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Agenda

ACCT4007 l Agency theory and corporate governance

Corporate Governance l Role of corporations in society

l Stakeholder hierarchy
l Interplay between financial reporting and corporate
governance
l Development of corporate governance

Topic 1
Introduction
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Agency Theory and CG Agency Theory and CG

l Corporations and Republics l Typical organizational structure of a corporation

Republics Corporations Shareholders

Voters Shareholders
Representatives Directors
Bureaucrats Managers Directors
(Government and agencies) (C-suites and management staff)

Senior management

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Agency Theory and CG Agency Theory and CG

l Power-sharing rule between shareholders and managers l Basis of modern corporation

Democracy – Separation of ownership and managerial control
Little power for managers
Ø Shareholders purchase stock, becoming residual
Strong shareholders’ rights to quickly and easily replace managers/directors
claimers (receive investment returns and bear
Dictatorship investment risks).
Extensive power for managers
Ø Professional managers are contracted (compensation
Restrictions on shareholders’ ability to replace managers/directors
contract) to be in charge of corporate operations,
l Why is a power-sharing rule between shareholders and making managerial decisions to generate returns on
managers needed for a corporation? shareholders’ investment.

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Agency Theory and CG Agency Theory and CG

l Agency problem arises when:
l Agency Problem – Type I
Ø The interests or goals of the principal (shareholders)
and the agent (managers) conflict.
Dispersed shareholdings
◇ Maximize shareholders’ value VS. Maximize managers’
personal benefits
Ø It is difficult or costly for the principal to verify whether the Conflict of Interests
agent behaves appropriately.
Ø Managers’ opportunistic behavior to seek personal benefits
◇ Excessive compensation
Shareholders Managers

◇ Perks (e.g., corporate jet for personal use)

◇ Reputation and other non-monetary benefits
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Agency Theory and CG Agency Theory and CG

l Agency Problem – Type II l Corporate governance is the system of principles,

policies, procedures and clearly defined
Concentrated shareholdings responsibilities and accountabilities used by
shareholders to overcome conflicts of interest inherent
in the corporate form.
Conflict of Interests Ø Eliminate or reduce conflicts of interest.
Ø Use the company’s assets in alignment of interest between:

Controlling Minority ◇ Shareholders and managers

Shareholders Shareholders ◇ Controlling and minority shareholders

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Role of Corporations in Society Role of Corporations in Society

l Corporations should create values for all stakeholders.

Ø Obtain capitals from stakeholders
◇ Financial capital from shareholders and creditors
◇ Labor (managerial) capital from employees (management)
Ø Conduct value-added activities
Ø Return sustainable value to their stakeholders.

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Role of Corporations in Society Goals of Corporate Governance

l All stakeholders are provided with incentives and opportunities
to reward corporations for good performance and discipline l CG is designed to achieve the following two goals.
them for poor performance. Ø Value creation goal : Shareholder value creation and
Ø Shareholder (investors) and creditors (lenders): enhancement through the development of long-term
◇ Reward good corporate performance by requiring a lower strategies to ensure sustainable operational
desired rate of return on investment (cost of capital) performance.
◇ Discipline poor corporate performance by disinvesting or
Ø Value protection goal : Corporate accountability to
demanding a higher rate of return on investment
protect the interests of shareholders and other
Ø Suppliers and customers:
stakeholders.
◇ Reward good corporate performance by actively and
favorably doing business with the company.
◇ Discipline poor corporate performance by restricting business
with the company.
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Stakeholder Hierarchy Stakeholder Hierarchy

l Eight layers in three general tiers Tier 1: Investors (Shareholders)

l Primary stakeholders
Ø Without investors (shareholders), the company would not exist.

l Importance of CG for investors (shareholders)

Ø Reduce agency costs due to separation of ownership and control
Tier 3
Ø Align the interests of management and shareholders
Ø Maximize shareholder wealth

Tier 2

Tier 1
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Stakeholder Hierarchy Stakeholder Hierarchy

Tier 1: Investors (Shareholders) Tier 1: Investors (Shareholders)

l Types of voting system

l Role of investors (shareholders) in CG
Ø Plurality voting system
Ø Shareholders: Participate and shape CG structure by
exercising voting rights to nominate, elect, or remove ◇ For uncontested director elections , a single vote for a
directors on the board. nominee can elect that director to a board regardless of number
of withholding votes.
Ø Board of directors: Directly responsible for protecting
shareholders’ interests and ultimately accountable to Ø Majority voting system
shareholders for the company’s business affairs. ◇ Requiring a director who received a majority of “against” or
“withhold” votes to resign.

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Stakeholder Hierarchy Stakeholder Hierarchy

Tier 2: Creditors (Lenders) Tier 3: Other stakeholders

l Conflict of interests l Other stakeholders who influence or are influenced, either

Ø Management may be motivated to transfer wealth from directly or indirectly, by corporate activities.
creditors to shareholders . Ø Employees
l Role of creditors in CG Ø Suppliers
Ø Demand for control over managerial actions by entering into Ø Customers
debt covenant contracts designed to protect creditors’ interests. Ø Government
Ø Community
Ø Society

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Stakeholder Hierarchy Interplay between Financial Reporting and CG

Tier 3: Other stakeholders Role of financial reporting in CG

l Impacts of CG on Tier-3 stakeholders l Good CG is supported by full disclosure .

Ø Smoothness along the value chain Ø Providing comprehensive financial data
◇ Maintain good relations with suppliers ◇ E.g., there has been a serious problem with the use of off-
◇ Improving customer satisfaction balance-sheet finance and special-purpose entities (SPEs)
Ø Relation with employees: Caring, working safety, etc. which conceal certain activities (e.g., omission of SPEs in
financial reports by Enron). Good CG requires full disclosure
Ø ESG: Environmental protection, social and community issues
in group accounts.
Ø Resolving conflicts with stakeholder activists

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Interplay between Financial Reporting and CG Interplay between Financial Reporting and CG

Role of financial reporting in CG Effect of CG on financial reporting

l Good CG is supported by full disclosure . [Continued] l Effective CG should ensure the quality of financial
Ø Providing comprehensive narrative information reporting.

◇ Provide forward-looking information , which are likely l Financial reports are typically scrutinized through several
to be very important in the future (e.g., corporate processes for the verification of their completeness and
strategies and opportunities, corporate sustainability reliability.
and environmental issues).
◇ Disclose CG information in annual reports.

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Interplay between Financial Reporting and CG Interplay between Financial Reporting and CG

Effect of CG on financial reporting Effect of CG on financial reporting

l Layers of financial reporting scrutiny l Six layers (gatekeepers) of scrutiny
Ø Management certification of the quality of financial statements in
presenting fair and true financial condition and results of operations
Ø CG oversight of financial statements , particularly audit committee
Ø Management certification and internal auditor’s assessment of
the effectiveness of internal control over financial reporting (ICFR)
Ø Independent audit reports on both fair presentation of financial
statements and effectiveness of ICFR
Ø SEC reviews of published financial statements and PCAOB (Public
Company Accounting Oversight Board) inspections of audit
quality
Ø Monitoring of published financial statements by users of financial
reports, particularly institutional investors and financial analysts .
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Interplay between Financial Reporting and CG Development of CG

Effect of CG on financial reporting
l Financial scandals in late 1990s and early 2000s (e.g., Enron,
l Responsibility of external auditors as a gatekeeper WorldCom) and 2007-2008 global financial crisis underscore the
Ø Be fully independent from the company importance of vigilant CG.

Ø Exercise professional skepticism when attesting to or relying l CG reforms occurred in U.S. to enforce more accountability for
on representations of management public companies

Ø Fulfill their professional responsibility to the investing public Ø Sarbanes-Oxley Act (SOX)

Ø Withdraw from the engagement when the integrity of their work Ø Dodd-Frank Act
is compromised due to factors beyond their control. Ø SEC implementation rules
l Effective corporate governance depends on the quality of value- Ø Listing rules of stock exchanges
adding activities of all gatekeepers.
Ø Best practices and guiding principles of professional organizations

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Development of CG Development of CG

l Previous primary focus of CG: Economic issue of l Effective CG can only be achieved when all participants :

creating long-term shareholder value Ø add value to the company’s sustainable long-term
performance
l Current trend of CG: Emphasis on social, ethical, and
Ø effectively carry out their fiduciary duty and professional
environmental issues
responsibilities
l CG has evolved from compliance requirements to a Ø are held accountable and personally responsible for their
business imperative of aligning management performance
interests with those of all stakeholders . Ø develop a practice of not only complying with applicable
regulations (e.g., laws and listing rules), but also committing to
doing the right thing and observing ethical principles of
professional conduct in avoiding potential conflicts of interest.

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Example: Apple Inc. (AAPL.NASDAQ)

Use Apple’s SEC filings as the example through the course: ACCT4007
ü 2019 annual report (Form 10-K) Corporate Governance
◇ For the fiscal year ended on 2019/09/28
◇ Filing date: 2019/10/31

ü 2020 proxy statement (Form DEF 14A)

◇ For the fiscal year of 2019
◇ Filing date: 2020/01/03
◇ Prepared for 2020 annual general meeting of shareholders held Topic 2
on 2020/02/26
Fundamentals and
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Regulatory Framework 32

Agenda Definition of CG

l Definition of CG
l The term used to describe the way a company is
l Aspects of CG (shareholder and stakeholder) managed, monitored, and held accountable .
l CG structure (principles, functions, and mechanisms) l No universally accepted definition.
l Sources of CG requirements l Defined in different ways and from different perspectives.
l CG reforms
l CG rating
l CG reporting
l Global differences in CG
l Business ethics

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Definition of CG Definition of CG

l View of capital providers (shareholders and creditors) l Regulatory perspective

Ø Dealing with the ways in which suppliers of finance to Ø The system of laws, rules, and principles that
corporations assure themselves of getting a return on regulate the power relationship among
their investment . shareholders, directors, and managers .
l Broader view of stakeholders Ø Focusing on enforcement of shareholders’ rights .
Ø A field in economics that investigates how to motivate
management by the use of incentive mechanisms
(such as contracts, organizational design, and
legislation) to act in the interests of stakeholders.

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Definition of CG Definition of CG

l Comprehensive definition for this course l Key objectives of CG

Ø A process
Ø Efficient and effective operational, financial, and social
Ø Affected by a set of legal and regulatory rules, market
performance.
mechanisms, listing standards, best practices, and efforts
of all CG participants (including the company’s directors, Ø Shareholder value creation and stakeholder value
officers, auditors, legal counsel, and financial advisors) protection.
Ø Creating a system of checks and balances with the goal of Ø High quality and transparency of financial reporting.
creating and enhancing sustainable shareholder value ,
while protecting the interests of other stakeholders (e.g.,
employees, suppliers, customers, and creditors).

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Aspects of CG Aspects of CG
Shareholder aspect
l Corporate governance has evolved:
l Principal-agent problem
Ø From “shareholder aspect” : Reducing agency costs for
Ø Shareholders (principals) provide capital to the company,
creating long-term shareholder value
which is run by management (agent) .
Ø To “stakeholder aspect” : Increasing value for all
Ø Principal-agent problem arises from two factors:
stakeholders by both meeting compliance requirements and
◇ 1) Separation of ownership and control
promoting strategic business imperative
◇ 2) Incomplete (or costly) contracts

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Aspects of CG Aspects of CG
Shareholder aspect Shareholder aspect

l 1) Separation of ownership and control l 2) Incomplete contracts or costly enforceable contracts

Ø Shareholders own corporations. between the agent and the principal
Ø Board of directors is elected. Difficulties in verifying management activities
Ø Executives are hired to make business decisions on behalf of  “Information asymmetry” between management and shareholders:
the shareholders. Management possesses information that is not disclosed or
Ø Interests of management and shareholders may not always available to investors
be aligned.  Management entrenchment

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Aspects of CG Aspects of CG
Shareholder aspect Shareholder aspect

l Two types of managerial failures may prevent management l Under the shareholder aspect, CG is designed to:
from acting in the best interest of shareholders: Ø Align the interests of management with those of
Ø Failure of managerial competence resulting from shareholders
unintentional mistakes or negligence in discharging Ø Reduce the agency costs
fiduciary duties Ø Ensure the enhancement of shareholder wealth
Ø Failure of managerial integrity caused by willful or
opportunistic behaviors (e.g., illegitimate earning
management and fraudulent activities)

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Aspects of CG Aspects of CG
Shareholder aspect Stakeholder aspect

l Specific roles of CG under shareholder aspect l Stakeholders: Individuals or groups who affect the company’s
(1) Providing incentives and opportunities for management to carry out its strategic decisions, operations, and performance, and are also
function effectively , and to maximize shareholder wealth by providing affected by the company’s decisions or activities.
executive compensation plans, ownerships, or stock options.
(2) Strengthening shareholder rights to monitor, control, and discipline l Broader view
management through enforceable contracts or legal protection. Ø Shareholders : Still primary recipient of the company’s reports
(3) Promoting shareholder democracy , through majority voting and shareholders’
on economic performance .
access to proxy materials for nomination and election of directors.
(4) Improving the vigilance of the board’s oversight function. Ø Stakeholders : More engaged in the company’s Multiple
(5) Holding directors accountable and liable for fulfillment of fiduciary duties . Bottom Lines (MBL) performance , including economic,
(6) Improving the effectiveness of both internal CG mechanisms (board of governance, ethical, social, and environmental issues.
directors, internal controls) and external CG mechanisms (external audit,
monitoring, and regulatory functions).

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Aspects of CG Aspects of CG
Stakeholder aspect Stakeholder aspect

l Performance of the company is measured by: l Under stakeholder aspect, CG is designed to:
Ø Key financial indicators: Earnings, market share, stock price Ø Maximize values for all stakeholders, including:
Ø Social indicators: Employment, customer satisfaction, fair ◇ Contractual participants: shareholders, creditors, suppliers,
trading with suppliers customers, and employees.
Ø Ethical indicators: Proper business culture, business code of ◇ Social constituents: local community; society and global
conduct partners; local, state, and federal governments; and
Ø Environmental indicators: Anti-pollution, preservation of environmental matters.
natural resources l Companies must be socially responsible.

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Aspects of CG CG Structure
Stakeholder aspect l Three interrelated components

l Influence of stakeholders on CG
Shareholders:
Ø Entitled to direct and monitor the company’s operations and affairs
Ø Influencing CG by exercising their voting rights to elect directors
Other stakeholders:
Ø Do not have the rights to direct or monitor the company
Ø Interests are protected under the contracts and laws

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CG Principles CG Principles
l Honesty l Resilience
Ø Telling the truth at all times, regardless of the consequences. Ø Resilient CG is sustainable and enduring in the sense that it will
Ø Establishing a trusting relationship among all CG participants. easily recover from setbacks and abuses .
Ø Corporate communications with both internal and external l Responsiveness
audiences, including public financial reports , should be
Ø Timely and appropriate responses to the requests and interests
transparent and trustworthy .
of all stakeholders .
Ø Reputation for honesty:
◇ E.g., response to investor activists regarding say-on-pay voting
◇ Can be earned over time through truthful and transparent
outcome
corporate communication.
Ø Responsive to changes in regulatory, social, and
◇ But can be easily destroyed through lies, deceptions, and
environmental issues .
frauds.

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CG Principles CG Principles
l Transparency l Transparency
Ø A company is not hiding relevant information , and disclosures Ø 1) Full disclosures of financial and non-financial information
are fair and reliable .
◇ Complete, fair, reliable, and understandable disclosures in
Ø Companies’ actions, governance, and financial and nonfinancial financial reports and non-financial information related to
aspects of its business should be easily available and
operations, structures, and executive compensation linked to
understandable by all parties concerned.
long-term financial performance.
SEC Chairman Christopher Cox, regarding the usefulness and transparency of both
financial and nonfinancial information provided to investors, states: Example: Readability of information disclosures
A proxy statement today may well contain all the required information, and yet ü Plain English guidelines
still not tell anybody much of anything … ü Not attempting to hide relevant, but potentially negative, information by
Investors and their directors have a right to the information. Complete. Clear.
disclosing it in vague sentences buried in the middle of a voluminous
Comprehensible. If someone orders a steak, you don’t give them a cow
document
and a meat cleaver. Investors should get all the information they need—and
they should get it in a form they can use .
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CG Principles CG Principles
l Transparency l Transparency
Ø 1) Full disclosures of financial and non-financial information Ø Transparent CG is open and understandable to all concerned
◇ Disclosure of significant events and transactions that could parties in terms of its goals, principles, mechanisms, and
possibly affect the judgment and decisions of stakeholders in functions.
dealing with the company.
Example: Corporate governance report
Example: Disclosure of related parties and related party transactions ü Included as an integral part of annual reports (Item 10 in 10-K)
ü Enron failed to disclose “Special Purpose Entities” (SPEs) that were ü Providing information about the company's risk management system,
established to exaggerate earnings and hide liabilities. internal controls, shareholders’ rights and meetings, and the board of
directors and its committees.

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CG Principles CG Principles
l Value-adding philosophy l Accountability
Ø All CG functions should add value to the company’s sustainable Ø All CG participants should be held accountable for their
performance. decisions, actions, and performance .
l Independence ◇ E.g., top management should accept accountability and
Ø CG process and its related mechanism should minimize or avoid responsibilities for the Multiple Bottom Lines (economic, ethical,
conflicts of interests and self-dealing actions of its key social, and environmental performance).
personnel.
l Competence
Ø Capability of those who carry out key functional responsibilities
(7 CG functions to be discussed later).

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CG Principles CG Principles
l Shareholder democracy and fairness l Shareholder democracy and fairness
Ø Shareholders should have the rights to: Ø Shareholder democracy is enhanced when shareholders are
◇ vote for the election of directors granted:

◇ receive periodic financial statements ◇ Access to proxy materials for the nomination of director

◇ demand access to corporate documents, including minutes of candidates

board meetings ◇ Majority voting for the election of directors

◇ submit shareholder resolutions that are placed in the annual ◇ Advisory voting for the approval of executive compensation
proxy statement
◇ vote on important business transactions (e.g., M&A)

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CG Principles CG Functions
l Ethical conduct
Ø CG should promote ethical conduct for all CG participants.
◇ Appropriate tone at the top
◇ Commitment by all employees throughout the company to
adhere to ethical behavior
Ø Integrate corporate culture of ethics into CG structure to
encourage all personnel to “ do the right thing” , which is vital to
the achievement of sustainable performance

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CG Functions CG Functions
Oversight function Managerial function

l Board of directors l Management team

Ø Led by CEO
l Fiduciary duty of overseeing managerial behavior in the best
interests of stakeholders Ø Supported by CFO and other senior executives

l Providing strategic advice to management l Responsible for running the company and manage its resources,
operations, and disclosures to maximize stakeholders’ benefits.
l Effectiveness of this function depends on directors’
l Effectiveness of this function depends on:
independence, expertise, authority, resources, composition,
Ø Alignment of interests between management and stakeholders
and accountability .
Ø Independence of the board from management (e.g., CEO duality)
Ø Proper executive compensation tied to sustainable performance
Ø Soundness of whistle-blowing policies

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CG Functions CG Functions
Compliance function Internal audit function

l Governing bodies l Internal auditors

Ø Policy-makers, regulators, standard-setting bodies, and l Providing both assurance and consulting services to the
professional organizations company in the areas of operational efficiency, risk management,
l Creating a compliance framework consisting of laws, internal controls, financial reporting, and governance processes.
regulations, standards, and best practices for companies to Ø E.g., assisting management in complying with the SOX by reviewing
comply with. management’s certifications on financial statements and internal
control over financial reporting (ICFR), and providing assurance on
the accuracy of these certifications.

l Effectiveness of this function depends on the independence,

objectivity, competence, experience, and integrity of internal
auditors.
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CG Functions CG Functions
Advisory functions Advisory functions

l Legal advisory function l Financial advisory function

Ø Legal counsels (lawyers) Ø Professional advisors and consultants
Ø Providing legal advice and assisting the company in complying ◇ Providing advice on financial planning, public filings, and
with applicable laws and other legal obligations and fiduciary disclosures to the management and the board.
duties. Ø Effectiveness of this function depends on professional
Ø Effectiveness of this function depends on legal counsels’ objectivity, independence, training, and experience of
professional objectivity, competence, and integrity . advisors and consultants.

