GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL Jesse Rey L. Meneses, CPA, CrFA, MBA Eugenio V. Villaceran, CPA, MBA, CTT First Edition Scanned with CamScannerCHAPTER Learning Objectives At the end of the chapter, the students will be able to: ‘a. articulate the need for corporate governance; b: understand the reasons’ on the occurrence of corporate scandals; c. — define corporate governance; d. —_ explain the goals of corporate governance; e. explain the concept of “agency problem”; and f. differentiate between the roles of “those charged with governance” and the ‘management team. Introduction ‘The 2000s did not sit well in the business and financial community. This turbulent decade will forever be'remembered in the vortex of history of modern business as a ‘time of accounting shenanigans and corporate failures. Corporate giants such as Enron, WorldCom, and Tyco among others collapsed and eventually filed for bankruptcy. When the dust has cleared, many employees lost their jobs and billion dollars of investments evaporated in thin air. These financial scandals sent shock waves across global stock markets affecting the investing community. When financial scandals of these magnitude happen, investors often ask the question, “Where were the auditors?” But to others, the question should have been, “Where was the corporate governance?” Scanned with CamScannerCase Analysis: “The Fall of Enron” Figure 1. Enron's office in Houiston, Texas, USA In 2001, Enron Corporation was a colossal energy company, with an annual revenue of more than 100 million. At that time, it ranked 7th in terms of revenue. Enron was formed in 1985 through the merger of Houston Natural Gas and InterNorth of Nebraska. During its early years, Enron had a simple business model, operating as a natural gas pipeline company centered on the delivery of specific amounts of natural gas.to utilities and other customers. However, after the deregulation of the electricity market in the early 1990s, Enron’s business evolved from hard assets to more complex and speculative energy derivatives. It also began to trade natural gas commodities. These, among others, increased the risk in Enron’s operations. Meanwhile, to finance projects and its ambitious aggressive business strategies, Enron's debts and its debt ratio increased. These movements in Enron’s financial leverage could affect the company’s stock price and, consequently, the stock options of corporate executives. Because of’ these, corporate executives began to window dress Enron’s accounting records to make it appear that the company’s financial condition is sound. Enron officials at that time were Chief Executive Officer (CEO) Jeffrey Skilling, Chief Financial Officer (CFO) Andrew Fastow, and Board Chair Kenneth Lay. One of the questionable accounting practices applied to Enron's corporate financials . was perpetrated through the use of improper transactions involving “special-purpose entities” (SPEs). SPEs are legal entities set up to accomplish specific and very narrow corporate objectives, However, in the case of Enron, many special purpose entities (SPEs) were simply created to conduct improper off-balance sheet accounting intended to hide massive losses and debts from the eyes of the investing public. Scanned with CamScannerThe audit committee members who were supposed to ensure’ proper accounting treatment merely. performed a cursory review of these SPE transactions. It was found: ‘out later that those members of the audit committee such.as John Mendelsohn and John Wakeham (Enron's independent directors) were receiving sizable “perks” from Enron. Mendelsohn, for instance, was the president of MD Andersen Cancer Center which receives cash donations from Enron. On the accounting side, these SPE transactions involved Enron receiving borrowed funds that were made to look like revenues, without recording the liabilities on the * company’s statement of financial position. This effectively resulted to. high revenues which bolstered the company’s profit ratio while, at the same time, showed a manageable leverage or debt level. As such, investors and stock analysts were made to believe that Enron was doing wel, at least financially, The SPE loans were guaranteed with Enron stock which, at that time, was trading at cover $100 per share in the New York Stock Exchange (NYSE). The start of the collapse was when Enron’s stock price declined. Creditors of Enron started to recall the loans due to the decline in the company’s valuation. The company found it too difficult to maintain its financial position. ; “In August 2001, Jeffrey Skilling resigned as CEO. This created a firestorm of controversies aver the ability of the company to continue business operations and led to loss of Enron’s reputation. The day after Skilling resigned, Enron's Vice President for Corporate Development, Sherron Watkins, sent an anonymous letter to Kenneth Lay. In her letter, Watkins expressed her fears that Enron “night implode in a wave of accounting scandals.” Enron eventually reported a third quarter 2001 loss of $618 million and a one-time adjustment decreasing shareholders’ equity by a staggering $1.2 billion. The adjustment was related to transactions with partnerships run by CFO Fastow. Fastow had created those off-balance sheet partnerships for Enron and for himself. He personally earned $30 million dollars in management fees from deals with those partnerships. Fastow’s conflict of interest was allowed because Enron's Code of Ethics was not strictly implemented. Hopes of financial rescue from