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CHAPTER 1 Governance, Ethics, and Managerial Decision Making

© 2009 Cengage Learning

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IntroductionCompanies need strong corporate governance and sound ethical practices:

•Scandals cause the public to lose faith in the company•Strong governance and sound ethics serve to make management more accountable to a range of stakeholders, including employees, investors, and customers•Both internal and external forces shape a company’s system of corporate governance and internal control

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Corporate Governance

Embodied in the processes that companies use to promote:

•Corporate fairness

•Complete and accurate financial disclosures

•Management accountability

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Corporate Governance

•Legal and regulatory requirements impact corporate governance

•Board of Directors meets with auditors•Audit committee composed entirely of independent directors

•No one set of corporate governance processes will fit all corporations

•Tailored to fit size, complexity of operations, stakeholders, and unique business risks

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Corporate Governance

Corporate governance systems are used by a company to promote fairness, complete and accurate financial reporting, and accountability.

Key Concept

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Internal Control

Internal Control: The policies and procedures that

provide reasonable assurance that a company’s

goals and objectives will be achieved.

Comprised of five elements:

1. The control environment.

2. Risk assessment

3. Control activities

4. Information and communication

5. Monitoring

Key Concept

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Elements of Internal Control

The Control Environment

Risk Assessment

ControlActivities

Information&Communication

Monitoring

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Control Environment

Owners’ and managements’ attitudes and general philosophy about Internal control and accountabilityOrganizational structureHuman resources policiesCommitment to competenceOversight by company’s board of directors

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Risk Assessment

Steps a company takes to identify and evaluate risks that can adversely impact its ability to successfully conduct businessAssessment occurs at every level in the

companyOnce identified, management evaluates

risks and takes steps to reduce risk to an acceptable level

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Control Activities

Segregation of Duties

Transaction Authorization

Safeguarding of Assets

Independent Reviews of Work

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Information and Communication

The accounting system used to initiate, record, process, and communicate

the company’s performanceTechnology has made computerized information systems widely available

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Monitoring

A company’s periodic assessment of its internal controls

Should be performed by employees who don’t have responsibility for recordkeeping or internal control

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The Impact of Information Technology on Internal

Control

Risks in a Technology- Intensive Environment

Internet-basedbusiness

Threats by current employees

Insider perpetratorsPerpetrators interceptingcredit card information,e-mail messages,company data

Sabotage by formeremployees

Unauthorized access to dataFictitious customers posing as legitimatecustomers

Denial-of-serviceattacks

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The Importance of Ethics

Business ethics

The interaction of personal morals with the processes and objectives of business

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The Importance of Ethics

Integrity is the cornerstone of ethical business practicesFailure to build a business on integrity carries costsMay lower employee morale, reduce customer loyalty, harm a company’s standing in the community

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The Importance of Ethics

Establishing an ethical business environment encourages employees to act with integrity and conduct business in a manner that is just and fair to other stakeholders.

Key Concept

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Stakeholder Analysis

Stakeholders affect or are affected by the company Stakeholder analysis alerts the company to various

stakeholder issues including political, social, and ethical

Steps include:1) Identify stakeholders2) Understand stakeholders’ interests3) Assess stakeholders power and influence4) Assess social, legal, ethical, and economic

responsibilities to stakeholders5) Develop strategies to address demands of

stakeholders

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Stakeholder Analysis

A stakeholder analysis approach is useful for identifying stakeholders and the social, legal, ethical, and economic responsibilities to those stakeholders.

Key Concept

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Ethics Programs

Ethics programs include:Written codes of ethicsEmployee hotlines and ethics call centersTraining programsEthics offices

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Code of Ethics

Three types of ethics codesCode of conduct

Lays out specific rules or standards of behavior

Credo or mission statementDescribes the vision of a company and frequently asserts a commitment to key stakeholders

Corporate philosophy statementAn broad outline of the company’s principles

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Code of Ethics

Three common types of codes of ethics include codes of conduct, mission statements, and corporate philosophy statements.

Key Concept

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Corporate Scandals

Fraud costs businesses and consumers billions of dollars each year. Accordingly, its prevention is of paramount importance.

Key Concept

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Sarbanes-Oxley Act of 2002

Management must provide certifications about internal controls.

Management must make its own assessment of the effectiveness of those internal controls.Must have external auditor attest to those

controls.Criminal penalties for financial statement

fraud increased.Whistleblower protection.

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Fraud

Defined as a

1) Knowingly false representation of a material fact made by a party

2) With the intent to deceive and induce another party to justifiably rely on the representation to his or her detriment

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Fraudulent Financial Reporting

Intentional misstatement of or omission of material, very significant information from a company’s financial statements

Generally requires management’s active involvement

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Management Fraud

Management fraud is typically the result of pressure on management to report good operating results. Commonly involves:

Improper revenue recognition

Overstating assets

Understating liabilities

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Types of Fraud

There are two types of fraud: fraudulent financial reporting and misappropriation of assets.

Key Concept

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Management Fraud

Fraud involving upper management can be very difficult if not impossible to

detect.

Key Concept

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Misappropriation of Assets

Involves the theft of a company’s assets.Usually committed by lower-level employees.Usually involves small amounts that do not

impact the financial statements.Usually involves cash, inventory, fixed assets.

KitingLappingExpense account abuse

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Causes of Fraud

People engage in fraudulent activity as a result of an interaction of forces within an individual and the external environment.

Combinations of pressure, opportunity, and attitude are likely to lead to fraud

The Fraud Triangle

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The Fraud Triangle

Situational Pressures & Incentives

OpportunitiesPersonal Characteristics& Attitudes

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Three forces typically contribute to fraud: situational pressures and incentives, opportunities, and personal characteristics and

attitudes.

Fraud

Key Concept