Chapter 8: Ethical Decision-Making: Corporate Governance, Accounting, & Finance

In the past few decades, corporate governance has come under the spotlight because
of high-profile scandals that involve misuse of corporate power and even alleged
unlawful activity by company officers. An essential element of an effective corporate
governance leadership includes arrangements for civil or criminal prosecution of people
who behave in unethical or participate in illegal acts in the name of the company.

Corporate governance refers in general to the rules, procedures, or laws whereby

businesses are regulated, operated, and controlled. Corporate governance may pertain
to internal elements established by the stockholders, officers, or constitution of a
company. It may also pertain to external elements such as clients, consumer groups,
and government regulations.

A clear and applied corporate governance presents a structure that works for the
advantage of all involved by ensuring that the company complies with accepted ethical
standards, best practices, and formal laws. Thus, companies have been established at
the regional, national, and global levels.

Professional Duties and Conflicts of Interest

Most, if not all, businesses give importance to business ethics and usually include it in
the company’s core values. It does not mean, however, that the company in its entirety
is ethical. Management must establish and model the core values of the company to be
able to build an ethical company.

There are a number of business professions that enforce rules and attests to the
fundamental fairness of the system. These professions may be called gatekeepers and
some examples are: accountants, financial analysts, attorneys, and auditors. They are
intermediaries and they act between different parties in the market and are bound to
ethical duties in their professions. All participants in the market – investors, boards,
management, and bankers – depend on these gatekeepers. When the independence
and integrity of gatekeepers become compromised, the market confidence suffers.

Investors depend on auditors to objectively assess a company’s financial statements.

Analysts provide unbiased assessments of a company’s creditworthiness so banks and
investors are able to make informed decisions. Attorneys make certain that companies
make decisions and transactions that adhere to the law. Credit rating agencies make
sure that there are no conflicts of interest that may affect the independence of their
ratings.
Chapter 8: Ethical Decision-Making: Corporate Governance, Accounting, & Finance
In the business context, the most common ethical issue that gatekeepers come across
involves conflicts of interest. A conflict of interest is a situation in which personal
and/or financial considerations have the potential to influence or compromise
professional judgment. Some examples of conflict of interest are as follows: accepting
a payment from another company for information about one’s employer; sharing
confidential information about one’s employer with a competitor; accepting consulting
fees and providing advice to another company for personal gain; etc. Fiduciary duties,
the legal obligations of a professional to act in the best interest of his clients, are
commonly in the area of finance or property. Some examples of fiduciary relationships
are: trustee and beneficiary, broker and client, and attorney and client.

The Sarbanes-Oxley Act of 2002

In July 2002 the Sarbanes-Oxley Act came into force and introduced major reforms to
the regulation of corporate governance and financial practice. Its main architects were
US Senator Paul Sarbanes and US Representative Michael Oxley and it protects
investors from probable fraudulent accounting activities by companies. The Sarbanes-
Oxley Act decreed strict changes to improve financial disclosures from companies and
impede accounting fraud. It was conceived as a response to accounting malpractice in
the early 2000s, when scandals such as Enron Corporation, Tyco International PLC,
and WorldCom rattled the confidence of investors in financial statements and required
an overhaul of regulatory standards.

The guidelines and enforcement tactics outlined by the Sarbanes-Oxley Act improve or
add to current legislation dealing with security regulations. The following provisions
have the biggest influence on corporate governance and boards:
● Section 201: Services outside the scope of auditors (prohibits various
forms of professional services that are determined to be consulting rather
than auditing).
● Section 301: Public company audit committees (requires independence),
mandating majority of independents on any board (and all on audit
committee) and total absence of current or prior business relationships.
● Section 307: Rules of professional responsibility for attorneys (requires
lawyers to report concerns of wrongdoing if not addressed).
● Section 404: Management assessment of internal controls (requires that
management fi le an internal control report with its annual report each year
in order to delineate how management has established and maintained
effective internal controls over financial reporting).
● Section 406: Codes of ethics for senior financial officers (required).
Chapter 8: Ethical Decision-Making: Corporate Governance, Accounting, & Finance
● Section 407: Disclosure of audit committee financial expert (requires that
they actually have an expert).

Sarbanes-Oxley Act entails requirements for verification of the statements by officers.

When a company’s executives and auditors are mandated to literally sign off on these
documents, verifying their veracity, fairness, and completeness, they are more likely to
personally guarantee their truth.