corporate “white knights,” Dynergy and ChevronTexacoCorp., almost bailed out Enron from bankruptcy when they announced a tentative agreement to buy the company for $8 billion. However, Enron's credit rating was downgraded to “junk” status in November. Eventually, Dynergy and ChevronTexacoCorp. withdrew their purchase agreement. After the purchase withdrawal, any hope of financially resuscitating of Enron collapsed. Enron's stock price plummet to only $0.40 per share and the company for bankruptcy. After the Enron bankruptcy, the Sarbanes-Oxley Act was passed with the objective of protecting corporate investors through strengthening of corporate governance, strict regulation of the audit profession and Internal controls over financial reporting. CHAPTER 1 Introdvtion to Corporate Governance’ Scanned with CamScannerQuestions: 1, When did the risk in Enron’s operations and business model become difficult to manage? 2. Is Enron a well-governed company? Provide substantial reasons. 3, How were investors affected by the bankruptcy of Enron? How about Enron’s employees? 4. _ Is window dressing of the corporate financials proper? How does it affect the analysis of investors regarding the financial health of the company? a 5, Were the independent directors of Enron really “independent”? 6. Are the management fees being received by CFO Andrew Fastow proper? 7. How can we prevent another scenario similar to the Enron issue? Definition of Terms Accounting shenanigans — accounting schemes that distort amounts and disclosures in the financial statements in order to hide financial problems and/or to paint a brighter picture of economic performance. itis synonymous with the term “window dressing.” ‘Agency problem ~ a situation that exists when the “agents” of the corporation use their authority for their own'benefit and not for the benefit of the “principal” or owners. The term “agents” pertains to corporate managers while “principal” pertains to the- shareholders of the company. Audit committee - committee composed of directors tasked to perform oversight of the financial reporting process, selection of the external auditor, and receipt of audit findings from both internal and external auditors. Board of directors — the governing body elected by the stockholders that exercises the corporate powers of a corporation, conducts all its business and controls its properties. Corporate governance — system of stewardship and control to guide organizations in fulfilling their long-term economic, moral, legal, and social obligations toward their stakeholders. Corporate Issuer — a corporation that issues securities such as stocks and bonds to the public, : Debt ratio—a measure of financial soundness computed as total liabilities divided by total assets. Energy derivatives — are complex financial instruments whose underlying asset is based ‘on energy products such as oil, natural gas, or electricity, Energy derivatives are traded on a formal exchange such as the Chicago Mercantile Exchange. 4 GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL, _ —_ Scanned with CamScannerEnterprise risk management - a process, effected by an entity’s board of directors, management, and other personnel, applied in strategy setting and across the enterprise that is designed to Identify potential events that may affect the entity, ‘to. manage risks to be within its risk appetite, and to provide reasonable assurance regarding the achievement of entity objectives. Executive director ~a director who has executive responsibility of day-to-day operations of a part or the whole of the organization. External auditor - independent accounting firm that renders a report or opinion on the financial statements of client-companies. Independent director’ a person who is independent of management and the controlling shareholder, and is free from any business or other relationship which could reasonably be perceived to materially interfere with his/her exercise of independent judgment in carrying out his/her responsibilities as a director. Internal controP - a process effected by.an entity's board of directors, management, ‘and other. personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance. ‘Management — a group of officers given authority by the board of directors to implement the policies it has laid down in the conduct of the business of the corporation. Nonexecutive director’ - a director who does not perform any work related to the operations of the corporation. Off-balance sheet accounting - the practice of not reflecting an asset and/or a liability on ‘the financial statements, Organisation for Economic Co-operation and Development (OECD) — inter-governmental entity founded in 1961 intended to stimulate economic growth through the formulation of policies for “better lives,” Publicly-listed company — a company whose shares of stock are traded in the stock market such as the Philippine Stock Exchange. ‘Sarbanes-Oxley Act - a corporate governance regulation passed in the United States réquiring the strengthening of corporate governance structures among corporate issuers, stricter regulation of the auditing profession, and assessment of internal controls over financial reporting among others. Special-purpose entity - an entity created for a narrow and specific business objective; for instance, an SPE is created simply for tHe purpose of obtaining finance. ‘Stakeholders — any individual, organization, or society at large who can either affect and/or be affected by the company’s strategies, policies, business decisions, and operations in