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CG Functions CG Functions
External audit function Monitoring function

l External auditors l Shareholders

l Lending credibility to financial reports Ø Particularly institutional shareholders (e.g., pension funds,
hedge funds, mutual funds, insurance companies) and
l Expressing audit opinions that financial statements truly and
investor activists
fairly represent, in all material respects, the company’s financial
l Empowered to vote for election and removal of directors
position and the results of operations in conformity with GAAP.
Ø Shareholder proposals on director election, executive
l Integrated audit of both financial statements and internal
compensation, and other issues
control over financial reporting .
l Effectiveness of this function depends on the participation and
l Effectiveness of this function depends on independence,
attentiveness of shareholders.
objectivity, competence, and integrity of external auditors in
Ø E.g., be attentive in looking after their investments by
providing a high-quality integrated audit.
participating in director election and engaging in proxy process.
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CG Functions CG Mechanisms
Monitoring function
l CG structure is shaped by:
l Other stakeholders
Ø Internal governance mechanisms
Ø Creditors: Debt covenant
Ø External governance mechanisms
Ø Financial analysts : Communicate with top management for
l Both internal and external mechanisms:
analyst forecasts and stock recommendation
Ø Monitor, control, reward, and discipline management.
Ø Protect stakeholders from corporate abuses and misconducts
Ø Align interests of insiders (management, directors, and officers)
with the interests of outsiders (shareholders and other
stakeholders)
Ø Create sustainable stakeholder value

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CG Mechanisms CG Mechanisms

l Internal mechanisms l External mechanisms

Ø Board of directors (particularly independent directors) Ø Capital market

Ø Internal audit functions (particularly audit committee) and Ø Market for corporate control (M&A)
internal controls Ø Labor market
Ø Insider ownership Ø Shareholder proposals by investor activists
Ø Best practices by professional organizations
Ø Policy interventions through regulations and enforcement by
court decisions.

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CG Mechanisms CG Mechanisms

l External mechanisms l External mechanisms

Example: Market for corporate control

Example: Capital Market
ü Inefficient and poorly performing companies are often a target for a
ü The mechanism of pricing securities can discipline managers. hostile takeover .
Investors could sell shares for poor-performing companies, leading to
sharp price decline.
Manager’s stock-based compensation (stocks and options) would Example: Managerial labor market
suffer losses. ü Managerial labor market can discipline managers.
ü Companies with good CG could obtain financing with lower cost of A manager’s past performance is evaluated by the market in their
capital. future employment .
The competition in the labor market encourages managers to behave
responsively.

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CG Mechanisms Sources of CG Requirements (U.S.)

Federal securities law

l The above market-based mechanisms alone could not solve
l Passed by Congress
corporate governance problems.
l Two fundamental laws after 1929 market crash:
l Both internal and external mechanisms (including policy
interventions) are needed. Ø Securities Act of 1933
Ø Securities Exchange Act of 1934
◇ Intended to protect the investors from receiving misleading financial
information and improve investor confidence in capital market.
◇ Established Securities and Exchange Commission (SEC) to
implement and enforce provisions of the securities acts.
◇ Primarily disclosure-based statutes : Require public companies to file
periodic reports with the SEC and disclose certain information to their
shareholders for decision-making.
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Sources of CG Requirements (U.S.) Sources of CG Requirements (U.S.)

Federal securities law Federal securities law

l Sarbanes-Oxley Act (SOX) of 2002 after financial scandals during l Dodd-Frank Wall Street Reform and Consumer Protection Act
the late 1990s and the early 2000s (Dodd-Frank Act) of 2010 after the 2007-2008 financial crisis:
Ø Expanded the role of federal laws in CG by providing measures Ø Minimize the probability of future financial crises and systemic
to improve corporate governance structures, financial distress
reports, and audit activities Ø Put in place CG measures for large financial services firms

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Sources of CG Requirements (U.S.) Sources of CG Requirements (U.S.)

State corporate laws State corporate laws

l Differ from one state to another l Intended to protect shareholder rights by enabling investors to:
l Establish standards of conduct for companies Ø elect directors
l Define fiduciary duties, authorities, and responsibilities of Ø inspect companies’ books and records
shareholders, directors, and management Ø approve certain business transactions (e.g., M&A)
Ø The board has a fiduciary duty to shareholders. Ø receive proxy materials
Ø The board determines the compensation of directors and officers. Ø receive disclosures for related-party transactions
Ø The board oversees managerial decisions and actions.

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Sources of CG Requirements (U.S.) Sources of CG Requirements (U.S.)

Listing standards Best practices

l Adopted by stock exchanges (e.g., NYSE, NASDAQ) l Recommended by professional organizations (The Conference
l Establish CG standards for listed companies Board, Business Roundtable Institute) and investor activists (Council
Ø Revised to comply with SOX and Dodd-Frank Act of Institutional Investors)
l Typically supplement the requirements of corporate and federal l Nonbinding guidelines to improve CG policies and practices
laws by providing specific CG guidelines . beyond laws and listing standards
Ø E.g., shareholder approval of executive compensation (say-on-pay Ø Examples:
voting since 2011)
◇ Separation of the positions of CEO and chair of the board
l Trend:
◇ Majority voting system (instead of plural voting system)
Ø Improving ESG (environmental, social, and governance)
disclosure and performance with the ultimate goal of
encouraging responsible long-term approaches to investment .
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CG Reforms CG Reforms
Sarbanes-Oxley Act (SOX) of 2002 Sarbanes-Oxley Act (SOX) of 2002
l Key provisions
l Background
Category 1: CG provisions
Ø Late 1990s to Early 2000s:
ü Set high standards and new guiding principles for CG
◇ Collapse of the dotcom market
Category 2: Financial Reporting provisions
◇ Economic downturn
ü Improve quality and transparency of financial reporting (including effectiveness of
◇ Financial scandals: Enron, WorldCom, Global Crossing, and Qwest ICFR and related risk management assessment)
(known as the Big Four scandals) cost investors over $460 billion. Category 3: Auditing provisions
◇ Numerous restatements of financial reports (e.g., Xerox, AOL, Tyco) ü Establishing an independent regulatory structure PCAOB (Public Company Accounting
◇ Concerns over auditors’ independence, objectivity, and credibility (e.g., Oversight Board) to regulate auditing practices of auditors who audit public
Arthur Andersen) companies.
ü Improve objectivity and credibility of audit functions and empower audit committee
Ø Need to restore investor confidence and public trust in financial reports
Category 4: Other provisions
and financial markets
ü Create more severe civil and criminal remedies for violations of federal securities laws
Ø Sarbanes-Oxley Act (Public Company Accounting Reform and Investor
ü Increase independence of securities analysts
Protection Act): Passed by the Congress and signed into law in July 2002 ü Enhance shareholder monitoring and democracy
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CG Reforms CG Reforms
Sarbanes-Oxley Act (SOX) of 2002 Sarbanes-Oxley Act (SOX) of 2002

Example: Apple’s Annual Report and Proxy Statement

ü [CG-3 & FR-1] CEO/CFO certification
ü [CG-2] At least one member on audit committee who is a
“financial expert”
ü [FR-3 & AF-9] Auditor’s assessment of IC over FR
ü [AF-11] Fees paid to the auditor

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CG Reforms CG Reforms
Sarbanes-Oxley Act (SOX) of 2002 Sarbanes-Oxley Act (SOX) of 2002

l Embedded benefit of compliance l Compliance cost

Ø Benefits to companies : Improved CG structure, quality and Ø Survey conducted in 2007 (sample: 2000 corporate executives):
transparency of financial reports, effectiveness of internal ◇ Total compliance costs decreased by 35% from $4.51 million per
controls, and audit quality. company in 2005 to $2.9 million in 2006.
Ø Benefits to investors : Increased protection against misleading ◇ No significant change in audit fees.
financial reports and thus better assessment of the risk and
◇ 78% of respondents reported that the costs to comply with
return of their investments.
Section 404 (internal control reporting by management and
Ø Positive effects on capital markets and economic growth . independent auditors) outweigh any benefits.

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CG Reforms CG Reforms
Dodd-Frank Act (2010) Dodd-Frank Act (2010)
l Background l Background
Ø 2007-2008 global financial crisis: Ø To minimize the probability of future financial crises and
◇ Caused by subprime crisis : Mortgage financing providers systemic distress
(Fannie Mae: Federal National Mortgage Association; Freddie Ø To address serious concerns about financial services firms’
Mac: Federal Home Loan Mortgage Corporation) and housing value-adding activities, ethics and governance (e.g.,
agencies, along with the excessive use of market-based short- accountability of board of directors, senior management, internal
term funding by financial service firms and external auditors, and other CG participants).
◇ Failures of five major financial institutions : Goldman Sachs Ø Dodd-Frank Act (Dodd-Frank Wall Street Reform and Consumer
Group Inc., Bear Stearns Co., Morgan Stanley, Lehman Protection Act of 2010): Passed by the Congress and signed into
Brothers Holdings Inc., and Merrill Lynch & Co. law in July 2010
◇ Costly government bailout of these firms
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CG Reforms CG Reforms
Dodd-Frank Act (2010) Dodd-Frank Act (2010)

l Purpose of Dodd-Frank Act is intended to: l Key changes of Dodd-Frank Act

Ø strengthen board oversight of management Ø Mostly pertain to financial institutions, credit rating agencies, and
derivatives market.
Ø position risk management as an important board responsibility
(1) Broaden the oversight role of Federal Reserve to regulate a larger
Ø link executive compensation schemes and practices with long- scope of financial services firms that could threaten the financial system.
term sustainable performance (2) Establish FSOC (Financial Services Oversight Council) to monitor the
systemic risk of financial institutions.
Ø encourage shareholders to take a more active role in CG (3) Establish the independent CFPB (Consumer Financial Protection Bureau)
Ø promote convergence in a set of globally accepted CG measures to oversee financial regulations and their enforcement .
(4) Regulate over-the-counter derivatives (e.g., Credit Default Swap).
Ø enable integration of business sustainability into CG
(5) Establish FIO (Federal Insurance Office) to oversee insurance companies
and their activities.
(6) Increasing accountability and transparency for credit rating agencies .
93 (7) Increase shareholder democracy (e.g., say-on-pay vote ) 94

CG Reforms CG Reforms
Dodd-Frank Act (2010) Dodd-Frank Act (2010)
l Main provisions l Main provisions [Continued]
Ø Shareholders’ nonbinding or advisory votes on executive Ø Claw-back provision
compensation ◇ Reclaiming incentive-based executive compensation when the
◇ Say on pay company subsequently restates its financial statements
◇ Say on golden parachutes (payments to executives because of material misstatements.
associated with M&As and major asset transactions)
Example: Apple’s Proxy Statement
Example: Apple’s Proxy Statement
ü Does Apple have claw-back provisions?
ü What is the percentage of favorable votes in Apple’s say-on-pay
voting?

95 96

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CG Reforms CG Reforms
Dodd-Frank Act (2010) Dodd-Frank Act (2010)
l Main provisions [Continued] l Main provisions [Continued]
Ø Disclosure requirements Ø Independence of compensation committee
◇ Graphs/charts showing pay-for-performance linkage
◇ CEO pay ratio: Ratio of CEO pay to the median of the Example: Apple’s Proxy Statement
employees’ compensation (excluding CEO pay)
ü How many independent directors on Apple’s compensation
◇ Explain why the company has chosen to combine or separate committee?
the board chair and CEO positions
ü Is the chair of compensation committee independent?

Example: Apple’s Proxy Statement

ü What is the CEO pay ratio of Apple?

97 98

CG Reforms CG Reforms
Dodd-Frank Act (2010) Consequences of CG reforms
l Shifting power balance between shareholders, directors, and management
l Main provisions [Continued]
Shareholders:
Shareholders:
Ø Standards on avoidance of conflicts of interest when retaining More proactive
ü More
ü proactive and
and attentive in monitoring
attentive in monitoring corporate
corporate performance
performance
compensation consultants Stronger power
ü Stronger
ü power to
to hold
hold directors
directors and
and executives
executives accountable
accountable
Directors:
Directors:
Ø Establishing risk committee in public nonbank financial
ü Stronger commitment,
ü Stronger commitment, independence,
independence, and
and accountability in fulfilling
accountability in fulfilling fiduciary
fiduciary
companies supervised by the Federal Reserve and bank holding duties
duties of
of overseeing
overseeing management’s
management’s decisions
decisions and
and performance.
performance.
companies with assets of more than $10 billion Executives:
Executives:
Ø Prohibiting brokers to vote on compensation matters (without ü Refocusing
ü Refocusing away
away from
from short-term
short-term earnings
earnings management
management toto achieving
achieving
sustainable
sustainable shareholder
shareholder value
value creation
creation
instruction from beneficial holders)
ü Improving quality of financial reports through executive certification
ü Improving quality of financial reports through executive certification of
of
internal
internal controls
controls and
and financial
financial statements.
statements.
Ø Small public company (with less than 700 million market
Audit function:
Audit function:
capitalization) is exempted from management certification and
ü More
ü vigilant oversight
More vigilant oversight of
of audit
audit committee
committee
audit opinion on ICFR (required by Section 404 of SOX), due to
Improving audit
ü Improving
ü audit quality
quality
compliance cost considerations. l Enhancing investor confidence in the capital markets
99 100

CG Rating CG Rating

l CG ratings organizations Example: GMI

Ø Institutional Shareholder Services (ISS)
Scoring algorithm based on hundreds of metrics (relevant to
Ø Governance Metrics International (GMI) governance quality and risk assessment) in six categories:
Ø Corporate Library ü board accountability
Ø Standard & Poor’s ü financial disclosure
Ø Moody’s Investment Service ü shareholder rights
Ø Glass Lewis & Co. ü executive compensation
Ø Equilar ü takeover defenses
ü reputation/regulatory problems

101 102

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CG Rating CG Reporting

l Objectives of CG reporting
l Uses of the CG ratings
Ø Assess quality and effectiveness of CG.
Ø Shareholders: Assessing stock returns
Ø Report on company vision, strategies, and missions in creating
Ø Bondholders: Determining costs of lending
stakeholder value and financial, economic, social, and
l Research findings environmental indicators .
Ø Companies with higher CG ratings have better stock Ø Report to interested stakeholders (e.g., shareholders, board
performance, lower cost of equity capital (because of of directors, executives, auditors, regulatory agencies).
perceived lower agency risk to shareholders), lower
systematic risk, and lower idiosyncratic (specific) risk.

103 104

CG Reporting CG Reporting

l Principles of CG reporting l Differences between CG reporting and financial reporting

Ø Disclose all relevant information about effectiveness of CG. Financial reporting CG reporting
ü Prepared in accordance with ü No single set of standards that are
Ø Focus on corporate sustainability performance .
GAAP widely agreed on
Ø Provide transparent information about corporate performance ü Audit required ü No mandatory assurance report
and its impacts on all stakeholders. ü No guidelines specifying the type and
level of assurance
Ø Assess the company’s responsiveness to the needs of its ü Primarily for shareholders and ü For a broad range of stakeholders with
stakeholders. creditors different and often competing interests
ü Mostly financial information ü Both financial (quantitative) and
nonfinancial (qualitative) information
Example: Apple that requires special skills in
What are the main contents of CG report of Apple? assessing credibility and reliability

105 106

Global Differences in CG Global Differences in CG

Country statutes
l No globally accepted CG structures and best practices
l (1) Legal system
l Factors affecting CG structures
Ø Common law (e.g., US and UK): More anti-director privileges to
Ø Country statutes
minority shareholders
Ø Corporate structures
Ø Code law (e.g., Germany): Less anti-director privileges
Ø Cultural differences
l (2) Investor protection
Ø Regulation-led (e.g., US): Regulations are established by the
SEC to protect investors.
Ø Shareholder-led (e.g., UK): Investors are responsible for
safeguarding their interests.

107 108

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Global Differences in CG Global Differences in CG

Corporate structures Corporate structures

l (1) Ownership structure l (2) Capital structure

Ø Dispersed ownership (e.g., US): Align the interests of Ø Shareholder-dominated (e.g., US): Enhance shareholder value
management and shareholders creation while protecting the interests of other stakeholders.
◇ Management have incentives to engage in earnings Ø Creditor-dominated (e.g., Germany): Focus more on protecting
management and focus on short-term considerations at the creditors (because banks play an important role in financing of
expense of sustainable shareholder value creation and long- capital)
term performance.
Ø Concentrated ownership (e.g., UK): Right balance between the
interests of minority and majority shareholders.

109 110

Global Differences in CG Global Differences in CG

Corporate structures Cultural differences

l (3) Board structure

l Some cultures (e.g., Germany) are more collective and
Ø One-tier board system (e.g., US): Directors are elected to risk averse than others (e.g., US).
oversee management in corporate operations.
Ø Two-tier board system (e.g., Germany): Supervisory board
advises, appoints, and supervises the management board in
managing the operations of the company.

111 112

Business Ethics Business Ethics

Solving an ethical dilemma
l Ethics is a set of moral principles (a theory or system of
Step 1: Step 2: Step 3:
moral values). Recognize an ethical Identify and analyze the Identify the alternatives,
l CG should create an ethical business environment in situation and the ethical principal elements in and weigh the impact of
issues involved. the situation. each alternative on
which all employees are encouraged and empowered to various stakeholders.
“do the right thing” . Use your personal ethics to Identify the stakeholders – Select the most ethical
identify ethical situations persons or groups who may alternative, considering all
and issues. Some be harmed or benefited. Ask the consequences.
businesses and the question: What are the Sometimes there will be one
professional organizations responsibilities and right answer. Other
provide written codes of obligations of the parties situations involve more than
ethics for guidance in some involved. one right solution; there
business situations. situations require you to
evaluate each alternative
and select the best one.

113 114

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Business Ethics
l Discussion:
Ø George, the CFO of Supreme Inc., is responsible for obtaining bank loans.
ACCT4007
Ø It has been the practice to negotiate loans from a number of banks.
Ø He has recently met David who had been on the same undergraduate Corporate Governance
course several years earlier.
Topic 2 (Supplement)
Ø They meets for a game of badminton and during the meeting, George
learns that David is the chief loans officer at Swift Commercial Bank
Understandability
(SCB).
Ø In the next three years, George negotiates all of the company’s loans
through SCB, and David arranges for George to receive substantial
allocations in IPOs.
Ø Over that period, George has done quite well out of taking up IPO
allocations and selling them on the market.
Ø Discuss the ethical issues involved.
115

Plain English Initiative Plain English Problems – (1)

The following description encompasses all the material terms and provisions of t
he Notes offered hereby and supplements, and to the extent inconsistent therew
ith replaces, the description of the general terms and provisions of the Debt Sec
urities (as defined in the accompanying Prospectus) set forth under the heading
“Description of Debt Securities” in the Prospectus, to which description reference
A Plain English Handbook: How to Create Clear SEC Disclosure Doc
uments (US Securities and Exchange Commission) is hereby made. The following description will apply to each Note unless otherwi
se specified in the applicable Pricing Supplement.

