this information public. The HHO
also makes no disclosures about its governance structures and was once criticised as
being ‘intentionally opaque in order to hide bad practice’.
In yielding to the media pressure to provide some information on its financial affairs, HHO
eventually published a pie chart on its website saying that its expenditure was divided
between animal shelters (57%), field work helping animals (32%), administration (6%) and
other causes (5%). This was the totality of its public financial disclosure.
Required:
Define ‘transparency’ and construct the case for greater transparency in the governance of
the Horace Hoi Organisation.!
! ! ! ! ! ! ! ! ! ! ! (8 marks)
Solution
Define transparency
Transparency is usually defined in terms of openness and adopting a default position of
information provision rather than concealment. This means that unless there is an
overwhelming reason not to disclose information of any kind (perhaps for reasons of
commercial sensitivity) then information should be disclosed or made available upon
request to any interested stakeholder.
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The case for greater transparency at HHO
Transparency is an important principle in corporate governance, including at HHO, for a
number of reasons.
In general, transparency has the effect of reassuring investors that their funds are being
responsibly stewarded and used for worthwhile investments. In the case of a charity, such
as HHO, without shareholders in the conventional sense, donors give money to support
the charity’s stated aims and purposes. With the relief of suffering to animals being a
prominent reason any donors give to HHO, the amount of money diverted for other
purposes, such as salaries, would be information of considerable interest.
Transparency would inform and placate HHO’s critics, including the journalists who are
investigating it. Public commentators like journalists are capable of causing damage to
HHO’s reputation and this in turn can affect donations and support for the organisation.
There are a number of potentially damaging allegations made against Mr Hoi including the
likelihood of large payments to himself and some profligacy in the purchase of the private
jet. These allegations could be rebutted if the organisation were to make the accounts
public and explain the case for the purchase of the jet. For a charity receiving money from
‘well-meaning individuals that care greatly about animal suffering’, the allegations have the
potential to do much reputational damage to the charity.
The publication of the financial data is an inadequate expression of transparency and
appears to be a poor attempt to give the appearance of providing information whilst
providing no useful detail at all. This would not meet any stakeholder’s information needs
and fails to address any of the concerns raised about HHO. It does not give any absolute
financial figures, for example, in terms of income and costs. Such a truncated summary
actually gives the impression, to any informed observer, of an attempt at concealment and
this provides a strong reason to provide a full financial statement.
Illustration 2
Using the scenario above...
Discuss the ways in which charities differ from public listed companies and explain how
these differences affect their respective governance structures.!
! ! ! ! ! ! ! ! ! ! ! (9 marks)
Solution
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Charities and public listed companies
Differences
Firstly, the two types of organisation are different in terms of regulation. Listed companies
are subject to all the provisions of company law plus any listing rules that apply. Listing
rules, such as the need to adopt the Combined Code in the UK, impose a number of
obligations upon listed companies such as non-executive directors, committee structures,
a range of reporting requirements, etc. Charities, in contrast, must receive recognition by a
country’s charity authority to operate and they then receive the concessions that charitable
status confers. This often involves favourable tax treatment and different reporting
requirements. Because charities are not public companies they are not subject to listing
rules although, depending upon the country’s rules, they may be subject to audit and have
some reporting requirements.
The second difference is in the strategic purpose of the organisation. Listed companies
exist primarily to make a financial return for their investors (shareholders). This means that
they employ and incentivise people, including directors, to maximise long-term cash flows.
Value is added by the creation of shareholder wealth and this is measured in terms of
profits, cash flows, share price movements and price/earnings. For a charity, the strategic
purpose is to support the charitable cause for which the organisation was set up. It is likely
to be a social or benevolent cause and funds are donated specifically to support that
cause and this expectation places a different emphasis on the purpose of governance.
