Corporate Governance

1. Chapter Ten:
Ethical Decision
Making: Trust in
Corporate
Governance,
Accounting, and
Finance
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Chapter Objectives 1
After reading this chapter, you will be able to:
1. Explain the role of accountants and other professionals as "gatekeepers."
2. Describe how conflicts of interest can arise for business professionals.
3. Outline the requirements of the Sarbanes-Oxley Act.
4. Describe the COSO framework.
5. Define the "control environment" and the means by which ethics and
culture can impact that environment.
6. Discuss the legal obligations of a member of a board of directors.
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Chapter Objectives 2
7. Explain the ethical obligations of a member of a board of directors.
8. Highlight conflicts of interest in financial markets and discuss the ways in
which they may be alleviated.
9. Describe conflicts of interest in governance created by excessive
executive compensation.
10. Define insider trading and evaluate its potential for unethical behavior.
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Ethical Decision Making 1
In almost every profession—whether it’s law or journalism,
finance or medicine or academia or running a small
businesspeople rely on confidential communications to do their
jobs. We count on the space of trust that confidentiality
provides. When someone breaches that trust, we are all worse
off for it.
Hillary Clinton
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Introduction 1
• The scandals of the early 2000s involved fundamental
questions of corporate governance and responsibility.
• There were a rash of problems associated with the financial
meltdown in 2007 to 2008.
• Ethics in the governance and financial arenas is now the most
visible issue in business ethics.
• As something that is essential in most social relationships,
trust is an ethically warranted reliance on another.
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Introduction 2
Analysts contend that corruption is evidence of a complete
failure in corporate governance structures.
• Corporate governance: The structure by which corporations are managed,
directed, and controlled toward the objectives of fairness, accountability,
and transparency.
• The structures generally will determine the relationship between the
board of directors, the shareholders or owners of the firm, and the firm’s
executives or management.
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Professional Duties and Conflicts of Interest 1
The collapse of Enron Corporation brought the ethics of finance
to prominence at the start of the 21st century.
Several important categories of business professionals—for
example, lawyers, auditors, accountants, and financial analysts—
function based on the internal controls that exist within market-
based economic system.
Role identities determine ethical duties and provide a source for
rules which determine how professionals ought to act.
• Gatekeepers: Act as "watchdogs" to ensure those in the marketplace play
by the rules and conform to the market functions as it should.
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Professional Duties and Conflicts of Interest 2
The most basic ethical business issue facing gatekeepers involves
a conflict of interest.
• This exists when a person holds a position of trust that requires that he or
she exercise judgment on behalf of others, but where his or her personal
interest and/or obligations conflict with the proper exercise of that
judgment.
Conflicts can arise when a person’s ethical obligations in their
professional duties clash with personal interests.
• Such professionals are said to have fiduciary duties—a legal duty,
grounded in trust, to act on behalf of or in the interests of another—to
their clients.
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Figure 10.1: Conflicts of Interest in Public CPA Activity
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Professional Duties and Conflicts of Interest 3
• Because professional gatekeeper duties are necessary
conditions for the fair and effective functioning of economic
markets, they should trump other responsibilities to one's
employer.
• But knowing one’s duties and fulfilling those duties are two
separate issues.
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Professional Duties and Conflicts of Interest 4
The gatekeeper function is necessary, but self-interest can make
it difficult to fulfill gatekeeper duties.
• Society has a responsibility to create institutions and structures that will
minimize these conflicts.
• Critics say government regulatory rules alone will not avert financial
crises.
• Extraordinary executive compensation and conflicts of interest within the
accounting and financial industries have created an environment where
watchdogs have little ability to prevent harm.
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The Sarbanes-Oxley Act of 2002 1
A string of corporate scandals shook investor confidence.
The U.S. Congress passed the Public Accounting Reform and
Investor Protection Act of 2002, commonly known as the
Sarbanes-Oxley Act.