general. This includes, among others, customers, creditors, employees, suppliers, investors, as well as the government and community in which it operates. CHAPTER Introduction to Corporate Governance Scanned with CamScannerStakeholder theory — states that the corporation exists not only for the benefit of the stockholders but also for the benefit and protection of the other stakeholders such ‘as employees, creditors, suppliers, government, and the society in general. Stockholder theory ~ theory stating that the corporation exists for the benefit of the shareholders or stockholders. Short-termism a term that connotes actions of corporate managers intended to increase short-term profits only. White knight - a “friendly” investor that purchases a target company at a fair price and with the support of existing management and directors. The Need for Corporate Governance: Sarbanes-Oxley Act The opening vignette highlights the need for corporate govetnancé. It is a must. Corporate governance, in a nutshell, is the effective way of “directing and controlling companies.” The way jin which companies are directed and controlled is of interest to investors, directors, managers, regulators, auditors, and practically, to everyone. In line with the above statement, corporate officers such as CEOs, CFOs, directors, and others, must act for the long-term best interests of shareholders and = other stakeholders. Without corporate governance, Figure 2. Sarbanes-Oxley Act or SOX Act as shown in the Enron scandal, it will be game over. The term “corporate governance” became a household name ever since the Enron and WorldCom fiascos struck the business world. As presented in the opening vignette, the Sarbanes-Oxley Act (SOX Act) was passed in the United States right after those financial ‘scandals. The SOX Act is primarily a corporate governance regulation. SoX seeks to strengthen the functioning of the board of directors in the oversight of managerial performance as well as enhancing board independence. Enhancing board independence essentially requires the appointment of more independent directors n corporate boards. Thesé independent directors, aside from being detached from operational duties, must not have:any business dealings with the company which could affect the exercise of objective and independent judgment. SOX regulations also require evaluation of internal controls to ensure reliable and transparent financial reporting to investors. Investors néed financial information to aid in their investment decisions. SoX also instituted improvements in the oversight of the conduct of audits of corporate financial statements, whistle-blower policies, and transparent disclosures of financial and nonfinancial information among others. 6 GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL Scanned with CamScannerThe following key points summarizes the important provisions of Sox: Strengthening of external duditor’s Independence: «The external auditor of a corporate issuer is prohibited from performing eight rnon-audit. services, namely: bookkeeping, information systems design and implementation, appraisal or valuation services, actuarial services, internal audit, management functions or human resources, investment adviser, and legal services unrelated to the audit. «Corporate. officers and directors are prohibited from fraudulently misleading or coercing their external auditors in the performance of their examination of the financial statements. ¢ | Members of the audit team must wait for a one-year period before accepting employment as CEO, CFO, or its equivalent in an audit client. + — Audit engagement partners must be rotated every five years. Proactive and more independent audit committees: «~All: covered companies must have audit committees wherein majority are to be “independent.” Audit committee members may not accept any consulting, advisory, or other compensatory fees from the issuing company. + Audit committees are directly responsible for the appointment, compensation, and oversight of the auditor’s work. © Disclosure as to the existence of a “financial expert” on the audit committee. Assessment of internal controls over financial reporting: * Managementis required to make an assessment of the effectiveness of the company’s ' internal controls over the financial reporting process. * The CEO and CFO must certify the assessment of internal controls over the financial reporting process, © Auditors are to perform an attestation of the management's assessment of internal controls over the financial reporting process. Fraud prevention * Provides criminal penalties for obstruction of justice or destruction of accounting and other documents Provides protection to “whistleblowers” who report fraud and other irregularities of corporate officials CHAPTER 1 7 Scanned with CamScanneronthe surface, the financial scandals of the 20008 seem to be merely accounting and financial reporting issues, However, a closer scrutiny of the facts would show that they are more of corporate governance Issues. The absence or lack of corporate mechanisms provided opportunity to accounting abuse and fraud, resulting to bankruptcies and affecting peoples’ lives and investments. Indeed, a sound corporate governance structure is amust. The SOX Law will be extensively discussed in the next chapter. Source: Public Company Accounting Oversight Board. 