We provide information to you about our notes in three separate documents tha
t progressively provide more detail: 1) the prospectus, 2) the prospectus supplem
ent, and 3) the pricing supplement. Since the terms of specific notes may differ f
rom the general information we have provided, in all cases rely on information i
n the pricing supplement over different information in the prospectus and the pr
ospectus supplement; and rely on this prospectus supplement over different info
rmation in the prospectus.
117 118

Plain English Problems – Long sentences Plain English Problems – (2)

The following description encompasses all the material terms and provisions of t
he Notes offered hereby and supplements, and to the extent inconsistent therew
ith replaces, the description of the general terms and provisions of the Debt Sec The foregoing Fee Table is intended to assist investors in understanding the costs a
urities (as defined in the accompanying Prospectus) set forth under the heading nd expenses that a shareholder in the Fund will bear directly or indirectly.
“Description of Debt Securities” in the Prospectus, to which description reference
is hereby made. The following description will apply to each Note unless otherwi
se specified in the applicable Pricing Supplement.
This table describes the fees and expenses that you may pay if you buy and hold s
hares of the fund.
We provide information to you about our notes in three separate documents tha
t progressively provide more detail: 1) the prospectus, 2) the prospectus supplem
ent, and 3) the pricing supplement. Since the terms of specific notes may differ f
rom the general information we have provided, in all cases rely on information i
n the pricing supplement over different information in the prospectus and the pr
ospectus supplement; and rely on this prospectus supplement over different info
rmation in the prospectus.
119 120

20
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Plain English Problems – Passive voice Plain English Problems – (3)

The foregoing Fee Table is intended to assist investors in understanding the costs a
The Board might approve these investments in advance.
nd expenses that a shareholder in the Fund will bear directly or indirectly.

This table describes the fees and expenses that you may pay if you buy and hold s
There is the possibility of prior Board approval of these investments.
hares of the fund.

121 122

Plain English Problems – Weak verbs Plain English Problems – (4)

At the Sandyhill Basic Value Fund, we will strive to increase the value of your sh
The Board might approve these investments in advance. ares (capital appreciation) and, to a lesser extent, to provide income (dividends).
We will invest primarily in undervalued stocks, meaning those selling for low pr
ices given the financial strength of the companies.

There is the possibility of prior Board approval of these investments.

Sandyhill Basic Value Fund, Inc. (the “Fund”) seeks capital appreciation and, sec
ondarily, income by investing in securities, primarily equities, that management
of the Fund believes are undervalued and therefore represent basic investment
value.

123 124

Plain English Problems – Abstract words

At the Sandyhill Basic Value Fund, we will strive to increase the value of your sh ACCT4007
Corporate Governance
ares (capital appreciation) and, to a lesser extent, to provide income (dividends).
We will invest primarily in undervalued stocks, meaning those selling for low pr
ices given the financial strength of the companies.

Sandyhill Basic Value Fund, Inc. (the “Fund”) seeks capital appreciation and, sec
ondarily, income by investing in securities, primarily equities, that management
of the Fund believes are undervalued and therefore represent basic investment
value.

Topic 3
Board of Directors
125 126

21
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Agenda Theoretical Background

l Theoretical background Separation of ownership and control

l Roles and responsibilities

l Fiduciary duties Agency problem
l Overview of board committee
l Board models Division of decision management and decision control
l Board characteristics
Decision management
l Director compensation Initiation and implementation of strategies
 Management’s responsibility
l Board selection
l Board evaluation Decision control
Ratification and monitoring of strategies
l Board accountability to shareholders  The board’s fiduciary duty
performed on behalf of shareholders
l Directors’ liability and business judgment rule
127 128

Theoretical Background Roles and Responsibilities

l Companies are typically required to form a board of directors to
l Theoretically, the board should resolve the agency problems
represent shareholders and make decisions on behalf of
and help align the interests of shareholders and management.
shareholders.
l However, a board’s close relation with senior executives can
l The board should also protect the interests of all stakeholders
create conflicts of interest within the boardroom .
who have direct or indirect human or physical capital interests in
Ø Senior executives (particularly CEO) are motivated to take
the company.
over the board by influencing election of directors and
l The board is ultimately responsible for corporate business
controlling director compensation .
affairs and governance.

129 130

Roles and Responsibilities Roles and Responsibilities

l Effectiveness of the board depends on:
A vigilant board should:
Ø Composition, structure, resources, diligence, and authority
ü proactively participate in strategic decisions
of the entire board
ü ask management tough questions
ü oversee management’s plans, decisions, and actions Ø Working relationships with other CG participants (including
ü monitor management’s ethical conduct, financial reporting, investors, management, external auditors, internal auditors,
and legal compliance legal counsel, professional advisors, regulators, and standard-
setting bodies)
The boardrooms should NOT be the “gentleman’s clubs” to:
✕ please the CEO
✕ rubber-stamp the CEO’s decisions (fail to challenge and
inquiry management decisions)

131 132

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Roles and Responsibilities Roles and Responsibilities

l Key specific aspects
ü Represent shareholders and create shareholder value .
Example: Apple’s Proxy Statement ü Align the interests of management with those of shareholders while protecting
the interests of other stakeholders .
ü What are the primary role and responsibilities of the
ü Define corporate value, mission, and goals .
board of directors in Apple?
ü Establish or approve strategic plans and decisions to achieve corporate
goals.
ü Appoint senior executives to manage the company in accordance with the
established strategies, plans, policies, and procedures.

ü Oversee the company’s performance , by setting objectives , establishing

short-term and long-term strategies to achieve these objectives, and
assessing the performance of senior executives in fulfilling their
responsibilities.

ü Develop and approve executive compensation schemes .

133 134

Roles and Responsibilities Fiduciary Duties

l Key specific aspects
l Meaning of fiduciary duty
ü Approve major business transactions (e.g., major operating, investing,
financial activities) and corporate plans, decisions, and actions according to Ø As shareholders’ guardians (corporate gatekeepers), directors
the bylaws.
must be trustworthy, acting in the best interest of
ü Review financial reports, earnings releases, and other reports filed with
regulators (SEC) or disseminated to the public shareholders .
ü Provide counsel to senior executives (especially CEO) on material strategic Ø In turn, shareholders have confidence in the directors’
decisions and risk management.
actions.
ü Ensure compliance with applicable laws, rules, and regulations.
ü Set the tone at the top by promoting ethical conduct throughout the company.
ü Evaluate the performance of the board , its committees (e.g., audit,
compensation, and nominating), and the members of each committee.
ü Hold the board, its committees, and directors accountable for the fulfillment of
the assigned fiduciary duties and oversight functions.
ü Oversee the sustainability of the company in creating long-term shareholder
value and protecting interests of other stakeholders.
135 136

Fiduciary Duties Fiduciary Duties

Elements of fiduciary duties Elements of fiduciary duties
l Key element 1: Duty of due care
l Key element 2: Duty of loyalty
Ø The manner in which directors should carry out their responsibilities.
Ø Refrain from pursuing directors’ own interests over the interests
To effectively fulfill the duty of due care, directors should:
of the company.
ü exercise the care that is expected of “ a reasonable person ” under the same
circumstances ◇ Unfair self-dealing transactions
ü be informed about the company’s business affairs ◇ Competing with the company
ü exercise a vigilant oversight function ◇ Using the company’s assets or confidential information for
ü assure a reliable information reporting process personal gain
ü monitor the compliance with applicable laws, rules, and regulations

137 138

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Fiduciary Duties Fiduciary Duties

Elements of fiduciary duties
Example: Enron and WorldCom l Additional element 1: Duty of good faith
In January 2005, former outside directors of Enron and Ø Acting in good faith in a manner that is believed and perceived
WorldCom, in admitting breaching their fiduciary duties , to be in the best interest of the company and its shareholders.
have settled liability lawsuits brought against them by
Ø Any irresponsible, reckless, irrational, and disingenuous
injured investors .
behavior or conduct by directors can breach duty of good faith.
They paid damages of $31 million (WorldCom: $18 million;
Ø Indications of bad faith
Enron: $13 million) from their own pockets for their
◇ Intentional disregard (gross negligence) for the duties of
companies’ failures.
due care and loyalty
◇ Knowingly violating or allowing the violation of applicable
laws, regulations, and rules

139 140

Fiduciary Duties Fiduciary Duties

Elements of fiduciary duties Elements of fiduciary duties
l Additional element 2: Duty to promote success l Additional element 3: Duty to exercise due diligence,
Ø Promote the success of the company for the benefit of its independent judgment, and skill
shareholders and other stakeholders. Ø Knowledgeable about and continuously updating the
Ø Duty to achieve shareholder value creation understanding of the companies’ business activities and

◇ Approving strategic goals, objectives, policies, and activities that

performance
generate sustainable performance and maximize shareholder wealth. Ø Using reasonable diligence and independent judgment in
Ø Duty to protect stakeholder value making strategic decisions

◇ Promoting the interests of employees

◇ Fostering fair business relationships with customers and suppliers
◇ Promoting ethical business conduct
◇ Considering the impacts on the environment, community, and society
141 142

Fiduciary Duties Fiduciary Duties

Elements of fiduciary duties Elements of fiduciary duties
l Additional element 4: Duty to avoid conflicts of interests l Additional element 4: Duty to avoid conflicts of interests
Ø Potential conflict of interest:
◇ Receive material gifts or benefits from a third party that is Example: Apple’s Proxy Statement

doing business with the company ü What is Apple’s policy of transactions between the

◇ Either directly or indirectly enters into a transaction or company and its directors?

arrangement with the company ü Does Apple allow backdating/repricing of stock options

◇ Obtain substantial loans from the company granted as compensation?

◇ Backdate (reprice) stock options

143 144

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Overview of Board Committees Overview of Board Committees

l Board committees are a subset of the board and perform specific Typical board committees
functions that assist the board in performing advisory and l Audit committee
oversight functions. Ø Responsible for the areas related to internal controls, risk
l Committee members address relevant issues and make management, financial reporting, and audit activities.
recommendations to the entire board for final approval . l Compensation committee

l Board committees normally function independently from each Ø Design, review, and implement directors’ and executives’
compensation plans
other, are provided with sufficient resources and authority , and
l Nominating committee
are evaluated by the board .
Ø Recommendation, nomination and election of directors
l Corporate governance committee
Ø Advise, review, and approve management strategic plans,
decisions, and actions in effectively managing the company in the
best interests of stakeholders
145 146

Overview of Board Committees Overview of Board Committees

Typical board committees

l Other special committees

Ø Finance committee Example: Apple’s Proxy Statement

Ø Disclosure committee ü What are the board committees of Apple?

Ø Executive committee
Ø IT committee

147 148

Board Models Board Models

l One-tier board model (US and UK) l Two-tier board model (Germany)

Executive (inside) directors

Perceived as decision managers
electing monitoring
Shareholders Supervisory board Management board
Non-executive (outside) directors
Managing
Power and duty to monitor the decisions
company

Ø The board with the majority of outside (independent)

directors can better monitor and control management, reduce
agency costs, and create shareholder value.

149 150

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Board Models Board Models

l Two-tier board model (Germany) l Two-tier board model (Germany)

Supervisory board is responsible for:

Management board is responsible for:
ü appointing and dismissing members of the management board
ü managing the company for the benefit of a wide variety of stakeholders
ü overseeing the function of the management board
ü reporting to the supervisory board periodically on its strategic decisions and
ü determining management’s compensation
actions, as well as the company’s performance and future growth prospects
ü reviewing and approving financial reports
ü preparing financial statements and MD&A
ü appointing, retaining, compensating, and overseeing the work of external
auditors ü establishing and monitoring internal controls and reporting on their effectiveness

ü establishing committees to carry out board oversight responsibilities

ü communicating with all stakeholders

151 152

Board Models Board Models

l Modern board model l Modern board model

Ø An emerging board model after recent CG reforms
Ø Strategic board
Ø Requiring the board to be proactively engaged in both
◇ Responsible for advising and approving management
strategic/advisory and oversight activities.
strategic plans, decisions, and actions
Ø Both strategic board and oversight board are equally
important. ◇ Consist of both executive and nonexecutive directors
(preferably with a majority of independent nonexecutive
electing advising directors)
Strategic board
Shareholders Executives
Oversight board
electing
monitoring Managing
company

153 154

Board Models Board Models

l Modern board model

Ø Oversight board
Example: Apple’s Proxy Statement
◇ Responsible for:
ü Which board model does Apple’s board belong to?
ü Overseeing the company’s business and affairs
ü Monitoring operating and financial reporting of senior ü Who are executive directors? Who are non-executive
executives directors?
ü Determining compensation for directors and officers
ü Evaluating board processes and performance
ü Nominating potential directors
◇ Audit, compensation, and nominating committees on oversight
board should be composed of independent directors.

155 156

26
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Board Characteristics Board Characteristics

Board leadership Board leadership

l The board is led by the chairperson. l Effectiveness of board meetings depends on the leadership
Ø Chairperson of the board (just like the CEO) should be the leader with ability of the chairperson to:
vision, strategy, business acumen, motivation, and problem-solving skills. Ø (1) set the agenda of board meeting
l Independent chairperson of the board can ensure maximum Ø (2) direct discussion
protection for shareholders.
l The chair is directly responsible for developing a boardroom that
facilitates the effectiveness of individual directors .

157 158

Board Characteristics Board Characteristics

Board leadership Board leadership

(1) Setting the agenda of board meeting (2) Directing discussion

ü In the case of CEO-chair separation :
ü Style of discussion:
◇ The board agenda is usually prepared by the chairperson in close
◇ The meetings will be short or lengthy, formal or informal, friendly or
collaboration with the CEO to ensure its appropriateness.
adversarial, relaxed or tense, efficient or inefficient, productive or
ü In the case of CEO-chair duality : nonproductive, responsive or nonresponsive, relevant or irrelevant, decisive or
indecisive, and predetermined or deliberative.
◇ The CEO should consult with lead director to ensure the agenda is relevant.
ü Documentation:

◇ Minutes of board meeting should provide a brief description of issues

discussed and the deliberation process, including voting, decisions, and
actions taken by the board.

159 160

Board Characteristics Board Characteristics

Board leadership CEO-Chair duality
l Allows the CEO to undertake both managerial and oversight
Example: Apple’s Proxy Statement functions.

ü Who is the chairperson? l Shareholders usually prefer to separate the positions for
strengthening the board’s independence and reducing the potential
ü Is he/she an independent director?
conflicts of interest.
ü What is the frequency of the board meeting? l If not separated, then it is preferable that the board consists of
substantial majority of independent directors .

Example: Walt Disney Company

At the 2004 Disney annual meeting, shareholders with 43% of share
ownership cast their votes to separate the positions of the CEO and
the chairperson of the board by removing Michael Eisner from the
position of the chair, although he continued to be the CEO.
161 162

27
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Board Characteristics Board Characteristics

CEO-Chair duality CEO-Chair duality

Benefits of CEO-chair separation:

ü CEO accountability would be improved. Example: Apple’s Proxy Statement
ü Potential conflict of interest would be reduced.
ü Does apple separate or combine the positions of
ü CG and operations would be improved.
chairperson and CEO?
ü The board responsibility to oversee management for
shareholders’ benefit would be more effective. ü What is the qualification of the chairperson?

Costs of CEO-chair separation:

ü Reducing the CEO’s authority when the power is shared with a
nonexecutive director.
ü Negative impact on the company if the non-executive chair is less
informed and possibly less experienced in a leadership role.

163 164

Board Characteristics Board Characteristics

Board composition Board composition
l Board size l Board size
Ø The board of public companies normally ranges between nine
Cost of large board size:
and fifteen directors.
ü Process of deliberation becomes time consuming and unwieldy
Ø A board with fewer than nine directors may be viewed as being
dominated and controlled by a small group .
Benefit of large board size:
ü More effective in monitoring managerial actions. Ø A board with more than fifteen directors is generally considered
◇ As the number of directors involved with monitoring increases, less efficient.
the opportunity for wrongdoing is decreased and collusion
becomes more difficult . Example: Apple’s Proxy Statement
ü What is the board size of Apple?

165 166

Board Characteristics Board Characteristics

Board composition Board composition
l Board independence
l Board independence
A director may not be independent if the director or his/her relative is (or in the past five
Ø Independent director should not have any relationship with years has been):
the company other than his/her directorship that may ü employed by the company or an affiliate
compromise the director’s objectivity and loyalty to ü an employee, director, or greater than 20% owner of a corporation that is one of
the company’s or its affiliate’s paid advisors or consultants
shareholders.
ü a paid advisor or consultant of the company and receives substantial amount of
revenue (e.g., more than $50,000) for the advisory services
ü employed by, or has had a 5% or greater ownership interest in, a third-party that
receives significant amount of payments from or provides significant amount
of payments to the company (e.g., the amount is equivalent to 1% of the annual
consolidated gross revenues of the company or the third-party provider)
ü an employee or director of a foundation, university, or other nonprofit
organization that receives material grants or endowments (e.g., $100,000 or 1%
of total grants) from the company or one of its affiliates or executive officers.
167 168

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Board Characteristics Board Characteristics

Board composition Interlocking directorships

l Board independence l Directors sit on other companies’ boards.

Ø Majority of directors should be independent (75% is suggested).
Ø Quality of directors’ independence , influence, and ability to act
Example: Apple’s Proxy Statement
independently is more important than the number or percentage. ü Does any director of Apple serve on other companies’
board?
Example: Apple’s Proxy Statement
ü What is percentage of independent directors on the
board of Apple?

169 170

Board Characteristics Board Characteristics

Board authority Board authority

l Decision-making authority of the board is granted through l Factors affecting board authority
shareholders’ election . Ø Nomination and election of directors are influenced by
l The board is authorized to hire, evaluate, compensate, and fire management.

senior executives . Ø Directors may become beholden to the CEO, so as to enjoy the
status, compensation, and other perquisites of directorship.
l SOX substantially expanded the authority of directors, particularly
audit committee, which is authorized to: Ø Independent outside directors may be influenced by insiders
(senior executives), due to:
Ø Hiring, firing, compensating, and overseeing the work of external
◇ Lack of adequate knowledge and expertise to assess the quality of
independent auditors .
managerial decisions
Ø Hiring and firing chief audit executive (CAE) and overseeing ◇ Lack of proper incentives to challenge managerial decisions
internal audit function ◇ Possibility that management controls flow of information to the board
171 172

Board Characteristics Director Compensation

Board resources
l Components of director compensation
l The board should have adequate legal, financial, and information
resources to effectively fulfill its oversight functions.
Retainer for board membership
Ø Staff support, internal or external advisors, and legal counsel
Ø Financial resources to compensate directors and officers and to hire
Fees for being a committee chair
external auditors, legal counsel, and other advisors Fees for attending board and committee meetings
Ø Information from management, internal auditors, external auditors, legal
counsel, and financial advisors.

173 174

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Director Compensation Director Compensation

l Best practices l Pros and cons of director ownership

ü Director compensation consists of a combination of both cash and stock .
Positive side of director ownership:
ü All directors should own stock in the company .
ü Align directors’ interests with those of shareholders.
ü Director compensation should be comparable to peer market group . ü Studies show that corporate performance could be
improved by share ownership as long as it is below 50%.
ü All unusual compensation should be reviewed and approved by
independent directors and disclosed in the proxy statement.

ü Pensions and postretirement benefits should not be granted to outside Negative side of director ownership:
directors.
ü Cause directors to perversely use short-term incentives to
ü Director compensation should be approved by shareholders .
artificially boost stock price.

175 176

Director Compensation Board Selection

Staggered (Classified) board

Example: Apple’s Proxy Statement l Only a portion of the board is elected each year.

ü What are the components of directors’ compensation in Apple?

Advantage of staggered board:
ü Is the design of director compensation consistent with best
ü Allow continuity of the board’s monitoring function.
practices?

Disadvantage of staggered board :

ü Annual reelection of the entire board becomes more difficult .
◇ Under a typical staggered structure, only 1/3 of the board is
elected each year for a three-year term .

177 178

Board Selection Board Selection

Staggered (Classified) board Voting systems for director election

l (Traditionally ) Plurality voting system

Ø Directors can be elected by the vote of a single share
Example: Apple’s Proxy Statement unless they are opposed by a dissident director.

ü Does Apple have the staggered board structure? Ø Give too much power to executive directors and
management to influence election of outside directors.

179 180

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Board Selection Board Selection

Voting systems for director election Voting systems for director election

l (Currently preferred) Majority vote system

Ø Directs are elected when favorable votes exceed 50% .
Example: Apple’s Proxy Statement
Ø Give shareholders the power to hold directors accountable
ü Does Apple use plurality or majority voting system for
for their actions and performance, and to elect the most
director election?
qualified directors.