Thirdly, the two are different in terms of stakeholders and societal expectations. Society
typically expects a business to be efficient in order to be profitable so that, in turn, it can
create jobs, wealth and value for shareholders. Society expresses its support for a
business by participating in its resource or product markets, i.e. by supplying its inputs
(including working for it) or buying its products. A charity’s social legitimacy is tied up with
the charity’s achievement of benevolent aims. Stakeholders in a business often have an
economic incentive to engage with the organisation whereas most stakeholders in a
charity have claims more concerned with its benevolent aims.
Governance arrangements
There can be a number of substantive differences between the governance structures of
public companies and charities. In a public company, a board consisting of executive and
non-executive directors is accountable to the shareholders of the company. The principals
are able to hold the board accountable through AGMs (annual general meetings) and
EGMs (extraordinary general meetings) at which they can vote on resolutions and other
issues to convey their collective will to the board. In a charity, the operating board is
usually accountable to a board of trustees. It is the trustees who act as the interpreters and
guarantors of the fiduciary duty of the charity (because the beneficiaries of the charity may
be unable to speak for themselves). The trustees ensure that the board is acting according
to the charity’s stated purposes and that all management policy, including salaries and
benefits, are consistent with those purposes.
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Lecture 2 - Agency Theory
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Illustration 1
Mary Hobbes joined the board of Rosh and Company, a large retailer, as finance director
earlier this year. Whilst she was glad to have finally been given the chance to become
finance director after several years as a financial accountant, she also quickly realised that
the new appointment would offer her a lot of challenges. In the first board meeting, she
realised that not only was she the only woman but she was also the youngest by many
years.
Rosh was established almost 100 years ago. Members of the Rosh family have occupied
senior board positions since the outset and even after the company’s flotation 20 years
ago a member of the Rosh family has either been executive chairman or chief executive.
The current longstanding chairman, Timothy Rosh, has already prepared his slightly
younger brother, Geoffrey (also a longstanding member of the board) to succeed him in
two years’ time when he plans to retire. The Rosh family, who still own 40% of the shares,
consider it their right to occupy the most senior positions in the company so have never
been very active in external recruitment. They only appointed Mary because they felt they
needed a qualified accountant on the board to deal with changes in international financial
reporting standards.
Several former executive members have been recruited as non-executives immediately
after they retired from full-time service. A recent death, however, has reduced the number
of non-executive directors to two. These sit alongside an executive board of seven that,
apart from Mary, have all been in post for over ten years.
Mary noted that board meetings very rarely contain any significant discussion of strategy
and never involve any debate or disagreement. When she asked why this was, she was
told that the directors had all known each other for so long that they knew how each other
thought. All of the other directors came from similar backgrounds, she was told, and had
worked for the company for so long that they all knew what was ‘best’ for the company in
any given situation. Mary observed that notes on strategy were not presented at board
meetings and she asked Timothy Rosh whether the existing board was fully equipped to
formulate strategy in the changing world of retailing. She did not receive a reply.
Required:
(a) Explain ‘agency’ in the context of corporate governance and criticise the
governance arrangements of Rosh and Company.
! ! ! ! ! ! ! ! ! ! ! (12 marks)
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Solution
Defining and explaining agency Agency is defined in relation to a principal. A principal
appoints an agent to act on his or her behalf. In the case of corporate governance, the
principal is a shareholder in a joint stock company and the agents (that have an agency
relationship with principals) are the directors. The directors remain accountable to the
principals for the stewardship of their investment in the company. In the case of Rosh, 60%
of the shares are owned by shareholders external to the Rosh family and the board has
agency responsibility to those shareholders.
Criticisms of Rosh’s CG arrangements
The corporate governance arrangements at Rosh and Company are far from ideal. Five
points can be made based on the evidence in the case.
There are several issues associated with the non-executive directors (NEDs) at Rosh. It is
doubtful whether two NEDs are enough to bring sufficient scrutiny to the executive board.
Some corporate governance codes require half of the board of larger companies to be
non-executive and Rosh would clearly be in breach of such a requirement. Perhaps of
equal concern, there is significant doubt over the independence of the current NEDs as
they were recruited from retired executive members of the board and presumably have
relationships with existing executives going back many years. Some corporate governance
codes (such as the UK Combined Code) specify that NEDs should not have worked for the
company within the last five years. Again, Rosh would be in breach of this provision.