2002. Sarbanes-Oxley Act. Accessed August 20, 2020. https:/ecaobus.org/About/History/Documents/PDFs/Sarbanes_Oxley_Act_of_2002.pdf Definition of Corporate Governance The new definition of corporate: governance can be found in the Pririciples of Corporate Governance crafted by the Organisation for Economic Co-operation and Development (OECD). The OECD is an inter-governmental entity founded in 1961 intended to stimulate economic growth through the formulation of policies for “better lives.” It defined corporate governance as: Corporate goverriance is the system of stewardship and control to guide organizations in fulfilling their long-term economic, moral, legal, and social obligations toward their Figure 3, Logo ofthe Organisation for Ecoriomic stakeholders. 4 Co-operation and Development Reference to OCECD website: Public Company Accounting Oversight Board. 2002: Sarbanes-Oxley Act. Accessed August 20; 2020. https://www.oecd.org/daf/ca/Corporaté-Governance-Principles-ENG.pdf The definition of corporate governance can be broken into three parts: * 1. __ Its a system of stewardship and control of corporate entities; 2. It is intended to fulfill long-term obligations (economic, moral, legal, social) of the company; and 3. It benefits the stakeholders. Concept of “Stewardship” and “Control” Corporate governance is distinct from operating and managing the business. ‘Management runs the business and is involved in the day-to-day operations of the company. However, the idea of doing business is not simply to operate a business. There must be an oversight or monitoring of corporate performance and operating results. This is the essence of stewardship and control. This role is being performed by the board of directors. Simply stated, management deals with “running the business” whereas corporate governance deals with “making sure that the business is being run properly.” 8 GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL, Scanned with CamScannerDuring pandemic times or during periods of economic difficulty, corporate governance plays a critical role. During the 1997 Asian financial crisis, companies that implemented effective governance survived. These companies had functioning corporate. boards which were able to. monitor liquidity, implement business continuity plans, and advice management on action plans to be undertaken. This is also’a sign of a well- governed company. Figuratively, corporate governance works like a “captain of the ship who must navigate the ship to safer waters in the midst of a bad weather.” Figure 4. The captain serves as the steward of the ship and controls its ‘moverent, Fulfillment of Long-term Obligations Corporate governance is not simply a deterrence to fraud nor an end in itself, Corporate governance is the process through which the company can fulfill its long-term ‘economic, moral, legal, and social obligations to stakeholders. In this sense, stakeholders include not only the investors but also creditors, suppliers, employees, government regulators, and even the society as a whole. Fulfilment of economic obligations would include providing sufficient returns to shareholders such as dividends. However, dividends can only be declared legally if and when there are sufficient earnings. To ensure the sufficiency of: revenues, profit, and dividends, the board of directors must periodically conduct an oversight of the financial performance of the company. If the company is performing adversely, the board of directors can question the management team for its unsatisfactory performance. It may also give advice to management on how to improve its operating results. Figure 5. Fulfillment of Long-term Economic Goals to Stakeholders (Cash flows, Profit, and Dividends) Payment of appropriate compensation to employees is one of the moral obligations of the company to its employees. Legal obligations would include being able to comply with legal requirements and contractual’ obligations. Fulfillment of corporate social responsibility is also within the objectives of corporate governance. CHAPTER 9 Introduction to Corparato Governance Scanned with CamScannerStockholder Theory and Stakeholder Theory Stockholder theory suggests that the corporation exists for the benefit of the shareholders or stockholders. Therefore, corporate managers (e.g., CEO, CFO) have a duty to maximize returns to the benefit of stockholders. * Onthe other hand, stakeholder theory states that the corporation exists not only for the benefit of the stockholders. It also exists for the benefit of the other stakeholders. The other stakeholders include employees, creditors, suppliers, government, and the society in general. While corporate managers have a duty to maximize shareholders’ returns, they also have a duty to the society as a whole. This would include paying taxes to the government, repayment of debts to creditors, and protecting the environment among others. It is noteworthy to mention that the OECD definition emphasizes the stakeholder theory. Rec recs Cy Greig Figure 6. The internal and external stakeholders. Long-term Sustainability Goal of Governance According to the OECD, “Corporate governance is a system of direction, feedback, and control using regulations, performance standards, and ethical guidelines to hold the board and senior management accountable for ensuring ethical behavior—reconciling long- F term customer ‘satisfaction with shareholder Tol value—to the benefit of all stakeholders and society.” Figure 7, The OECD definition gives focus on long-term and sustainable growth rather than jst short-term profits 40 GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTRA Scanned with CamScanner‘To ensure that corporate managers act in the best interests of the owners, the