Example: Intel
In January 2006, Intel’s board amended the company’s bylaws to
replace its plurality vote standard with majority vote system .
This move by Intel is viewed positively by its shareholders in
holding its directors more accountable and in bringing democracy to
its boardroom.
181 182

Board Evaluation Board Evaluation

Evaluation approach Evaluation criteria

l Performed formally and regularly ( at least annually ) through: l Generally accepted benchmarks for board evaluation
Ø Fulfillment of oversight functions
Ø Self-evaluation : More in depth
Ø Transparency and accountability
Ø Outside consulting evaluation : More independent
Ø Overseeing of conflicts of interest
Ø Establishment of goals and strategies
Example: Apple’s Proxy Statement Ø Assessment of management’s performance

ü How often does Apple evaluate the board’s performance? l Individual directors’ evaluation
Ø Ability, integrity, financial literacy, strategic perspective, decision making
and judgment, teamwork, communication, leadership, and business
acumen.

183 184

Board Evaluation Board Evaluation

Evaluation criteria Evaluation criteria

Example: Apple’s Proxy Statement

Example: Apple’s Proxy Statement
Evaluate the effectiveness of Apple’s board in the following aspects:
Evaluate the effectiveness of Apple’s board in the following aspects:
(2) Board quality
(1) Board independence
ü Directors sit on no more than four corporate boards?
ü There are no more than two inside directors?
ü The board has at least one outside director experienced in the
ü There are no insiders on the audit, nominating, and compensation
company’s core business?
committees?
ü At least one director is a CEO of a company of similar size?
ü There are no outside members who directly or indirectly draw
consulting, legal, or other fees from the company? ü All directors attend at least 75% of meetings?

185 186

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Board Evaluation Board Evaluation

Evaluation criteria Evaluation criteria

Example: Apple’s Proxy Statement Example: Apple’s Proxy Statement

Evaluate the effectiveness of Apple’s board in the following aspects: Evaluate the effectiveness of Apple’s board in the following aspects:
(3) Board activism (4) Board accountability
ü The board meets regularly without management present? ü All board directors own a minimum amount of stock?
ü The board evaluates its own performance every year? ü The company does not offer pension benefits to its directors?
ü Audit committee meets at least four times a year? ü The board stands for election every year?

187 188

Board Accountability to Shareholders Board Accountability to Shareholders

l The board is accountable to shareholders for protecting Example: Pfizer

their rights and interests . On June 28, 2007, Pfizer announced that its board of directors will have face-
to-face meetings with institutional investors on CG policies and practices.
To effectively discharge its accountability to shareholders, the board should:
Pfizer is the first public company to initiate such meetings in providing an
ü consider adopting shareholder proposals that received a majority of opportunity to institutional investors to offer comments and perspectives on
votes cast for or against. governance policies and practices, including executive compensation.
ü take actions on recommendations approved by the majority of Other practices of communications with shareholders:
shareholders. Ø shareholder access to lead director and board committee chairs through e-mail

ü interact with large shareholders , respond to communications from Ø regularly reviewing communications received from shareholders
shareholders, and consider their views, inputs, and insights on important Ø regular participation of directors in investor conferences
governance and oversight functions. Ø use of “plain English” to make disclosures more understandable to investors

ü attend the annual shareholder’s meeting and be willing to respond to Ø open and candid communications with shareholders
shareholder questions. Ø addressing of all stakeholders’ viewpoints on governance, including
shareholders, employees, customers, suppliers, and government
189 190

Directors’ Liability
Board Accountability to Shareholders
and Business Judgment Rule

l Business judgment rule applies in determining the liability of

the directors who are held responsible for fiduciary duties.
Example: Apple’s Proxy Statement
l Directors are not reasonably expected to have first-hand
ü How can shareholders communicate with Apple’s board? knowledge of all company business affairs under their oversight
capacity.
Ø In most circumstances, directors make decisions by relying on
information furnished by corporate officers , employees,
and professionals, including legal counsel and accountants.
Ø Nevertheless, directors are responsible for ascertaining the
validity and quality of information provided to them.

191 192

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Directors’ Liability Directors’ Liability

and Business Judgment Rule and Business Judgment Rule
Scenario 1:
l Under business judgment rule:
Directors are entitled to rely on information provided by
Ø Directors who make decisions in good faith , based on
management .
rational reasoning and an informed manner, can be
Fiduciary duty is breached if a director relies on information protected from liability to shareholders on the grounds that
that he or she knows is not reliable . they have appropriately fulfilled their fiduciary duty .
Ø In the absence of evidence of gross negligence, business
Scenario 2:
misconduct, and fraud , directors are typically provided with
Usually directors will not be held liable for losses caused by broad discretion to make decisions and carry out their
their decisions . fiduciary duties, without facing challenges of legal liability .
However, directors are held liable if they engage in the Ø Directors cannot and should not be expected to guarantee
production and distribution of materially false, fraudulent, or corporate success and compliance.
misleading information to investors that influence stock prices.
193 194

Directors’ Liability
and Business Judgment Rule
l Unresolved issue
ACCT4007
Ø To what extent outside directors can breach their fiduciary
duties and how irresponsible they must be to face legal liability. Corporate Governance
Example: Walt Disney Company
The Delaware judge had harsh criticism for Disney directors but concluded
that they had acted legally.
ü The plaintiffs’ claim: Directors breached their fiduciary duties of due care
and good faith in failing to oversee generous compensation and severance
packages for former Disney president, Michael Ovitz.
ü The court’s decision: Directors did not breach their fiduciary duties to
shareholders in deciding to hire the Disney president and then fire him as
Topic 4
the president 14 months later at a cost of $140 million. Board Committees
195 196

Overview of Board Committees Overview of Board Committees

Audit committee l To effectively use the time and expertise of directors,

companies may combine certain committees.
Compensation committee

Nominating committee Example: Apple’s Proxy Statement

Corporate governance committee ü Does Apple combine certain functions of committees

into one?
Other special committees
Finance committee
Disclosure committee
Others

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Importance of Audit Committee

Financial scandals of the late 1990s and early 2000s

Part I: Audit Committee Failure of audit committee in performing oversight function

People raised the question: “ Where was the audit committee? ”

Audit committee should have act as guardians of investor interests by

assuming oversight responsibilities in the areas of financial reporting , audit
activities, and compliance with laws, regulations, and ethical standards.

SOX requires public committees to have an audit committee ,

consisting of independent directors with no personal, financial, or
family ties to management.
199 200

Importance of Audit Committee Evolution of Role of Audit Committee

SEC’s requirement of audit committee (Rules 33-8220 and 34-47654: l Traditional role:
Standards Relating to Listed Company Audit Committees):
Ø Liaison between management and external auditor to
ü Independence of audit committee members preserve auditor independence
ü Audit committee’s responsibility to select and oversee independent l Current role:
auditors
Ø Overseeing internal controls, financial reporting, and
ü Procedures for handling complaints regarding accounting practices
audit activities
ü Authority of the audit committee to engage advisors

ü Funding for independent auditors and any outside advisors engaged by

audit committee

201 202

Definition of Audit Committee Definition of Audit Committee

l (More comprehensive) Definition for this course
l Legal definition (Section 205[a] of SOX)
Ø A committee composed of independent nonexecutive
Ø A committee (or equivalent body) established by and
directors
amongst the board of directors of an issuer
Ø In charge of oversight functions of ensuring responsible
Ø For the purpose of overseeing the accounting and
corporate governance , a reliable financial reporting
financial reporting processes of the issuer and audits
process, an effective internal control structure , a
of the financial statements of the issuer
credible audit function , an informed whistleblower
Ø If no such committee exists with respect to an issuer, the
complaint process , and an appropriate code of
entire board of directors of the issuer will be responsible.
business ethics
Ø For the purpose of creating long-term shareholder value
while protecting the interests of other stakeholders .
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Relations with Other CG Participants Relations with Other CG Participants

l Relation with management

l Relation with board of directors
Ø Audit committee
Ø Audit committee
◇ Efficiently interact with management by asking
◇ Assist the board in fulfilling its fiduciary duties .
appropriate questions pertaining to internal controls,
◇ Assist the board by bringing specialization and
financial reporting, audit activities, risk assessment,
expertise in the areas of financial reporting, internal
corporate governance structure, codes of ethics, and
controls, risk management, and audit activities.
whistleblower programs.
Ø The board
Ø Management
◇ Delegate authority and provide resources to audit
◇ Provide sufficient information .
committee

205 206

Relations with Other CG Participants Relations with Other CG Participants

l Relation with internal auditor l Relation with external auditor

Ø Audit committee
Ø Audit committee
◇ Hire, compensate, and fire external auditors
◇ Hire, oversee, compensate, and fire the head of the
◇ Oversee audit work by reviewing audit scope, plan, and
internal audit department (chief audit executive) findings and evaluating auditor’s performance
Ø Internal auditor Ø External auditor
◇ Ultimately accountable to audit committee ◇ Ultimately accountable to audit committee

◇ Report audit findings directly to audit committee ◇ Submit reports of audits on ICFR and financial reporting to
management via audit committee.
◇ Evaluate effectiveness of audit committee and consider
ineffective audit committees as material weaknesses in
internal control
207 208

Accountability of Audit Committee Key Responsibilities of Audit Committee

l Ultimately accountable to the board

l Report quarterly to the boards Example: Apple’s Proxy Statement
l Report annually to shareholders ü What are the responsibilities of Apple’s audit committee?
l Evaluated annually by the board

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Key Responsibilities of Audit Committee Key Responsibilities of Audit Committee

l (1) Internal control l (2) Financial reporting

Ø Oversee internal control structure to assure: Ø Oversee financial reporting process to ensure integrity
◇ efficiency and effectiveness of operations and transparency of financial disclosures (e.g.,

◇ reliability of financial reporting reviewing annual and quarterly financial statements, and
other financial reports)
◇ compliance with applicable laws and regulations
(SOX’s requirement of certifying ICFR) Ø Prevent financial fraud by enhancing oversight of the
board, improving internal controls, and mitigating
collusion between management and employees.

211 212

Key Responsibilities of Audit Committee Key Responsibilities of Audit Committee

l (3) Audit activities [Continued]

l (3) Audit activities
Ø Evaluation of independent auditors
Ø Oversee both internal and external audit activities
◇ Evaluate at least annually independent auditor’s
◇ Hire, compensate, and fire independent auditor and
qualifications, independence, and performance
chief audit executive (head of internal audit
department) ◇ Evaluation process includes a review of:

◇ Review reports of independent auditors on financial ü Quality control system

statements and ICFR, and internal audit reports ü Audit planning
ü Staff assignments
ü Performance of lead partner
ü Inspection or peer review reports
213 214

Key Responsibilities of Audit Committee Key Responsibilities of Audit Committee

l (3) Audit activities [Continued] l (3) Audit activities [Continued]

Ø Preapprove permissible non-audit services Ø Disclosures
◇ Ensure understanding of all permissible non-audit ◇ Preapproval policies for all audits and all
services permissible non-audit services established by the
◇ Evaluate qualifications of providers of preapproved audit committee
non-audit services ◇ Two most recent years of all independent auditor
◇ Select the best provider considering auditor fees in the four categories of audit, audit-related, tax,
independence from management and all other services.

215 216

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Key Responsibilities of Audit Committee Key Responsibilities of Audit Committee

l (4) Code of ethical conducts

Example: Apple’s Proxy Statement
Ø Oversee the establishment and enforcement of the
ü Who is Apple’s external auditor?
code of ethical conducts
ü What is the preapproval policy of audit committee in Apple?
Ø Ensure that an appropriate “tone at the top” policy is
ü Does Apple disclose the fees paid to external auditors by
implemented to promote ethical conduct throughout the
categories?
company

217 218

Key Responsibilities of Audit Committee Key Responsibilities of Audit Committee

l (5) Whistleblower program l (6) Enterprise risk management

Ø Oversee the establishment and enforcement of Ø Oversee ERM by identifying, measuring, managing,
whistleblower programs and monitoring risks to ensure financial reporting
integrity.
◇ Opportunity for confidential and anonymous
submissions of complaints about suspected
Example: Apple’s Proxy Statement
financial and accounting irregularities.
ü What is audit committee’s responsibility of ERM in Apple?
◇ Procedures for collection and treatment of
complaints (e.g., hotline, fax, mail, confidential
website).

219 220

Key Responsibilities of Audit Committee Composition of Audit Committee

Committee size
l (7) Corporate governance
l SEC requires:
Ø Participate with other board committees in overseeing
Ø At least three members
effectiveness of corporate governance without Ø Usually ranges from three to six members
assuming managerial responsibility
Example: Apple’s Proxy Statement
ü What is the audit committee size of Apple?

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Composition of Audit Committee Composition of Audit Committee

Committee independence Committee independence
l Solely composed of independent nonexecutive (outside) directors l Importance of independence
Criteria of independence: Ø Improving quality of financial reports by assisting in reducing
financial reporting misstatements
ü Not receiving any compensation other than that is determined as a board
member ◇ Increasing interactions with internal auditors

ü Not providing any advisory or consulting services to the company they ◇ Improving quality of financial statement audits by
serve, its affiliates, or other business ties engaging higher-quality auditors

ü Not having been employed by the company or its affiliates within five years Example: Enron
One audit committee member is the wife of an influential senator who
ü Not having been a member of immediate family of the company’s
received substantial campaign donations from Enron.
executives or its affiliates within five years
Another committee member is a university president whose medical
research center received a significant endowment from Enron.
223 224

Composition of Audit Committee Composition of Audit Committee

Committee independence Member qualifications
l All members: financially literate
l At least one member: designated as financial expert
Example: Apple’s Proxy Statement
Attributes of “audit committee financial expert” (defined by SEC):
ü Are all audit committee members of Apple independent
directors? ü Understanding of GAAP and financial statements

ü Ability to assess the application of GAAP to financial reporting

ü Experience of preparing, auditing, analyzing, or evaluating financial

statements for a comparable company, or experience of actively
supervising one or more persons engaged in such activities

ü Understanding of internal controls for financial reporting and audit

committee functions

225 226

Composition of Audit Committee Authority and Resources of Audit Committee

Member qualifications
l Authorities delegated by the board to:
Ø hire, compensate, and fire both independent and internal
Example: Apple’s Proxy Statement auditors

ü Who is/are designated as financial expert(s) in Apple? Ø engage independent counsel and other advisors
Ø conduct any investigations deemed necessary
l Audit committee should be provided with sufficient funding
for payment and compensation to independent auditor,
internal auditor (chief audit executive), legal counsel, and
other advisors.

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Audit Committee Meetings Audit Committee Meetings

l Provide a forum for candid, open, and constructive l Meeting frequency

dialogue between committee members, management, Ø At least four times a year (to review quarterly financial
internal auditors, and external auditors. reports)
l Committee chair sets the tone for the nature, flow, agenda,
frequency, and length of the meetings. Example: Apple’s Proxy Statement
ü What is the frequency of audit committee meetings in
Apple?

229 230

Audit Committee Meetings Audit Committee Meetings

l Typical participants of the meetings l Typical participants of the meetings

Ø Members of audit committee Ø Should internal auditors attend the meetings?
Ø Senior executives
Ø Internal auditors ü Internal auditors are “eyes and ears” of audit committee .

Ø External auditors ü Chief audit executive (head of internal audit department)

should attend all formal meetings.

231 232

Audit Committee Meetings Audit Committee Meetings

l Typical participants of the meetings
l Typical participants of the meetings Ø Should senior management attend the meetings?
Ø Should external auditors attend the meetings? Positive side of attendance:
ü Signal the commitment of senior executives to effective audit
ü Integrated audit of financial statements and ICFR committee oversight functions
ü Underscore the importance of the meetings
underscores the importance of the attendance.
ü Lead partner should attend all formal meetings. Negative side of attendance:
ü Prevent open and candid dialogue between audit committee and
internal/external auditors
ü Undermine the authority of committee chair

Possible solution:
ü Combination of formal meetings with the presence of senior
executives and informal meetings with only internal/external auditors
233 234

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Audit Committee Reporting Audit Committee Reporting

l Regular reports or minutes of meetings to the board l Formal annual report to the shareholders
Ø Describing the committee’s agenda, activities, and
Example: Main Contents of Apple’s Audit Committee Report
recommendations
ü Formation and composition of audit committee
l Formal annual report to the board
ü Responsibilities of audit committee
Ø Summarizing the authorities, duties, oversight
ü Auditor independence
responsibilities, resources, funding, performance, and
ü Meeting with both management and external auditor for
recommendations for the current year and the agenda
discussion
for the next year
ü Recommendations to the board

235 236

Evaluation of Audit Committee Evaluation of Audit Committee

l Formal evaluation
l Informal evaluation
Ø By the board
Ø Audit committee’s performance is scrutinized by
◇ Annual performance assessment
shareholders, corporate governance activists, rating
Ø By independent auditor
agencies, and regulators.
◇ Assessment of the effectiveness of the audit committee
oversight function of ICFR
Ø By management
◇ Evaluation as part of overall assessment of ICFR in
compliance with SOX

Example: Apple’s Proxy Statement

ü Does audit committee of Apple conduct annual self-evaluation?
237 238

Legal Liability of Audit Committee Legal Liability of Audit Committee

l Audit committees are expected to exercise due diligence in: l Audit committee members can be held liable for:
Ø Determining facts based on the information they Ø Breaking fiduciary duty
receive from management and others. Ø Distribution of materially false or misleading information to
Ø Making judgments about events in which they have no investors
expertise. l Under the business judgment rule:
Ø It is regarded as fulfillment of fiduciary duty, in the absence
of gross negligence, even if the decision is later proven to
be incorrect.

239 240

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Structure of Compensation Committee

l Best practice:
Ø All independent outside directors
Part II: Compensation Committee ◇ U.S. listing rule: At least three independent directors
Ø Rotate periodically
Ø Knowledge and experience in compensation-related
issues
Ø Exercise due diligence and professional judgment

241 242

Structure of Compensation Committee Responsibilities of Compensation Committee

l Responsible for setting compensation plans to:

Example: Apple’s Proxy Statement Ø Retain good directors and managers

ü Are the Apple’s compensation committee members Ø Motivate optimal performance that creates shareholder value
independent? l Categories of responsibilities
ü Do they have experience in compensation-related issues? Ø Evaluation of directors and design and implementation of
director compensation plans [Discussed in Topic 3]
Ø Evaluation of senior executives and design and implementation
of executive compensation plans [To be discussed later in
this Topic and more in Topic 5]

243 244

Responsibilities of Compensation Committee Use of Compensation Consultant

Compensation committee should:

ü Ensure that consultants are independent of management and provide

Example: Apple’s Proxy Statement objective and relevant advice to the committee.
ü What are the responsibilities of Apple’s compensation
ü Retain and control consultant appointment, retention, dismissal, scope of
committee? the work, and oversight and monitoring of work.

ü Allow consultants to perform limited services for management in rare

cases, and properly disclose in the reports to compensation committee.

245 246

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Use of Compensation Consultant Executive Compensation Design

l Objectives
Example: Apple’s Proxy Statement Ø Proper design and implementation of fair executive
ü Who is Apple’s compensation consultant? compensation of base salaries, annual bonuses, and long-term
incentive packages
ü Is the consultant independent?
Ø Retain competent and ethical executives
ü What is the role of the consultant?
Ø Link compensation to sustainable performance
[More details will be discussed in Topic 5]

247 248

Say-on-pay Vote Say-on-pay Vote

l SEC Final Rule 33-9178: Shareholder Approval of Executive l Frequency of SOP voting failure is consistently low.
Compensation and Golden Parachute Compensation (2011)
l Non-binding SOP vote held at least once every three years
Ø 1,580 (75%) out of 2,118 Russell 3000 firms hold SOP each
year during 2011-2016 (Semler Brossy, 2017).
l Disclosure requirement
Ø Disclose voting results in Form 8-K within four business days
after the SOP is held.
Ø Disclose whether and how the previous SOP voting results are
considered in setting executive pay, in the CD&A of proxy
statement in the subsequent year.
Source: End of Year Report – 2016 Say-on-pay Results (for Russell 3000 firms).
Semler Brossy. January 1, 2017.
249 250

Say-on-pay Vote Compensation Disclosures

l SEC rule of compensation disclosure (July 26, 2006)

Example: Apple’s Proxy Statement Ø Comprehensive changes in the disclosure requirements
ü What is say-on-pay voting outcome of Apple at its Ø Companies should provide greater disclosure in CD&A
2019 annual shareholders’ meeting? section of proxy statements regarding compensation

ü Does Apple hold say-on-pay vote at the 2020 annual philosophy, policies, and detailed compensation design of
directors and executives.
shareholders’ meeting?