The Internal Control Environment

The Committee of Sponsoring Organizations of the Treadway Commission
(COSO) describes internal control as a process, carried out by a company’s board of
directors, management and other employees, fashioned to provide reasonable
assurance concerning the achievement of objectives. Simply put, internal control is: a
process, carried out by people, and designed to achieve objectives.

A company executes internal controls regularly. For instance, an employee inputs his
password to log in to the system; an employee submits a day-off request to the
supervisor for approval; and an Accounting Manager reviews bank account
reconciliations.

Based on the COSO framework, internal control is made up of five integrated

components:
● Control Environment: the culture or tone of a company
● Risk Assessment: risks that may prevent the attainment of corporate
objectives.
● Control Activities: policies and procedures that support the control
environment.
● Information and Communication: aimed at supporting the control
environment through impartial and honest communication of information.
● Monitoring Activities: to provide assessment capabilities and to uncover
vulnerabilities.

Out of the five components, control environment provides the foundational basis for
carrying out internal controls in a company because control environment sets the tone
of a company and it is the foundation for all other components of internal control,
providing discipline and structure.

The board of directors and management set up the control environment through
policies, procedures, processes, standards and structures giving the basis for carrying
out internal controls in a company.
Chapter 8: Ethical Decision-Making: Corporate Governance, Accounting, & Finance

Going Beyond the Law: Being an Ethical Board Member

The board is the party responsible for the company’s highest decision-making level and
legal authority. The ruling board has authority over and is accountable for the affairs of
the company. The board consists of individual board members who act together as a
whole and is responsible for the advancement of the company, the continuity of the
company and the identity of the company. Each member of the board has a number of
responsibilities and expectations to fulfill.

Legal Duties of Board Members

Board members are the fiduciaries who govern the company towards a sustainable
future by choosing sound, ethical, and legal governance and financial management
policies. The law dictates three clear duties on board members; the duties of care, good
faith, and loyalty.
● Duty of Care: This refers to the manner the board makes decisions that
impact the business’ future. It is the board’s duty to thoroughly examine all
possible decisions and how they may affect the business. Since a
company's board of directors is assigned with making very critical
decisions, it is essential that each member takes each issue earnestly and
sufficiently considers all options. As expected, business decisions usually
have to be made within financial or time constraints and that means the
investigation is limited. For that reason, the board is only required to
employ the same level of care and diligence to its process of decision-
making that could be reasonably expected from a judicious person under
similar situations.
● Duty of Good Faith: The second fiduciary of directors is the duty to act in
good faith. It is one of obedience; it requires the board to faithfully obey
the company’s mission. Even after it sensibly investigates all the choices
before it, the board has the responsibility to select the option it believes
best serves the interests of the business and its shareholders.
● Duty of Loyalty: This means the board is mandated to put no other
causes, interests or affiliations before its loyalty to the company and its
investors. Board members must avoid personal or professional
transactions that put their own self-interest or that of another person or
business before the interest of the company. This can be crucial if one or
more board members has an absolute interest in an entity with which the
governed company does business.

Beyond the Law, There is Ethics

Chapter 8: Ethical Decision-Making: Corporate Governance, Accounting, & Finance
When it comes to discretionary decision-making boards of directors have, the law can
only answer a limited number of questions. The Sarbanes-Oxley Act tried to answer
more but there are still numerous questions about it. Who does the board represent?
That is a question the law is expected to answer but it has still remained unclear to
some extent. By law, the board has an obligation to the stockholders of the company
but many are uneasy with this restricted approach to board responsibility and contest
that the board is also the keeper of the company’s social responsibility.

There may be executives who question the board’s legal right to inquire about the ethics
of its executives and others. If a board is knowledgeable of a usual procedure that it
considers to be unethical but that is entirely within the domain of the law, on what
grounds can the board mandate the executive to halt the procedure? The board can
impede actions to protect the lasting sustainability of the company. Despite the type of
the unethical behavior, stakeholders like consumers or personnel can be negatively
affected by unethical acts which can negatively affect the company which could lead to
the downfall of the company in the future. It is a fact that it is the board’s fiduciary duty
to protect the company by inhibiting unethical acts. If corporate executives violate
universal principles of decency and respect for human dignity, people will demand a
penalty. Subsequently, a board has a duty to hold its executives to this higher standard
of ethics instead of merely obeying the legal rules.