following are being implemented: External dnd internal audits; Oversight of managerial performance by the board of directors; Management compensation is linked to corporate performance and/or stock price; Code of ethical conduct; Internal controls; and 29 Fe pe ‘Government regulation (e.g., Sarbanes-Oxley, SEC regulations). Difference Between Governance and Management Governance and management are two distinct functions. Management takes charge of the day-to-day operations: of the business. Simply stated, management deals with “running the business.” AIR). Snaocataae Governance, on the other hand, is ae sperations “ensuring that the business is being run properly.” Furthermore, this oversight and governance role is being performed by the board of directors together with various Figure 8, The Roles of the Board of Directors and board committees~such as the audit Management , committee and risk oversight committee. Board Eerie When it comes to setting the future direction of the company, the board of directors approves the company’s strategic plans and long-term capital investment proposals. It is the. management who will implement these plans. Managers will carry out projects intended to provide the company with steady revenue and cash flow streams. The board of directors, though detached from operating these projects, must conduct af oversight 6f actual performance, : Board Independence For an appropriate oversight and assessment of managerial, performance, the board of directors must be both objective and competent, Otherwise, the result of any performance assessment will not be truthful and will not meet its intended objectives. In the case of small and family-owned businesses, the managers are also the members of the board. This is acceptable since the business has no public accountability due to its size and nature. In case of poor managerial performance or fraudulent activities, ‘only the 12 GOVERNANCE. BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL Scanned with CamScannerfamily members suffer the consequences. However, it will be a different case when it comes to a bank or a publicly-listed company. ‘When a bank is ordered “close” by the Bangko Sentral ng Pilipinas (BSP) or goes bankrupt, many depositors are affected. When a listed company closes, the shares of many investors evaporate into nothing. That is why there is strict regulation regarding the composition of the board of directors of a bank and a publicly-listed company. Government regulators require a minimum number of independent directors in the corporate boards of these entities. ‘An independent director is a person who is independent of management and the controlling shareholder, and is free’from any business or other relationship which’ could reasonably be perceived to materially interfere with his/her exercise of independent judgment in carrying out his/her responsibilities as a director. An independent director is generally expected to’pérform/an honest assessment of managerial performance that director who is part of management. On the other hand, nonexecutive directors (NEDs) are those who are not involved in operations and are not corporate officers. Independent directors are automatically NEDs but not all NEDs are independent directors. Board Setups There are two types of corporate board setups, namely: 1. all-executive board; and 2. board with nonexecutive directors. An all-executive setup is a board comprised solely of executive or corporate managers. As discussed previously, this is often the case for small or family-owned corporations. The second type is often the case for publicly-listed companies and other regulated entities such as banks and insurance companies. Governance Structures Majority - Executive Board All Executive Board ==) [cen] mcs con o-emcioe dc a “Grom Figure 9, An All-Executive Board Figure 10. A Combination of Executives and Nohexecutives in the Board. CHAPTER! 43 Introduction to Corporate Governance Scanned with CamScannerGuide Questions: Is managing the business the same as “oversight, stewardship, and control”? Explain. Why should independent directors be detached from operations? In your opinion, is corporate governance applicable to family-owned businesses? Sees The OECD definition of corporate governance highlights the fulfillment of the company’s long-term obligations. Why is this so? What is the problem of “short-termism? Explain how this could be addressed. Explain the agency problem. Provide substantial examples. Is corporate governance confined to simply complying with laws and regulations? oN a ow Should corporations be allowed to regulate themselves? Why or why not? ‘Activity 1: Class Deate There seems to be aclash between stockholder theory which holds that the corporation exists for ry e ry the benefit of the shareholders and the stakeholder oe. theory which states that stakeholders should also. ta” be benefited. Divide the class into two groups and |v RI hold a debate as to which view should be followed bya modern corporation. Causes of Corporate Faiures Activity Research on reliable interest sources on other high-profile corporate governance failures (e.g., = WorldCom, Tyco; Parmalat). For each WORLDCOM high-profile company, identify the : causes of the corporate failure, Scanned with CamScannerActivity 3: ANALYZING THE EFFECTS oF THE WoRLDCom AccounrinG FRAUD ‘The WorldCom accounting fraud in 2002 was one of the largest scandals in the United States. CEO Bernard Ebbers and senior executives devised a scheme to inflate profit in order to maintain the company's stock