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Compensation Disclosures Compensation Committee Report

l All aspects of executive compensation should be fully and fairly l Contents CCR
disclosed in plain English in annual proxy statement
Ø 1) Two statements
Ø Philosophy of compensation policy
◇ Reviewed and discussed the CD&A with management
Ø Benchmarking peer groups
◇ Recommend to the board for CD&A to be included in
Ø How executive compensation is linked to performance
proxy statement and annual report
Ø How much directors and executives are paid (salary and
Ø 2) Compensation discussion and analysis (CD&A)
short- and long-term compensation incentives)
Ø Perquisites
◇ E.g., use of corporate airplanes, automobiles, and housing

253 254

Role of Nominating Committee

l Ensure proper composition of the board , including

director’s independence, skills, diversity, and commitment.

Part III: Nominating Committee l Evaluate and nominate directors to the board.
l Facilitate the election of directors by shareholders.

255 256

Responsibilities of Nominating Committee Responsibilities of Nominating Committee

l Reviewing the performance of current directors

Example: Apple’s Proxy Statement
l Assessing the need for new directors
ü What are the responsibilities of Apple’s nominating
l Identifying and evaluating the skills, background,
committee?
diversity, and knowledge of candidates
l Having an objective nominating process for qualified ü Did Apple hold director election at its 2020 annual

candidates shareholders’ meeting?

l Assisting in the election of qualified new directors

257 258

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Role of CG Committee

l Consisting of both executive and nonexecutive directors

l Ensure a proper power sharing balance :
Part IV: Corporate Governance Committee Ø board vs. management
Ø board vs. shareholders
Ø management vs. shareholders

259 260

Responsibilities of CG Committee

Develop, assess, and continuously improve governance structure, mechanisms,

processes, and practices by:

ü Maintaining board independence

ü Ensuring directors receive relevant, reliable, and timely information to Part V: Other Special Committees
effectively carry out their oversight responsibilities

ü Working as a liaison between the board and management by providing

opportunities for directors to express their concerns about CG

ü Regularly reviewing CG and recommending changes to the board

ü Keeping the board updated on new CG reforms , including legislations,

regulatory developments, rules, listing standards, and industry best practices

ü Periodically speaking directly to employees other than senior executives

ü Periodic evaluation of social, ethical, and environmental performance

261 262

Finance Committee Disclosure Committee

l Approve major transactions (e.g., M&A, R&D) above l Usually led by corporate counsel (lawyer) or CFO.
specified threshold (e.g., above $100,000).
l Responsible for reviewing and monitoring the filings to
l Provide guidance on financial decisions and policies . regulators (e.g., 10-Ks filed with SEC), earning releases,
l Advise management on enterprise risk management conference call scripts, and presentations to the
activities. investors by senior management.

263 264

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Other Committees

l Executive committee ACCT4007

Ø Make decisions on behalf of the entire board of directors Corporate Governance
between regular board meetings
l IT committee
Ø Address and oversee IT issues (e.g., to enhance internal
control over financial reporting)

Topic 5
Management Function
265 266

Overview of Management Function Overview of Management Function

l Top management team: l CG is needed to:

Ø Led by CEO Ø Avoid concentration of power in the hands of

Ø Supported by the CFO and other senior executives management
Ø Appropriately balance power-sharing authority between
Example: Apple shareholders, boards of directors, and management
ü What is the composition of Apple’s top management l Under the oversight of the board, management is fully
team? responsible for acting in the best interests of
shareholders and other stakeholders for all managerial
functions.

267 268

Categories of Management Responsibilities Categories of Management Responsibilities

1) Operating process 2) Financial reporting process

l Mainly involve strategic decisions made by management to l Management should report both financial and nonfinancial
improve efficiency of operations, so as to generate profit and create
information that assist investors to predict future cash
shareholder value
flows from operating, investing, and financing activities.
a) Operating activities
ü Designing products and services l Management is responsible for integrity and quality of all
ü Marketing and delivering products internal and external financial and nonfinancial reports.
ü Invoicing products
ü Servicing customers
Ø True and fair presentation of financial position and results
b) Investing activities of operations
ü Investing in both human and capital resources
Ø No manipulation to exaggerate earnings or misstate
b) Financing activities
assets, liabilities, expenses, or revenues
ü Funding investments and expenditures through internal funds, issuing
stocks or debt
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Categories of Management Responsibilities Functions of Corporate Officers

3) Compliance process l Competent and ethical corporate officers (C-Suites)

l Compliance with all applicable laws, regulations, and Ø Chief Executive Officer (CEO)
standards (including environmental, social, and ethical Ø Chief Financial Officer (CFO)
standards and best practices) Ø Chief Risk Officer (CRO)
Ø Others
◇ Chief Development Officer (CDO)
◇ Chief Governance/Compliance Officer
◇ Chief Operating Officer (COO)
◇…

271 272

Functions of Corporate Officers Functions of Corporate Officers

Chief Executive Officer (CEO) Chief Executive Officer (CEO)

l Leader of managerial function l Key challenges faced by CEO

Ø All other senior executives look to CEO for direction and Ø (1) Fiduciary duty
guidance ◇ Duty of loyalty: Act solely for the benefit of the company
l Personal attributes, ethical values, and professional and its shareholders
characteristics of CEO: ◇ Duty of due care
Ø In line with values, visions, and strategic plans of the Ø (2) Duality
boards and shareholders ◇ A challenge to establish a right power-sharing balance
Ø Key to long-term survival and success and stakeholder between CEO, directors, and shareholders
value creation

273 274

Functions of Corporate Officers Functions of Corporate Officers

Chief Executive Officer (CEO) Chief Executive Officer (CEO)

l Key challenges faced by CEO l Key challenges faced by CEO

Ø (3) Succession planning Ø (4) Financial knowledge
◇ In cases of CEO turnovers, departures, and retirements ◇ Sufficient knowledge and understanding of financial risks,
internal control, and financial reporting
Effective CEO succession plan is vital to:
Example: WorldCom
ü Sustainable performance of the company
ü Many CEOs of companies where accounting frauds have occurred
ü Effectiveness of corporate governance claimed that they knew nothing of the financial malfeasance.

ü Better performance of current CEO ü However, CEOs’ pleas of innocence are not valid arguments of
defense in the lawsuits.
ü Smoother transition
ü A defense of CEO ignorance about financial fraud did not prevail in
ü Success of new CEO the WorldCom trial when its former CEO Bernard J. Ebbers was found
guilty of securities fraud, false regulatory filings, and conspiracy.
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Functions of Corporate Officers Functions of Corporate Officers

Chief Executive Officer (CEO) Chief Executive Officer (CEO)

l Key challenges faced by CEO l Key challenges faced by CEO

Ø (5) Self-serving Ø (5) Self-serving
◇ Conviction for self-serving and engagement in fraud,
Examples:
conspiracy, and filing false financial reports
ü WorldCom: Bernard Ebbers, the Former CEO, got 25 years in prison
 Greatly damaged integrity and reputation of CEOs. for his involvement with one of the largest corporate frauds in U.S.
 High demand for competent, ethical, and history.
ü Parmalat: Calisto Tanzi, the founder and CEO of the Italian dairy and
accountable CEOs.
juice giant that collapsed in an $18 billion fraud, stands trial for the
alleged market securities violations.
ü Tyco International: Dennis Kozlowski, the former chairman and
CEO, was convicted of fraud, conspiracy, and grand larceny charges.

277 278

Functions of Corporate Officers Functions of Corporate Officers

Chief Executive Officer (CEO) Chief Financial Officer (CFO)

l A major CG participant involved in internal control, financial

Question: Determine how the following situations could
reporting, and strategy execution .
affect the power of a CEO.
Ø Ensure the effectiveness of ICFR and quality of both
ü CEO serves as the chair of the board
internal and external financial reports
ü CEO serves on board committees
Ø Assist the board in strategic decision making
ü CEO tenure
[Internal control: To be discussed in Topic 6A]
ü Independent directors on the board
ü Interlocking directors
ü Directors hired after the CEO’s tenure began

279 280

Functions of Corporate Officers Executive Compensation

Chief Risk Officer (CRO) l The board and its compensation committee should develop

l Oversee the overall strategies of ERM (Enterprise risk an effective, rewarding, and reasonable executive

management) in identifying and managing risks compensation program tailored to achieve the company’s
mission and strategic goals.
l Oversee proper implementation and compliance of policies
related to various risks (e.g., financial risk, operational risk, l The program should align with industry considerations

etc.) and be subject to approval by shareholders through

advisory say-on-pay votes .
[Risk management: To be discussed in Topic 6B]

281 282

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Executive Compensation Executive Compensation

Objectives Objectives

l Attract and retain talented management

l Pay-for-performance linkage Example: Apple’s Proxy Statement
Ø An integral component of monitoring function of CG ü What is the philosophy of Apple’s executive
Ø An important way for shareholders to assess the compensation design?
performance of executives
Ø Establishment of attainable, reasonable, and objective
performance target and proper payout structure to
reward executives for outstanding performance

283 284

Executive Compensation Executive Compensation

Concerns about weak pay-for-performance linkage Concerns about weak pay-for-performance linkage
l MSCI’s 2016 report (Marshall and Lee, 2016)
l MSCI’s 2016 report (Marshall and Lee, 2016)
Ø For a sample of firms included in the MSCI USA Index, the
correlation between CEO compensation and total shareholder
returns is consistently negative (although small) during 2005-
2014.
Reference: Marshall, R., and L. Lee. Are CEOs Paid for Performance?
Evaluating the Effectiveness of Equity Incentives. MSCI ESG Research,
July 2016.

Reference: Marshall, R., and L. Lee. Are CEOs Paid for Performance? Evaluating
the Effectiveness of Equity Incentives. MSCI ESG Research, July 2016. 285 286

Executive Compensation Executive Compensation

Concerns about weak pay-for-performance linkage Compensation components

l Wall Street Journal article by Francis and Lublin (2016) l Salary

Ø Set at a level that reflects responsibilities, tenure, and capabilities.
Ø None of the top-ten highly paid CEOs in S&P500 firms is among
the top-ten best performers in 2015. Ø Comparable with peer companies

Reference: Francis, T., and J. Lublin. 2016. CEO Pay Shrinks 4.6% but l Annual cash incentive pay (bonus)
Offers Weak Reflection of Performance. Wall Street Journal, June 2, 2016. Ø Reward superior performance that meets or exceeds predetermined
annual performance targets
l Long-term incentive pay (LTIP)
Ø Grants of stocks and stock options (rights to buy stocks in the future)
Ø Reward superior long-term performance to align interests of
executives and shareholders

287 288

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Executive Compensation Executive Compensation

Compensation components Compensation components

l Severance payments l Retirement arrangements

Ø Provided only in the event of wrongful termination, death, or Ø Pension plans and supplemental retirement packages
disability under non-control change situations. l Clawback provision
Ø Not for poor performance, failure to renew a contract, or
Ø Executives need to repay incentive compensation to the
resignation under pressure.
company if they engage in corporate scandals or fraudulent
l Change-of-control payments financial activities that cause restatements of financial
Ø Best practice recommends no change-of-control payments statements or significant harm to the company.
when the company is acquired.

289 290

Executive Compensation Executive Compensation

Compensation components Typical performance metrics

l Accounting metrics
Example: Apple’s Proxy Statement
Ø Revenue
ü What are the components of executive compensation in
Ø Earnings per share (EPS)
Apple?
Ø Return on assets (ROA) or Return on equity (ROE)
ü Are severance payments provided to Apple’s executives?
Ø Cash flow: operating cash flow, free cash flow
ü Are retirement benefits provided to Apple’s executives?
l Total shareholder return (TSR)
ü Is there clawback provision in Apple?
Ø Typically for evaluating long-term performance and for LTIP
payouts
Ø Limitation: Stock price fluctuations may not be associated with
the performance of executives
291 292

Executive Compensation Executive Compensation

Typical performance metrics Typical performance metrics

l Economic profit or economic value added (EVA)

Ø Incorporate cost of capital Example: Apple’s Proxy Statement
◇ Net operating profit minus cost of capital ü What performance measure are used by Apple to evaluate
Ø Rarely used executives?
l Operational metrics ü Does Apple use peer benchmarking?
Ø Customer satisfaction
ü What is the policy of using corporate jet by CEO?
Ø Reserve replacement for oil and gas exploration companies
Ø …
l Qualitative factors
Ø Achievement of strategic goals
Ø … 293 294

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Financial Reporting Requirement (U.S.) Financial Reporting Requirement (U.S.)

Main filings Typical contents of annual report

l Audited financial statements

US public companies are required to file with SEC:
l MD&A of financial condition and results of operations
ü Audited annual reports ( Form 10-K) l Management’s report of the effectiveness of ICFR
l Management certifications of financial statements and internal
ü Reviewed quarterly reports ( Form 10-Q)
controls

ü Current reports on major events ( 8-K) l Independent auditor’s report on financial statements
l Independent auditor’s report on the effectiveness of ICFR
ü Proxy statements ( DEF 14A)
l Five-year summary of selected financial data
ü Other filings

295 296

Financial Reporting Requirement (U.S.) Financial Reporting Challenges

Typical contents of annual report Initial adoption or changes of accounting policies

Example: Apple’s Annual Report

Example: Apple’s Annual Report
ü Find out the key sections (as shown in the previous slide)
in the annual report of Apple. ü What are the recent accounting changes faced by Apple?

297 298

Financial Reporting Challenges Financial Reporting Challenges

Off-balance sheet arrangements Timely disclosure of financial information

l Senior management is mostly responsible for the majority of the l Disclosure of financial information on a “rapid and
accounting violations.
current basis”.
l Lease accounting is one of the areas of financial reporting that
are most susceptible to manipulation and frauds.

Example: Apple’s Annual Report

ü How does Apple account for leases?
ü When does Apple adopt the new lease accounting?

299 300

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Financial Reporting Challenges Financial Reporting Challenges

Non-GAAP financial measures Non-GAAP financial measures

l A numerical measure of historical or future financial l Concerns over aggressive use of non-GAAP financial
performance, financial position or cash flows that measures
excludes the amounts that are included in the most l Regulation G
directly comparable measure calculated and presented
Ø Reconciliation of non-GAAP financial measures to
in accordance with GAAP.
the related GAAP financial measures
Ø E.g., adjusted operating income excludes certain
expense or revenue items identified as nonrecurring.

301 302

Financial Reporting Challenges Financial Reporting Challenges

Rule-based vs. principle-based accounting standards Rule-based vs. principle-based accounting standards

Rule-based approach:
Recommendation:
ü Easier to implement
ü Leaving too little room for judgment to improve the quality and transparency
ü A hybrid of focusing on an objectives-based approach in
establishing accounting standards based on an improved and
ü Easier to manipulate financial figures
consistently applied conceptual framework
ü Principle-based standard + Implementation guidance
Principle-based approach:
ü Considering the substance of business transactions rather than legal form
ü Difficult to structure transactions for earnings manipulation
ü Requiring more professional judgment (but inconsistent accounting
treatment of similar transactions could lead to low comparability)

303 304

Financial Reporting Challenges Financial Reporting Challenges

Conceptual framework for financial reporting Earnings management

l New IASB conceptual framework l Incentives of manipulating earnings

Ø Capital market:
l Updated FASB conceptual framework
◇ Influence market price
◇ Meet/beat analyst earnings forecast
Ø Contracts:
◇ Debt covenant
◇ Executive compensation

Question:
What are potential ways of manipulating earnings?
305 306

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Financial Reporting Challenges Financial Reporting Challenges

Global convergence in financial reporting Global convergence in financial reporting

l IFRS is commonly used worldwide. l U.S.’s consideration on IFRS adoption

l Convergence of IFRS and U.S. GAAP should benefit the Ø August 2008: The SEC’s Proposed IFRS Roadmap
global capital market by reducing differences in global ◇ Require all U.S. public companies to file their financial
accounting policies and practices. statements using IFRS, beginning in 2014.
Ø February 2010: The SEC’s Commission Statement in
Support of Convergence and Global Accounting Standards
◇ Reaffirm its commitment to IFRS.

307 308

Financial Reporting Challenges Financial Reporting Challenges

Global convergence in financial reporting Global convergence in financial reporting

l U.S.’s consideration on IFRS adoption [Continued]

l U.S.’s consideration on IFRS adoption [Continued]
Ø Convergence projects by FASB and IASB
Ø July 2012: The SEC’s Work Plan for the Consideration of
Incorporating IFRS into the Financial Reporting System for ◇ Convergence is no longer likely for the convergence
U.S. Issuers projects of financial instruments, insurance and leases
(while the converged revenue recognition guidance was
◇ No timetable for IFRS adoption.
issued)
Ø February 2014: The SEC’s Draft Strategic Plan for 2014-2018
◇ No new joint projects are currently being contemplated.
◇ Work to promote high-quality, financial reporting worldwide,
◇ The boards are expected to shift attention to their
but it does not mention IFRS specifically
individual agendas.
Source: IFRS Adoption by Country (PWC, 2016) .
309 310

Financial Reporting Challenges Financial Reporting Challenges

Global convergence in financial reporting Global convergence in financial reporting

l IFRS around the world (by 2018) l IFRS around the world (by 2018) [Continued]

Source: IFRS.
311 Source: IFRS. 312

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Financial Reporting Challenges Financial Reporting Challenges

Global convergence in financial reporting Global convergence in financial reporting

l IFRS around the world (by 2018) [Continued] l IFRS around the world (by 2018) [Continued]

Ø Of the 166 jurisdictions, 144 (87%) require IFRS for all or most Ø 12 jurisdictions permit (but not require) IFRS: Bermuda, Cayman
domestic publicly accountable entities (listed companies and Islands, Guatemala, Honduras, Japan, Madagascar, Nicaragua,
financial institutions) in their capital markets, including: Panama, Paraguay, Suriname, Switzerland; Timor-Leste.

◇ 31 EU member states. Ø 1 jurisdiction requires IFRS only for financial institutions:

Uzbekistan.
◇ Jurisdictions adopting IFRS virtually word-for-word: Australia,
Source: IFRS.
Hong Kong, New Zealand, South Korea.
Source: IFRS.

313 314

Management Responsibilities
Financial Reporting Challenges
for Internal Control
Global convergence in financial reporting IC framework

l IFRS around the world (by 2018) [Continued]

Ø 9 jurisdictions neither require nor permit IFRS.
◇ 1 jurisdiction is in the process of adopting IFRS in full: Thailand
◇ 1 jurisdiction is in process of converging its national standards
substantially (but not entirely) with IFRS Standards: Indonesia
◇ 7 jurisdictions use national or regional standards: Bolivia,
China, Egypt, India, Macao, U.S., Vietnam.

Source: IFRS.

315 316

Management Responsibilities Management Responsibilities

for Internal Control for Internal Control
IC framework IC framework

l Disclosure controls and procedures l Internal control over financial reporting (ICFR)
Ø Information disclosed is accurate and complete . Ø Transactions are recorded properly in accordance with
Ø Information is gathered, recorded, processed, management’s authorization .
summarized, and reported in the required time period . Ø Financial statements are prepared in accordance with
GAAP.
l ICFR is broader, because disclosure controls and
procedures may exclude some components of ICFR (e.g.,
disposition and safeguarding assets).