• The act is enforced by the Securities and Exchange Commission (SEC) and
applies to more than 15,000 publicly held companies in the U.S. and some
foreign issuers.
• The European Union 8th Directive covers many of the same issues.
• Some states issues similar legislation that apply to private firms.
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The Sarbanes-Oxley Act of 2002 2
No regulatory "fix" is perfect.
• The act is intended to provide protection where oversight did not exist.
• Oversight in terms of accountability and responsibility.
The following sections impact corporate governance and boards.
• Section 201.
• Services outside the scope of auditors—no consulting rather than auditing.
• Section 301.
• Public company audit committees, mandating majority of independents on
any board and total absence of current or prior business relationships.
• Section 307.
• Rules of professional responsibility for attorneys.
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The Sarbanes-Oxley Act of 2002 3
• Section 404.
• Management assessment of internal controls.
• Section 406.
• Required codes of ethics for senior financial officers.
• Section 407.
• Disclosure of audit committee financial expert
• Requires that they actually have an expert.
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The Internal Control Environment 1
Internal control mechanisms are established internally to comply
with financial reporting laws and regulations.
One way to ensure controls is to utilize a framework advocated
by the Committee of Sponsoring Organizations (COSO).
• COSO: A voluntary group of audit and accounting organizations seeking to
improve reporting through a combination of controls and governance
standards called the Internal Control-Integrated Framework.
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The Internal Control Environment 2
The elements comprising control structure are:
• Control environment.
• Control environment: Cultural issues such as integrity, ethical values,
competence, philosophy, and operating style.
• Risk assessment.
• Control activities.
• Information and communications.
• Ongoing monitoring.
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The Internal Control Environment 3
• COSO standards for internal controls moved audit,
compliance, and governance from a numbers orientation to
concern for the organizational environment.
• Both internal factors such as the COSO controls and external
factors such as the Sarbanes-Oxley requirements must be
supported by a culture of accountability.
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The Internal Control Environment 4
COSO developed a new system, Enterprise Risk Management-
Integrated Framework in 2004.
• Serves as a framework for management to evaluate and improve their
firms’ prevention, detection, and management of risk.
• Expands on the prior framework to include "objective setting."
• Assists an organization in resolving ethical dilemmas based on a firm’s
mission, its culture, and tolerance for risk.
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Ethical Decision Making 2
Whenever an institution malfunctions as consistently as boards
of directors have in nearly every major fiasco of the last forty or
fifty years, it is futile to blame men. It is the institution that
malfunctions.
Peter Drucker
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Going Beyond the Law: Ethical Board Members
The corporate failures of recent years would suggest:
• A failure on the part of corporate boards.
• A failure of government to impose high expectations of accountability on
boards of directors.
In many cases, boards and executives operated within the law.
• Some actions may not have been ethical or in the best interests of
stakeholders, but they were legal.
The law offers some guidance on minimum standards for board
member behavior, but is the law enough?
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Legal Duties of Board Members
U.S. law imposes three clear duties on board members.
• The duty of care is the exercise of reasonable care by ensuring that
executives carry out responsibilities and comply with the law.
• The duty of good faith is one of obedience, requiring faithfulness to the
organization’s mission.
• The duty of loyalty requires faithfulness from board members by giving
undivided allegiance when making decisions affecting the organization.
• Conflicts of interest are always to be resolved in favor of the organization.
The Federal Sentencing Guidelines suggest the board exercise
"reasonable oversight" with respect to the implementation and
effectiveness of the ethics/compliance program.
• The program should have adequate resources, levels of authority, and
direct access to the board.
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Beyond the Law, There is Ethics 1
Questions that we expect the law to answer but remains unclear.
• Whom does the board represent?
• Who are its primary stakeholders, ethically speaking?
• If the board is aware of an unethical, but legal, practice—on what basis
can the board require the practice to cease?