price, The perpetrators improperly recognized as assets WorldCom's telecommunication line expenses to assets. The amount of the improper capitalization amounted to $3.8.illion as initially discovered by WorldCom's internal audit head Cynthia Cooper. Eventually, it as found out by forensic accountants that the total amount of the fraud was $11 billion. Required: Using the following table, analyze the effects of the accounting fraud. Indicate under each “effect” column if the account is understated or overstated. Total Assets Total Line Expenses Netcom Net cash inflow from operations CHAPTER 1 Introduction fo Corporate Governance 15 Scanned with CamScannera Bae Corporate Governance: _—/ ers: What is a Well-governed 2 Organization? Learning Objectives At the end of the chapter, the students will be able to: ‘a. _ articulate the important provisions of the Sarbanes- Oxley Act; b. articulate the principles of the OECD framework of corporate governance; c. _ discuss the functions of the board of the directors; d, differentiate between the roles of executive and nonexecutive directors; e. differentiate between the “comply” approach and the “comply or explain” approach to regulating corporate governance; f. articulate the essential principles of SEC Code of Corporate Governance for Publicly- Listed Companies; and &. describe the issue in the governance of related party transactions. Introduction High-profile corporate blunders such as Enron and WorldCom highlighted the need for effective corporate governance structure in every organization, whether big or small Corporate regulations such as the Sarbanes-Oxley Act (SOX) require strict rules when it comes to the governance of covered entities. The OECD Principles of Corporate Governance, on the other hand, provide guidance in defining what a well-governed organization is. Corporate laws, alongside the Philippine SEC Code of Corporate Governance, come into play and require various regulations for Philippine companies. 7 Scanned with CamScanner‘Adherence to these laws, the ‘regulations, principles, and codes of corporate governance are the gauge by which we can conclude whether a company is well-governed or not. The theme of this chapter is that when a company is able to comply with corporate governance laws, regulations, principles, and codes, only then we can truly say that it is a well-governed organization. At the Outset: What is a Well-governed Organization? Movingaway from a legal or regulatory perspective of corporate governance, one can also conclude that a company is well-governed ifit implements effective risk management and internal control processes. Risk Management Figure 11. Governance encompasses risk management and internal control. ‘As shown in Figure 11, the universe of corporate governance encompasses ‘the spheres of risk management and internal control. According to the OECD Principles of Corporate Governance, in particular, Principle #12: “To ensure governance in the conduct of its affairs, the company should have a strong. and effective internal control system and enterprise risk management framework.” A well-governed organization is one which implements effective risk management and internal control systems. As shown in the diagram, internal control is the innermost circle, Internal control addresses internal events that affect the company’s operations, reporting, and compliance, Examples of these internal events are theft of assets, errors in the recording of transactions, and machine breakdowns among others. There are events that are beyond the scope of internal control, They are the “external events.” These external events would include economic recessions, natural calamities, pandemics, and negative impact of stiff competition among others, To address these negative external events, the company needs to implement a sound risk management. 18 GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL, Scanned with CamScannerInternal control and risk management are defined as follows: Internal control! —a process effected by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance. Enterprise risk management? ~ a process, effected by an entity's board of directors, management, and other personnel, applied in strategy setting and across the enterprise, that is designed to identify potential events that may affect the entity, manage risks to be within its risk appetite, and provide reasonable assurance regarding the achievement of entity objectives. Sarbanes-Oxley Act (SOX Law): A “Rules-based” Corporate Governance Regulation Figure 12, Senator Paul Sarbanes and Representative Michael Oxley The Sarbanes-Oxley Act (or SOX Act) is-a United States federal law that aims to protect investors by requiring more reliable and more accurate corporate disclosures. The ‘Act was spurred by major accounting scandals, such as Enron and WorldCom (today called MCI Inc.), that tricked investors and inflated stock prices. Spearheaded by Senator Paul ‘Sarbanes and Representative Michael Oxley, the Act was signed into law by then President George W. Bush on July 30, 2002. ‘As described in the introduction on corporate governance in Chapter 1, the SOX Act is primarily a corporate governance regulation. It is a law that has detailed rules compared to other corporate codes that are more principles-based rather than rules-based. The following are the most important sections of the Act: > Section 302 Financial reports and statements must certify that: The documents have been reviewed by signing officers and passed internal controls within the last 90 days. The documents are free of untrue statements or misleading omissions. The documents truthfully represent the company’s financial health and position. (CHAPTER? (Corporate Governance: What isa Well-governed Organization? 