317 318

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Management Responsibilities Management Responsibilities

for Internal Control for Internal Control
IC framework Management’s evaluation of ICFR

l Internal control (COSO: Committee of Sponsoring l Determine the frequency of evaluation

Organizations of the Treadway Commission) Ø Annual evaluation (more comprehensive)

Ø Internal control is a process, effected by an entity’s board Ø Quarterly evaluations (less extensive)

of directors, management, and other personnel , l Identify the evaluation framework

designed to provide reasonable assurance regarding the Ø E.g., COSO framework
achievement of objectives in the following categories:
l Review and evaluate any significant changes in ICFR
◇ Reliability of financial reporting
Ø E.g., corrections of material weaknesses identified by
◇ Effectiveness and efficiency of operations management or in the audit report
◇ Compliance with applicable laws and regulations

319 320

Management Responsibilities Management Responsibilities

for Internal Control for Internal Control
IC reporting IC reporting

l Management reporting on disclosure controls and l Management report on ICFR

procedures Ø Section 404 of SOX:

Example: Apple’s Annual Report Management should document and assess the design
and operation of ICFR and report on the assessment of
ü How does Apple report management’s evaluation of
the effectiveness of ICFR
disclosure controls and procedures?

321 322

Management Responsibilities Management Responsibilities

for Internal Control for Internal Control
IC reporting IC reporting
l Management report on ICFR l Management report on ICFR
Mandatory internal control report should be integrated into annual report ,
including the following assertions:
Example: Apple’s Annual Report
ü management’s responsibility for establishing and maintaining adequate
and effective ICFR ü Does management’s annual report on ICFR of Apple
ü framework used by management in the assessment of the effectiveness of include the assertions as shown in the previous slide?
design and operation of ICFR
ü management’s assessment of the effectiveness of the design and operation
of ICFR
ü disclosure of any identified material weaknesses in ICFR
ü disclosure that the independent auditor has issued an attestation report
on management’s assessment of the effectiveness of ICFR
ü inclusion in annual report of the attestation report of independent auditor
323 324

54
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Management Responsibilities Management Responsibilities

for Internal Control for Internal Control
IC reporting IC reporting
l Management certification on ICFR
l Management certification on ICFR
The CEO and CFO must certify that they:
Ø Section 302 of SOX: ü have reviewed the reports , believe that the report neither contains untrue statements
nor omits material facts , and agree that the financial statements and other financial
Management should assess and report on the information are fairly presented .

effectiveness of disclosure controls and procedures ü are responsible for establishing and maintaining disclosure controls and
procedures and ICFR (design, evaluate, and present the conclusions about the
and ICFR. effectiveness)

ü have disclosed to the audit committee and external auditors all significant
deficiencies and material weaknesses in internal controls that could adversely affect
the company’s ability to record, process, summarize, and report financial information and
also have disclosed any fraud , material or not, that involves management or other
employees who have a significant role in the company’s ICFR

ü have indicated whether there have been significant changes in ICFR subsequent to the
date of their evaluation, including remediations of their previously identified
significant deficiencies and material weaknesses .
325 326

Management Responsibilities
Enterprise Risk Management
for Internal Control
IC reporting
l ERM has become an integrated part of CG.
l Management certification on ICFR l Definition of ERM (COSO)
Ø A process, effected by an entity's board of directors ,
Example: Apple’s Annual Report
management , and other personnel , applied in strategy
ü How does Apple’s management certify about ICFR? setting and across the enterprise, designed to identify
potential events that may affect the entity, and manage
risks to be within its risk appetite , to provide
reasonable assurance regarding the achievement of
entity objectives.
[To be discussed in Topic 6B]

327 328

Tax Accounting
l Opportunity for tax avoidance
ACCT4007
Ø Delinking of financial reporting and tax reporting
Ø Transfer pricing
Corporate Governance
Ø Related-party transaction (transfer profits to low-tax
Topic 5 (Supplement)
regions or tax heavens)
Lease Accounting
l Is tax avoidance by the company good or bad for
shareholders?

329

55
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IFRS Standards for Leases IFRS Standards for Leases

• IFRS 16
– Joint IASB-FASB project on accounting for le
IAS 17 ases started in July 2006

– Issued in December 2004 and effective on Januar – First exposure draft published in 2010
y 1, 2005 – Second exposure draft published in 2013
– Final standard issued in 2016 and effective o
n January 1, 2019

331 332

Lease vs. Purchase with loan

What is a Lease?
Two potential options when an entity needs to use an asset

– Option 1: Leasing over the whole useful life of th

Rental payments e asset

Lessor Lessee – Option 2: Outright purchase financed by a loan

Legal owner User Different legal forms
(Supplier) (Customer)
– Option 1: No legal ownership
Identified
asset
Transfer the right of use – Option 2: Legal ownership
Same commercial effects

– Use the asset for the entire economic life

– Identical payment made in each time period
333 334

Lease vs. Purchase with loan Lease vs. Purchase with loan

If accounted for in accordance with the legal forms, the two options ha
ve different impacts on the financial statements.
– Leasing arrangement would result in the liabilities being ex As the two options have essentially the same commercial effect, the

cluded from statement of financial position. y should be accounted for in the same manner.
However, in other types of leasing arrangements (e.g., the lease ter
– Effects on lessee
m covering only partial useful life of the asset), the commercial effec
• Unrecorded liabilities  Lower gearing (leverage ratios)
t could be arguably different from outright purchase.
• Unrecorded assets  Higher return on assets
– Information would be misleading to users when the two o
ptions are reported differently.

335 336

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Need for a New Lease Accounting Approach Adopted by IAS 17

Distinguish between two types of leasing arrangement

It is necessary for an accounting standard to ensure:
– Leases representing in substance an outright
– Leasing arrangement are accounted for in a
purchase of the asset by the lessee financed
ccordance with commercial effects (followin
by a loan from the lessor are classified as fin
g “substance over form ” principal), by appro
ance leases.
priately recognizing assets and liabilities ass
– Other leases are classified as operating lease
ociated with leasing transactions.
s.
– The accounting treatment can mitigate the
problem of “off-balance-sheet financing ”.

337 338

Approach Adopted by IAS 17 Approach Adopted by IAS 17

Classification criteria Finance lease

– The extent to which risks and rewards incidental to ownershi – A lease which transfers substantially all the ri
p of a leased asset lie with the lessor or the lessee. sks and rewards incidental to ownership of a
Risks of ownership
n asset to the lessee.
– Losses from idle capacity or technological obsolescence
– Title may or may not eventually be transferre
– Asset breakdown and repairs
– Theft
d.
Operating lease
Rewards of ownership
– Benefits derived from the asset while in use – A lease other than finance lease (substantial
• Profitable operation over the asset’s economic life risks and rewards incidental to ownership are
• Gain from appreciation in value not transferred).
• Realization of a residual value
339 340

Criticism of Lease Model in IAS 17 Criticism of Lease Model in IAS 17

– Distinction between finance and operating leases based on

– Fail to provide a faithful representation of leasing transacti
the perception of the “risks and rewards” is inherently subj
ons
ective.
• Lessees are not required to recognize leased assets and
– Inconsistency with the definition of liabilities in the “Conce
liabilities in operating leases.
ptual Framework”
• Key financial ratios (e.g., gearing ratios and return on as
• As operating leases are often non-cancellable, oper
sets) indicate a less favorable position for lessees when
ating lease commitments do meet the definition of
recognizing leased assets and associated liabilities in th
e statement of financial position, compared with non-re liabilities.
cognition (in accordance with the legal form). • However, no liabilities would be required to be rec
ognized under operating leases.

341 342

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Improvements in IFRS 16 IFRS 16 vs. IAS 17

Accounting for lessees

– More faithful representation of a lessee’s as – A single accounting model: Right-of-use accounting model
sets and liabilities – Remove the distinction between operating and finance leases.
– Recognize assets and liabilities for all leases (similar to finance leas
– Greater transparency of a lessee’s financial l es in IAS 17), except for short-term leases or leases of low value a
everage and capital employed ssets (treated like operating leases in IAS 17).
Accounting for lessors
– Enhanced disclosures of lease transactions – No substantial changes: Retaining the distinction between operati
ng and finance leases
– Increased disclosure regarding a lessor’s risk exposure (especially r
esidual value risk).

343 344

Accounting for Lessees under IFRS 16

US Standards for Leases
– Right-of-use accounting model
– Recognize assets and liabilities for all leases, ex
SFAS 13
cept for short-term leases or leases of low value
– Issued and effective in 1976
assets.
Asset = Liability + Equity ASU No. 2016-02 (Topic 842)
Cash Right-of- (–) Lease (–) (–)
use
asset
Accumulated
Depreciation
liability Depreciation
expense
Interest
expense
– Issued in February 2016
Lease
commencement
XXX XXX
– Effective for fiscal years beginning after Decemb
Annual depreciation XXX XXX
er 15, 2018
Annual mortgage XXX (–) XXX
repayment XXX

345 346

IFRS Standards for Leases

• Lessee accounting under ASU Topic 842
ACCT4007
– Balance sheet : Recognize right-of-use asset
and lease liability
Corporate Governance
Topic 5 (Supplement)
– Income statement: Retain the classification o
f finance vs. operating lease Conceptual Framework
of Financial Reporting
Ø Finance lease: Recognize interest on lease
liability separately from depreciation of rig
ht-of-use asset
Ø Operating lease: Recognize a single lease
cost on a straight-line basis 347

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IASB Conceptual Framework Qualitative Characteristics of Financial Information

for Financial Reporting (2018)
Fundamental qualitative characteristics
– Relevance
Issued by the IASB in March 2018
• Materiality (Entity-specific aspect of relevance)
Replacing the 2010 version of conceptual framework
– Faithful representation
Effective date Enhancing qualitative characteristics
– Immediately for standard setter – Comparability
– January 1, 2020 for preparers who develop accounting – Verifiability
policies based on the conceptual framework – Timeliness
– Understandability
Cost constraint on useful financial reporting
349 350

Elements of Financial Statements Recognition Criteria

An item is recognized only if it results in useful information

Financial position (i.e., information with both relevance and faithful representat
– Asset ion) provided to primary users.
– Liability
• [Main changes]
– Equity – New recognition criteria refer explicitly to the qualitative characteristic
s of useful information.
Financial performance – The revision aims to develop a more coherent set of concepts, not to
– Income increase or decrease the range of assets and liabilities recognized.

– Expense • [Old recognition criteria]

– It is probable that future economic benefits associated with the item will f
low to or from the entity.
– The item has a cost or value that can be measured reliably.
351 352

Recognition Criteria – Relevance Recognition Criteria – Faithful Representation

Whether recognition of an item results in faithful representation may be affec
ted by:
Whether recognition of an item results in relevant information may be
affected by: – Measurement uncertainty
– Existence uncertainty : Uncertain whether an asset or liability exists. • Arise when monetary amounts cannot be observed directly and
need to be estimated.
• E.g., Whether an entity has the right to receive economic resourc
e from another entity in a lawsuit (i.e., whether the asset exists) i – Recognition inconsistency (a scenario of accounting
s uncertain (e.g., contingent asset), until the existence uncertaint mismatch)
y is resolved by court ruling.
• Arise if certain related assets or liabilities in a transaction are n
• E.g., Whether an entity has the obligation to pay compensation f ot recognized.
or alleged act of wrongdoings to another entity (i.e., whether the
liability exists) is uncertain (e.g., contingent liability), until the exi – Presentation and disclosure of information about th
stence uncertainty is resolved by court ruling. e asset or liability, and resulting income, expenses
– Low probability of the inflow or outflow of economic benefits or changes in equity
353 354

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Measurement Bases – Historical Cost Measurement Bases – Current Value

Current value measurement bases

Historical cost measurement base
– Updated to reflect conditions at the measurement date.
– Provide information derived (at least in part) from the price
of the transaction that gave rise to the asset or liability. – Provide information about changes in prices (i.e., estimate
s of cash flows) and other factors.
– Do not reflect changes in values, except for impairment of
an asset or a liability becoming onerous. – Types of current value measurement bases:

– One way to apply the historical cost measurement basis to • Fair value
financial assets and financial liabilities is to measure them • Value in use (for asset) and Fulfillment value (for liabilit
at amortized cost . y)
• Current cost

355 356

Measurement Bases – Fair Value Measurement Bases – Fair Value

Fair value hierarchy
The price that would be received to sell an asset or paid to transfer a li – Level 1 input: Quoted prices (unadjusted) in active markets
ability in an orderly transaction between market participants in the p for identical assets or liabilities that the entity can access a
rincipal (or most advantageous) market at the measurement date un t the measurement date.
der current market condition. – Level 2 input: Inputs other than quoted prices included wit
Market-based measurement (from the perspective of market participant hin Level 1 that are observable for the asset or liability, eith
er directly or indirectly.
s): Reflect market participants’ current expectations about the amou
• Quoted prices for similar assets or liabilities in active markets
nt, timing and uncertainty of future cash flows.
• Quoted prices for identical or similar assets or liabilities in ma
To estimate fair value, an entity should use appropriate valuation techni rkets that are not active .
ques by maximizing the use of relevant observable inputs and mini • Other observable inputs
mizing the use of unobservable inputs. – Level 3 input: Unobservable inputs for the asset or liability.
Reference: IFRS 13 – Fair Value Measurement.

357 358

Measurement Bases
Measurement Bases – Current Cost
– Value in Use & Fulfillment Value

Value in use (for asset): Present value of cash flows (or other ec
Current cost of an asset: Considerations that would be paid for an eq
onomic benefits) that an entity expects to derive from the u
uivalent asset at the measurement date.
se of an asset and from its ultimate disposal.
Current cost of a liability: Considerations that would be received for a
Fulfillment value (for liability): Present value of cash (or other e
n equivalent liability at the measurement date.
conomic resources) that an entity expects to be obliged to t
ransfer as it fulfills a liability.
Entity-specific measurements (from the perspective of the repo
rting entity): Reflect entity-specific current expectations abou
t the amount, timing and uncertainty of future cash flows.

359 360

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Presentation and Disclosure Profit or Loss vs. OCI

Information about assets, liabilities, equity, income and e Statement of profit or loss
xpenses is communicated through presentation and di – Primary source of information about financial perfo
sclosure in the financial statements. rmance
Effective communication of information in financial state – In principle, all income and expenses are classified
ments makes that information more relevant and contr and included in the statement of profit or loss.
ibutes to a faithful representation of an entity’s assets,
liabilities, equity, income and expenses.

361 362

Profit or Loss vs. OCI Profit or Loss vs. OCI

Other comprehensive income
– In exceptional circumstances , the HKICPA may decide that certain Unsolved issues faced by IASB
income or expenses are exclude from the statement of profit or l
oss and included in OCI, if such decision results in more useful in – It is not possible to produce a robust conceptual d
formation (relevance and faithful representation) provided in the efinition of profit or loss.
statement of profit or loss.
– No consensus is reached regarding a clear way of
– Only for income or expenses arising from a change in current val
ue distinguishing between profit or loss and OCI.
– In principle, income or expenses included in OCI are reclassified – It is urgently needed to have the guidance on the
(recycled) to profit or loss in a future period.
use of OCI.
– The HKICPA may decide the items NOT to be reclassified (recycle
d), when the reclassification (recycling) does not result in more u
seful information (relevance and faithful representation) provided
in the statement of profit or loss.
363 364

FASB Conceptual Framework

for Financial Reporting
ACCT4007
Corporate Governance
Updated chapters (2018)
– Chapter 1: The Objective of General Purpose Financial Reporting
– Chapter 3: Qualitative Characteristics of Useful Financial Information
Under amendments
– Elements of Financial Statements
– Recognition and Measurement in Financial Statements
– Presentation of Financial Statements
Topic 6A
Internal Audit Function and
Internal Control System 366
365

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Internal Audit Function

(Pre- vs. Post-SOX)
Pre-SOX reform Post-SOX reform
Ø Voluntary internal audit function Ø Mandatory internal audit function
Ø Outsourcing of internal audit function Ø Objective internal auditors

Part I: Internal Audit Function Ø Improper oversight of internal audit Ø Oversight by audit committee
Ø Auditing services to management Ø Reporting responsibility to audit committee
Ø Provide assurance and consulting
services in the areas of operational
efficiency, financial reporting, internal
control, risk management, and other CG
processes
Ø Inadequate resources and authority Ø Adequate resources and authority
Ø Lack of cooperation with external auditor Ø Better cooperation with external auditor
Ø Regarded as the “eyes and ears” of Ø Regarded as the “eyes and ears” of audit
management committee

367 368

Roles and Responsibilities Internal Auditors

of Internal Auditors as Assurance Providers
l Internal audit function is performed by internal auditors. l Provide assurance reports for internal use by management
l Internal auditors provide objective and independent assurance Ø Assist management in complying with the requirements of SOX
and consulting services designed to add value and improve by reviewing management’s certifications on financial
corporate sustainable performance in the areas of: statements and ICFR and providing assurance on the
Ø operational efficiency completeness and accuracy of these certifications.
Ø financial reporting Ø Provide audit opinions on risk management process,
Ø internal control internal control systems, and other governance measures
Ø risk management for internal as well as regulatory purposes.
Ø social responsibility Ø Assist management in the preparation of integrated
Ø ethics sustainability reports and assurance of reliability of
information included in the reports.

369 370

Internal Auditors Internal Auditors

as Consultants as Consultants
l Consulting services to the board (especially audit committee) l Training services to employees
Ø Consultation in overseeing financial reporting, internal control, Ø Audit training services to all personnel within the company,
risk assessment, whistle-blower programs, and code of including the training of:
business ethics.
◇ Financial reporting
l Consulting services to management
◇ Internal control procedures and assessment
Ø Consultation in the areas of operational effectiveness and
◇ Risk management
efficiency, internal control assessment, risk management,
financial reporting, and compliance with applicable laws, ◇ Information technology
regulations, and standards. ◇ Compliance with applicable laws, regulations, and standards
Ø To maintain independence and objectivity , internal auditors
should not step into the management decision-making function
in their consulting activities and should refrain from making
decisions on behalf of management.
371 372

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Authorities of Internal Auditors Effectiveness of Internal Audit

l Authorities are granted by the board (especially audit committee) l Internal auditors should be independent by directly
Ø Full and free access to audit committee . reporting to the board and audit committee .
Ø Unrestricted access to company’s records, documents, l Internal audit function should have adequate staff with
property, and personnel , which are required to conduct
financial and accounting knowledge and experience .
internal audits.
Ø Authority to discuss initiatives, policies, and procedures
regarding risk assessment, internal control, compliance,
financial reporting, and other governance processes with
management and other CG participants .

373 374

Effectiveness of Internal Audit Effectiveness of Internal Audit

l Five steps for establishing effective internal audit function l Five steps for establishing effective internal audit function

1) Appoint the right person to be Chief Audit Executive (CAE). 2) Establish a written audit charter.

ü Head of a company’s internal audit function ü Specifying the purpose, authority, and responsibility of internal audit function

ü Competent and knowledgeable in internal auditing standards, tools,

3) Develop an audit strategy.
methodology, and practices

ü Supervising properly internal audit activities ü Developed by CAE in collaboration with management and approved by the
audit committee
ü Communicating effectively with audit committee, management, and
internal audit staff
ü Specifying audit plans, scope, nature, procedures, and timing of all internal
ü Demanding productive performance and ethical conduct from internal audit activities.
audit staff

375 376

Effectiveness of Internal Audit Effectiveness of Internal Audit

l Five steps for establishing effective internal audit function l Five steps for establishing effective internal audit function

4) Implement the audit strategy.

5) Establish quality assurance and performance evaluation.
ü Effective implementation of internal audit strategy requires:
◇ Proper audit plans
ü Evaluate the effectiveness of internal audit function annually
◇ Sufficient resources including ethical, and highly specialized and
competent staff (adequate training and proficiency in accounting,
economics, taxation, finance, information technology, and quantitative ü Performance of CAE should be evaluated by management and reviewed
methods) by the audit committee
◇ Commitment from senior management
◇ Approval by audit committee

377 378

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Effectiveness of Internal Audit

l PwC’s 2014 Survey about the effectiveness of internal audit

Ø Subjects: Around 1,900 internal audit professionals
Ø About 49% of senior management and 64% of board Part II: Internal Control System
members agree that internal audit is performing well
and providing significant value as trusted adviser and
assurance provider .

