Ethics and the Conduct of Business Eighth edition Chapter 13 Governance, Accountability, and Compliance Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

Modules 13.1: Corporate Governance 13.2: Corporate Accountability 13.3: Corporate Compliance Conclusion: Governance, Accountability, and Compliance Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

Learning Objectives 13.1: Identify the moral arguments and legal rules for shareholders’ control of publicly held corporations, and the additional considerations for protecting the interests of other stakeholders 13.2: Critique how financial reporting, corporate management roles, and the law function to prevent fraud and other kinds of corporate misconduct, and the flaws in the system that have allowed major scandals 13.3: Evaluate the components of corporate ethics programs, the federal guidelines designed to punish and prevent misconduct, and how adopting a code of ethics benefits companies Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

Introduction: Governance, Accountability, and Compliance Fraud at WorldCom Creative accounting Unraveling of the scheme Points to consider Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

13.1: Corporate Governance (1 of 2) Objective: Identify the moral arguments and legal rules for shareholders’ control of publicly held corporations, and the additional considerations for protecting the interests of other stakeholders 13.1.1: Shareholder Control Overview Justifying control Public policy Incentives The market 13.1.2: The Shareholders' Contract Residual risk bearer Solutions 13.1.1: Shareholder Control Point 1- Overview Many publicly held for-profit organizations Shares bought and sold by public in public organizations Shares owned by the founder in private organizations Initial public offering Point 2- Justifying control Shareholders have right to make major decisions Objective of for-profit organizations is shareholder profit maximization Doctrine of shareholder primacy Justification of shareholder primacy has two sources Significance of the two sources of support Point 3- Public policy Corporate governance guided by two concepts Separation of ownership Shareholders assigned day-to-day control to managers Shareholders relieved themselves from legal responsibilities Shareholders are providers of equity capital Point 4- Incentives Investors of equity capital have strongest incentives to achieve efficiency Groups with less incentive for risk Two features considered from the point of public policy Point 5- The market Shareholders provide capital and get profit in return Shareholders have certain control rights on the firm Nexus-of-contracts view of a firm Corporate governance a contract between firm and shareholders Shareholders as residual risk bearer 13.1.2: The Shareholders' Contract Point 1- Residual risk bearer Creates contracting problems for shareholders Fixed claims are easy to be assured in contracts Profit of the firm cannot be mandated in the contract Point 2- Solutions To accept role of risk bearer in conditions they have control over Without control, the cost of capital would be much higher Shareholders ask managers to put in their best effort to be profitable Imposing fiduciary duty on managers Shareholders more economical in bearing the cost of residual risk Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

13.1: Corporate Governance (2 of 2) Objective: Identify the moral arguments and legal rules for shareholders’ control of publicly held corporations, and the additional considerations for protecting the interests of other stakeholders 13.1.3: Shareholders and Stakeholders Overview Stakeholder theory Protecting stakeholders Return to stakeholders 13.1.3: Shareholders and Stakeholders Point 1- Overview Employees, customers, suppliers, community members, shareholders as a group are stakeholders Groups vital to success of corporations Effective management of stakeholders important for success Point 2- Stakeholder theory Descriptive Instrumental Normative Point 3- Protecting stakeholders Conducting thought experiments Two reasons why each group would prefer shareholder model Point 4- Return to stakeholders Fairness in distribution Decision on distribution should be made by the government Contracts and legal rules best protect each group’s return Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

Figure 13.1: Measures for Corporation Accountability American system for corporate accountability Financial reporting Corporate management Criminal law Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

13.2: Corporate Accountability (1 of 2) Objective: Critique how financial reporting, corporate management roles, and the law function to prevent fraud and other kinds of corporate misconduct, and the flaws in the system that have allowed major scandals 13.2.1: Financial Reporting Overview Accounting and auditing Job pressure Conflict of interest Confidentiality and expectations gap 13.2.1: Financial Reporting Point 1- Overview Company financials first line of defense Serve as an important check on management Tempting vehicles for committing fraud Point 2- Accounting and auditing Accounting is recording and presentation of financial transactions Must keep track of revenues and expenditures Auditing is inspection of accounting records Could easily spot wrongdoings and fraud Point 3- Job pressure To achieve financial picture that top executives want To meet earning expectations May be pressured to go along with inaccurate financial treatments Point 4- Conflict of interest CPA firms have many interests May have a financial relationship with the company they audit May have clients who are competitors of the company being audited Conflicts arise when CPA firm provide auditing and consulting services to a client Conflicts result from dual loyalty of auditors Point 5- Confidentiality and expectations gap Accountants have a strict duty of confidentiality Should file a report with the SEC Any information about suspected wrongdoing should not be disclosed Gap exists between what public expects from auditors and what auditors actually do Gap can be closed if auditors are made more effective in detecting fraud Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