19 Scanned with CamScannerthe documents must be accompanied by a list of ail deficiencies or changes in inter controls and information on any fraud involving company employees, ies Financial reports which include financial statements for external reporting purposes are required to be certified by the CEO and the CFO. The certifications must explicitly state that they have reviewed such corporate, financials and that they are free of untruthful financial representations. This is made in order to prevent corporate executives from making the excuse that they have not reviewed the financial statements if, subsequently, they are found to contain material misstatements or omissions that negatively affect investors’ decisions. : This requirement also requires corporate executives to perform a careful review of the amounts and disclosures reflected in the financial statements, thereby increasing the reliability of the reports. > Section 401 Financial statements are required to be accurate. Financial statements should also reflect disclosures of any off-balance liabilities, transactions, or obligations. Off-balance sheet is an accounting term for asset, liability, or any transaction that is not recorded on the balance sheet simply because the asset is not legally owned or the lability isnot a direct liability ofthe reporting entity. Prior to the changes in the accounting standards on leases, the most typical off-balance sheet item is an operating lease. An operating lease is not typically reflected as a liability on the balance sheet. In this case, the reporting entity shall disclose future lease payments on the lease contract to provide additional information to readers of the financial statements. > Section 404 Companies must publish a detailed statement in their annual reports explaining the structure of internal controls used. The information must also be made available regarding .the procedures used for financial reporting. The statement should also assess the effectiveness of the internal controls and reporting procedures. Under Section 404 of SOX Act, management is required to make an assessment of the effectiveness of the company’s internal controls over the financial reporting process. The CEO and CFO must certify the assessment. of Internal controls over the financial reporting process. This was required because the governance and controls on the recording process of Enron failed to prevent the massive accounting fraud. |, RISK MANAGEMENT, AND INTERNAL CONTROL 20 Scanned with CamScannerIn addition, the accounting firm that audited the financial statements must also assess the internal controls of the company and issue a report thereon. > Section 409 Companies are required to urgently disclose drastic changes in their financial position or operations, including acquisitions, divestments, and major personnel departures. The changes are to be presented in clear, unambiguous terms, A more detailed disclosures on significant changes in the structure of the company such as mergers and acquisitions must be made in. financial reports. This information are important to investors. in assessing the company’s overall financial position. In’ addition, disclosures - of divestments must also be done. Mergers mean the combining into. one of two or more’ companies. Divestments, refer to the disposal of a business that was previously held by a company. > Section 802 Section 802 outlines the following penalties: Mergers and Acquisitions Any conipainy official found guilty of concealing, destroying, or altering dacuments, with the intent to disrupt an investigation, could face up to 20 years in prison and applicable fines. ‘Any accountant who, knowingly aids conipany officials in destroying, altering, or falsifying financial statements could face up to 10 years in prison. ANDERSEN Figure 13, Document-shredding and Arthur Andersen, CPAS R2 ‘cHAPTE: 24 Corporate Governance: Whats a Wel: governed Organization? Scanned with CamScannerDestroying documentary evidence and obstructing investigations of a corporate fraud now carry heavier penalty of up to 20 years'in prison. In the Enron fraud case, the audit partner and staff. of premier accounting firm Arthur Andersen got,indicted for obstruction of justice through destruction of audit evidence, This resulted to the downfall of the world’s formerly number one accounting firm. ‘Any company that is under the scope of the SOX Act must comply with all of the legal provisions if one can be considered a well-governed organization. Source: Public Company Accounting Oversight Board. 2002. Sarbanes-Oxley Act. Accessed August 20, 2020. https://pcaobus.org/About/History/Documents/PDFs/Sarbanes_Oxley_Act_of_2002.pdf Benefits of SOX Act to Investors After the implementation of the SOX Act, financial crimes and accounting fraud became less frequent®, Organizations were discouraged from attempting to inflate figures such as revenues and net income. The SOX Act has become a deterrent to corporate crimes like obstructing justice, securities fraud, mail fraud, and wire fraud. The maximum, sentence term for securities fraud was increased to 25 years, while the maximum prison time for the obstruction of justice was increased to 20 years. The act increased the maximum penalties for mail and wire fraud from five years of prison time to 20 years. Also, the SOX significantly increased the fines for public companies committing the same offense.