It has been suggested that board members be given additional responsibilities beyond
the law to survey and to investigate the companies that they represent. It is said that an
honest conversation is the best manner for understanding what the board members
know and do not know. Board members must know how the company makes profits and
whether consumers and clients really do pay for products and services. The financial
flow of the company says a lot about what moves the company. Board members must
also be demanding in their inquiries about corporate vulnerabilities. They must discover
what factors could cause the company to fall and what competitors might do to aid it.
Making certain the data regarding vulnerabilities is regularly and consistently sent to the
executives and the board forges effective prevention. The board needs to fully
comprehend the direction the company is headed and whether it is realistic to get there.

This will be less likely if the company is not living within its means or if it is squandering
much of its growth profits to its executives in compensation.

Conflicts of Interest in Accounting and the Financial Markets

Chapter 8: Ethical Decision-Making: Corporate Governance, Accounting, & Finance
In the legal and accounting field, possible conflicts of interest can emerge before or
during the course of an encounter. Most companies have rules and procedures in place
that control how conflicts are determined and managed, to ascertain that customer and
public interests are not threatened.

Conflicts that surface in the accounting field are very similar to those that take place in
the legal field. In the world of accounting, conflicts regularly happen when a company
provides various services to the same customer, such as audit, tax, forensic accounting,
and bankruptcy services. The ethical issues and possibility for conflicts surrounding
accounting practices go over simple combining services. They may involve falsifying
documents, underreporting income, illegally evading income taxes, allowing or taking
questionable deductions, and engaging in fraud.

Even though accounting bodies have issued counsel regarding how possible conflicts
can be determined and managed, the way in which they are essentially resolved is
highly subject to professional judgment. A number of big accounting firms have
professional standards groups that assess possible conflicts, and decide if an
assignment must be accepted or declined. But, regardless of the decision made by the
accountant, it is vital still for legal counsel to comprehend how a specific accounting firm
determines conflicts, and identifies if that conflict can be successfully managed.

Executive Compensation
The financial payments and non-monetary benefits given to high level management in
exchange for their work on behalf of a company. The kinds of employees that are
usually paid with executive compensation packages include chief executive officers,
corporate presidents, vice presidents, chief financial officers, managing directors and
other senior executives.

Executive compensation is a very significant factor to consider when assessing an

investment opportunity. Executives who are unsuitably compensated may not have the
incentive to act in the best interest of shareholders, which can be costly for those
shareholders. Assessing executive compensation can be a daunting task for the
individual investor.

One of the most common ways to assess executive compensation is by comparing pay
and performance. It is unfortunate that a number of executives are given raises and
bonuses even when their companies are struggling. Comparing pay to stock
performance can aid in determining if executives are being overly compensated. The
particular metric used frequently is comparing the change year-over-year in executive
Chapter 8: Ethical Decision-Making: Corporate Governance, Accounting, & Finance
pay increases to the change year-over-year in stock price. If the change in the stock
price outpaces the change in pay, the executive is not overpaid. Another widespread
way to assess executive compensation is to compare an executive to his trade peers.
Most executives should be paid equally as their peers but currently, market leaders
usually have CEOs that are paid a little more than their industries,.

New laws have been passed to help satisfy investor concerns over executive
compensation. Changes in The Securities and Exchange Commission (SEC) reporting
requirements have pushed companies to incorporate an Executive Compensation
Discussion & Analysis portion to go with all future pay documentation in all SEC forms.
Other laws have been more forthright in restraining practices that the companies use.
One example of this was the elimination of the deferred compensation tax shelter that
aided many executives evade millions in taxes. Also, improvements in other tax
loopholes have made it more difficult for boards to rationalize large payouts and hide
these payouts from investors.

Insider Trading
The buying or selling of a security by someone who has access to important confidential
information about the security is called insider trading. It can be illegal or legal
depending on when the trade is made by the insider. It is considered illegal when the
material information is still confidential. Trading while having special knowledge is unjust
to other investors who do not have access to such knowledge.

Illegal insider trading involves tipping others with any kind of confidential information.
Legal insider trading occurs when directors of the company buy or sell shares, but they
disclose their transactions legally. The SEC has policies to protect investments from the
effects of insider trading. Legal insider trading occurs in the stock market weekly. The
SEC necessitates transactions to be electronically submitted promptly and must also be
put on the company’s website.