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Beyond the Law, There is Ethics 2
Some suggest boards have a responsibility beyond the law to
explore and investigate the organizations that they represent.
• What could drag the firm down and what could competitors do to help it
along that path?
It is the board members’ ultimate duty to provide oversight,
which is impossible without knowing the answers to these
questions.
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Ethical Decision Making 3
Trust, but verify.
Ronald Reagan
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Conflicts of Interest in Accounting and the Financial Markets 1
Conflicts of interest extend beyond the board room to the
financial arena—trust and structures that promote it are integral
issues for all involved in the finance industry.
• Real or perceived, conflicts can erode trust and often exist as a result of
varying interests of stakeholders.
Accounting, by its very nature, is a system of principles applied
to present the financial position of a business and the results of
its operations and cash flows.
• It is hoped that adherence to these principles will result in fair and
accurate reporting of this information in a format that can readily be
interpreted by others.
• Whether an accountant is considered a watchdog or a bloodhound
depends on whether they are hired internally or externally.
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Conflicts of Interest in Accounting and the Financial Markets 2
The American Institute of Certified Public Accountants (AICPA)
publishes professional rules to prevent accountants from being
put into conflicts.
• GAAP, or generally accepted accounting principles, established by the
Financial Accounting Standards Board stipulates methods of gathering and
reporting information.
• Accountants are also governed by the AICPA's Code of Professional
Conduct.
Can these standards keep pace with readily changing accounting
and financing activities in newly emerging firms?
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Executive Compensation 1
Few areas of corporate governance and finance have received as
much public scrutiny as executive compensation.
• In 1965, the average CEO pay was 20 times as much as the average worker
pay.
• By 2000, CEO pay had risen to 376 times as much as the average worker’s
pay.
• Even after a decline the ratio remained high—in 2020—351 times.
Skyrocketing executive compensation packages raise numerous
ethical questions.
• Greed and avarice are the most apt descriptive terms for the moral
character of such people from a virtue ethics perspective.
• Give rise to fundamental questions of distributive justice and fairness.
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Executive Compensation 2
• Serious ethical challenges arise against these practices even
from within the business perspective.
• Beyond issues of personal morality and economic fairness,
excessive compensation raises ethical issues of corporate
governance and finance.
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Executive Compensation 3
In theory, compensation packages serve interests in two ways:
• They provide an incentive for executive performance.
• They serve as rewards for accomplishments.
In practice, reasonable doubts exist for both rationales.
• In many cases there is no correlation between compensation and
performance.
• There is a diminishing rate of return on incentives beyond a certain level.
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Executive Compensation 4
Another crucial governance issue is the disincentives that
compensation packages and reliance on stock options provide.
• Executives have incentive to focus on short-term stock price rather than
long-term corporate interests.
• A case can be made that stock options may be to blame for the corruption
involving managed earnings.
• Excessive compensation can also involve a variety of conflicts of interests
and cronyism.
Another large concern is the cross-fertilization of boards.
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Figure 10.2: Duties of the Board and Senior Executives That May Give
Rise to Conflicts of Interest
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Insider Trading 1
• Trading of securities by those who hold private inside
information that would materially impact the value of the
stock and that allows them to benefit from buying or selling
stock.
• Illegal insider trading occurs then corporate insiders provide
"tips" to family members, friends, or others to buy or sell the
company's stock based on that information.
• "Private Information" includes privileged information that has
not yet been released to the public.
• The Securities and Exchange Commission has treated the
detection and prosecution of insider trading violations as one
of its enforcement priorities.
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Insider Trading 2
Insider trading may also be based on a claim of unethical
misappropriation of proprietary knowledge.
• Proprietary knowledge refers to the knowledge only those in the firm
should have, knowledge owned by the firm and not to be used by abusing
one’s fiduciary responsibilities to the firm.
Considered patently unfair and unethical as it precludes fair
pricing based on equal access of information.
Is there sufficient deterrent to discourage insider trading in our
markets today?
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