‘ Thus, investors benefited by having access to more reliable information and were able to have a sound basis for their investment decisions.> Costs to Businesses While the SOX Act benefited investors, compliance costs increased for small businesses, According to a 2006 SEC report, smaller businesses with a market capitalization of less than $100 million faced compliance costs averaging 2.55% of revenues, whereas larger businesses only paid an average of 0.06% of revenue, The increased cost burden was mostly carried by new companies that had recently gone public.® Repercussions’ Due to the additional cash and time costs of complying with the SOX Act, many companies tend to put off golng public until much later, This leads to a rise In debt financing and venture capital. Scanned with CamScannerOECD Principles of Corporate Governance The selected SOX requirements discussed previously are in the form of Tepslation; hence, they are considered | OEC D rules-based kinds of corporate governance ‘ mechanisms. Now we turn to another corporate governance framework but is considered to be principles-based rather than rules-based. The Organisation for Economic Co-operation and Development (OECD) formulated the Principles of Corporate Governance. This framework serves as guide in the crafting of corporate governance systems for companies ° across various industries. The iain areas of the OECD Principles® are: 1, _ Ensuring the basis for an effective corporate governance framework. The corporate governance framework should promote transparent -and efficient markets, be consistent with: the rule of law, and clearly articulate the division of responsibilities among different supervisory, regulatary, and enforcement authorities. 11. The rights of shareholders and key ownership functions. The corporate governance framework should protect and facilitate the exercise of shareholders’ rights. le | The equitable treatment of shareholders. The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights. IV. The role of stakeholders in corporate governance. The corporate governance framework should recognize the rights of stakeholders established by law or through mutual agreements and encourage active cooperation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises. V. _ Disclosure and transparency, The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company. VI. The responsibilities of the board, The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders. Source: Organisation for Economic Cooperation and Development. 2004. Principles of Corporate Gavernance. ‘Accessed October 26, 2020, https://www.oecd.org/daf/ca/Corporate-Governance-Principles-ENG. pdf CHAPTER? Ccorporeta Governance: Whats a Well-gevermed Orgenization? 23 Scanned with CamScanner«Functions of the Board of Directors : A well-governed company should have competent, objective, and a functioning board ‘of directors, As discussed in the previous. chapter, the board of directors does not manage the business; that is the role of senior and middle management. The board does the ‘governance, Simple stated, “management” pertains how executives ran the company. * *Governance”, on the other hand, pertains to “making sure that the business is being ran properly.” Ina well-governed company, the directors do not play a o) passive role and simply let management decide and executive whatever corporate action. The directors should play an active role in the oversight of managerial performance as well as in the formulating of strategic and operational decisions. & i © In the sphere of corporate governance, the: most important duty of the board of directors is that of oversight. Figure 14. Oversight of Oversight refers to the board's in-depth review and scrutiny Operations, Managers’ Actions, of the effectiveness of operations, finances, and management and Financial Performance actions. For instance, during board meetings, the directors evaluate whether or not the profit earned by the business represents a sufficient return to shareholders. If not, the directors will ask probing questions to corporate executives as to the causes of the poor Profitability. The board will then require management to formulate actions and strategies for the improvement of profit during the next period. Also, the directors make an assessment whether a proposed capital expenditure Project is viable. One Question that is critical in this respect is “Is the project. viable?” ‘To answer this question, the proposed projects’ internal rate of return (IRR), net present value (NPV), and other measures of financial viability will be calculated by management, Subject to review by the board. Only when the proposal is expected to generate sufficient future operating cashflows to the business wil the board release Its approval. The board, through its audit committee, also addresses potential fraud or irregularity that may affect the company and, consequently, the shareholders. For instarice, the board attempts to ensure that there Is no conflict of interest on the Part of, corporate executives and managers that will result in self;dealing. Self-dealing happens when an officer of the company executes or approves a corporate transaction that will benefit his/her own personal interest, not for the benefit of the company’s shareholders, The board has other roles but the above are the most important in the context of corporate governance. ‘24 GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTE. Scanned with CamScanner