13.2: Corporate Accountability (2 of 2) Objective: Critique how financial reporting, corporate management roles, and the law function to prevent fraud and other kinds of corporate misconduct, and the flaws in the system that have allowed major scandals 13.2.2: Executives and Directors Role of CEO Role of directors 13.2.3: Criminal Prosecution Overview Theoretical problems Practical problems 13.2.2: Executives and Directors Point 1- Role of CEO Makes most important decisions Has the greatest amount of knowledge Influence selection and retention of board members Creating right incentives can be achieved by four main means Point 2- Role of directors Directors elected by shareholders Directors select and monitor CEOs Board exercises control through various committees Due to structural features, boards fail to prevent wrongdoing Board members should have control systems capable of detecting misconduct 13.2.3: Criminal Prosecution Point 1- Overview Fraud and conspiracy to commit fraud are criminal offenses Criminal offense involves harm to the state Civil offenses arise due to violation of some regulations Criminal prosecutions are state actions Civil suits brought by either state or private individuals Point 2- Theoretical problems Corporations lack the two essential elements of criminal liability Corporation lacks a body that can be punished Difficult to determine when employees act on behalf of corporation or on their own Point 3- Practical problems Prosecutors face great difficulty in building a case New cooperative approach is the result of two developments If corporations cooperate with investigators, they are less likely to be criminally prosecuted Company executives faced with a choice Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

13.3: Corporate Compliance (1 of 3) Objective: Evaluate the components of corporate ethics programs, the federal guidelines designed to punish and prevent misconduct, and how adopting a code of ethics benefits companies 13.3.1: Program Components Overview Components Integrity strategy 13.3.2: Program Benefits Main benefit Other benefits 13.3.1: Program Components Point 1- Overview Ethics program consists of rules and policies Rules and policies include culture and value Compliance with rules and policies are secured with various procedures and systems Procedures and systems are essential functions Point 2- Components Code of ethics Ethics training for employees Means of communication Reporting mechanism Audit system and a system of conducting investigation Point 3- Integrity strategy Fostering right conduct Motivates employees by appealing to their values and ideals 13.3.2: Program Benefits Point 1- Main benefit  To prevent ethical misconduct Main loss from employee misconduct has been company’s reputation Point 2- Other benefits  Provides a managerial tool for adapting organization to rapid change Helps organizations manage relations with external constituencies Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

13.3: Corporate Compliance (2 of 3) Objective: Evaluate the components of corporate ethics programs, the federal guidelines designed to punish and prevent misconduct, and how adopting a code of ethics benefits companies 13.3.3: Federal Sentencing Guidelines Overview How do guidelines work Effective ethics programs 13.3.3: Federal Sentencing Guidelines Point 1- Overview Adoption of effective ethics program Imposing a just sentence on any convicted organization Influencing the conduct of all organizations Achieved through formulating guidelines Guidelines provide fines to punish an organization and compensation to the victims Point 2- How do guidelines work Determining a base fine Culpability score Point 3- Effective ethics programs Prevent or detect every instance of wrongdoing Must practice due diligence Steps to be followed in due diligence No solid reason that ethics programs are more effective Corporations may create window dressings programs Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

Table 13.1: Determining a Culpability Score Points added to 5 Points subtracted from 5 + 5 points if high-level personnel were involved in the wrongdoing – 1 to 5 points for: reporting an offense + 3 points if the organization obstructed the investigation or prosecution of the crime cooperating with the investigation + 2 points if similar misconduct had occurred before accepting full responsibility Ranges from 1 to 10 Starting with 5 points and adding and subtracting 5 points for certain factors Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

13.3: Corporate Compliance (3 of 3) Objective: Evaluate the components of corporate ethics programs, the federal guidelines designed to punish and prevent misconduct, and how adopting a code of ethics benefits companies 13.3.4: Codes of Ethics Overview Types of codes Reasons for adoption 13.3.4: Codes of Ethics Point 1- Overview First step in developing ethical program Recent phenomenon Point 2- Types of codes Codes of conduct Mission statement Corporate philosophies Point 3- Reasons for adoption To clarify standards Effective means for disseminating standards Enables employees to do what they believe to be right Even well-written codes of ethics have limitations Everyone in the company should have ownership of the code Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved

Conclusion: Governance, Accountability, and Compliance Corporations should be legally structured Corporations must be held accountable There must be a control environment within the corporation Copyright © 2017, 2012, 2009 Pearson Education, Inc. All Rights Reserved