Succession planning for senior positions in the company seems to be based on Rosh
family membership rather than any meritocratic approach to appointments (there doesn’t
appear to be a nominations committee). Whilst this may have been acceptable before the
flotation when the Rosh family owned all of the shares, the flotation introduced an
important need for external scrutiny of this arrangement. The lack of NED independence
makes this difficult.
There is a poor (very narrow) diversity of backgrounds among board members. Whilst
diversity can bring increased conflict, it is generally assumed that it can also stimulate
discussion and debate that is often helpful.
There is a somewhat entrenched executive board and Mary is the first new appointment to
the board in many years (and is the first woman). Whilst experience is very important on a
board, the appointment of new members, in addition to seeding the board with talent for
the future, can also bring fresh ideas and helpful scrutiny of existing policies.
There is no discussion of strategy and there is evidence of a lack of preparation of
strategic notes to the board. The assumption seems to be that the ‘best’ option is obvious
and so there is no need for discussion and debate. Procedures for preparing briefing notes
on strategy for board meetings appear to be absent. Most corporate governance codes
place the discussion and setting of strategy as a high priority for boards and Rosh would
be in breach of such a provision.
There is no evidence of training for Mary to facilitate her introduction into the organisation
and its systems. Thorough training of new members and ongoing professional
development of existing members is an important component of good governance.
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Lecture 4 - The Board
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Illustration 1
KK is a large listed company. When a non-executive directorship of KK Limited became
available, John Soria was nominated to fill the vacancy. John is the brother-in-law of KK’s
chief executive Ken Kava. John is also the CEO of Soria Supplies Ltd, KK’s largest single
supplier and is, therefore, very familiar with KK and its industry. He has sold goods to KK
for over 20 years and is on friendly terms with all of the senior officers in the company. In
fact last year, Soria Supplies appointed KK’s finance director, Susan Schwab, to a non-
executive directorship on its board. The executive directors of KK all know and like John
and so plan to ask the nominations committee to appoint him before the next AGM.
KK has recently undergone a period of rapid growth and has recently entered several new
overseas markets, some of which, according to the finance director, are riskier than the
domestic market. Ken Kava, being the dominant person on the KK board, has increased
the risk exposure of the company according to some investors. They say that because
most of the executive directors are less experienced, they rarely question his overseas
expansion strategy. This expansion has also created a growth in employee numbers and
an increase in the number of executive directors, mainly to manage the increasingly
complex operations of the company. It was thought by some that the company lacked
experience and knowledge of international markets as it expanded and that this increased
the risk of the strategy’s failure. Some shareholders believed that the aggressive strategy,
led by Ken Kava, has been careless as it has exposed KK Limited to some losses on
overseas direct investments made before all necessary information on the investment was
obtained.
As a large listed company, the governance of KK is important to its shareholders. Fin Brun
is one of KK’s largest shareholders and holds a large portfolio of shares including 8% of
the shares in KK. At the last AGM he complained to KK’s chief executive, Ken Kava, that
he needed more information on directors’ performance. Fin said that he didn’t know how to
vote on board reappointments because he had no information on how they had performed
in their jobs. Mr Kava said that the board intended to include a corporate governance
section in future annual reports to address this and to provide other information that
shareholders had asked for. He added, however, that he would not be able to publish
information on the performance of individual executive directors as this was too
complicated and actually not the concern of shareholders. It was, he said, the performance
of the board as a whole that was important and he (Mr Kava) would manage the
performance targets of individual directors.
Required:
(a) Explain the term ‘conflict of interest’ in the context of non-executive directors
and discuss the potential conflicts of interest relating to KK and Soria Supplies if
John Soria were to become a non-executive director of KK Limited.
! ! ! ! ! ! ! ! ! ! ! (8 marks)