379 380

Fraud and Internal Control Fraud and Internal Control

l Internal control system is vital to prevent frauds . l Question: Match each situation with the fraud triangle
l Fraud: factors (opportunity, financial pressure, or rationalization)
Ø Dishonest act by an employee that results in personal that best describes it.
benefit to the employee at a cost to the employer . a) An employee’s monthly credit card payments are nearly
l Factors that contribute to fraudulent activity: 75% of their monthly earnings.
b) An employee earns minimum wage at a firm that has
reported record-high earnings for each of the last 5 year.
c) An employee has an expensive gambling habit.
d) An employee has check writing and signing
responsibilities for a small company, and is also
Ø Opportunity: Lack of control
responsible for reconciling the bank account.
Ø Financial Pressure : Incentives
Ø Rationalization : Justification of dishonest actions 381 382

COSO’s IC framework (2013) COSO’s IC framework (2013)

l COSO: Committee of Sponsoring Organizations of the Treadway l COSO Cube (2013)

Commission
l Definition of internal control
Ø A process
Ø effected by an entity’s board of directors , management , and
other personnel
Ø designed to provide reasonable assurance
Ø regarding the achievement of objectives relating to
operations, reporting, and compliance

383 384

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Objectives of Internal Control Objectives of Internal Control

l Operations objective: Increase effectiveness and l Reporting objective: Enhance quality and transparency
efficiency of operations of financial reporting
Ø Assignment of responsibility to specific employees Ø Reducing the risk of errors (unintentional mistakes) and
Ø Achieving operational and financial performance goals irregularities (intentional misrepresentations).

Ø Safeguard assets from employee theft, robbery, and ◇ E.g., preparation of a bank reconciliation.
unauthorized use. l Compliance objective: Ensure compliance with laws
◇ E.g., use of a cash register to safeguard assets. and regulations
◇ E.g., use of cash register tapes to document sales and
applicable sales taxes.

385 386

Components of Internal Control Principles of Internal Control Activities

l Control environment
l Establishment of Responsibility
Ø “Tone at the top” : Top management should make it clear that the
company values integrity and unethical activity is not tolerated. Ø Control is most effective when only
l Risk assessment one person is responsible for a
Ø Identify risk factors for the business and determine the ways of given task.
managing risks .
Ø Establishing responsibility often
l Control activities requires limiting access only to
Ø Design policies and procedures to address the specific risks.
authorized personnel , and then
l Information and communication identifying those personnel.
Ø Effectively communicate all relevant information internally and externally .
l Monitoring
Ø Periodically monitor the adequacy of internal control system and report
significant deficiencies to top management and the board.
387 388

Cases of Internal Control Weakness (1) Principles of Internal Control Activities

l Maureen Frugali was a training supervisor for claims processing at

Colossal Healthcare.
l Segregation of Duties

l As a standard part of the claims processing training program , Ø Different individuals should be
Maureen created fictitious claims for use by trainees . These responsible for related activities .
fictitious claims were then sent to the Accounts Payable (AP) Ø The responsibility for record-
department. After the training claims had been processed, she was keeping for an asset should be
to notify AP department of all fictitious claims, so that they would
separate from the physical
not be paid.
custody of that asset.
l However, she did not inform AP department about every
fictitious claim . She created some fictitious claims for entities
that she controlled (that is, she would receive the payment), and
she let AP department pay her.
l What is the missing control?
389 390

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Cases of Internal Control Weakness (2) Principles of Internal Control Activities

l Lawrence Fairbanks, the assistant vice-chancellor of communications

at Aesop University, was allowed to make purchases of under
l Documentation Procedures
$2,500 for his department without external approval . Ø Companies should use
l Unfortunately, he also sometimes bought items for himself , such as prenumbered documents , and
expensive antiques and other collectibles. all documents should be
l How did he do it? He replaced the vendor invoices he received with accounted for .
fake vendor invoices that he created. The fake invoices had Ø Employees should promptly
descriptions that were more consistent with the communications forward source documents for
department’s purchases. He submitted these fake invoices to the
accounting entries to the
accounting department as the basis for their journal entries and to
accounting department.
the Accounts Payable department as the basis for payment .
l What is the missing control?

391 392

Cases of Internal Control Weakness (3) Principles of Internal Control Activities

l To support their reimbursement requests for travel costs

l Physical Controls
incurred, employees at Mod Fashions Corporation’s design center
were required to submit receipts . The receipts could include the
detailed bill provided for a meal, or the credit card receipt provided
when the credit card payment is made, or a copy of the employee’s
monthly credit card bill that listed the item.
l A number of the designers who frequently traveled together came
up with a fraud scheme: They submitted claims for the same
expenses. For example, if they had a meal together that cost $200,
one person submitted the detailed meal bill , another submitted the
credit card receipt , and a third submitted a monthly credit card
bill showing the meal as a line item. Thus, all three received a $200
reimbursement.
l What is the missing control?

393 394

Cases of Internal Control Weakness (4) Principles of Internal Control Activities

l At Centerstone Health, a large insurance company, the mailroom each day l Independent Internal Verification
received insurance applications from prospective customers. Mailroom
employees scanned the applications into electronic documents before the Ø Records periodically verified by an employee who is
applications were processed. Once the applications are scanned they can be independent.
accessed online by authorized employees using the passwords which are
the same as the user IDs . Ø Discrepancies reported to management.
l Insurance agents at Centerstone Health earn commissions based upon
successful applications . The sales agent’s name is listed on the
application. However, roughly 15% of the applications are from customers who
did not work with a sales agent .
l Two friends—Alex, an employee in record keeping, and Parviz, a sales agent—
thought up a way to perpetrate a fraud. Alex identified scanned applications that
did not list a sales agent. After business hours , he entered the mailroom and
found the hardcopy applications that did not show a sales agent . He wrote
in Parviz’s name as the sales agent and then rescanned the application for
processing. Parviz received the commission, which the friends then split.
l What is the missing control?
395 396

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Cases of Internal Control Weakness (5) Principles of Internal Control Activities

l For more than a decade, the top executives at the Italian dairy products
company Parmalat engaged in multiple frauds that overstated cash and l Human Resource Controls
other assets by more than $1 billion while understating liabilities by
between $8 and $12 billion. Ø Bond employees who handle
l Much of the fraud involved creating fictitious sources and uses of cash . cash.
Some of these activities incorporated sophisticated financial transactions with
subsidiaries created with the help of large international financial institutions. Ø Rotate employees’ duties and
However, much of the fraud employed very basic, even sloppy, forgery of require vacations.
documents. For example, when outside auditors requested confirmation of
bank accounts (such as a fake $4.8 billion account in the Cayman Islands), Ø Conduct background checks .
documents were created on scanners, with signatures that were cut and
pasted from other documents . These were then passed through a fax
machine numerous times to make them look real (if difficult to read). Similarly,
fictitious bills were created in order to divert funds to other businesses owned
by the Tanzi family (who controlled Parmalat).
l What is the missing control?

397 398

Cases of Internal Control Weakness (6) Principles of Internal Control Activities

l Ellen Lowry (previously fired by the former employer ) was the desk
manager and Josephine Rodriquez was the head of housekeeping at the l Question: The internal control procedures in Edmiston
Excelsior Inn, a luxury hotel. The two best friends were so dedicated to their Company make the following provisions. Identify the
jobs that they never took vacations , and they frequently filled in for other principles of internal control that are being followed in
employees. In fact, Ms. Rodriquez, whose job as head of housekeeping did
each case.
not include cleaning rooms, often cleaned rooms herself, “just to help the staff
keep up.” a) Employees who have physical custody of assets do not
l The fraud was detected when Ms. Lowry, the desk manager, missed work have access to the accounting records.
due to illness. Ms. Lowry provided significant discounts to guests who paid b) Each month, the assets on hand are compared to the
with cash. She kept the cash and did not register the guest in the hotel’s
accounting records by an internal auditor.
computerized system . Instead, she took the room out of circulation “due
to routine maintenance.” Because the room did not show up as being used, c) A prenumbered shipping document is prepared for
it did not receive a normal housekeeping assignment. Instead, Ms. Rodriquez, each shipment of goods to customers.
the head of housekeeping, cleaned the rooms during the guests’ stay.
l What is the missing control?
399 400

Principles of Internal Control Activities Limitations of Internal Control

l Question: Identify which control activity is violated in each l Costs should not exceed benefit.
of the following situations, and explain how the situation
Ø Controls may vary with the risk level of the activity.
creates an opportunity for fraud or inappropriate
accounting practices. ◇ E.g., management may consider cash to be high risk
and maintaining inventories in the stockroom as lower
a) Once a month, the sales department sends sales
invoices to the accounting department to be recorded. risk. Thus, management would have stricter controls
for cash.
b) Nick Sewell orders merchandise for Silo Company. He
receives merchandise and also authorizes payment for l Human element
merchandise. l Size of the business
c) Several clerks at Guillen’s Groceries use the same
cash register drawer.

401 402

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Fraud and Internal Control

l Question: Match each situation with the fraud triangle factors
ACCT4007 (opportunity, financial pressure, and rationalization) that best
Corporate Governance describes it.
a) An employee’s monthly credit card payments are nearly
75% of their monthly earnings. [Financial Pressure]
b) An employee earns minimum wage at a firm that has
reported record-high earnings for each of the last 5 year.
[Rationalization]
c) An employee has an expensive gambling habit. [Financial

Topic 6A Pressure]
d) An employee has check writing and signing responsibilities
Internal Control System for a small company, and is also responsible for reconciling
(Suggested Answer) 403
the bank account. [Opportunity]
404

Cases of Internal Control Weakness (1) Cases of Internal Control Weakness (1)

l Maureen Frugali was a training supervisor for claims processing at l What is the missing control?
Colossal Healthcare.
Ø Establishment of responsibility.
l As a standard part of the claims processing training program ,
Maureen created fictitious claims for use by trainees . These
Ø The healthcare company did not adequately restrict the
fictitious claims were then sent to the Accounts Payable (AP) responsibility for authorizing claims transactions. The
department. After the training claims had been processed, she was training supervisor should not have been authorized to
to notify AP department of all fictitious claims, so that they would create claims in the company’s “live” system .
not be paid.
l However, she did not inform AP department about every
fictitious claim . She created some fictitious claims for entities
that she controlled (that is, she would receive the payment), and
she let AP department pay her.
l What is the missing control?
405 406

Cases of Internal Control Weakness (2) Cases of Internal Control Weakness (2)

l Lawrence Fairbanks, the assistant vice-chancellor of communications l What is the missing control?
at Aesop University, was allowed to make purchases of under
Ø Segregation of duties.
$2,500 for his department without external approval .
Ø The university had not properly segregated related
l Unfortunately, he also sometimes bought items for himself , such as
purchasing activities . Lawrence was ordering items ,
expensive antiques and other collectibles.
receiving the items , and receiving the invoice . By
l How did he do it? He replaced the vendor invoices he received with
receiving the invoice, he had control over the
fake vendor invoices that he created. He submitted these fake
invoices to the accounting department as the basis for their journal documents that were used to account for the purchase
entries and to the Accounts Payable department as the basis for and thus was able to substitute a fake invoice.
payment.
l What is the missing control?

407 408

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Cases of Internal Control Weakness (3) Cases of Internal Control Weakness (3)

l To support their reimbursement requests for travel costs l What is the missing control?
incurred, employees at Mod Fashions Corporation’s design center
Ø Documentation procedures.
were required to submit receipts . The receipts could include the
detailed bill provided for a meal, or the credit card receipt provided Ø Mod Fashions should require the original, detailed
when the credit card payment is made, or a copy of the employee’s receipt. It should not accept photocopies , and it should
monthly credit card bill that listed the item.
not accept credit card statements .
l A number of the designers who frequently traveled together came
Ø In addition, documentation procedures could be further
up with a fraud scheme: They submitted claims for the same
expenses. For example, if they had a meal together that cost $200, improved by requiring the use of a corporate credit card
one person submitted the detailed meal bill , another submitted the (rather than a personal credit card) for expenses.
credit card receipt , and a third submitted a monthly credit card
bill showing the meal as a line item. Thus, all three received a $200
reimbursement.
l What is the missing control?

409 410

Cases of Internal Control Weakness (4) Cases of Internal Control Weakness (4)
l At Centerstone Health, a large insurance company, the mailroom each day l What is the missing control?
received insurance applications from prospective customers. Mailroom Ø Physical controls.
employees scanned the applications into electronic documents before the
applications were processed. Once the applications are scanned they can be Ø Centerstone Health lacked two basic physical controls that could
accessed online by authorized employees using the passwords which are have prevented this fraud.
the same as the user IDs .
◇ First, the mailroom should have been locked during nonbusiness
l Insurance agents at Centerstone Health earn commissions based upon hours, and access during business hours should have been
successful applications . The sales agent’s name is listed on the
tightly controlled .
application. However, roughly 15% of the applications are from customers who
did not work with a sales agent . ◇ Second, the scanned applications supposedly could be accessed
l Two friends—Alex, an employee in record keeping, and Parviz, a sales agent— only by authorized employees using their passwords. However, the
thought up a way to perpetrate a fraud. Alex identified scanned applications that password for each employee was the same as the employee’s
did not list a sales agent. After business hours , he entered the mailroom and user ID. Since employee user-ID numbers were available to all other
found the hardcopy applications that did not show a sales agent . He wrote employees, all employees knew all other employees’ passwords.
in Parviz’s name as the sales agent and then rescanned the application for Unauthorized employees could access the scanned
processing. Parviz received the commission, which the friends then split.
applications. Thus, Alex could enter the system using another
l What is the missing control?
411
employee’s password and access the scanned applications. 412

Cases of Internal Control Weakness (5) Cases of Internal Control Weakness (5)
l For more than a decade, the top executives at the Italian dairy products
company Parmalat engaged in multiple frauds that overstated cash and l What is the missing control?
other assets by more than $1 billion while understating liabilities by
Ø Independent internal verification.
between $8 and $12 billion.
l Much of the fraud involved creating fictitious sources and uses of cash . Ø Internal auditors at the company should have
Some of these activities incorporated sophisticated financial transactions with independently verified bank accounts and major
subsidiaries created with the help of large international financial institutions.
However, much of the fraud employed very basic, even sloppy, forgery of
transfers of cash to outside companies that were
documents. For example, when outside auditors requested confirmation of controlled by the Tanzi family.
bank accounts (such as a fake $4.8 billion account in the Cayman Islands),
documents were created on scanners, with signatures that were cut and
pasted from other documents . These were then passed through a fax
machine numerous times to make them look real (if difficult to read). Similarly,
fictitious bills were created in order to divert funds to other businesses owned
by the Tanzi family (who controlled Parmalat).
l What is the missing control?

413 414

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Cases of Internal Control Weakness (6) Cases of Internal Control Weakness (6)
l Ellen Lowry (previously fired by the former employer ) was the desk
l What is the missing control?
manager and Josephine Rodriquez was the head of housekeeping at the
Excelsior Inn, a luxury hotel. The two best friends were so dedicated to their Ø Human resource controls.
jobs that they never took vacations , and they frequently filled in for other
Ø Ellen, the desk manager, had been fired by a previous
employees. In fact, Ms. Rodriquez, whose job as head of housekeeping did
employer. If the Excelsior Inn had conducted a
not include cleaning rooms, often cleaned rooms herself, “just to help the staff
keep up.” background check , it would not have hired her.
l The fraud was detected when Ms. Lowry, the desk manager, missed work Ø The fraud was detected when Ellen missed work due to
due to illness. Ms. Lowry provided significant discounts to guests who paid illness. A system of mandatory vacations and rotating
with cash. She kept the cash and did not register the guest in the hotel’s
days off would have increased the chances of detecting
computerized system . Instead, she took the room out of circulation “due
to routine maintenance.” Because the room did not show up as being used, the fraud before it became so large.
it did not receive a normal housekeeping assignment. Instead, Ms. Rodriquez,
the head of housekeeping, cleaned the rooms during the guests’ stay.
l What is the missing control?
415 416

Principles of Internal Control Activities Principles of Internal Control Activities

l Question: The internal control procedures in Edmiston
l Question: Identify which control activity is violated in each
Company make the following provisions. Identify the
of the following situations, and explain how the situation
principles of internal control that are being followed in
creates an opportunity for fraud or inappropriate
each case.
accounting practices.
a) Employees who have physical custody of assets do not
a) Once a month, the sales department sends sales
have access to the accounting records. [Segregation of
invoices to the accounting department to be recorded.
duties]
b) Nick Sewell orders merchandise for Silo Company. He
b) Each month, the assets on hand are compared to the
receives merchandise and also authorizes payment for
accounting records by an internal auditor. [Independent
merchandise.
internal verification]
c) Several clerks at Guillen’s Groceries use the same
c) A prenumbered shipping document is prepared for
cash register drawer.
each shipment of goods to customers. [Documentation
procedures] 417 418

Principles of Internal Control Activities Principles of Internal Control Activities

l a) Once a month, the sales department sends sales l b) Nick Sewell orders merchandise for Silo Company. He
invoices to the accounting department to be recorded. receives merchandise and also authorizes payment for
Ø Violate the control activity of documentation procedures . merchandise.
Source documents should be promptly forwarded to the Ø Violate the control activity of segregation of duties .
accounting department so accounting entries can be Different individuals should be responsible for related
made. This control activity helps to ensure timely activities, such as these three related purchasing
recording of sales transactions and contributes directly to activities. Many abuses could occur: placing orders with
the accuracy and reliability of the accounting records. friends; approving fictitious invoices for payment.

419 420

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Principles of Internal Control Activities

l c) Several clerks at Guillen’s Groceries use the same ACCT4007

cash register drawer.
Corporate Governance
Ø Violate the control activity of establishment of
responsibility. Guillen’s would be unable to determine who
was responsible for a cash shortage; this lapse could
even encourage employee theft.

Topic 6B
Risk Management System
421 422

Intuition about Risks Intuition about Risks

S&P 500 Index (2001/01-2020/09) Shanghai Composite Index (2001/01-2020/09)

Source: Yahoo Finance.

Source: Yahoo Finance.
423 424

Intuition about Risks Intuition about Risks

RMB/USD exchange rate (2001/01-2020/09) Gold (Comex) price (2001/01-2020/09)

Source: Yahoo Finance.

Source: Yahoo Finance.

425 426

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Intuition about Risks What is Risk?

l Uncertainty about the future l Risks refer to volatility of outcomes (representing the value
of assets, equity, or earnings, etc.) leading to unexpected
l Losses that suddenly rise in an entirely unexpected way
losses.
l Fluctuation in the market
l The risks lie in:
Ø How variable the losses are ( Volatility)
Ø How likely to encounter the losses ( Probability)
l Higher volatility indicates higher risk.
l Volatility of returns is influenced by risk factors, and by the
interaction between risk factors .

427 428

Business Risk Business Risk

l Classic risks of the world of business, such as uncertainty
about: l Business decisions risk
Ø Demand for products Ø E.g., product development choices, marketing strategies,
Ø Price that can be charged for products and choice of organizational structure
Ø Cost of producing and delivering products Ø Strategic risk
Ø ... ² Risk of significant investments for which there is
l A corporation willingly assumes business risk to create a a high uncertainty about success and profitability.
competitive advantage and add value for shareholders. ² Decisions made by the board or top executives .
l Two types:
Ø Business decisions risk
Ø Business environment risk

429 430

Business Risk Business Risk

l Business environment risk l Wise and cautious exposure to business risk is a core
Ø Macroeconomic risks: competency of all business activity.

² Economic cycles l Symmetric: Creating both gains and losses.

² Fluctuations in incomes and monetary policies l Managed through core tasks of management (e.g.,

Ø Competition risk choices about channel, products, and suppliers, how

products are marketed, inventory policies, etc.)
Ø Technological innovations risk

431 432

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Financial Risk Market Risk

l Risks which relate to possible losses owing to financial l Risk of losses arising from changes in the level or volatility
market activities
of market prices and rates .
Ø Market risk
Ø Equity prices
Ø Liquidity risk
Ø Interest rates
Ø Credit risk
Ø Foreign exchange rates
l For industrial firms :
Ø Optimize carefully the exposure to financial risks
Ø Commodity prices
Ø Concentrate on managing exposure to business risks
l For financial institutions :
Ø Manage financial risks actively (assume, intermediate, or advise
on financial risks)

433 434

Market Risk Market Risk

1) Equity Price Risk 2) Interest Rate Risk

l Risk associated with volatility in stock prices l Decrease in the value of fixed-income security as a result of
Ø General market risk increase in market interest rates
² Sensitivity of an instrument or portfolio value to the change in Ø Example: 3-month U.S. treasury bill funded by 3-month
the level of broad stock market indices . Eurodollar deposits

² Cannot be eliminated through portfolio diversification. ² Both pay 3-month interest rates.

Ø Specific (idiosyncratic) risk ² The two rates are not perfectly correlated with each other.

² Portion of stock price volatility determined by characteristics ² The spreads between their yields may vary over time.
specific to the firm (e.g., line of business, quality of --> Imperfect offset or hedged position
management, or breakdown in production process). --> Basis risk
² Can be diversified away.

435 436

Market Risk Market Risk

3) Foreign Exchange Risk 4) Commodity Price Risk
l Arise from unhedged or imperfectly hedged positions in l Classification of commodities
foreign-currency-denominated assets and liabilities leading to Ø Hard commodities or nonperishable commodities
fluctuations in profits or values as measured in domestic ² Precious metals: gold, silver, and platinum ...
currency.
² Base metals: copper, zinc, and tin ...
Ø Soft commodities or commodities with a short shelf life that are
Question:
hard to store:
If a Chinese company signed a sales contract with a U.S. ² Mainly agricultural products: grains, coffee, and sugar ...
company, with fixed selling price denominated in USD, in early Ø Energy commodities: Oil, gas, electricity ...
2018. What would be the impact of CNY/USD exchange rate
movement on the corporate performance of the Chinese
company for the year of 2018?
437 438

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Liquidity Risk Liquidity Risk

Trading liquidity risk Trading liquidity risk

l Transaction cannot be conducted at prevailing market prices (i.e.,

can be conducted only with significant concession in prices ), Question:
because temporarily there is no appetite for the deal on the other side What are the impacts of trading liquidity on the valuation
of the market.
estimates in Fair Value Accounting for Financial
l Related to the size of the transaction (relative to normal trading
Instruments?
volume) and the immediacy of the transaction.
Ø The faster and the larger the transaction, the greater the potential for loss.
l Usually observed in the spread between bid and ask prices .
Ø When markets are illiquid, dealers expect to sell at relatively high prices
and buy at relatively low prices.

439 440

Liquidity Risk Liquidity Risk

Funding liquidity risk Interaction between Trading and Funding liquidity risk

l Inability to meet payments or obligations , which may lead l Arise when portfolio contains illiquid assets that must be sold at
to early liquidation. less than fair market value.
l Especially for portfolios that are leveraged and subject to Insufficient cash reserves due to poor performance
margin calls from the lender. --> Need for cash payments to meet the demand from the lender
--> Involuntary liquidation of the portfolio at depressed prices
--> Losses from forced sale
--> More lenders demand cash payment
--> Cycle of losses continue …

441 442

Credit Risk Credit Risk

Main Types:
l Risk of losses owing to:
Ø The fact that counterparties are unwilling or unable to l Default risk: Debtor’s incapacity or refusal to meet debt obligations

fulfill contractual obligations , or (interest or principal) by more than a reasonable relief period from the
due date (usually 60 days in banking industry).
Ø Increased risk of default during the term of the transaction.
l Bankruptcy risk : Risk of actually taking over the collateralized assets
l More generally, credit risk can be defined as the potential loss in
of a defaulted borrower or counterparty.
mark-to-market value that may be incurred due to the occurrence of
l Downgrade risk : Perceived creditworthiness of the borrower or
a credit event.
counterparty deteriorates.
Ø E.g., credit risk of the loan portfolio of a bank arises when a
Ø Examples:
borrower fails to make a payment, either of the periodic interest
² Credit rating downgrade by rating agencies (e.g., S&P, Moody’s, Fitch)
charge or the periodic reimbursement of principal on the loan.
² Increase in credit spread of the borrower

443 444

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Credit Risk Credit Risk

Main Types: Main Types:

l Settlement risk : Risk due to exchange of cash flows when a l Sovereign risk : Risk arising from an action by a sovereign nation.
transaction is settled.
Ø Example: A country imposes foreign-exchange controls,
Ø Arise when counterparty may default after the institution already making it impossible for counterparties to honor their
made its payment. obligations.
Example: Herstaatt Bank
A famous incident is the failure of Herstaatt Bank, a small regional German bank.
On June 26, 1974, at 15:30 Central European Time, the German authorities
closed the bank. The bank was very active in the foreign-exchange markets (e.g.,
foreign currency swaps). At the time of closure, some of its U.S. counterparties
had irrevocably sent large amounts of Deutsche marks but had not yet received
dollars in exchange because U.S. markets had just opened. These U.S. banks
became exposed to losses on the full amount they had sent. This created
disruptions in financial markets and sent global transaction volumes in a tailspin.
Therefore, settlement risk is also known as Herstaatt risk.
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Operational Risk Operational Risk

Inadequate or Failed Processes, People, and Systems
l Risk of loss resulting from operational weaknesses . l Breakdowns in information, transactions processing and
Ø Inadequate or failed processes, people, and systems settlement systems and problems in back-office operations
(recording of transactions and reconciliation of individual trades).
Ø External events
l Model Risk
Ø Risk of losses due to:
² 1) Use of a wrong model
² 2) Improper use of the right model (use of wrong inputs or
misapplication of the model)
Ø Examples:
² Valuing American options uses the Black-Scholes-Merton model, which
strictly holds for European options. If it is used to price American options,
it can undervalue the option.
² Use of a bad estimate of volatility in the Black-Scholes-Merton model.
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Operational Risk Operational Risk

Inadequate or Failed Processes, People, and Systems Inadequate or Failed Processes, People, and Systems

l People Risk l Technology Risk

Ø Risk of looses due to: Ø Computer systems risk (e.g., computer/network breakdowns,
² 1) Unintentional errors (e.g., “fat finger error” – pushing the hacking from outside)
wrong button on a computer, inadvertently destroying a file, or l Legal Risk
entering the wrong value for the parameter input of a model)
Ø Arising from lawsuits and exposure to fines and penalties from
² 2) Fraud (e.g., intentionally falsifying information) supervisory actions and private settlements.
Ø Example: Ø Counterparties losing money on a transaction may find legal
² Rogue traders falsify their positions after they incur a large market grounds for invalidating the transaction to avoid meeting obligations
loss. --> Interaction with market risk (e.g., lack of authority to engage in the transaction; claiming
Note: Rogue trader is an individual in a company who enters into unsuitable to the client’s needs or level of expertise).
either high-risk unauthorized transactions or high-risk authorized --> Interaction with credit risk
transactions that are not being monitored.
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Operational Risk Reputation Risk

External Events
l The damage (in addition to immediate monetary losses)
caused to the ongoing business of a company from damaged
l Events completely outside the control of companies
reputation.
Ø Natural disasters (e.g., fires, floods)
Ø Examples: Enron, Worldcom, and other fraud cases.
Ø Human-driven disasters (e.g., terrorist attack)
l Especially for banks
Ø Survey by PwC and Economist Intelligence Unit (EIU) in
August 2004
² 34 % of 134 international bank respondents believed that
reputation risk is the biggest risk to corporate market value
and shareholder value faced by banks.
² By contrast, only 25% rank each of market and credit risk as
the biggest risk.

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Regulatory Risk Political Risk

l Arising from of changes in regulations or interpretation of

existing regulations. l Arising from changes in political environment (i.e., actions
Ø Existing regulations could be changed such that new regulations taken by policymakers that significantly affect the way an
are more restrictive or more costly. organization runs its business).
Ø Unregulated markets are subject to the risk that they will Ø Examples: Imposition of capital controls; nationalization.
become regulated, thereby imposing greater costs and more
restrictions.

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Tax Risk Accounting Risk

l Proper accounting for derivatives may involve considerable

l Arising from uncertainty associated with tax laws
confusion, especially when derivatives are complex.
Ø Especially for the taxation of derivatives transactions
l Accounting standards for derivatives may differ across
which is an area of much confusion and uncertainty.
countries.
Ø Tax laws may not already cover the new instruments, and
Ø U.S.: Accounting Standards Update 2017-12 (TOPIC 815) –
thus considerable uncertainty can exist about how such Derivatives and Hedging (replacing SFAS 133; effective in 2018)
instruments will be taxed.
Ø International: IFRS 9 – Financial Instruments (replacing IAS39;
effective in 2018)
Ø Non-IFRS: Domestic standards

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Systematic Risk Systematic Risk

Origin
May be triggered by losses or simply the perception of increased risk
l The potential for the failure of one institution to create a chain
(potential losses) in an institution.
reaction or domino effect on other institutions, and
--> Leading to panic about the soundness of the institution, or to a
consequently threaten the stability of financial markets and more general “flight to quality” away from risky assets and toward
even global economy . assets perceived to be less risky.
--> Causing serious market disruptions across otherwise healthy
segments of the market.
--> These disruptions may trigger panicked “margin call” requests,
obliging counterparties to put up more cash or collateral to
compensate for falling prices.
--> Consequently, borrowers may have to sell some of their assets at
fire-sale prices, pushing prices further down, and creating further
rounds of margin calls and forced sales.
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Systematic Risk Discussion about Risk Categories

l Interconnections and dependencies among financial firms Question:

exacerbate systemic risk under crisis conditions.
What are risk exposures in each of the following cases?
Ø Example: The failures and near-failures of Bear Stearns, Lehman
Case 1: Laker Airlines
Brothers, and AIG during the financial crisis of 2007–2009 all
contributed to systemic risk by creating massive uncertainty about Case 2: Nokia
which of the key interconnections would transmit default risk.
Case 3: Argentina’s financial crisis
l In the U.S., the Dodd-Frank Act focuses on systemic risk.
Case 4: Everbright Securities
Ø Financial Stability Oversight Council (FSOC) is established to
identify systemic risks and recommend policies to regulators.

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Case 1: Laker Airlines Case 2: Nokia

Part 1:
l In the late 1970s, Laker Airlines had a problem, but it was a problem l In 1999, Nokia launched a huge and costly effort to explore the new
we all might like to have – there were more British vacationers lining market for cell phones that allowed users to get on the Internet,
up for Laker’s flights than he had seats to fill. watch movies, and play video games. Nokia spent hundreds of
l At the time, the U.S. dollar was weak, so a U.S. vacation was a millions of dollars launching a string of “smartphones”, allocating
bargain. 80% of its R&D budget ($3.6 billion a year) to software, much of it
l Laker Airlines solved the problem by buying five more airplanes, designed to give phones computer-like capabilities. Nokia also race
financing them in U.S.-dollar debt. to thwart the threat of Microsoft’s coming “first to market” with similar
l Laker Airlines’ revenues were primarily in pounds – from those British software for smartphones (which would set the standards for this
vacationers – but the payments for the new aircrafts were in dollars. new market).
l Retrospectively, it appears that Nokia focused on the wrong battle
and picked the wrong competitor. Smartphones proved to bulky and
too expensive for many consumers, and remained (at that time) a
tiny presence in the market.
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Case 2: Nokia Case 2: Nokia

Part 1 [Continued]: Part 2:
l Moreover, in concentrating on smartphones, Nokia neglected one l In the subsequent years until 2013, Nokia failed to successfully adjust its
of the hottest growth sectors in cell phones, i.e., cheaper mid-range strategy to capitalize on the smartphone revolution. The company faces

models with sharp color screens and cameras, giving competitors significant competition in the smartphone market, including Apple and
competitors that have adopted Google’s Android.
(e.g., Samsung and Motorola) a rare opportunity to seal market
l Ironically, given Nokia’s earlier concern that Microsoft would introduce first-
share. The bet that phones would one day converge with
to-market software for smartphones, Nokia’s strategy in early 2013 was to
computers was premature.
deploy Microsoft Windows (in lieu of their own Symbian operating system)
l Nokia’s global market share plunged from 35% to 29% by mid- in order to market their product more attractive.
2003. In 2003, Nokia sold 5.5 million smartphones, far short of l Nokia might succeed in its strategy, or Nokia could be acquired. The
Nokia’s target of 10 million. In the first quarter of 2004, Nokia’s company has extensive cash holdings, significant strategic value (say, for
sales fell 2% in a global cell phone market that grew 40% from the Microsoft), and patents that could potentially be worth billions. However,
year before, as measured by the number of units sold. Nokia has destroyed significant shareholder value: its share price has
dropped by a factor of 10 and is less that its cash holding per share, wile
its credit rating has been downgraded to junk status.
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Case 3: Argentina’s Financial Crisis Case 4: Everbright Securities

Aug. 16, 2013: Shanghai Composite Index
l In December 2001, Argentina announced that it would stop paying
interest on its $135 billion foreign debt. This was the largest sovereign
default ever.
l In January 2002, the fixed-exchange-rate system was abandoned for
the Argentinian peso, which promptly devalued from 1 peso per USD
to more than 3 pesos.
l What was totally unexpected, however, was the government’s
announcement that it would treat differentially bank loans and
deposits. Dollar-denominated bank deposits were converted into
devalued pesos, but dollar-denominated bank loans were converted
into pesos at a one-to-one rate. This mismatch rendered much of the
banking system technically in solvent because loans (bank assets)
overnight became less valuable than deposits (bank liabilities).
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Issues Addressed in Risk Management Risk Management vs. Hedging

l Hedging
l How are risks defined?
Ø An activity of reducing risk by using financial derivatives or
l How are risks identified and measured? other instruments
l Which risks are worth taking on a regular basis or on
l Risk management
occasion, which should never be taken , and which should be
Ø A more comprehensive view of managing risk
hedged?
Ø A proactive, anticipative, and reactive “process” (not just an
l How are risks reduced or eliminated? What strategies should
“activity”) that continuously monitors and controls risk
be used?
Ø Involve reducing or increasing risk, such as:
l How are the processes of risk taking and risk elimination
monitored? ² Taking higher risk to earn higher returns

l How can the risk management policies and activities be ² Increasing the level of risk that is reduced by too much

communicated to investors and stakeholder efficiently? l For industrial (non-financial) companies , risk
management is mostly related to hedging.
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Simple Examples of Hedging Risks Simple Examples of Hedging Risks

Example 1 Example 2

l You have stock A, which is expected to drop in price during l You have stock A, which is expected to drop in price during
economic recession. economic recession.
l There is stock B, which is expected to rise in price during l There is NO stock B as in the previous example.
economic recession. l The financial market can create a derivative product which
l You can use B to hedge the risk of A can give some payment to you if the recession strikes.
l If you combine B and A, you have a portfolio which is not as l Such derivative product can be either forwards or options.
risky as A (and B)
l We call this effect as diversification.

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Simple Examples of Hedging Risks Simple Examples of Hedging Risks

Example 3 Example 4

l You lend money to a borrower who may default, and thus l You are organizing an outdoor music concert which will be
you experience loss if this happens. held in the spring season. But on the scheduled day, it may
l The financial market can create a derivative product which be raining, and you don’t feel good about it.
can give some payment to you if the default happens. l The financial market can create a derivative product which
l Again, such derivative product can be either forwards or can give some payment to you if it rains on the concert day.
options. l Again, such derivative product can be either forwards or
options.

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Hedging Operations vs. Hedging Operations vs.

Hedging Financial Position Hedging Financial Position
Hedging Operations Hedging Operations

l Selling process : Pricing policy for exporting its products

l Production process : Hedging cost of raw materials (e.g.,
to foreign countries
gold for a jewelry manufacturer), so as to better compete in
the marketplace Ø Example:

Ø Example: ² A U.S. high-tech company in the infrastructure business

is submitting a bid to supply equipment in Germany over
² An American manufacturer buys components from a
a period of three years, at predetermined prices in
French company.
euros.
² The American company can hedge by fixing the Euro-
² If most of the high-tech company’s costs are in U.S.
U.S. exchange rate to avoid the foreign currency risk.
dollars, then it is natural for the company to hedge the
future euro revenues.

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Hedging Operations vs.

Framework for Risk Management
Hedging Financial Position
Hedging Financial Position l Risk management refers to the design and implementation
of procedures for:
l Hedging values of assets and liabilities on the balance sheet Ø Identifying the level of risk that an entity wants
Ø Examples: Ø Measuring the level of risk that an entity currently has
² Swap a fixed interest rate for a variable interest rate for Ø Taking actions that bring the actual level of risk to the
a bond investment desired level of risk
² Hedge the interest rate risk on a bank loan Ø Monitoring the new actual level of risk so that it
continues to be aligned with the desired level of risk
l The process is continuous and may require adjustments
in any of these activities to reflect new policies,
preferences, and information.

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Framework for Risk Management Framework for Risk Management

1) Determining the objective 1) Determining the objective

l Determine risk appetite by the board l Make clear the “ risk limits”
Ø Quantitative measure: Financial targets, such as capital Ø Example :
adequacy, earnings volatility, debt or other external credit ² A British company might decide to:
ratings. ü Avoid dollar exposures of more than $5 million.
Ø Qualitative statement: Reputational impact, management ü Tolerate fluctuations of the dollar rate within the
effort, and regulatory compliance. exchange rate zone of $1.45 to $1.60 to the pound, but
to hedge currency risks that fall outside these limits.

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Framework for Risk Management Framework for Risk Management

2) Identifying and quantifying the risks 3) Instruments for risk management

l Which risks to hedge

l Internal instruments (Natural hedge)
l Quantify the relevant risks
Ø Example 1: A U.S. firm with assets denominated in British
Ø Volatility measured by standard deviation
pounds can borrow in pounds with the same time-to-
Ø Value-at-risk ( VaR) measure
maturity as the assets.
Ø …
l Disclosure requirement in the U.S:
Ø Example 2: A division with a euro liability may be hedged
internally against another division with euro-denominated
Ø Since 1998, the SEC has required to assess and quantify the
exposure to financial instruments that are linked to changes in assets.
interest rates, exchange rates, commodity prices, and equity
prices.

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Framework for Risk Management Framework for Risk Management

3) Instruments for risk management 4) Constructing and implementing a strategy

l External instruments l Example: U.S. company exporting to U.K. is expecting to

Ø Exchange-traded instruments vs. over-the-counter (OTC) receive 5 million British pounds three months from today
instruments and wishes to hedge the downside risk (i.e., the risk that
² Exchange-traded instruments: More standardized; More the pound will devalue).
liquid ² Strategy: Buy a put option for the full quantity (i.e.,
² OTC instruments: Tailored to customers’ needs; Lack of notional amount of 5 million pounds) and the whole
liquidity; Potential credit risk term (i.e., 3 months) of the exposure.

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Framework for Risk Management Enterprise Risk Management (ERM)

5) Performance evaluation l Also named Integrated/Firmwide Risk Management
l Centralized risk governance
l Evaluate periodically.
l A coordinated process for managing risk on a firmwide
l Assess whether goals are achieved.
basis, across types of risks, locations, and business
l The board should also decide whether to change the
lines.
policy of the company.
l Aim at measuring, controlling, and managing the overall
risk of the institution.

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Enterprise Risk Management (ERM) Discussion

l The management of risks is more of an art than a science.

Ø Not just build specialized mathematical measures of risk,
but also build a wider risk culture (from enterprise-wide Example: Apple’s 2019 Annual Report
risk management perspective). ü How does Apple hedge the market risks? (Item 7A)
Ø All key staff members (from the back office to the
boardroom, and from the bottom to the top) understand
how they can affect the risk profile of the organization
(including risk management practices, concepts, and
tools).

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